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September 27, 2007

Is Lowe's Forecasting a 2-year Drought?
by Chad Hudson

Lennar reported third quarter results this week. On a GAAP basis the homebuilder lost $3.25 per share, which included a $3.33 per share charge for asset impairments, which equates to $848 million. Revenue dropped 44% due to a 41% drop in deliveries coupled with a 6% drop in average price. New orders dropped 48% and the cancellation rate was 32%. Backlog dropped 60% in dollar value to $2.2 billion. Gross margins, excluding valuation adjustments, shrunk to 14.0% compared to 19.5% last year, but were up 50 basis points sequentially. The most notable comment from the conference call was that, "it is apparent there is a growing backlog of existing homes both from speculators and owner occupied that are not selling at yesterday's prices and they are now re-priced in order to sell." Stuart Miller, President and CEO of Lennar, also commented that:

In our last conference call, I noted the three things will have to happen before we see a stabilization and recovery in the market. They were number one, inventories on both new and existing homes will have to stabilize first and then be absorbed. Number two, the mortgage markets will need to settle and number three, consumer confidence is going to have to be restored so that purchasers once again believe in the ultimate value of their home....we have not only not seen evidence of any of these items resolving, but instead we have seen further deterioration throughout our third quarter.

Robert Stevenson, analyst for Morgan Stanley, questioned the persistent cancellation rate. He noted that a larger percentage of homes being sold are already completed and one wouldn't think that a person purchasing home that has the ability to close within days or weeks would cancel, some probably do because of not being able to get financing. But this would imply that the cancellation rate for the homes that are under construction is a lot higher. As these buyers walk away, it adds to the difficulty of getting inventory under control. One reason this might be happening, is the company also acknowledged that the amount the company requests as a deposit has dropped to help spur orders. This also lowers the opportunity cost for walking away. There is a chance that investors are trying to pick a bottom by buying houses under construction with the mindset if housing has rebounded I'll keep it, otherwise I'm not out much.

Existing home sales dropped to 5.5 million, slightly higher than forecasts, but 250,000 lower than in July and lowest since August 2002. Inventory continued to climb and given the lower sales volume, now accounts for ten months supply. The median and average prices were relatively flat, up 0.2% and down 0.3% respectively. But remember this is the median and average of all the homes that were sold. It does not measure the price of individual houses. This measure of home prices will generally lag other housing data since buyers that have the finances to purchase a $250,000 home will usually go ahead and purchase a $250,000 home, but that home could have been a $300,000 home last year. Geographic mix also plans a role. Sales in the West were off by almost 22% compared to last year, which would also bring the average price down. The house price index compiled by professors Robert Schiller and Karl Case dropped 3.9% in July compared to last July. This index uses the "repeat sales method" of measure home price so it is a much better representation of what housing prices are doing. Note this was just July data. Since the mortgage mess hit in August, there is little chance of this index getting any better any time soon.

Evidence continued to mount that consumers have started to curtail spending. Lowe's announced that this year's earnings would "at the low end or slightly below its prior guidance of $1.97 to 2.01." The company cited "drought conditions" as the reason for the short fall, but then proceeded to expect "mid-single digit growth in 2008." If we use the low end for 2007 of $1.97 and 5% growth for next year, earnings look to be only $2.07. This compared with consensus estimate of $2.26. CSFB noted that "they pointed to severe drought conditions as the reason for the near term shortfall. They significantly lowered their 2008 expectations which means that they either have a better weather forecaster than the rest of us or they are projecting that housing will not be recovering any time soon (we would go with the latter)."

On the same day, Target lowered its expectations for September same store sales. The retailer expects September same stores sales to increase 1.5%-2.5% compared to previous guidance of 4.0-6.0%. Traffic was weaker than the year-to-date trend, especially in Florida and the northeast. Target has been one of the better performing retailers and has consistently posted higher same store sales growth greater than what the ICSC reports for the industry as a whole. In fact, since 2006, Target's same store sales have been on average 179 basis points higher than the ICSC index. Its sales have lagged the industry in only three of the 20 past months. The trade group lowered its estimate of September same store sales to 2%. If Target's same store sales are now expected to be 2%, there is a good chance that overall sales will not be that strong.

After the Labor Department reported that jobs were actually lost in August, investors have been focused any indication of whether or not the labor market has really loosened or if July was an anomaly. Resource Connection, which provides staffing needs and specializes in finance and account professionals, reported that first quarter revenue and earnings missed Wall Street estimates. Furthermore the company said that second quarter revenue growth would be only 10% compared to its goal of 20% growth for the year.

The manufacturing sector has held up much better than the consumer side of the economy. Durable goods orders dropped 4.9% in August following the 6.1% surge in July. Excluding transportation orders were off only 1.8%. Non-defense capital good orders dropped 12.6%, but remain 5.4% higher than last year. Electrical equipment orders were the strongest compared to last year, up 11.2%, while primary metals was the weakest, down 1.5%.

Chad Hudson
Mid-Week Analysis
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