2 Retail Debacles: Why the Sector Remains Risky

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Readers of my articles are well aware that I have been warning repeatedly that investors should stay away from retailers, or at the very least, that investors should be very selective and only invest in ultra-safe “best of breed” retailers such as Wal-Mart (NYSE:WMT).

On Tuesday, several retailers reported earnings. While a couple of reports were fairly positive (e.g., Home Depot (NYSE:HD)), two companies came out with earnings reports that reaffirm my conviction: stay away from retailers unless they are defensive, “best of breed names.” The two stocks I have in mind are Dick’s Sporting Goods (NYSE:DKS), which fell 18 percent, and Staples (NASDAQ:SPLS), which fell 12.5 percent. Let us look at both earnings results to see why investors sold off shares so aggressively.

Dick’s reported earnings that weren’t that bad on the surface. The company reported EPS of 50 cents per share versus analyst estimates of 52 cents per share, which is a miss, but it is hardly more than a rounding error. Furthermore, net sales increased by 7.9 percent, which isn’t bad considering that we saw essentially flat retail sales in the U.S. in April. While margins weakened, this is common nowadays for the industry. However, investors were concerned with the company’s guidance.

The company said that it was changing its guidance to reflect weakness in two of its segments: hunting and golf. As a result, its full-year EPS guidance dropped to $2.70 t0 $2.85 per share for 2014 against the previous estimate of $3.03 to $3.08 per share. While this comes to about 25 cents per share — which doesn’t seem like that big a deal for a company with a $43 per share stock — investors are concerned that the company will see a long-lasting decline in its earnings due in large part to margin contraction.

Staples reported a sharp decline in its earnings on a combination of declining sales (negative 3 percent) and margin compression. As a result, net EPS declined by over 40 percent to 15 cents per share. Staples’ business is shrinking. Not only is the company a victim of the weak retail environment, but the business and office supply sub-sector more generally is experiencing a contraction thanks to corporate cost cutting as well as competition coming from non-specialty retailers such as Target (NYSE:TGT), Wal-Mart, Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY) and others.

As a result, the company closed 16 stores in the quarter in order to cut down on expenses. It also has plans to shut down another 80 locations. But while investors were aware of these factors already, they were surprised by the company’s reduced guidance. The company also gave a wide range of potential net earnings figures, from 9 cents to 14 cents per share. Furthermore, it announced that it expects to take a pretax charge of $105 million to $155 million. This brings the company’s total 2014 restructuring charges up to $240 million to $360 million.

These two stories show just how vulnerable retailers are. Both companies are leaders in the sporting goods and in the office supply retail sub-sectors, respectively, and yet weakness in the retail landscape as well as dominance by a few large players make them risky investments.

With weak guidance coming from these two companies, it is no wonder that retail stocks took a dive on Tuesday. The SPDR Retail ETF (XRT) fell by 2.5 percent, and it is down more than 7 percent for the year. Also, technically, it appears to be rolling over. It crashed from about $88 per share to $77 per share at the beginning of the year only to rebound. However, the rebound didn’t take the fund to new highs despite the fact that we saw new highs in stocks more generally. Furthermore, the fund is seeing strong resistance at important moving averages: the 50-day moving average and the 200-day moving average.

With these points in mind, as well as weakness coming out of other retailers such as Wal-Mart, I suspect that the sector has more room to run on the downside. As a result, investors need to either be very selective or they need to simply avoid the sector entirely.

Disclosure: Ben Kramer-Miller has no positions in the stocks mentioned in this article.

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