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September 30, 2004

Revising Down
by C. Hudson / R. Bend

Last week, the National Association of Realtors reported that sales of existing homes fell to a 6.54 million annualized rate from 6.72 million last month. Economists were expecting a much smaller decline to 6.63 million. The decline should be taken with a block of salt; existing home sales in August were still one of only six months that had sales greater than 6.5 million. New home sales on the other hand jumped from a 1.082 million to a 1.184 million unit pace in August. This was about 30,000 more than economists had forecasted.

The Conference Board reported that consumer confidence slipped 1.9 points in September. This was the second straight decline and surprised economists, who were expecting a slight gain. Most of the drop came from the present situation component, which fell more than five points to 95.5. Over the past two months, consumers have gotten skeptical of the labor market. Those that viewed employment as plentiful have dropped from 19.7% in July to 16.8% in September, while those believing its hard to find employment have jumped from 35.7% in July to 28.3% in September. While confidence in the labor market has diminished lately, it is far better than a year ago when only 9.9% thought employment was plentiful and 35.1% thought it was hard to get a job. It is also noteworthy that views regarding the labor market are polarized. The percent of respondents that expect the job situation to improve over the next six months increased, but so did the percent that expect it to worsen.

The third quarter is about to close. Unless there is a miracle, this will be the first quarter since the second quarter of 2003 that S&P 500 earnings will not increase by at least 20% year-over-year. It is also the first time since the third quarter last year, that negative earnings pre-announcements have outnumbered positive pre-announcements. These pre-announcements have forced analysts to lower their projected growth rate for S&P 500 earnings. Analysts currently expect the S&P 500 to increase earnings by 14.2% during the third quarter. This is 70 basis points lower than at the beginning of the month and 60 basis points lower than at the beginning of the quarter. The last time earnings grew slower than what was estimated at the beginning of the quarter was during the fourth quarter of 2002, which concluded a series that had eight of nine quarters of slower than estimated earnings growth. While not a large decline, the decline in estimates has been broad-based as analysts have lowered the expected growth rate for eight of the ten sectors. Only consumer discretionary (from 21% to 22%) and energy (form 34% to 40%) sectors have had growth estimates increased this month. After the past two weeks, several companies in the consumer stables sector lowered earnings guidance. It should not be surprising that consumer stables had the largest decline, from 8% to 5%. Also remember that most of the positive revisions that happened in the second quarter were concentrated in the energy and materials sectors. Additionally, estimates for the fourth quarter have also declined.

Last Tuesday, AutoZone, the country's largest retailer of automotive parts and accessories, reported disappointing sales results. For the fiscal fourth quarter, same store sales declined 3%, surprising investors who sent the stock down 2% on the day. The auto parts retailers have had a tough summer that appears to be trending into the fall. This past Friday, two more companies in that business offered further negative news to the marketplace. Pep Boys, the Philadelphia based parts retailer, cited weak consumer spending and high gas prices as the reasons that poor summer results have continued. Later that same day, Monro Muffler Brake said second quarter same store sales will be flat and guided earnings for the quarter toward the low end of the expected range.

Although several auto parts retailers are experiencing weaker sales, AutoZone has been lagging its competitors for several quarters. AutoZone management cited higher gasoline prices for the weak consumer traffic, it even went as far as to say that it was the first time they had seen a statistically significant relationship between gasoline prices and the number of transactions at their stores. Despite the fact that the average number of transactions declined, average ticket for the quarter was up. We think a much more plausible reason for its lackluster performance stems more from its store base not being as appealing as its competitors.

During the conference call that followed the release of third quarter earnings, the company said that their, "store base is older than our competitors on average with our average store being just over eight years old. We believe that if our store base was just three years younger our same stores sales would average five-points higher than they currently do." We find this a strange admission. Over the past several years, the company's primary capital expenditure has been buying back its own stock. If older stores were a concern, wouldn't if be a better use of funds to update and/or remodel its stores. Just doing some quick back of the envelope calculations, during 2002 and 2003 the company spent almost $1.6 billion buying back stock and reduced the number of shares outstanding by about 21 million shares, which works out to about $77 per share. With the stock currently trading at $76, this does not appear to have been a good investment, except for the fact that the company must have very few projects that have positive ROI. According to the company it only costs $600,000 to build a store, so it would not cost much to update or remodel them. If this would boost same store sales by 5% and its 10% profit margin could be maintained, actually the marginal 5% increase in sales should leverage quite a bit off the existing SG&A expense, the company could earn an additional $30 million per year. This works out to be about $8,000 per store. If the company is trying to maintain a 15% return on capital, investors are left to assume it would take more than $55,000 to get their stores up to par.

Chad Hudson & Ryan Bend
Mid-Week Analysis
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