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August 23, 2007

Wal-Mart Rolls Back More Than Prices
by Chad Hudson

Earlier this month, the ICSC reported that chain store sales advanced only 2.6% in July. This was the fourth consecutive month that same store sales increased by less than 3%. Furniture sales have been negative for over a year, and apparel sales have been volatile, but the 4.4% drop in July was the largest drop (excluding April 2006, which suffered from the Easter shift) since at least November 2004 (as far back as Bloomberg has data). The bifurcation between discount and luxury continued in July. Same store sales at discount stores increased only 2.3% and overall department stores increased 2.8%. Luxury department stores posted a 10.3% increase. In five of the seven months this year, luxury department sales have increased at a double-digit pace.

Last week, the government released its tally on retail sales. While the month-over-month change of 0.3% exceeded economists' estimates of 0.2%, the year-over-year increased only 3.1%. This was the lowest year-over-year increase (excluding April) since August 2004. Lackluster auto sales negatively impacted sales. Excluding auto sales, retail sales increased a stronger 4.2%. While this was not as weak as the headline number, it was almost exactly the average monthly year-over-year change for the year, which is far short of the 7% and 8% year-over-year gains that were common during 2004, 2005 and the first part of 2006.

Retail sales have not shown any indication that results are on the upturn. Chain store sales have increased less than 3% during the past two weeks as reported by the ICSC. Additionally, the trade group forecasts that August same store sales will increase between 2.0 and 2.5%.

Wal-Mart was one of the first retailers to report second quarter earnings and foreshadowed the results for the rest of the sector. Same store sales increased 1.9% in the second quarter. Grocery, entertainment and pharmacy sales were the strongest and the company said it was disappointed with is merchandise sales. Wal-Mart has stated that it plans to be more aggressive on price in order to drive traffic. Gross margins showed the effects of this strategy. Gross margins were down 30 basis points from last year. Operating margin was further impacted by deleveraging of SG&A expense caused by the lackluster same store sales growth. EBIT margin dropped to 5.6%, 40 basis points lower than last year. This was the lowest EBIT margin for a second quarter in since 2004. Lower prices did help shrink Wal-Mart's heavier inventory levels. Inventories increased only 6.5% compared to total sales growth of 8.8%.

A few of the specialty retailers have been especially hard hit. Tween Brands reported second quarter earnings per share of $0.07. This was about half the $0.15 that analysts were expecting. It was another retailer that mentioned the shift in the school year and tax-free events in Texas and Florida as impacting results. This begs the question that if second quarter was impacted by this shift, why was full year guidance lowered by $0.30 - $0.35 per share when the second quarter miss was only eight cents? American Eagle Outfitters reported that net income increased 13% on a 17% increase in revenue. While second quarter results were slightly better than analysts expected, the teen apparel retailer issued third quarter guidance that was below analysts' estimates. Abercrombie & Fitch also guided third quarter results lower than current estimates.

Home Depot and Lowe's have been impacted by the weak housing market and the second quarter was not any different. Home Deport reported that total sales dropped 1.8% driven by a drop of 5.2% in same store sales, which was better than analysts were expecting. Weakness was mostly attributed to a drop in the average transaction. The average ticket dropped 2.8% while the total number of transactions increased 1.1%. Results at Lowe's were better, but remained depressed. Lowe's reported that second quarter earnings jumped 9% to $0.67 per share. This exceeded analysts' estimates of $0.60 per share. Sales increased 5.8%, but same store sales dropped 2.6%. Analysts were expecting same store sales to drop by 3%.

The housing market shows very little signs of stabilizing. Last week, the National Association of Home Builders reported that its index measuring optimism dropped two points to 22, which was the sixth consecutive decline and a sixteen-year low. While all three components fell the index that measures buyer traffic dropped three points to 16, which was the lowest level ever record since the index started in 1985.

Homebuilders face several headwinds. Not only has the supply of homes on the market soared, but the number of foreclosures has surged as well. According to RealtyTrac Inc. the number of foreclosure notices sent in July jumped to almost 180,000, 93% higher than last year. Foreclosures in California almost tripled to 39,013. Florida experienced a drop of 9% from June, but the 19,179 foreclosures were 78% higher than last July. In Nevada, there was one foreclosure for every 199 homes, which was the highest ratio in the country. The drop in the domestic auto industry has had an impact on the Detroit housing market. The number of foreclosures in Detroit jumped 70% in July. Not from last year, but from June. Additionally, one out of every 97 homes in Detroit is in foreclosure.

The weak housing market has started to impact consumer behavior. A recent survey by CNW Research found that 13.6% of the potential car buyers have canceled their purchase plans. Last year, only 10.1% were canceling their plans. Of the 13.6% that have canceled their purchases, 17.6% cited home-related issues, which were split up between lower home equity (11%) and higher monthly payment (6%). The recent ABC news survey dropped nine points to -20. This was the largest dropped since at least 1991. Views on personal finances dropped ten points to 6, lowest since October 2004. Consumers continue to want to spend. The buying climate component dropped eight points to -30. This component held up better than the other two components of the comfort index. It is still higher than it was just two months ago.

There is growing evidence that the problem in the mortgage market has started to spread. The biggest concern is if the flow of credit to consumers gets restricted. The back-to-school shopping season has not gone very well and retailers are now starting to get ready for the holiday season. There is much greater risk now that the coming holiday season will not be as robust as predicted just a month ago. Over the past several years, the aggressive expansion of retailers has paid off as consumers enjoyed ever increasing prosperity. Wage growth has been strong for several years and up until a year ago soaring housing prices allowed consumers easy access to cheap credit in the form of home equity loans or cash-out refinancing. Obviously the housing market has undergone a dramatic change over the past year and it remains to be seen what the impact will be on the labor market. It is very possible that the labor market benefited significantly from the housing market and is now starting to feel the impact. According to placement firm Challenger, Gray & Christmas 40,000 workers have lost jobs at mortgage lending firms and another 20,000 jobs have been lost at construction companies.

Chad Hudson
Mid-Week Analysis
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