Connecting the Dots

By: Tony Sagami | Fri, Nov 18, 2005
Print Email

I love Thanksgiving. I really, really do.

It isn't the great food or the great college football rivalries that make Thanksgiving so great.

What I really love is the opportunity to be with your family and close friends. These special family traditions mean even more to me since my oldest child, Ryan, left to attend Texas A&M.

Thanks to Ryan, watching the Texas/Texas A&M game is now a Thanksgiving tradition for the Sagamis.

Another long-standing Thanksgiving tradition is for the women to abandon the couch potato men on Friday to hit the big post-Thanksgiving sales.

The retailers call the Friday after Thanksgiving, Black Friday. Despite the ominous name, Black Friday is a great day for retailers. Not only is it the biggest retail sales day of the year, it is also the crossover point where they go from being in the "red" to making money -- or being in the black -- for many retailers.

While the Wall Street crowd has vision of sugarplums dancing in their heads, I believe that Black Friday is going to be a big disappointment. I say that because a lot of retailers are sending out some very pessimistic signals.

Jive Turkey #1: Trading of American Express stock was temporarily halted on Wednesday when CEO Ken Chenault surprised Wall Street with a warning that its Q4 results would fall short of Wall Street's eager forecasts.

"I do appreciate the optimism that's been out there. But I can tell you that number is far too aggressive."

Far too aggressive? Gee, what a surprise -- overly optimistic analysts.

American Express blamed its problem on a surge in bankruptcies and expects to get hit for $200 million more in charge-offs than in Q3.

Chenault also said that the jump in bankruptcy filings "impacts the entire industry," which means that you can expect more of these warnings when we enter Q4 earnings season.

It would, however, be a mistake to blame all of American Express' problems on the change in bankruptcy laws. The problem is simply that Americans are spending and charging less.

"There are a number of analysts projecting fourth-quarter EPS growth from continuing operations of over 25%, well above our long-term target of 12% to 15%."

12% to 15% earnings growth is hardly gangbuster growth and evidence that Americans are simply not charging as much on their credit cards.

Whether consumers are feeling the strain of a mountain of debt, maybe their feeling the pinch from his energy prices, or simply cutting back on their spending, this warning from American Express is an important warning signs that you shouldn't ignore.

Jive Turkey #2: Teen retailer American Eagle Outfitters dropped its Q4 profit forecast from 76 cents to 73-75 cents.

That's bad enough, but two other details tell me that business is even worse than Wall Street expects.

==> Profit margins were 2% lower in Q3 of this year than Q3 of 2004.

==> Unsold inventory grew by 24% in the last 12 months. That's a whole bunch of markdowns waiting to happen.

Are American Eagle's problems a result of fickle teenage fashion taste or is it a manifestation of more serious consumer spending slowdown? Only time will tell, but the evidence is starting to pile up.

Jive Turkey #3: Jo-Ann Stores reported a Q3 loss and blamed the shortfall on "dramatically" declining consumer traffic.

In Q3 of 2004, Jo-Ann Stores made 30 cents a share of profits, but managed to lose 18 cents this year. Year-to-date same-store sales are up just 0.3%.

"Unfortunately, we did not anticipate the extent of the slowing demand and customer traffic, which has dramatically declined in the third quarter. We now face the challenge of liquidating excess inventory in a very difficult retail environment."

"The result has been and likely will continue to be deteriorating gross margins, as we are forced to take markdowns to sell through inventories."

Dramatically declined? Very difficult retail environment? Those are the words of a very worried retailer that doesn't expect business to rebound any time soon.

Jive Turkey #4: When I hear discounter retailers, like Ross Stores, complain about business, it tells me that something is very wrong.

Ross Stores cut its Q4 and fiscal 2006 guidance and warned the Jack-and-the-beanstalk crowd to tone down its expectations.

Ross Stores now expects to make 44-47 cents of Q4 profits, which is below the 45-48 it has previously forecast. For the year ending in February, Ross expects to earn $1.60 to $1.70, well below the $1.77 Wall Street is expecting

Jive Turkey #5: Ruth Chris Steakhouse reported a good third quarter but warned Wall Street to tame down its Q4 appetite.

Instead of hitting the Wall Street forecast of 25 cents of Q4 profits, Ruth Chris said it now expects to report 17 to 19 cents instead.

Company executives are blaming Hurricane Katrina for the shortfall, but I call baloney. Hurricane Katrina was definitely a problem in Q3, but I don't buy that excuse for the fourth quarter.

