How to Play the Retail Sector in the Second Half of 2013

How to Play the Retail Sector in the Second Half of 2013

It's been a turbulent couple of months for the retail sector, as investors are digesting a mixed bag of consumer data and earnings reports.

Consumer confidence and consumer spending have largely risen year-to-date, with Americans seeing an improved employment outlook, higher stock prices, and a resurgent housing market. However, the recovery may be short-lived, as stock prices have turned lower in recent weeks. Markets closed the month of August with the worst monthly performance since May 2012. And home prices, which traditionally lag the market, unexpectedly plunged 13.4% in July.

Given the above, is it time to be bullish or bearish on consumer-related stocks? Let's take a look at the following consumer "report cards" before making a decision.

The winners
Underlying fundamentals at Urban Outfitters have exceeded actual gains in the stock price, which may present a compelling opportunity for readers.

Back on Aug. 19, Urban Outfitters reported record Q2 sales and earnings on the back of new product offerings, higher merchandise margins, and new store openings. Earnings per share came in higher than expected at $0.51 compared to $0.48 consensus, on a record $759 million in revenue. Comparable-store sales also rose 9% during the May 1 through July 31, adding to the company's impressive quarter.

While Urban Outfitters trades at a premium 24 times price-to-earnings ratio, the valuation is justified when considering that management continues to deliver outstanding results. Revenue at Urban Outfitters has grown 14.3% in the last 12 months, while earnings have increased an impressive 42.6%.

The company's board of directors is voting with their pocketbooks that shares remain inexpensive, announcing a 10 million share-repurchase plan on Aug. 28. The new plan will allow Urban Outfitters to repurchase 6.7% of outstanding shares, putting a floor under the current stock price.

Readers might consider Urban Outfitters with a 12-month investment horizon. The Philadelphia-headquartered company operates under the Urban Outfitters, Anthropologie, Free People, Terrain, and BHLDN brands.

The losers
As I hinted in the introduction, not all of the retail sector is cheerful and sanguine, as evidenced by results at teen retailers such as American Eagle Outfitters , Aeropostale, and Abercrombie & Fitch.

Shares of American Eagle are reaching an 18-month low as the company reported Q2 earnings and cut its Q3 guidance in half. Second-quarter results came inline with expectations, as the company reported $0.10 EPS on $727 million in revenue. However, third-quarter guidance was sharply reduced to a $0.14-$0.16 range, a huge shortfall compared to the $0.35 consensus.

My research indicates that 'AAA' retailers--a term I coined for American Eagle, Aeropostale, and Abercrombie & Fitch-- have fallen out of favor with U.S. teen shoppers in favor of newer, trendier stores such as H&M, Forever 21, and Zara. Ironically, the parent company of Zara is the largest global specialty retailer, followed by Swedish-based H&M in second place. U.S.-headquartered Gap is the third largest specialty retailer.

Readers might consider exiting their position in the AAA retailers, as these companies appeal to a narrow range of consumer. In contrast, Urban Outfitters appeals to shoppers of all ages, and the company has momentum going into 2H 2013.

And the undecided
On Aug. 28, Williams-Sonoma reported better-than-expected second quarter 2013 results. The company provided investors with the "trifecta"--beating earnings and revenue estimates while raising its financial guidance for the second half of 2013.

Management announced earnings of $0.49 on revenue of $982 million, higher than consensus estimates of $0.47 and $940 million, respectively. Full-year earnings guidance rose to $2.69-$2.79 from a previous $2.67-$2.77.

What's not to like with the Williams-Sonoma report?

First, investors looked past the fabulous scorecard at marginal details. Same-store sales fell 0.4% at the namesake Williams-Sonoma brand, in contrast to sales growth at Pottery Barn and West Elm. Second, the company introduced promotional pricing at its brand-name stores, causing margins to decline slightly based on past comparisons. I believe readers can look past these concerns, and management's guidance remains conservative in my view.

In March, Williams-Sonoma announced a 41% dividend increase and three-year $750 million share-repurchase program. This massive buyback will allow the company to repurchase nearly 15% of outstanding shares, based on recent market prices. All in all, I believe Williams-Sonoma is attractively priced, and long-term investors should consider buying the stock.

Foolish bottom line
The only certainty in retail is that the consumer remains uncertain--notably in the low-to-mid range of spending.

Readers might consider limiting their retail exposure to company-specific stories, which have provided a strong forecast. The 'AAA' retailers of American Eagle, Aeropostale, and Abercrombie & Fitch have fallen out of favor with teen shoppers, and it's unlikely that the preferences of these young adults will change in the near future.

Stocks that have performed well should continue to deliver for the remainder of the year. Urban Outfitters presents a unique opportunity, given its strong outlook and new share-buyback plan. Williams-Sonoma made similar announcements, but the company needs to prove itself with a higher net margin in coming quarters.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

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John Macris has no position in any stocks mentioned. The Motley Fool recommends Urban Outfitters and Williams-Sonoma. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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