Gone Shopping

	Elliott Gue PF Newsletter.com
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Holiday sales reports are in and higher-end retailers carried the season. Here's how to profit.

According to the Census Bureau, December retail sales rose 8.7 percent over 2003 levels, the largest growth for the key holiday shopping month since 1999.

But if you dig a little deeper into the weekly sales reports, it's clear that this positive spending environment didn't benefit all retailers equally. In fact, as much as a third of US retailers badly missed sales expectations for the season; outstanding sales growth from most luxury retailers balanced out these losses.

Of course, the sales reports weren't the only items to land the retailers on the front pages--there's nothing like a few juicy mergers to focus Wall Street's attention on a sector. K-Mart announced the purchase of Sears in an $11 billion deal.

And early in 2005, rumors abounded that Federated Department Stores, the parent of Macy's, was in talks to purchase May Department Stores (NYSE: MAY), owner of the Hecht's and Lord &Taylor brands.

The retailers generally outpaced the S&P 500 over the past year but that outperformance was due to solid results from a small handful of names—the key to investing in the group is selectivity. Below we'll profile a few of our favorites as well as a few names to avoid.

The department stores offered mixed performances on the sales front this year with the more upscale merchants outpacing the so-called "middle market" retailers.

There's a good reason for that dichotomy. Rapidly rising oil prices tend to hit lower income consumers the hardest because fuel costs account for a much larger share of these consumers' disposable income.

So too any up-tick in interest rates; wealthy consumers are far less likely to carry high interest balances on credit cards or rely on mortgage refinancing to fuel spending. That helped stores catering to the well heeled to outperform the rest of the sector.

May Department Stores saw some of the worst performance on the sales front, reporting a 3.3 percent decline in same-store sales for the month of December.

May has had trouble over the past few years with excess inventories. Traditionally, the company has built inventories aggressively over the summer months and into early autumn, hoping to sell all those goods in the holiday season. If those sales didn't emerge, May would slash prices to move the goods, sharply reducing profit margins.

There's no conclusive evidence May has moved beyond its past woes. But, the company has taken some steps in the right direction and a change in management this month might accelerate the pace of change. There may be shorter-term trading opportunities in middle market chains like May but longer-term investors should avoid these stocks.

For the long haul, focus on upscale department store chain Neiman Marcus (NYSE: NMG/A).  Neiman sells more expensive jewelry, top clothing brands and accessories, all items that tend to attract wealthy clients. Even better, Neiman reported solid sales to foreign visitors taking advantage of the weak US dollar. All told, Neiman showed an 11 percent jump in same-store sales in December.

On the financial front, Neiman is in particularly good shape, holding over $250 million in cash and a relatively low debt burden. Management signaled confidence this month by raising the company's quarterly dividend payout. Neiman Marcus is a buy under 67.

Also at the luxury end of the retail spectrum sits Coach, a manufacturer, designer and retailer of branded leather goods including wallets, purses and luggage.

While Coach goods are considered luxury items, the company prices its products at a 30 to 50 percent discount to premium European leather brands. That mix of high quality at a reasonable cost has proven a huge hit with consumers.

Not only did the company beat sales forecasts for the Christmas season, but Coach also wasn't forced to discount its products to generate sales—operating profit margins remained steady at over 30 percent for the quarter, among the fattest in the industry. Buy Coach under 57.

Of course, no article on retailers would be complete without mentioning the world's largest chain, Growth Portfolio holding Wal-Mart. Wal-Mart has been upgrading most of its US stores to the company's larger "Supercenter" format in recent years.

Supercenters normally include pharmacies and grocery stores; these everyday shopping items provide the traffic in Wal-Mart locations. And in the retail business, traffic translates directly into sales—shoppers buying groceries often can be tempted into buying higher margin products like consumer electronics.

Outside the US, Wal-Mart is well positioned to benefit from high-growth markets like Mexico and China. Buy Wal-Mart under 57.

Usually lumped in the discount space with Wal-Mart, Target (NYSE:TGT) focuses on an entirely different niche. While the company sells traditional discount items like private label apparel, it's best known for more expensive, higher quality items like home furnishings, kitchen supplies and bathroom fixtures. Many of these items sport well-known brand names.

Target also tends to attract a wealthier clientele than Wal-Mart. Wealthier Americans are less affected by high energy prices and a slowdown in consumer lending than low-income consumers. This helped Target beat sales forecasts handily for December. Target is a buy under 52.

Finally, retailers focused on the teenage market are notoriously volatile. In this issue, we recommend shorting Aeropostale (NYSE: ARO) in the Advantage Portfolio.

Elliott Gue will be available to take your questions until Thursday, February 3. Please use the form below to submit your questions.