Retail stocks get marked down

J.C. Penney predicted a good year in the spring, then slashed fourth quarter earnings estimates in the fall.

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NEW YORK ( Fortune) -- A fundamental retailing rule is to take markdowns early and deep.

But retailers don't seem to be adhering to that model when it comes to their earnings forecasts. While several companies slashed fourth quarter guidance last week, it may be too little, too late. Analysts are concerned that the numbers are still too high given the uncertainty heading into this year's holiday shopping season.

Macy's (Charts, Fortune 500), Kohl's (Charts, Fortune 500) and J.C. Penney (Charts, Fortune 500) took the opportunity last week when they reported third quarter results to damp down expectations for the remainder of the year, but some analysts said the predictions are still too rosy, setting the stage for further disappointment in the months ahead.

Still to come are third quarter earnings from dozens of specialty retailers, and analysts expect many of them to make discouraging comments about the fourth quarter. Companies that are likely to trim guidance going forward include Limited Brands (Charts, Fortune 500), Talbots (Charts) and Chico's FAS (Charts), these analysts said.

Predicting how shoppers will behave during the all-important holiday season is never easy. This year is even more complicated thanks to an unseasonably warm fall and uncertain credit markets, both of which have tempered consumer spending and left retailers with fatter inventories.

Most analysts are predicting that retail sales will rise in the low single digits for the November-December period, a slowdown from prior years but far from a disaster. If the weather returns to more seasonable, cooler temperatures, retailers stand a chance of picking up much needed sales momentum.

But even in the best scenario, some analysts worry that company earnings projections are based on unrealistic assumptions.

Macy's, for instance, last week reaffirmed fourth quarter earnings guidance of $1.70 to $1.80 a share, even though it now expects sales for the period to fall about $100 million light of earlier expectations. How does it make up the difference?

According to J.P. Morgan analyst Charles Grom, Macy's is counting on a slight improvement in operating margin during the fourth quarter, on a two-year running average. Such margin expansion "in this environment looks aggressive," Grom noted in a recent research report, especially since Macy's margins have contracted on average for the first three quarters of this year.

One way for retailers to increase their margins is by selling more merchandise at full-price. That seems like a tall order for Macy's, given the overall slowdown in consumer spending, not to mention integration problems the company is facing related to its 2005 acquisition of the May Department Stores Company. To improve sales at the former May stores, Macy's has increased - not decreased - its level of promotional activity this holiday season.

Kohl's is also basing fourth quarter estimates on steady margins, an assumption that may prove too sanguine. Though the company reduced same-store sales and earnings guidance for the period, it expects gross margins to hold flat at 35.3 percent.

Morgan Stanley's Michelle Clark, in a note to clients, warned that the company's margin estimate was unrealistic, given higher-than-expected inventory levels heading into the fourth quarter and the difficult economic environment. As a result, she continued, fourth quarter "guidance may be lofty."

Like its rivals, J.C. Penney fell on its sword last week and slashed fourth quarter earnings estimates to $1.65 to $1.80 a share, down from a previous forecast of $2.41 a share. Since the company has waffled on predictions this year - raising them twice, before lowering them - analysts have not ruled out further reductions.

J.C. Penney initially predicted a good year. Back in May the company raised its full year guidance by 5 cents to $5.49, and then added a penny to that estimate in August, before slashing its outlook to $4.63 to $4.78 last week.

"The company has not been known for its rock solid forecasting," noted Carol Levenson of Gimme Credit, "and we think it's wise to assume the fourth quarter may be worse than currently anticipated."

To be sure, many retail stocks appear inexpensive, having lost a large chunk of their value over the past six months.

While further bad news may not drag them much lower, there is little reason to expect these stocks to trade higher, either - at least not with the continued uncertainty for the coming months. As a result, investors may do better to shop elsewhere this holiday season.