Retailers' Rally Faces Tough Winter

By JOHN JANNARONE The spring rally has been a relief for shares of embattled retailers. Can the economy recover in time to justify the new optimism? The key is the holiday season, when retailers make the vast majority of their money. Investors are betting that by the fourth quarter the economy will have stabilized and consumers will be ready to spend again. In anticipation, discretionary retailers have far outperformed the market since the trough in early March. Shares of Macy's and J.C. Penney, for instance, have nearly doubled from their lows. That reflects both a hope that earnings may have bottomed and that debt burdens have become more manageable as credit markets become more forgiving. There is a natural temptation to call the big bounce early. After all, retail stocks tend to rise at the first sign of an actual recovery. They did so in early 2003, heralding a broader market bounce. This time around, however, the recession is far deeper. The unemployment rate stands at 8.5%, and Dallas Federal Reserve Bank President Richard Fisher said earlier this month it will likely surpass 10% before improving. Meanwhile, analysts began to increase earnings estimates for J.C. Penney and Macy's in late February, since when estimates for combined earnings of S&P 500 companies have continued to slide. Macy's itself said on Feb. 24 it expected to earn between 40 and 55 cents a share this fiscal year, but analysts now expect about 60 cents. Macy's stock, trading at its highest level since October, is valued at 21 times earnings -- a rich valuation unless healthy holiday spending is virtually in the bag. Macy's new restructuring steps will save costs by consolidating operations, but the boost to earnings growth will only come once. Also, it will be tough for Macy's to expand through capital expenditure because it risks breaking the terms of its $2 billion credit-revolver agreement. The company has $1.3 billion in cash, but the revolver is an important buffer with $2.7 billion in debt maturing by the end of fiscal 2012. On top of consumer worries, Penney is burdened by pension-fund losses. The company expects to take a noncash charge of $322 million related to a deficit on its pension plan. Even excluding that charge, the company is trading at 22 times this year's expected earnings. Of course, the likes of Penney and Macy's should gain some business if other competitors fold. But as general department stores, they won't benefit to the extent of Best Buy, for example, which operates in a specialist niche that no longer contains bankrupt Circuit City. General retailers will benefit from a meaningful rebound in consumer spending. But with easy credit now gone, investors should beware betting too heavily on a bumper Christmas. Write to John Jannarone at john.jannarone@wsj.com