(Bloomberg) -- Investors aren’t pricing enough bad news into shares of discretionary retailers, according to UBS Group AG.
Urban Outfitters Inc., Burlington Stores Inc. and Ross Stores Inc. dropped on Wednesday after analyst Jay Sole downgraded the apparel-focused retailers to sell from neutral. He also downgraded Foot Locker Inc. to sell from neutral amid increasing competition and lowered Bath & Body Works Inc., a retailer of candles, lotions and soaps, to neutral from buy.
“The market is too focused on potential margin recapture and not focused enough on downside risks to sales,” he wrote in a research note.
Sole’s base case is that a recession will significantly pressure sales of non-athletic apparel and home goods, though he said some investors still view this as a worst-case scenario. On average, Sole slashed his 2023 earnings-per-share estimates across his coverage of softlines retail by 10%.
The S&P Composite 1500 Apparel Retail Index has gained 7.9% in the past year, fueled largely by resilient results from TJX Cos., while the S&P 500 Index has slumped 13%. Still, 13 of the 18 retailers in the index declined in that period as consumers reined in discretionary spending and companies offered discounts to tame bloated inventories, denting margins.
Sole has been anticipating that slowing consumer spending will cause the industry’s earnings outlook to weaken throughout the year, leading to lower earnings estimates and pressure on stock valuations. His conviction has increased after the latest UBS data on consumer spending intentions for apparel signaled that industry sales growth trends will deteriorate. He also called out recent “financial sector challenges.”
“We think Fed rate hikes will have a more negative impact than previously thought,” Sole wrote.
Despite the bearish views, brands with exposure to athletic footwear, China’s reopening from pandemic restrictions and high-income consumers are best positioned in the current environment, according to Sole. Some of his top picks are Nike Inc., Hoka owner Deckers Outdoor Corp., Swiss sneaker maker On Holding and Skechers USA Inc.
Athletic-wear companies have been a standout in the consumer discretionary sector in recent weeks, with demand for athletic apparel and sneakers holding up even as consumers pull back in other categories. Lululemon Athletica Inc. surged 13% on Wednesday in the biggest advance in four years after its net revenue and earnings-per-share forecasts for the year topped Wall Street’s expectations.
The upbeat report followed better-than-anticipated sales projections from Dick’s Sporting Goods Inc. and Foot Locker earlier this month. On Holding notched its best week since its September 2021 initial public offering last week after projecting sales growth of almost 40% this year. Nike, meanwhile, recently reported quarterly sales that beat Wall Street’s expectations as the sportswear brand worked down its excess inventory, but profitability missed estimates.
“Stocks best positioned to outperform are likely those with strong growth outlooks not fully priced-in,” Sole wrote.
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