Retail Industry

Through Wednesday's close, the S&P Retail Index (RLX) is sitting on gains of about 26% year-to-date, significantly above the roughly 8% gain for the S&P 500. The strong relative performance of retailing stocks thus far has been due to low expectations, "less bad" sales declines and cost cutting efforts limiting the recession’s bottom-line impact.

This combination has allowed retailers to post strong earnings thus far. Going forward, however, retailers are going to have a harder time beating estimates because expectations have climbed higher, while "less bad" results and cost cuts are already reflected in estimates.

Moreover, for the retailers to deliver better-than-expected results in the months ahead, the upside will have to come from an improvement in sales growth. This is unlikely because there are simply too many headwinds for the consumer to overcome.

These headwinds include wealth destruction from the housing and equity markets and higher unemployment, which has reduced discretionary income. Additionally, financial institutions have tightened credit standards and reduced or eliminated credit lines altogether. The stricter lending environment is reducing the consumers' ability to borrow and spend.

In past downturns, consumers relied heavily on credit cards to finance spending. In the current recession, consumers are not resorting to credit cards as they did in the past. In fact, revolving debt balances are falling, as financial institutions reduce credit limits, increase interest rates or cancel accounts. Without the ability to take on more debt, consumers are spending less in retail stores, saving more of their income and paying down credit card balances.

What's more, recent retail sales demonstrate that the consumer is still not heading to the mall to make discretionary purchases. Consumers are buying products they need like food, health products and gasoline. Retail sales remain soft with most of the weakness in consumer discretionary areas such as home furnishings, electronics and appliances, and department stores.

The best-performing areas of retail remain defensive, including grocery stores, drug and healthcare stores, and auto parts retailers. As a result, we continue to favor defensive retailers over the more discretionary retailers.

OPPORTUNITIES

We continue to see value among the defensive retail stocks, such as supermarkets and discounters.  Whole Foods (WFMI - Analyst Report) and Winn-Dixie (WINN - Snapshot Report) look good in the supermarket space. Whole Foods, the natural foods chain, appears to have shaken off the doubts weighing on its prospects with its impressive fiscal third quarter results. The company not only beat the Zacks Consensus Estimate, but also raised guidance for the year.

Winn-Dixie, the operator of more than 500 supermarkets in the Southeastern U.S., also recently provided a positive fiscal fourth quarter pre-announcement and fiscal 2010 guidance. The company has a strong balance sheet, with almost no net debt, and remains on-track with its store remodeling effort.

WEAKNESSES

Retailing stocks have experienced huge run up this year, and many are at risk of giving back those gains if a second half recovery does not materialize. The stocks that we believe are the least attractive are those that are well off their lows, but will continue to experience weak sales trends into 2010. Among the supermarkets, we consider Safeway (SWY - Analyst Report) as vulnerable to continued competitive pressures from discounters.

We also remain wary of convenience store operators Pantry (PTRY - Snapshot Report) and TravelCenters of America (TA - Snapshot Report), as evident from both companie's weak recent results. The weak outlook for gasoline demand and overall tepid mechanize sales is expected to keep earnings under pressure for the convenience stores.

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