Retailers procure goods in large quantities directly from manufacturers or wholesalers and sell them in smaller quantities to customers through retail shops or online platforms. As consumer spending is the key to the viability of any economy, the health of the retail industry becomes an important economic indicator.

As a leader in the retail business, the United States provides ample growth opportunities for all types of retail companies. The retail industry covers everything in its scope, ranging from internet catalog sales, auto dealers, convenience stores, vending machines and clothing — thus dividing retailers into numerous categories. Retailers of all sizes, including individual direct marketers or direct sellers, small- to medium-sized franchise unit owners, and large big-box store operators compete in the U.S.

From a growth perspective, the retail industry ranks among the dominant U.S. industries and employs an enormous workforce. Retail sales represent approximately 30% of consumer spending, which itself accounts for more two-thirds of the economy.

Correlation with the Economy

After high political and economic drama in 2013, the year 2014 opened to a soft start given the not-so-convincing emerging economies and a severe winter that locked consumers indoors. However, following the weather improvement through the second half of February the business seemed to have picked up putting the U.S. economy on the growth path. So far this year, the S&P 500 has gained roughly 1.9%, The Nasdaq Composite Index rose about 4.0%, while the Dow Jones Industrial Average lost a marginal 0.5% with a major recovery seen in February.

Despite volatility in the indices so far, the economic outlook for 2014 remains positive based on favorable economic data and an improved consumer and business outlook. This view is further supported by the recent Economic Report issued by the White House Council of Economic Advisors on Mar 10, 2014, wherein President Obama’s advisers signaled that the U.S. economy is set to improve in the next two years. One could discount the value of the White House report on partisan grounds, the report’s overall views and conclusions are completely in-line with market consensus and even the projections of the U.S. Federal Reserve’s FOMC members.

The White House report suggests that economic strength is on the cards for the U.S. economy as the unemployment rate have bottomed to levels not reached in over five years, fiscal deficits have been reduced by over 50%, the housing market has rebound, manufacturers are adding jobs for the first time since the 1990s and exports are picking up.

Looking ahead, the report projects Real GDP to grow in the 3.2% — 3.4% range during the four years through 2017, while market analysts’ continue to suggest about 3% economic growth (GDP) in 2014. Further, the report anticipates the unemployment rate to drop to 5.5% by the end of fourth quarter of 2017 compared to the current unemployment rate of 6.7% (as of February-end) as reported by the Bureau of Labor Statistics on Mar 12, 2014.

Further, the report suggests faster growth in consumer spending in 2014 compared to the 2% rate during the past three years as households continue to substantially lower their debts, thus improving their spending appetite.

However, the recent Conference Board’s data on Consumer Confidence Index reflected a 1.3 points fall to 78.1 in Feb 2014, following a rise in January to 79.4. Meanwhile, the University of Michigan’s Consumer Sentiment survey showed a 0.5% sequential and 5.2% year-over-year improvement to 81.6 in Feb 2014.

With economic activity gradually gaining traction, the Federal Reserve has so far reduced its monthly bond purchases by $20 billion to $65 billion, in two rounds of $10 billion tapering each. However, the timing of the next round of tapering remains uncertain. In the last Fed meeting in January, policymakers had voted in favor of a plan to reduce the monthly bond purchases by $10 billion at each future meeting. The Federal Open Market Committee did not meet in February.

Looking back, the Federal Reserve had initiated a monthly stimulus program of $85 billion to boost economic growth and keep interest rates low. The Fed now lowered its purchase of mortgage-backed securities by $5 billion to $30 billion a month and its purchase of Treasury securities by another $5 billion to $35 billion per month.

The Fed had earlier indicated that it would ease monetary stimulus only after considering the job scenario, inflation and economic growth. However, officials are still trying to convince investors that despite the tapering, they would try to keep the interest rates near zero until the unemployment rate drops below 6.5%. The Fed aims to bring the inflation rate to 2% to stimulate economic growth, as chances of deflation lower the incentives.

