Is The Consumer Rolling Over?
During the past couple of weeks, there have been a significant amount of evidence released indicating the economy is much weaker than practically everyone thought. This week, the Federal Reserve decided not to lower interest rates, but said, "The softening in the growth of aggregate demand that emerged this spring has been prolonged in large measure by weakness in financial markets and heightened uncertainty related to problems in corporate reporting and governance." The Fed announcement came two weeks after the government revised GDP showing the economy actually contracted during the first three quarters of last year, and grew only 1.1% in the second quarter. Lastly, retailers have been saying that sales are slowing and are lowering forecast for the second half.
Last week, Best Buy announced that it would miss analysts' estimates for the quarter ending August 31. In its press release, Best Buy said, "Our June results were in line with our expectations, but comparable store sales softened significantly in July, finishing the month essentially flat." Best Buy said they were "identifying ways to pare expenses in the second half." As companies continue to focus on cost cutting, the recovery in business investment will get pushed back further. Additionally, the days of aggressive expansion are over. Companies will have to rely more on same store sales growth than on growth coming from new stores. With same store sales growth usually hovering around mid-single digits, the high valuations that retailers have enjoyed could be at risk. On the same day, Ultimate Electronics announced earnings would come in at five to seven cents a share, about half of the 13 cents analysts were forecasting. Ultimate also cited that sales slowed in the last two weeks of July. These two stores were benefiting from the "cocooning effect" that resulted from September 11, not to mention the historic amount of cash extracted out of residential real estate. While one data point does not make a trend, it sure appears that the landscape is changing.
Federated Department Stores indicated that sales were flat for its second quarter compared to last year as same store sales fell 2.6%. This was the sixth consecutive quarterly decline in same store sales. While Federated does expect to post an increase of one to three percent during the next two quarters, it is lower than the 3% to 3.5% increase it previously expected. A Dow Jones story said that department stores "have seen many of their customers flock to discounters during the economic slowdown," then notes that Wal-Mart's net income "surged 26%." While, we agree that this certainly had been happening, it appears consumers are starting to retrench. Earlier this week, Wal-Mart lowered its same store sales growth guidance for the third quarter. Instead of 4% to 6% same store sales growth, Wal-Mart now expects 3% to 5%. This is still better than most retailers and Wal-Mart pointed out that the comparisons to the year ago period are more difficult in September. We find that reasoning a little odd since Wal-Mart knew what the comparisons would be. I can understand why same store sales growth would be impacted, but not how more difficult comparisons would cause a change in expectations by the company.
JC Penney revealed that because of the market conditions last year, it would have to fund its pension fund with cash from operations. JC Penny estimates the additional expense will impact EPS by $0.25 this year and between $0.20 and $0.30 next year. JC Penney expects enough improvement in operations that the additional pension expense will not impact its financial targets. Even if that is true, this represents a significant portion of the $1.57 EPS analysts expect JC Penney to earn next year. In the past these payments were not made, which helped earnings to accelerate so rapidly throughout corporate America. Additionally, companies had increased their assumed rate of return on plan assets. This further reduced the amount companies had to fund their pension plans using funds from operations. Companies have started revising down their assumed rates of returns, a trend that is likely to continue. Several companies still have assumed rates of returns of 9% and 10%. With bond yields hovering around 40-year lows, equities will have to post some extremely impressive returns for pension portfolios to earn double digit returns again. In fact, Maria Bartiromo had Bill Gross and John Bogle on her new CNBC show, After Hours, about a month ago (yes, I admit to watching). During the interview the two concurred that 6% or 7% return assumption would be appropriate.
While talking about accounting issues, the conference call on MTR Gaming revealed that part of its earnings miss was due to changing its accounting. The most amazing instance was the change to expense cost of uniforms, before the company had capitalized them. This change occurred after their auditors questioned the practice. While not a huge amount, only $125,000 for the quarter, it shows what lengths companies used to inflate earnings. As companies continue to "come clean", earnings growth will undoubtedly slow. Slower growth usually leads to lower multiples. Lower multiples on lower earnings do not make a bull market.
There seems to be new evidence every weak which indicates that the commercial real estate market remains depressed and without any signs of a recovery. Last week, Nortel sold a building in Silicon Valley for $24 million. The building had been on the market for over a year with an asking price over $50 million. According to a San Jose Business Journal story, Nortel had invested over $23mm in the building between 1995 and 2000. Nortel insists it spent much less. The price per square foot worked out to be $65. To put in prospective, the most expensive commercial real estate deal last year in Silicon Valley was the VeriSign campus at $884 per square foot and the cheapest deal last year was $74 per square foot.
After being recession resistant, the consumer might be the next domino to fall. The wild card continues to be homeowners' willingness to extract equity out of their houses either through refinancing or home equity loans. This is magnified by the panic buying of Treasury and Agency debt whenever there appears to be any sign of economic or financial stress. Most of this buying is trading related as holders of mortgage backed securities (MBS) have to hedge their portfolios. When homeowners refinance the MBS are paid back faster than anticipated. This leaves the holders of MBS with more cash that will be reinvested at the lower prevailing rates. Investors in mortgage backs then in anticipation of pre-payments, buy Treasuries to hedge their re-investment risk. With mortgage backed securities making up a large percentage of the market, this can become an extremely vicious cycle.
Right now a lot of the retailers are hoping that the dip in July is not a start of a trend. Just as in other times of economic or financial stress, bonds have taken off, pushing interest rates to new lows. Before these low rates set off waves of refinancings and home equity loans. The current economic stress has pushed interest rates to new lows again. But, is there enough equity in homes left after all the previous refinancings and home equity loans? And will consumers continue to feel comfortable borrowing to finance their lifestyle? We will have to wait and see.