Plain and simple, business is slowing and the dog-ate-my-homework excuse doesn't fly with me.

Jive Turkey #6: Target is one of the hottest, most successful retailers in the U.S., but business isn't so good.

Target warned that its November sales are going to fall short of its 4-6% forecast and admitted that its Q4 results would fall short of expectations.

Instead of $1.07 cents of Q4 profits, Target now says it will make 90 cents instead.

We're not talking about a pint-sized retailer here. We're talking about one of the largest, most important retailers in the U.S. and an extremely important data point about the health of the retail business.

Jive Turkey #7: Perhaps the most important piece of the puzzle is the news from Wal-Mart that it is going to especially aggressive this holiday season.

Wal-Mart has started its holiday advertising campaign earlier than year than any year in its history.

Wal-Mart is promising aggressive price discounts, which means pitiful profits for everybody else. For example, Wal-Mart will be selling a Hewlett-Packard Pavilion ze2308wm notebook computer for $398, an HP Photosmart E317 digital camera for $98.88; a Lexmark all-in-one printer, scanner and copier for $39.88; and a 12-cup coffeemaker, food chopper or 2 quart slow cooker for just $4.24.

You watch. I believe that you're going to hear retailers report satisfactory top line sales, but very disappointing bottom line profits.

All those aggressive discounts will no doubt make my wife, mother-in-law, sister, and daughter very happy, but it won't do much for the bottom line of retailers or the investors that own them.

Retail stocks have enjoyed a mini-rally since bouncing off their October lows, but I believe it won't be long until they give up their gains, fall back to their October lows, and fall even lower.

You'll have to decide what's right for you, but I wouldn't touch a retail stock with a 10-foot pole. I especially think the mall-based retailers (The Gap, Abercrombie & Fitch, Limited Brands), department stores (Nordstrom's, Federated, J.C. Penney, Saks), and consumer electronics (Best Buy, Circuit City, Radio Shack) are the most vulnerable.

About the only company that I am confident will have a good Christmas is a company that may surprise you --- Microsoft.

In six more days, Microsoft is going to launch its next generation game console, the Xbox 360.

Microsoft already has 18 new video games lined up for release at the same time. Three of those 18 games --- Kameo: Elements of Power, Perfect Dark Zero and Project Gotham Racing 3 --- are produced by Microsoft itself, which means even more profits.

I believe the Xbox360 will be one of the big gangbuster sellers this holiday season and give Microsoft's stock a big boost.

Additionally, Microsoft has a "B" rating from Weiss Ratings, largely because of its rock-solid balance sheet that includes a $40 billion cash horde and forward P/E of only 18 times earnings.

In the interests of full disclosure, I should tell you that my Stock Market Dogs subscribers recently bought call options on Microsoft. While you could say that I am "talking my own book," I think I'm putting my money where my mouth is.

Microsoft is an unconventional way to play the holiday selling season, but that's how hard I think it is going to be to find a retail winner. If I'm right, the oldies radio station that I like so much won't be the only place you'll hear about a Blue Christmas.


 

Tony Sagami

Author: Tony Sagami

Tony Sagami
Harvest Advisors.

Tony Sagami

Tony Sagami is the owner and founder of Harvest Advisors, an investment research and money management company. Sagami has been managing money for more than 20 years and is one of the early pioneers in the application of technical and quantitative analysis to mutual funds and stocks.

Tony is a man that wears several hats. In addition to Harvest Advisors, he has launched several successful technology companies. Tony is the owner of Monocle Systems, a popular investment analytical software program that has been used by thousands of professional money managers and sophisticated individual investors. Tony is also co-owner of AdvisorSquare, one of the largest web design and hosting companies in the world.

Tony is a frequently quoted expert, appreciated for his frank and unconventional view. Tony has appeared in publications such as the Wall Street Jouranl, Barrons, Kiplingers, Smart Money, Business Week, New York Times, Washington Post, Investors Business Daily, Bloomberg, Financial Planning Times, Mutual Funds Magazine, Chicago Tribune, LA Times, and many others.

A graduate of the University of Washington, Tony enjoys coaching youth sports, serving his community as an active Rotarian, and exploring the all the beauty that Montana has to offer. Tony is a Paul Harris Fellow, an Eagle Scout, and married to his first-and-only wife and father of 4 wonderful kids.

Copyright © 2005 Harvest Advisors and Tony Sagami

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com