Key Metrics

The key data in the retail industry analysis is comparable-store sales (comps), as it excludes sales at newly opened and closed stores. The sales data for most retailers have been in the doldrums for the past three months, owing to a short and promotional holiday season in December followed by the inclement weather due to the polar vortex throughout January and most of February.

While the latest key metrics data released last week reflected negative February comps for many retailers, there were others that benefited from the improved customer traffic due to a return to normal weather in late February. This was positively timed with the government’s tax refunds, thus boosting the purchasing power of consumers.  As a result, the key metric data for February was a mixed bag.

The aggrieved retailers list for the month was topped by The Gap Inc. ( GPS ), which posted a 7% fall in comps and a 3.8% decline in net sales to $929 million for February. Other major losers on the list include the off-price retailer of apparels, footwear and accessories, Stein Mart Inc. ( SMRT ), which registered a 2.1% decline in February comps, while total sales dipped 2.5%.

The Buckle Inc. ( BKE ), a retailer of casual apparels, footwear and accessories for men and women, posted a 1.4% decline in comps when compared with Feb 2013 results. However, net sales increased by a marginal 0.2% to $89.5 million. Discount store operator Fred’s Inc. ( FRED ) reported a 2.2% fall in comps on top of a 1.5% decline last year. Net sales for Feb 2014 were down 1% to $157.5 million.

On the other hand, the list of gainers despite the alarming weather was led by drugstore operator Walgreen Co. ( WAG ), which posted a 4.5% rise in comps and a 5% increase in total sales. This was followed by L Brands Inc. ( LTD ), Costco Wholesale Corp. ( COST ) and Zumiez Inc. ( ZUMZ ), all of which posted a 2% rise in comps for February.

Sales for the clothing retail chain L Brands rose 5.2% to $750 million, while the warehouse retailer Costco Wholesale delivered sales growth of 4% to $7.90 billion. Meanwhile, Washington-based retailer of sports-related teen apparel Zumiez reported an 8.8% increase in sales to $48.4 million from $44.5 million in the year-ago period.

Drugstore chain retailer Rite Aid Corp. ( RAD ) reported 1.5% growth in comparable-store sales for Feb 2014, while total drugstore sales climbed 2.4% to $2.515 billion for the month. Apparel and accessories retailer Cato Corporation ( CATO ) reported a 1% rise in comps with a 3% improvement in net sales.

However, the U.S. retail and food services sales data for Jan 2014 were disappointing. According to the U.S. Census Bureau, the retail and food services sales fell 0.4% sequentially but improved 2.6% year over year to $427.8 billion.

Trends to Rule 2014

The retail industry is rapidly evolving with a dramatic change in consumer buying habits. Consumers today are knowledgeable, more inquisitive and choosy. Satisfying customers and enriching their buying experience require new strategies. Modern retailing, interestingly enough, is a new game with new rules.

According to the National Retail Federation’s (NRF) monthly economic review published on Feb 6, 2014, retail industry sales (excluding automobiles, gas stations and restaurants) is projected to grow 4.1% for 2014, modestly higher than the preliminary 3.7% growth registered in 2013. Further, given the recent boom in the digital world, NRF anticipates solid growth for the online business this year capturing growth rates in the 9% — 12% range against 10.3% growth in 2013.

Some of the trends that are expected to rule the retail sector going forward include increased technological solutions, incorporating customer feedback and targeting additional audiences with products and services.

Omnichannel Retailing the New Norm: The sluggish U.S. economy and continued weakness in Europe have driven retailers to focus on buyers’ needs and lure them with innovative products, attractive discounts, free shipping and the ease of shopping through smartphones and tablets. As these efforts failed to pay off, retailers felt the need for a better channel to connect with customers and engage them through all possible means.

This gave rise to the omnichannel approach, which focuses on providing more touch points and multiple channels to customers. This approach facilitates the use of all possible mediums to engage consumers, including brick and mortar stores, online and mobile at the same time or alternatively.

