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February 16, 2006

Buying Everything Except the Kitchen Sink
by Chad Hudson

Consumers made it back to the mall after the holidays. Retail sales jumped 2.3% in January, and increased 2.2% excluding auto sales. Estimates were for 0.9% and 0.8% respectively. While gasoline sales accounted for a large part of the gain, excluding automobile and gasoline sales, retail sales were up 1.8%, the highest since March 2004. On a year-over-year basis, retail sales increased 8.9% and 9.8% excluding autos. This was the strongest sales growth since June. Last January, retail sales only increased 5.4% on a year-over-year basis, so some of the increase could be due to a weaker comparable period. Sales should also be strong in February. Last February, sales increased only 5.6%. Starting in March, the comparables get much more difficult. The average year-over-year increase between March and September is 8.2%, with June and July both being over 10%. Strength was seen across the board. Apparel stores had sales up 9.7% over the past year, general merchandise up 6.9%. Both were the best since June. Furniture sales were up 9.5%, which was the second largest increase since April 2004. Grocery stores were the weakest with sales up only 1.9%, but restaurants posted a 10.2% gain, best results since December 2004.

Last week, we mentioned that it was likely that retailers would report strong results for the fourth quarter. If results from Abercrombie & Fitch and Too are any indication of how the industry fared, we will be proven correct. They were two of the first retailers to report fourth quarter earnings and posted strong results. Abercrombie & Fitch reported fourth quarter sales increased 40% driven by 28% same store sales growth. Gross margin increased 20 basis points to the highest level ever for the fourth quarter. Strong same store sales growth led to operating leverage, resulting in operating margins increasing 300 basis points to 27.8%. Too also reported fourth quarter results that were stronger than analysts forecasted. After experiencing a "low single-digit comp" in December the company lowered its guidance for fourth quarter earnings. The company had lowered its guidance in January following disappointing December same store sales. However, in January, the company had a "low double-digit positive comp." It was the best January comp since 1998. While the company said same store sales have continued to track at a double-digit pace in February, management only guided for comp sales to increase 3% in the first quarter. While business continues to be strong, there is some caution within the industry.

Industrial production unexpectedly dropped in January by 0.2%. Economists were expecting a 0.2% increase. December's growth was revised upward from 0.6% to 0.9%. Utilities dropped 10.1%, which accounted for almost the entire decline. Manufacturing production rose 0.7% and is 4.5% higher than a year ago. Over the past year, home electronics has increased 25.3% and business equipment has jumped 10.7%. Capacity utilization also fell 0.3% from a revised 81.2% to 80.9%. December's revision to 81.2% was the highest utilization rate since September 2000. Similar to the production decline, utilities accounted for most of the drop. Manufacturing utilization increased 0.4% to 80.5%, the highest pace since July 2000.

Over the past month, most of the homebuilders have announced lower order rates. Last week, KB Home filed its 10-K and commented on its outlook:

There are signs, however, that consumer demand in the United States for residential housing at current prices is softening. For example, the U.S. Census Bureau reported that single-family housing starts in December 2005 were approximately 12% lower than in November 2005 and approximately 8% lower than in December 2004. The Bureau also reported that the median sales price for new homes fell approximately 3% in December 2005 relative to the median sales price in December 2004. Our results to date in fiscal year 2006 reflect these broader market trends. In the first two months of the year, we have experienced an increase in home order cancellations and a decline in net orders for new homes when compared to the same period last year.

It followed up by saying that, "If the current trends do not improve, we may be required to moderate our revenue guidance for fiscal year 2006."

Last week, David Rosenberg, chief economist at Merrill Lynch, published a note detailing how the hot housing sector has accounted for a disproportionate amount of economic growth over the past four years. Since the end of 2001, residential investment has increased 66% from $476 billion to $790 billion, or about 13.5% per year. Total economic growth over the past four years has been about $2.5 trillion, or 24%. Residential investment has grown almost three times faster than the overall economy and has accounted for 12.5% of total economic growth over the past four years. This surge has lifted the share that residential investment accounts for in total GDP from about 4.7% (close to its long-term average of 4.6%) in 2001 to 6.2% during the fourth quarter of 2005. This was the largest share of economic activity that residential investment had since 1951. Furthermore, Rosenberg calculated that after accounting for the increased spending due to cash-out refinancing and consumers feeling more wealthy, housing accounted for 55% of GDP growth in 2005.

The other concern regarding the housing market is all the adjustable rate mortgages that are expected to reset this year. According to the Mortgage Bankers Association, $330 billion worth of adjustable rate mortgages will reset this year with another $700 billion in 2007. With the threat of higher mortgage payments, several mortgage companies have been advertising fixed rate mortgages, and are starting to get creative with new fixed rate products. During its conference call discussing fourth quarter earnings, Accredited Home Lenders discussed it 40-year loan product. It created a 40-year amortizing 30-year loan. This has a lower monthly payment than a standard 30-year fixed mortgage, but includes a balloon payment in the thirtieth year. The popularity of this product has soared. During the second quarter of 2005 it accounted for only 1% of its volume. During the fourth quarter it has surged to 41% of its volume. Part of the growth was due to a shift from interest-only products. Its interest-only products accounted for 9.5% of it volume in the fourth quarter, down from 17.3% during the second quarter.

The economy has clearly rebounded from the 1.1% pace in the fourth quarter. Any weakness currently in the economy seems to be confined to residential real estate. If housing continues to exhibit weakness, it is highly likely that consumer will not be able to maintain the pace of consumption. At this point, the market anticipates the economy to continue to expand. The fed funds futures market has priced in a 90% chance of fed funds reaching 5% by the FOMC meeting on June 29, and an almost certainty by the August 8 meeting.

Chad Hudson
Mid-Week Analysis
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