UBS analyst downgrades retail stocks, says investors aren't pricing enough

According to UBS Group AG, investors aren't pricing enough bad news into shares of discretionary retailers.

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 downgraded Foot Locker Inc. to neutral from buy due to increasing competition and downgraded Bath Body Works Inc., a retailer of candles, lotions and soaps.

He wrote in a research note that the market is too focused on potential margin recapture and not focused enough on downside risks to sales.

He said that a recession will pressure sales of non-athletic apparel and home goods, but he said some investors still view this as a worst-case scenario. Sole slashed his earnings-per-share estimates by 10% across his coverage of softlines retail.

The S&P Composite 1500 Apparel Retail Index has risen 7.9% in the past year, fueled by resilient results from TJX Cos, while the S&P 500 Index has slumped 13%. In the same period, 13 of the 18 retailers in the index declined as consumers reined in discretionary spending and companies offered discounts to tame bloated inventories, which hurt margins.

Sole believes that slowing consumer spending will cause the industry's earnings outlook to weaken over the year, leading to lower earnings estimates and pressure on stock valuations. After the latest UBS data on consumer spending intentions for apparel signaled that industry sales growth trends will deteriorate, his conviction has increased. 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 of brands with exposure to athletic footwear, China is 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.

In the past few weeks, athletic-wear companies have been a standout in the consumer discretionary sector, with demand for athletic apparel and sneakers holding up even as consumers pull back in other categories. Lululemon Athletica Inc. increased by 13% on Wednesday, the biggest advance in four years, after its net revenue and earnings-per share forecasts for the year surpassed Wall Street expectations.

The upbeat report followed better than anticipated sales projections from Foot Locker and Dick s Sporting Goods Inc. earlier this month. On Holding had its best week since its initial public offering in September 2021, after forecasting sales growth of almost 40% this year. The sportswear brand worked down its excess inventory, but its profitability didn't meet Wall Street expectations, and recently reported quarterly sales that beat Wall Street's expectations.

The stocks that are most likely to beat are those with strong growth outlooks that are not fully priced-in, Sole wrote.

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