This strategy provides customers the ease of selection, purchase and exchange of a product through multiple channels. For example, a customer may select a product online, buy it through his phone and may have the option to exchange the same by visiting a store without any hassle. Some retailers who are already benefiting from this strategy include Staples Inc. ( SPLS ), Macy’s Inc. ( M ), Nordstrom Inc. ( JWN ) and Chico’s FAS Inc. ( CHS ).

Personalized in-store Experience: With the growth of the .com era and an evolved consumer, retailers are pulling up their socks to reinvent their marketing style, evolving from the previous mass advertising and promotions format to a more personalized method, which will impress today’s omnichannel customer. The consumer today seeks a more direct communication through an app on their smartphone or an internet chat on the company’s website. Moreover, the customers prefer tailored offers and recommendations online as well as in stores.

Increasing Use of Mobile Wallet Technology: With everything in retail undergoing a sea change, the modes of payment used when shopping have also evolved drastically. The increasing use of smartphones, tablets and mobile technology has given rise to a new mobile application called ‘mobile wallet’ through which customers can be make payments instantly using their smartphones or tablets. Though cash and credit cards will remain the primary payment methods, the use of mobile wallets is catching up quickly among mobile users for the convenience it offers.

The popularity of this app among customers is driving retailers to adapt this payment mode by collaborating with some of the mobile wallet providers available in the market like PayPal, Google Wallet, Square Wallet, Dwolla, and more.

In a recent stride in this direction, leading car rental company Avis Budget Group Inc. ( CAR ) fused its express rental service Avis Preferred with the Google Wallet application. Moreover, the PayPal app has gained recognition with a wide array of retailers including Abercrombie & Fitch Co. ( ANF ), Advance Auto Parts Inc. ( AAP ), Aeropostale Inc. ( ARO ), American Eagle Outfitters Inc. ( AEO ), Barnes & Noble Inc. ( BKS ), Foot Locker Inc. ( FL ), Guitar Center, Jamba Inc.’s ( JMBA ) Jamba Juice, J.C. Penney Company Inc. ( JCP ), Jos. A. Bank Clothiers Inc. ( TM ), Nine West, Office Depot Inc. ( JOSB ), Rooms To Go, Tiger Direct and Toys R Us.

Technology-Friendly Brick & Mortar Stores: With shoppers increasingly becoming tech savvy, the brick and mortar stores need to brace themselves to move away from their old-fashioned layouts and adopt innovative in-store technologies. The simplest way to do this is the adoption of in-store mobile devices, through which customers can make payments, see product demonstrations, gather information and connect to social networks.

A step in this direction was demonstrated by Apple Inc. ( AAPL ), which equipped its associates with iPhones to enable them to assist customers and receive payments anywhere in the store. This reduces billing queues and ensures efficient management of space, making stores less congested.

Further, retailers are exploring new ways to use mobile devices in-store. They are looking for mobile apps that track customers as they shop, sending them tailored offers related to the store section they are in; recommending items based on past purchases; or allowing shoppers to program automated shopping lists.

In-store technologies that customers look for in stores these days include mobile point of sales, price checkers, self-checkout payment lanes, information kiosks, digital signage, etc. Other innovative technologies that will prove effective to engage customers both in-store and elsewhere are smart shelves, Wi-Fi hot spots, point-of-sales (POS) systems, virtual storefronts and endless aisles.

Reinvention of Loyalty Programs: Loyalty programs offer an edge to retailers as customers come back for more offers. However, the age old reward programs are losing popularity among shoppers as the offers are sometimes irrelevant and the benefit accumulation is slow.

With the trends changing in retail, retailers are now perking up their loyalty programs replacing loyalty cards with customized offers based on social information, behavioral patterns of shoppers, frequently bought items and other such details. Retailers who have shown stringent focus on enhancing rewards on their loyalty schemes include Nordstrom, Rite Aid Corp. ( RAD ), Office Depot and many others.

Impact of Social Media on Shopping Decisions: With the growth of the social networking sites and its use by the masses, business firms have also entered social media to promote their business. Through the social platforms retailers can advertise their brand and launch new products and campaigns. Companies also offer mobile coupons exclusively through these platforms, largely influencing the buying decisions of shoppers.

