A Little goes a Long Way for this Sector

Low-hanging fruit. That's what most retailers have already picked in their quest to cut costs and boost margins. The economic downturn in 2008 was hugely beneficial for this group as they right-sized costs to offset dismal sales. Once sales ticked up just a bit from the bottom, profit reports became quite impressive.

Trouble is, sales gains have petered out -- the June same-store sales reports that just rolled in were fairly uninspiring. And so has investor enthusiasm for this sector. During the past three months, the SPDR S&P Retail (AMEX: XRT) exchange-traded fund (ETF) has fallen -20% to a recent 36.

Investors have come to think that the still-slow economy means flat or even negative profit growth for this group. But that sell-off creates opportunity for far-sighted investors. A closer look at industry financial statements reveals an important trend. Overhead costs are so lean, inventories are so low and gross margins are so strong, that only a modest improvement in sales would yield far more robust profit gains.

Let's look at Macy's (NYSE: M) as an example. The company posted its first fiscal Q1 profit in four years.

Macy's Q1 ($ millions)	Q1 2009	Q1 2010	Q1 2011	Q1 2012
Sales	$5,747	$5,199	$5,574	$5,747
Cost of Goods Sold	$3,527	$3,219	$3,378	$3,483
Gross Margin	38.6%	38.1%	39.4%	39.4%
Overhead Expenses	$2,190	$2,094	$2,020	$2,020
Operating Margin	0.5%	-2.2%	3.2%	4.3%
Operating Income	$30	-$114	$176	$244
EPS	-$0.14	-$0.21	$0.05	$0.07

As this table shows, cuts in overhead coupled with stronger gross margins (which is the result of better inventory control and thus less markdown activity) turned red ink into black ink. Macy's makes almost all of its profit during the holidays, but if it can do better in the out-of-season quarters, then full year results should get a nice lift.

In this table, I've gone ahead and looked at what first quarter results might look like next year. With the lower overhead and firmer gross margins in place, I wondered what profits would look like if first-quarter sales rose +3%, back to where they were just before the downturn hit. Turns out, operating income would jump +39% to $244 million, translating into an EPS gain from $0.05 in the most recent quarter into $0.07 in EPS in next year's fiscal first quarter. That helps explain why analysts think Macy's can boost full-year profits next year by +16% on just a +2% sales gain.

Notably, Macy's earned nearly $2 a share in fiscal 2007 and fiscal 2008, so analysts think per share profits can exceed that mark, even as they also assume sales will be about -5% lower than those 2007 and 2008 levels. They're not dreaming. That's what happens when companies are forced to operate on a much leaner basis.

Action to Take --> You can run this same exercise for so many retailers. Many of them have much tighter inventories, much lower overhead expenses, and thus greater sales leverage when compared to the "good old days of 2007."

When the unemployment rate starts to fall (which could be very soon, or still a ways away), look for analysts to modestly boost their retail sales forecasts and much more aggressively boost profit forecasts. Other retailers I like include Kohl's (NYSE: KSS) for its unfailing sales execution, micro-cap Casual Male (Nasdaq: CMRG) for its focus on the underserved big-and-tall men's niche, Christopher & Bank's (NYSE: CBK) for its strong brand resonance among Midwest females and Citi Trends (Nasdaq: CTRN), a fast-growing apparel retailer catering to inner-city consumers.  

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