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3 Top Retail Stock Picks For 2014

Thursday, January 16, 2014 - 1:00pm

The start of a new year is a time of reckoning for retailers.

A quick reassessment of the post-holiday landscape can reveal bloated inventories, unsustainably weak profit margins and a need to radically alter the business model.

Indeed, J.C. Penney (NYSE: JCP) has already started the process of shrinking its store base, and other retailers are likely to make similar moves in coming months. In the face of the Amazon.com (Nasdaq: AMZN) juggernaut and still-weak consumer spending, the nation simply has too many brick-and-mortar stores.

But there is a contrarian case to be made for the nation's retail sector. Many retail stocks have stumbled badly and now sport solid value. More importantly, the slowing improving employment picture should help lift retail spending, perhaps moderately in 2014, and more robustly in 2015, when economists think the national unemployment rate may fall towards 6%.

With that in mind, I've been tracking the retail stocks I've covered in the past six to 12 months. Here's an update for those picks that are on my radar for the quarters ahead.

1. Best Buy (NYSE: BBY)​
I profiled this fallen retailer nearly two years ago, noting that it still generated impressive cash flow, even it had to figure out how to beat back the competitive threats posed by Amazon and Wal-Mart (NYSE: WMT). Frankly, I underestimated the extent to which management could reinvigorate the store base through better merchandising and pricing strategies. Investors grew to love this retail turnaround, pushing shares above $40.

But Best Buy stumbled this holiday season. Severe holiday competition led management to slash prices throughout December to keep moving the goods. Consumer electronics are updated often, and retailers can't remain passive and allow inventory to build up, as new models will make it much harder to sell older unsold models. The aggressive pricing led to a roughly 2-percentage-point reduction in operating margins, compared to management's target, in the all-important holiday season. And that's a tough blow for Best Buy, which generate two-thirds of its annual profit in the fiscal fourth quarter.

But this is not a broken business, despite the 30% share price plunge. Fiscal 2014 results will still be much stronger than analysts though possible when this company was really struggling in 2012. And management still has a path to further shave overhead expenses and expand its online presence.

My take: The improving employment picture in 2014, coupled with those initiatives, will set the stage for decent-to-solid EPS growth in Best Buy's new fiscal year, which begins Feb. 1. Analysts will be tweaking their fiscal 2015 forecasts when management issues fresh guidance in late February, but this 30% plunge is bound to look like an overreaction.​

2. Lululemon (Nasdaq: LULU)​
Back in November, I predicted a tough year ahead for this purveyor of yoga clothing, but I didn't think it would come crashing down so quickly. Shares have plunged 29% since then, and the factors that could go wrong did.

After the first move down in this stock, some investors and analysts saw a chance to bottom-fish. Analysts at DA Davidson upgraded the stock to "buy" (with a $73 price target) on Jan. 7, noting that "despite the 2013 hiccups the Lululemon brand remains the leader in an attractive category." They noted that store traffic over the holidays appeared to be quite solid. They ominously added that "kitchen sink guidance remains a possibility," meaning that new CEO Laurent Potdevin may look to lower expectations to set an attainable bar for 2014.

A week later, these analysts were forced to reassess their bullish view, as Lululemon said sales in January were off to a very slow start. Though DA Davidson stuck with that "buy" rating, the price target was lowered to $64. They concede that shares are likely to go nowhere until management issues fresh guidance in March.

That gives investors the time to make their own assessments. It will be helpful to track the newsflow for this company in coming weeks to see if Lululemon is retaining mindshare with its key demographic. As I cautioned back in November, "Gap Inc. (NYSE: GPS), Under Armour (NYSE: UA) and Nike (NYSE: NKE) all have either unveiled or announced plans to unveil yoga apparel. You don't have to question whether the yoga apparel market is still growing or plateauing, but you can question whether Lululemon can still count on strong market share when these three great retailers all aim their sights at the company."

Is rising competition the problem here? Maybe or maybe not, but Lululemon is now being written off too readily, and if the new CEO can pull the right levers, there's no reason this company can't get back on track fairly quickly.

3. Francesca's (Nasdaq: FRAN)​
Lastly, investors should revisit this fallen angel. I profiled this boutique retailer for StreetAuthority's sister site ProfitableTrading.com back in November, noting that a "recent slowdown can be chalked up to growing pains."

Francesca's management really proved its mettle this holiday season, maintaining very tight inventory levels, which helped to avoid markdowns and retain profit margins. Shares have rebounded 20% since then, but remain quite undervalued.

Filling out the company's national sales footprint should fuel 15% to 20% annual sales growth, while shares trade for a reasonable 17 times forward earnings.​

Risks to Consider: The still-weak levels of consumer sentiment, coupled with Amazon's voracious appetite for market share, could exact more pain on the retail sector in 2014.

Action to Take --> These three retailers appear to share little in common, except that they are in the midst of choppy growth. While some caution is warranted with Lululemon, the company's missteps do not appear fatal. Meanwhile, Best Buy is re-emerging as an impressive GARP (Growth at a Reasonable Price) opportunity after getting ahead of itself in 2013, while Francesca's Holdings looks poised to regain much of the ground it lost in 2013.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.