Is Housing the Differentiating Factor?

By: Chad Hudson | Thu, Nov 20, 2003
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The residential construction report released by the Commerce Department on Wednesday provided four positive data points for the housing sector. Housing starts jumped 3.2% in October to 1.960 million. Besides beating economists estimates by over 100,000, it topped the 17-year high set last month. Additionally, September's starts were revised upward by 17,000 to 1.905 million. Adding to the euphoria was that building permits increased 5.2% to 1.973 million. This was the highest level since February 1984. Similar to housing starts, September permits were upwardly revised by 15,000 to 1.875 million. It was interesting to see how divided the growth was geographically. All the strength was in the South, up 4.9%, and the West, up 17.7%. The Northeast and Midwest were both down, 18% and 8% respectively. Permits are usually seen as an indicator of future growth, so the outlook remains strong.

The outlook for housing was further enhanced by the 13.5% surge in the purchase application index from the Mortgage Bankers Association. This was biggest weekly increase since May 30, 2003 and is less than 10% from the high that was set on May 30. The refinance index continues to stabilize around the 2,000 level. During the latest week it dropped 2% to 2,043.9.

Even as mortgage rates have stabilized around 6%, the number of buyers opting for an adjustable rate mortgage has continued to climb. Twenty-seven percent of mortgages applications were for ARMs. Up until July, the percent of ARMs remained under 16%. In fact, since 1990 there has only been three periods when more than 25% of home buyers chose ARMs. These were in 1994, 1996, and late 1999 and early 2000. Those previous periods were when mortgage rates peaked above 8%, not 6% as they are now. As I have stated before, this increase in the number of ARMs with interest rates still at low historical levels indicates that homebuyers are stretching themselves by buying the most expensive house they can be approved for. While adjustable rate mortgages account for about 27% of applications, they are heavily skewed to more expensive houses. They account for 39.9% of the dollar volume.

Home Depot and Lowe's have benefited from the housing craze. Both home improvement retailers beat analysts' estimates and guided forecasts higher for the current quarter. The primary driver for both companies was higher than anticipated same store sales. Home Depot's same store sales increased 7.1% in the third quarter. This was the fastest pace in four years. The company also experienced a 130 basis point decline in SG&A expense. These factors helped push earnings up 25% to $0.50 per share, a nickel above analysts' estimates. Higher sales were driven by a 9.4% increase in the number of customer transactions along with a 4.9% increase in the average ticket.

Lowe's also beat analysts' estimates due to strong comparable sales. Lowe's earned $0.56 per share during the third quarter. This was three cents better than Wall Street predicted and 30% ahead of last year's results. Comparable sales soared 12.4%, which management called the "strongest comparable store sales growth in Lowe's modern history". Wall Street was focused around 7%-8% comps. Strong comp sales combined with new stores led to total sales increasing 23.5%. The strength was strong geographically. All 18 geographic regions posted positive same store sales and 14 showing double digit comps. Additionally, all 18 product lines experienced an increase in comps with 11 having double digit growth. Gross margin increased 46 basis points. Its average ticket increased 7% and customer traffic increased 16%.

After Kohl's reported first quarter earnings back in May, I discussed how the retailer was losing its luster as the high growth retailer, Kohl's Turns Cold. Additionally, Kohl's had way too much inventory on hand. Over the past two quarter Kohl's has worked to reduce its bulging inventory. During the second quarter, gross margins declined 250 basis points from the year ago period as the retailer marked merchandise down in order to move it out the door. This helped slow down the inventory build to 18% from 27% in the first quarter. This was still higher than the 14.9% increase in total sales, but inline with square-footage growth. At this time management said that it planned to have year-end inventory growth in the single digits. In order to accomplish this goal, Kohl's continued to lower prices in the third quarter. Gross margins dropped 80 basis points from the year ago level, but inventory rose 16.7%, which outpaced sales growth of 11.7%. One of the main contributors to the increase in inventory was the slowdown in same store sales. Management guided that it expected 3% comps in the third quarter, but same store sales actually declined by 1.3%. Kohl's is in a very difficult position. Not only are same store sales slowing, and actually dropping, but its customers are most likely getting accustomed to the sales and lower priced merchandise that Kohl's resorted to. In fact, management said that it expects gross margin to decline by 50 basis points during the fourth quarter. High growth is also able to mask operating problems, which become apparent once growth slows. There are countless companies that have failed to effectively manage the transition from high growth to sustainable growth.

One company that has effectively transitioned is Wal-Mart. While, Wal-Mart's third quarter results disappointed Wall Street, earnings and sales were both up double digits. In fact, its same store sales growth was 5.7% for the quarter, which was the highest level in five quarters. The company noted that warmer weather necessitated apparel mark downs during the quarter that hurt margins by 9 basis points. Unfortunately, bottom line results were below Wall Street's forecast along with fourth quarter guidance. These two factors caused investors to resulting in its stock dropping about 5%.

It is hard to reach the conclusion that the economy is weakening. There is starting to be some differentiation among retailers. One of the prime factors is how close the retailer is to the housing industry. Housing continues to be the pillar of strength and offers a safe haven to companies that can take advantage of this strength. Ironically, whenever there is a whiff of disappointing economic data, there is a flight to bonds. This pushes interest rates lower, which in turn blows more air into the housing bubble. Picking the top of the housing market has been a foolish endeavor, but it is certainly getting frothy. The median home in Los Angles County rose 22% to $322,000 in October from last October. This is an increase of $60,000. This is over 40% more than the $42,189 median household income for Los Angles County, according to the 2000 Census. And that is tax-free.


Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis

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