Retail Climbs but the Rally May Not Last

 In Market and Investment Insights

Research Analyst Josh Cummings discusses the recent outperformance of retail stocks, but says he’s still cautious about the industry long term.

It is well known that e-commerce is shaking up the business models of traditional retailers. So it may come as a surprise to learn that stocks of several brick-and-mortar stores have been delivering eye-popping returns this year. Some of the best performance in the industry has come from small-cap clothing stores, such as Abercrombie & Fitch, up 63.0%; Urban Outfitters, up 31.4%; and American Eagle Outfitters, up 30.5% (all returns are year to date through June 22). But even large-cap names have posted strong results, including Macy’s (+52.0%), Kohl’s (+38.5%) and Target (+18.5%). By comparison, the S&P 500® Index has climbed only 4.0% over the same period.

A Healthy Consumer is Lifting Retail Stocks…

Much of this outperformance reflects today’s healthy U.S. consumer. Lower income tax rates, a strong job market, rising wages and mild spring weather have helped boost personal spending. In turn, retail sales have been trending higher. And while e-commerce certainly has benefited – online sales expanded by 16.4% year over year during the first quarter – roughly 90% of retail sales still occur in the physical world. As consumers spend more, much of the incremental shopping occurs in brick-and-mortar stores.

…But Long-Term Challenges Remain

While these numbers may look enticing, we remain cautious. The long-term structural challenges that have previously caused retail stocks to underperform have not abated. E-commerce made up 51% of core retail sales growth in 2017, and will likely continue to make up a significant portion in the future. As sales move online, brick-and-mortar stores must invest in e-commerce to retain shoppers. But, in doing so, costs rise (as firms build digital platforms and manage new variable expenses, such as shipping) and profit margins get squeezed. As a result, while same-store sales numbers may hold steady or even improve, other metrics of corporate health likely will not.

In May, for example, Target reported 3.7% traffic growth for the first quarter of its 2018 fiscal year, one of its strongest quarters in a decade. Even so, the general merchandiser struggled in other ways: First quarter operating income margin was 6.2%, down from 7.1% for the same period in 2017. The decline reflected the growing influence of e-commerce (which made up some of the quarter’s traffic growth), as well as “pressure from digital fulfillments costs,” according to a company statement. Target also is raising capital expenditures, as the retailer undertakes store remodels and tries to fend off competition from Amazon.

S&P Retail Select Industry vs. S&P 500 Index

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Retail stock performance has lagged the broader market in recent years – a trend that could continue given the threat from e-commerce.Source: Bloomberg. Data are weekly and from 5/31/08 to 5/31/18. S&P Retail Select Industry is an equity benchmark for U.S. retail-related securities.

This type of vulnerability could come back into focus if consumer confidence wanes. After all, the biggest benefits of this year’s tax reform accrued to the highest earners, and tax cuts for individuals are slated to decrease over time. Gasoline prices have climbed, while the personal savings rate fell by more than a percentage point in 2017. Consumers cannot spend indefinitely. When the shopping slows, retail’s outperformance could take on new meaning: a couple of good quarters in a potentially bad decade.

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