Thursday, July 23, 2009

Smart Stocks for Penny-Wise Consumers

In a recent speech, National Economic Council Director Larry Summers made some eloquent points about the future of the American financial system:

"The rebuilt American economy must be more export-oriented and less consumption-oriented, more environmentally oriented and less fossil-energy-oriented, more bio- and software-engineering-oriented and less financial-engineering-oriented, more middle-class-oriented and less oriented to income growth that disproportionately favors a very small share of the population."

Dealing with the "less consumption-oriented" part is where things gets tricky. People are saving more, and by the looks of things, they will keep doing that for some time. The savings rate of 6.9% is near its 50-year average, but it's nowhere near the 12% level it reached in the last severe recession in 1982. I believe that the savings rate has a lot higher to climb -- and that many retailers will miss their formerly irresponsible customers.

Yet with a shift in consumer spending habits will come new investing opportunities. So let's examine both sides of the equation.

Retail is vulnerable
As bad the job market is, it's even worse for teens. The nonprofit Employment Policies Institute estimates the teen unemployment rate at 24%, its highest level since 1965. And that's bad news for retailers that cater to the teen demographic.

A case in point is Abercrombie & Fitch (NYSE: ANF). Being in my late 30s, I'm definitely not part of Abercrombie's target audience, but from my vague recollections of visiting its stores years ago, I remember that the clothes are pretty nice and definitely appeal to the teen/college crowd. But the company's recent numbers say it all -- June same-store sales fell at an alarming 32% rate. I remember that prices on Abercrombie's merchandise used to be pretty high. With the savings rate climbing and unemployment likely to rise as well, I just don't see how a company like Abercrombie will see things improve in the next couple of years.

Best Buy (NYSE: BBY) is not as straightforward a case as Abercrombie. It has less competition, thanks to the Circuit City bankruptcy, but its high-priced electronics are especially vulnerable when customers cut their budgets.

Best Buy's first-quarter sales fell by 5% in its domestic stores and 14% internationally, even with Circuit City gone. And according to the Consumer Electronics Association, shipments of electronics in the United States are estimated to fall by 7.7% this year, the first such decline since 2001. On the positive side, shares trade at less than 12 times forward earnings, and Best Buy pays a 1.5% dividend and has a relatively strong balance sheet.

The main question is just how frugal consumers will get. If they give up on big-ticket, high-margin items, then Best Buy and other retailers of high-end products, such as Tiffany (NYSE: TIF), will suffer.

Countertrend retail
We already know that Amazon.com (Nasdaq: AMZN) is thriving, but there are other retailers that benefit from the consumers' frugality. For instance, the trend away from buying new cars has pushed GM and Chrysler into bankruptcy, but buying fewer new cars means doing more repairs on old ones. And if you're a do-it-youselfer, you can save money. This is where AutoZone (NYSE: AZO) steps in.

The company has seen an average annual earnings growth of around 23% over the past decade and currently trades at 12 times forward earnings. It's a good play on the frugality trend. And if my assumptions about higher savings rates and rising unemployment are correct, the company's business is unlikely to stop booming soon.

But some may be concerned that earnings are peaking. For instance, smart-money investor Eddie Lampert recently sold more than 3 million AutoZone shares for a nice gain. But there's nothing wrong with booking profits, and Lampert still controls more than 20 million shares, for a 37% stake in the company. It will be informative to see how much longer Lampert keeps this huge position. I like the stock, but I'd wait for a pullback after its recent run-up.

Worth more than a dollar
Last, dollar stores such as 99 Cents Only Stores (NYSE: NDN) and Family Dollar (NYSE: FDO) have been doing great as a group. As the ultimate frugal choice, it's easy to see why. 99 Cents reported earnings more than twice consensus estimates for the latest quarter. And Family Dollar, although technically not a pure dollar store, also performed well, with a 36% rise in profits on an 8% sales jump. Family Dollar also just raised full-year profit forecasts.

The two companies are clearly at different stages in their business life cycles. 99 Cents trades at an expensive forward price-to-earnings multiple of 23. But its sales are growing rapidly, and with its focus on beleaguered California, the bet is that this will continue. Family Dollar is a bigger company, trading at 13 times forward earnings. It may not have as much room for growth as 99 Cents, but it is better geographically diversified. Take your pick.

While consumers are saving more -- which is a negative for the retail sector in general -- they are also shifting their spending habits. These are just a few ideas of how to profit from that shift.

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