Additionally, these social platforms provide an insight into what the customers will buy in the stores based on the interest shown by them regarding products featured on these sites.

Investing in Big Data to Track Shoppers: With the growing need for giving personal attention to shoppers, retailers are widely investing in big data solutions that help accumulate information regarding the behavior patterns, history and background of customers. The analysis of this data facilitates the prediction of customer reaction, formulating pricing strategies, offering shopper-specific discounts and providing personalized recommendations to shoppers.

Growth of Retail in Emerging Markets: Having tapped most of the potential in the domestic markets, a pattern recently noticed among retailers is their venture into the emerging markets. Most retail chains are witnessing growing demand for their products in countries like Brazil, the Middle East, China and India, targeting to grow exposure in these countries over time. Some of the retailers venturing into these markets include The Gap, The Clorox Company ( CLX ), Ralph Lauren Corp. ( RL ), V.F. Corp. ( VFC ) and Tiffany & Co. ( TIF ).

Challenges and Some Remedial Measures

The retail industry is highly competitive and encounters significant challenges. With a slow recovery in the U.S. economy, consumers remain exposed to macroeconomic factors including interest rate hikes, increase in fuel and energy costs, credit availability, unemployment levels, and high household debt levels, which may negatively impact their discretionary spending and eventually adversely affect the growth and profitability of retail companies.

Macroeconomic Conditions: Retail is no different from other U.S. industries, which is highly dependent on the economy to prosper. Such heightened dependence on the economy and factors like job growth and interest rates indicate that a speedy recovery of the economy is vital for the health of the retail industry. While the unemployment rate has decreased considerably over time, consumers are now beginning to draw out their savings to spend, anticipating some economic recovery.

Lack of Focus on Research & Development: Despite the focus shifting to consumers in retail, there still remains a conservative approach among retailers when it comes to research and development budgets. Looking from another perspective, given the rising use of digital and social media, retailers lag customers when it comes to adopting new technologies and platforms.

This ever-changing technological scenario demands continued investment in research & development to remain updated. For example, the mobile point of sales technology introduced some years back as a new innovation has now become a must-have in retail stores.

To prosper in this high-tech era, retailers need to hold back on the adoption of every new technology and focus only on the ones that help enhance their brand proposition. Identifying the best options and investments in that direction will help fetch results.

More Data Analysis Raises Consumer Privacy Risk: Though the tracking systems developed to study consumer behavior are doing well for retailers, their sustainability is questionable as customers may be irked by such tracking over time. As a result, they may register for ‘Do Not Track’ systems to prevent tracking.

In order to address this issue, companies should educate shoppers on the benefits for such data analysis. Customers need to be informed that the tracking systems installed in their stores are solely for data collection and will not hinder their privacy in any way.  

Zacks Industry Rank

Within the Zacks Industry classification, Retail/Wholesale (one of 16 Zacks sectors) is divided into two categories — Nonfood Retail-Wholesale and Food/Drug- Retail/Wholesale under the Medium (M) Industry Group and further sub-divided into 14 industries at the expanded (X) level — Building Products-Retail/Wholesale, Internet Commerce, Retail/Wholesale Auto/Truck, Retail-Apparel/Shoe, Retail-Consumer Electronic, Retail-Discount, Retail-Drug Store, Retail-Jewelry, Retail-Miscellaneous/Diversified, Retail-Restaurants, Retail-RGN Department, Retail-Supermarket, Retail/Wholesale-Auto Parts and Retail/Wholesale CMP.

We divide the 16 Zacks sectors into 60 M-level industries and 250 X-level industry groups. We rank all the 250 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is ‘Positive,’ between #89 and #176 is ‘Neutral’ and #177 and higher is ‘Negative.’

