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May 31, 2007

Will Consumers Rebound?
by Chad Hudson

Inflation fears eased after the Labor Department released the latest Producer Price and Consumer Price Indexes. The Labor Department reported that consumer prices rose 0.4% in April and only 0.2% excluding food and energy. The year-over-year change dropped slightly to 2.6% from 2.8% last month, which was the largest increase since last August. While economists tend to follow the core rate because the energy and food components are historically more volatile and have contributed more "noise." The underlying trend of consumer prices was generally captured in the core rate. This does not seem to be the case now. Food inflation has been trending higher than overall consumer prices for quite some time. Looking at the two-year stacked growth rate, which eliminates some of the volatility often cited, food prices increased less then the core rate for 83% of the months between 1980 and 1995. Since then food inflation has outpaced core inflation 64% and more recently, 38 of the past 48 months. It seems too convenient to dismiss these rising prices when there has been a clear trend of higher prices and not simply "noise." Then considering the "core" rate also dismisses the rise in energy prices, the analysis borders on bizarre.

Producer prices also moderated in April. Prices in the manufacturing sector increased 0.7%, down from a 1% gain in March. This was higher than the 0.6% increase economists forecasted, but lower than the 1% gain last month. Similar to the consumer price index, economists focused on the fact that the core rate was unchanged and the year-over-year growth dropped to 1.5%, the slowest rate this year.

The Federal Reserve released the minutes of the May FOMC meeting this week. While economists were pleased to see the core inflation measures moderate, the Fed still felt "that the risks around the anticipated moderation in inflation were to the upside; and some noted that a failure of inflation to moderate could entail significant costs.' The Fed continues to expect economic growth to moderate and that will alleviate inflation pressures. The slowing housing market will be the main reason for economic growth easing. The members on the FOMC now expect that the "correction of the housing market is likely to continue to weigh heavily on economic activity through most of this year - somewhat longer than previously expected."

Housing starts unexpectedly rose in April to 1.528 million annualized units. Economists were expecting the number of starts to drop to 1.48 million. That is about where the good news ends. March starts were revised down by 27,000 units to 1.491 and the number of permits issued fell by 140,000 to the lowest level June 1997. Since the number of permits is usually viewed as a forward indicator, its likely that housing starts will fall in the coming months. The monthly survey from the National Home Builders Association revealed that homebuilders have become less optimistic. The index of builder optimism dropped for the third consecutive month in April. The three point drop in the index to 30 matched the lowest level of optimism since early 1991 (the index dropped to 30 in September last year).

New home sales surged in April to 981,000 annualized units from 844,000 in March. This was the highest level this year, it was also significantly better than the 860,000 economists expected. Perhaps the driving force for the surge in sales was the 10.9% drop in the median price. A portion of the decline in median price was likely due to a geographic mix shift as sales in the West, where prices are the highest in the country, dropped 26% from last year and sales in the less expensive South were flat. While that might explain a portion of the drop, new home prices have been kept higher through the use of incentives. These incentives result in higher actual transaction prices, but lower the assumed price the homeowners pays. Earlier this month, Centex reported that its pricing was flat compared to last year, but incentives accounted for 8.3% of the selling price compared to 3.7% last year. Sales of existing homes failed to bounce in April. Instead, sales of existing home dropped to an annualized rate of 5.99 million units from a 6.15 million rate last month. This was the slowest pace of home sales since June 2003. Prices, however, held up much better than new home prices, and were down only 0.7% compared to last year.

The weak housing market has damped sales at the large home improvement retailers. Home Depot and Lowe's both reported that first quarter earnings fell year-over-year. Earnings from continuing operations fell 24% at Home Depot. Same store sales fell 7.6% and gross margins contracted 80 basis points. Profits were impacted by the deleveraging of SG&A by almost 200 basis points. Lowe's results were slightly better. Earnings dropped 9.4%. Same store sales dropped 6.3%. Margins were not as impacted as Home Depot. Gross margin was flat and SG&A deleveraged by 160 basis points.

Wal-Mart reported first quarter earnings that met analysts' estimates of $0.68 per share, but sales were slightly below its internal plan. This was the fourth consecutive quarter that Wal-Mart didn't achieve its sales goal, but hit (or exceeded) its EPS estimates. Earnings benefited from a 19% decline in other expenses along with a 22% jump in other income. Earnings before interest and taxes (EBIT) from retail operations increased only 5.6%. At the Wal-Mart division, same store sales increased only 0.6% compared to Wal-Mart's initial plan of 1-3% increase and gross margin fell by 26 basis points. Wal-Mart said that second quarter earnings would be $0.75-$0.79 per share with the mid-point falling two pennies below analysts' estimates at the time. Inventory grew slightly faster than sales.

While Wal-Mart had one of its weakest quarters in years, Target's first quarter results were much better. Same store sales rose 4.3%, which was the 11th consecutive quarter that Target outpaced Wal-Mart's same store sales. Gross margins expanded 39 basis points to 32.6% and SG&A declined by 34 basis points to 22.7%. Inventory declined on a per sq. foot basis by 1.1%.

After posting strong March sales, earlier this month, retailers announced that April sales decelerated sharply. Thomson Financial's index of same store sales dropped 1.8% in April, which was the lower than the 0.4% gain analysts forecasted. Wal-Mart's same store sales dropped 3.5%, which was their worst month since at least 1995. Excluding Wal-Mart, same store sales were better, but still fell 0.4%. The shift of Easter was the primary cause of the strong March and weak April sales. After combining March and April to eliminate the Easter shift, same store sales increased 2.1% and 3.6% excluding Wal-Mart. Additionally, the weakness in April was broad based as 85% of retailers posted results that were below analysts' estimates.

The government's tally on retail sales also revealed that April was weaker than expected. The Commerce Department reported that retail sales fell 0.2% in April and increased only 3.1% from last year. This was the weakest year-over-year growth since August 2004. Much of the weakness was due to the shift of Easter, which was a week earlier this year compared to last year. By comparing the cumulative sales of March and April its possible to negate much of the Easter distortion. Even this revealed that retail sales were weaker than the recent trend. The combined overall sales increased 4.2%, which is higher than any monthly result (except March) this year. While it is easy to look at retail sales in April and conclude consumer spending fell off a cliff, the actual data reveals that consumer spending was inline with recent trends. The recent ICSC surveys do point to a weaker May. There was a brief acceleration during the second week of May when year-over-year sales increased to 2.6%, but sales growth slid back down to 1.9% last week. This was the third week of growth below 2.0% in the past four weeks.

While the weak housing market is expected to cause consumers to curtail spending at some point, consumers continue to be optimistic. Consumer Confidence rose 1.7 points in May to 108. The increase was led by a 1.9 point jump in those that thought business conditions were good. The index hit 29.4, less than half-a-point from the highest levels in the past six years reached in March and October last year. Offsetting the optimism over business conditions, only 17.7% thought their income would increase over the next six months. This was the lowest level since last May when 17.0% expected to receive more income. It was also interesting that the percentage of consumers planning on buying a car over the next six months rose 70 basis points to 3.9%, the highest since May 2005.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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