Bargain Hunting: Have Investors Set Retail Expectations Too High?

Retailers will have to manage Wall Street's expectations carefully this year. A couple of unexpectedly strong quarters have put investors in what some warn is an irrationally exuberant mood.

As first-quarter results rolled out for major retailers, investors seemed almost disappointed. Not with the earnings, which have been positive across the board, but with merchants' caution in projecting future earnings. On several investor conference calls, even companies that have raised their guidance faced questions about why those estimates weren't higher.

"Expectations have definitely gotten a little bit ahead of themselves on the street," says Robert Samuels, a retail analyst at Phoenix Partners Group. Yes, sales have grown and earnings have benefited from the inventory and cost controls that retailers put into place during the recession. But investors are too focused on the same-store sales figures, which have grown for seven months straight, and are losing sight of the big picture, Samuels says.

Rising Costs Could Reduce Profit

That big picture includes rising costs at Chinese factories. As Brian Sozzi, a Wall Street Strategies retail analyst, notes in a report, several merchants' first-quarter reports warned that they would face higher costs as a result. In addition, retailers are investing in their businesses again after the sharp cost cutting that kept them afloat in 2009, he adds. But investors still expect retailers to keep delivering high earnings numbers.

"The market, having seen the strong same-€store sales increases in [the first quarter of 2010], was looking for more meat on the earnings line and it hasn't come home to roost," Sozzi writes in a note to investors. "There are risks to the outlooks in the second half of 2010 that are being underappreciated."

Another of these risks is the cost of materials, such as cotton for apparel. Retailers say materials prices are rising, but U.S. shoppers aren't yet ready to spend more on those goods. "It's impossible to raise prices; the consumer is just not going for it," Samuels says. "The consumer is trained now to wait for the promotions."

Retailers Face Tough Crowd

Retailers are aware of the mounting pressures. Even while reporting better-than-expected first-quarter results, they held the line as far as expectations for the rest of the year. "We don't want to get ahead of ourselves," was a common refrain from retail chief financial officers on conference calls this week. Both Macy's Karen Hoguet and Kohl's Wes MacDonald used those same words when asked if they were being too conservative in their forecasts.

J.C. Penney (JCP) CEO Mike Ullman faced the same question after the company raised its earnings guidance to $1.64 per share, up from the $1.55 per share it had previously forecast. Penney's shares fell almost 3%, even after it posted an income that almost doubled in the first quarter. Ullman warned that the economic recovery is going to take longer than people think, with inflation taking a toll in the second half. He also expressed concern about the cost of goods, especially the cost of the Asian cotton used in jeans and T-shirts. "We hope to be able to reengineer our product to protect our customers ... but it's a concern to the whole industry," he said.

Executives at Macy's (M), who already raised their guidance twice in the two weeks leading up to their better-than-expected earnings report, were pressed to raise earnings projections yet again. Macy's posted earnings of 5 cents per share for the quarter, compared to a loss of 21 cents per share a year ago, and comparable sales -- which had been expected to be flat -- were up 0.9%. But Hoguet said that the economic outlook is still hazy enough to remain guarded about consumer spending, adding that Macy's gains have come mainly from stealing market share from rivals.

Analysts also apparently think Kohl's Corp. (KSS), which reported a 45% growth in net income for the first quarter, was lowballing when it only raised its earnings guidance for the year to between $3.57 per share and $3.75 per share, up from a previous estimate of between $3.40 per share and $3.63 per share. The analysts' consensus is $3.77 per share.

Some Good News

Still, companies' outlooks did include an additional cause for optimism beyond sale-store sales. While the results of retailers' credit operations were mixed, many retailers said those operations were doing better as they saw fewer delinquencies on store cards. For example, Nordstrom (JWN), which posted a 43.8% increase in quarterly earnings and a 12% growth in comparable sales, said its delinquency rate dropped by 1.1 percentage points since the fourth quarter, down to a rate comparable to the first half of 2009.

"It does feel that we're cycling through that initial period when a lot of customers fell behind for one reason or another," Chief Financial Officer Mike Koppel said on a conference call Thursday. The improvement comes from tighter standards for approving credit, as well as from customers doing a better job of managing their credit, he said. However, he added: "Delinquency trends are still above historical highs ... that shows us that consumers are still challenged."

All in all, retailers are facing a bruising fight for market share in the second half of the year as they try to lure reluctant shoppers to their stores. Some large retailers, such as Gap (GPS), will be able to negotiate with their suppliers to keep costs down, but others will have to eat the cost increases to remain competitive, Samuels says.

And investors will have to look more closely at profit margins and inventory levels -- and focus less on same-store sales -- if they want to pick the winners.