The Zacks Industry Rank for Retail/Wholesale-Auto Parts is #2, Retail/Wholesale CMP #11, Retail-Jewelry #43, Building Products-Retail/Wholesale #50, Retail-Drug Store #67, Retail/Wholesale Auto/Truck #75, Retail-RGN Department #190, Retail-Restaurants #199, Retail-Supermarket #199, Retail-Miscellaneous/Diversified #205, Retail-Apparel/Shoe #222, Internet Commerce #223, Retail-Discount #240 and Retail-Consumer Electronic #255.

On analyzing the Zacks Industry Rank for the constituent industries in this space, it is apparent that the overall outlook for the Retail/Wholesale sector is Negative.

Earnings Trends

The broader Retail/Wholesale sector portrays a discouraging earnings trend. The fourth-quarter 2013 results for the sector were disappointing in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings beat ratio was 61.1%, while the revenue beat ratio was 25%. Total earnings for this sector declined 1.6% year over year, in contrast to 6.2% growth registered in the third quarter of 2013. Total revenue improved only 1.9% in the quarter versus a 3.7% jump in the previous quarter.

Looking at the consensus earnings expectations for the quarter ahead, the picture looks slightly bright with earnings expected to grow 2.3% in the first quarter of 2014 and 8.7% in the second quarter of 2014, registering full-year 2014 growth of 10.3%. Going into the next year, earnings expectations look encouraging with projected earnings growth of 14.4% for the full-year 2015.

For more details about the earnings of this sector and others, please read our ‘ Earnings Trends ‘ report.

Retailers are trying to remain competitive primarily by shifting focus to the long-term horizon and finding innovative solutions to create value, reduce operating costs and mitigate risks throughout the enterprise.

Right-sizing inventories, enhancing efficiency and competence and bringing in technological advancements are the key agendas that retailers are focusing on. Moreover, cost-containment efforts and merchandise initiatives to improve margins are top priorities.

Retail, owing to its huge spectrum, remains a lucrative investment avenue for investors. The sector reflects consumer spending trends, an important parameter to gauge the health of the economy. Thus, identifying future winners from this sector would be a good investment decision.

We recommend few stocks in the sector at this point, as these companies are showing significant growth despite the secular headwinds. The stocks in our coverage with a Zacks Rank #1 (Strong Buy) include Barnes & Noble Inc. ( BKS ), Christopher & Banks Corp. ( CBK ), Zale Corp. ( ZLC ), Zynga Inc. ( ZNGA ), Iconix Brand Group Inc. ( ICON ), Michael Kors Holdings Ltd. ( KORS ), Spartan Stores Inc. ( SPTN ) and Hanesbrands Inc. ( HBI ).

Additionally, we prefer stocks with a Zacks Rank #2 (Buy), namely AutoZone Inc. ( AZO ), Herbalife Ltd. ( HLF ), Foot Locker Inc. ( FL ), Rite Aid Corp. The Kroger Company ( KR ), G-III Apparel Group Ltd. ( GIII ), Columbia Sportswear Company ( COLM ), Joe’s Jeans Inc. ( JOEZ ), Under Armour Inc. ( UA ) and Burlington Stores Inc. ( BURL ).

On the other hand, there are stocks that do not hold promise in the near term, and carry a Zacks Rank #4 (Sell) and Zacks Rank #5 (Strong Sell). These include Aarons Inc. ( AAN ), American Eagle Outfitters Inc. ( AEO ), Big 5 Sporting Goods Inc. ( BGFV ), Chico’s FAS Inc. ( CHS ), Office Depot, Groupon Inc. ( GRPN ), Coach Inc. ( COH ), Brown Shoe Co. Inc. ( BWS ), Best Buy Companies Inc. Dillard’s Inc. ( DDS ), Dollar Tree Inc. ( DLTR ), Lululemon Athletica Inc. ( LULU ), DSW Inc. ( DSW ), Aeropostale Inc. ( ARO ), The Buckle Inc. Nordstrom Inc. Target Corp. ( TGT ), Costco Wholesale, Ross Stores Inc. ( ROST ), Family Dollar Stores Inc. ( FDO ), L Brands, The Men’s Wearhouse Inc. ( MW ), Express Inc. ( EXPR )  and Cabela’s Incorporated ( CAB ).