Retailers Worried About All-Important Holiday Sales

While the holiday season is generally expected to drum up cheer, retail stocks may not join the party this year.

With U.S. consumers expected to keep a much tighter rein on expenses, retail companies are looking at a rather gloomy holiday season and overall fourth quarter.

One of the retail gauges — the Standard & Poor's retail index (search) — may log its first fourth-quarter decline in nine years, which analysts warn can only be avoided by a warmer-than-usual winter, an easing of crude prices or heightened innovation from retailers.

"If we saw a milder winter, or a reduction in energy prices and commodity prices, that will certainly increase the consumers' discretionary income and spur interest in retail stocks," said Larry Peruzzi, a senior equity trader at The Boston Co. Asset Management. "Retailers need to be more creative in figuring out ways to bring consumers back into the stores."

When September retail sales were reported earlier this month, chains that sell gasoline, including Wal-Mart Stores Inc. (WMT) and Costco Wholesale Corp. (COST), posted better-than-expected sales growth. But several apparel retailers and department stores missed forecasts, and some trimmed profit forecasts as heavy markdowns eroded margins.

"Retailers are caught in a 'Catch-22' situation," said Britt Beemer, head of America's Research Group, which tracks consumer trends. "Their costs, such as transportation costs, are going up and this is not going to change in the short term. Meanwhile, their consumers are going to be extremely deal focused."

If retailers don't offer strong incentives to consumers during the holiday season, Beemer expects markdowns of as much as 60 percent to 70 percent after Christmas.

Meanwhile, cost pressures persist. In a recent earnings conference call, warehouse operator Costco Wholesale Corp.'s chief financial officer said that manufacturers are no longer discussing price increases for their products with the company and are simply announcing the price hikes to retailers.

"Clearly, I think there's more pressure today," said Richard Galanti, Costco's CFO.

The lackluster performance of the retail stocks is reflected in the 1.5 percent drop in the S&P retail index so far in the current quarter.

The retail gauge has risen an average 16 percent in the fourth quarter over the last eight years, within a range of 1 percent in 2002 to 40 percent in 1998.

If retail stocks do not rebound in the final quarter of 2005, it will be their first fourth-quarter decline since 1996.

Some fund managers are optimistic about a revival in the retail sector simply because they perceive the market as being overly pessimistic, which increases the chances of retailers outperforming expectations.

"Because everyone is expecting a weak Christmas, the market is in for a surprise because I don't think American consumers are going to cut back on spending," said Ted Parrish, a principal at Henssler Asset Management, whose portfolio includes shares of discount retailer Target Corp. (TGT) and drugstore chain Walgreen Co. (WAG).

Most analysts still expect a decent performance in the upcoming holiday season from Wal-Mart, which has already vowed aggressive discounts, and Target, which is expected to benefit from the trading down of customers accustomed to shopping in luxury stores.

"Retailers that are not catering that well to the middle- and upper-income customers are going to have a tough time," said Bill Dreher, an analyst at Deutsche Bank Securities.