Retail Stocks Out of Gas as Cost Pressures Rise

Retail stocks sold off aggressively Friday, threatening to end the sector's winning streak, as worries spread that rising cotton prices would pinch profits more than some had expected.

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It's been no secret that cotton costs were on the rise, but until Gap's and Aeropostale's earnings reports late Thursday, some may have expected that retailers would be able to pass those costs along to their customers.

TheGap, the largest U.S. specialty apparel retailer, said its product costs would be up about 20 percentin the second half of the year, and that inflation would offset any price increases the company would be able to put in place, especially for its value brands such as Old Navy.

While Aeropostale said business trends were so uncertain, the company declined to provide an earnings forecast for the second half of the year.

Both Aeropostale and Gap shares hit 52- week lows, and Gap shares saw their biggest percentage drop in nearly 10 years.

BMO Capital Markets analyst John Morris analyst has been arguing for some time that retailers with pricing power will be able to offset the mounting commodities costs.

Morris blames Gap's problems on "product misfires" that have worsened the pressure from rising costs.

Still, analysts have similar concerns about teen retailers American Eagle Outfitters and Aeropostale.

Needham analyst Christine Chen downgraded the retailer to hold from buy, citing the margin pressures and the strength of the company's two competitors Abercrombie & Fitch and Aeropostale.

Chen said she has already seen signs that American Eagle has not been able to make its price increases stick, and cited an accelerating rate of sales promotions and discounting by the retailer during its fiscal first and second quarters for this stance.

Chen expects American Eagle will meet her lowered fiscal first-quarter earnings estimate of 13 cents a share when it reports earnings next Wednesday. But she also expects the retailer will forecast second-quarter earnings below Wall Street's consensus estimate of 13 cents a share. Chen expects the teen retailer to post earnings of 10 cents a share in the second quarter.

Stifel Nicolaus analyst Richard Jaffe, who downgraded Aeropostale to hold following the company's earnings report, said he expects the company's fashion missteps, which offered customers poor color choices and styles that looked to old to continue into the second quarter.

But the selloff in retail stocks extended well beyond these three retailers. Prior to the selloff, retail stocks had outpaced the broader market, with the S&P 500 Retail Index up nearly 12 percent over the past two months. That's double the gain in the S&P 500 index during the same period. But the steep declines in retail stocks Friday had the sector posting wider losses than the S&P 500.

Jan Kniffen, CEO of Jay Rogers Kniffen, told CNBC that he had been expecting investors to change their opinion on retail stocks.

“As inflation starts to run through here, consumers at the low-end, in particular…are going to have a really hard time with no wage growth buying 15-percent more expensive apparel,” said Kniffen.

Kniffen said retailers who sell products to lower-income customers will feel the pinch more than those who sell to higher income levels. That's because the price increases are much more noticeable at the lower price points.

Also, these customers have already seen their disposable income shrink in the wake of higher gasoline and food costs.

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