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Retailers Starting to Show Cracks

Retail stocks have held up amazingly well. However, they are starting to experience weakness as investors are starting to realize that the economic slowdown is not reversing as soon as expected. Plus, there is increasing coverage that the economy will slip into a classically defined recession if consumer spending falls any further. Generally, department stores and higher-end apparel retailers are facing the most difficult environment. Saks experienced an 8.5% decline in sales, with same store sales falling 4.4%. Sears sales for the second quarter fell 8.6%, and May Department Stores eked out a 1.6% gain, but same store sales decreased 3.1% in the second quarter. Discount stores such as Wal-Mart and Target are clearly leading the industry. Wal-Mart posted phenomenal same store sales growth of 5.7% for the quarter, with Target reporting a respectable 3% gain. Both retailers experienced accelerating sales as the quarter ended. Same store sales in July were 6.3% and 4.6% for Wal-Mart and Target respectively.

Gap and Abercromie are two apparel retailers that have come under pressure lately. Abercrombie has had a roller coaster ride over the past two weeks, after having a stellar year up to August. First, it reveals that same-store sales dropped 14% in July, sending the stock down 17%. Just a week later it announced second quarter earnings that beat estimates by a penny on sales growth of 22%, however same store sales fell 8% in the quarter. Abercrombie stated it might boost earnings 10% in the second half, and could do so on negative comps. Merrill Lynch is calling for sales to increase by 15%, with comp sales declining 3%. Gap also disappointed investors last Friday when it reported that income fell 50% from last year. Gap might prove to be an indicator to what might happen to the rest of the industry. Gap reported healthy total sales growth of 10%, however its same store sales were down 9%. While Wall Street generally came to the aid of Abercrombie, Prudential quote from its research following the quarter sums up Wall Streets current stance on Gap, "We hate to throw in the towel when a stock is already down, but we're not finding anything to hold on to here." We cannot help but wonder if Wall Street will not have the same views on other retailers after the fact as well.

These two retailers are the poster children of aggressive growth. Abercrombie and Gap have grown their store base by 38% and 21% respectively over the past year. Ambercrombe expects to add 138 stores this year, an increase of 34%. High-growth retailers always end up tripping over themselves as new cannibalize existing stores and stores are opened in less desirable locations. Eventually, retailers must grow based on its existing stores. When those sales are declining at a double-digit rate, it makes it challenging.

Retailers selling durable goods are also doing quite well, as they are benefiting from the refinancing boom. Lowe's is benefiting from consumers pouring money into their house. After all we all know by know that houses are perpetually increasing assets. Lowe's posted 16% growth in its second quarter, citing increase in appliance sales, millwork, and paint. For the quarter ended in May, Best Buy missed Wall Streets estimates. However, it appears to be benefiting from the refi boom as well. Digital products were its highest growth area, increasing by 68%. In its 10-K, Best Buy included an interesting statement regarding its acquisition of Musicland: "The Company acquired Musicland Stores Corporation (Musicland) in the fourth quarter of fiscal 2001 to continue its revenue growth beyond 2005, when the company expects to complete its Best Buy store expansion in the United States." When Best Buy has to count on its growth coming from existing stores, it will be very difficult to justify a 30 times multiple to earnings.

The immediate future for retailers does not look too rosy either. The Wall Street Journal published an article about how retailers have a dim outlook for the Christmas season. Orders for the key Christmas season are being reduced and delayed. Manufactures generally start shipping goods to retailers for the Christmas season starting now. However, those orders are instead being canceled. Hal Upbin, CEO of Kellwood, said the canceling and postponing of orders is "certainly been at higher levels than I've experienced anytime I can remember." Upbin has been in the industry for thirteen years. Federated Department Stores has made contingency plans in case same store sales to not meet its 1% - 2% decline for the second half of the year. Children's Place is ordering 25% less merchandise for its day after Thanksgiving promotion. Eddie Bauer anticipates entering the holiday season with about 8% lower inventory levels compared to last year. PricewaterhouseCoopers expects this Christmas season to be the weakest since the early 90's, when the economy was in recession. Retailers are definitely going to be an interesting sector to watch during the second half of the year.

Dow Jones Newswires carried a story yesterday that throws more doubt on the viability of the mobile Internet and 3G. The wireless industry pointed to Japan as the model on how the mobile Internet would prosper. However, Japan is not similar to the rest of the world in several pertinent areas. First of all, Internet penetration is very low and the mobile phones were their first introduction to email. Also, a large portion of Japanese use public transportation and have time to kill, thus the games and cartoons were a big hit.

Last week, Michael Dell, CEO of Dell Computer, indicated that it plans on continuing its battle for market share. Dell said "When we sell desktop and notebook computers, we make a profit. When our competitors sell them, they lose money." It looks like computer prices will continue to decline, and it is likely that someone will give up soon.

Hewlett-Packard threw its hat in the 2002 recovery arena. Commenting of its third-quarter performance, Hewlett's CEO, Carly Fiorina, said she does not "see any signs of improvement in the market before 2002. She also said "the economic downturn has spread to every geography."

Siebel's CEO, Tom Siebel, was less diplomatic in his forecast, "I don't think we have begun to see the carnage in information technology companies that are going to fail." Other tidbits include, "We got in kind of a bubble situation. The world went crazy in the last two years… Sanity is returning." Siebel is looking for "this turnaround around Q3 of next year."

Japanese banks are lobbying regulators to delay legislation which would require them to disclose the market value of their derivative products. According to Norma Securities said that the "unofficial" reason for seeking the delay is "the potential threat to earnings volatility from ineffective hedging." Japanese banks have already be granted a one-year reprieve. Banks were to start disclosing positions starting after March 2001, meaning next month's half-year results were supposed to be the first period of disclosure. In the low interest rate environment Japanese banks have had a difficult time accelerating earnings needed to dispose of bad debts. Compounding matters is the continued decline in Japanese equity markets, now hovering around 17-year lows.

Goldman strategist Abby Joseph Cohen lowered her earnings estimates and price targets for the S&P 500. Cohen joins a growing crowd in reducing the future outlook. Her new forecast calls for earnings this year to hit $51.50, down from $56.00, and $56.00 for 2002, down from $61.50. Cohen shaved 50 points off her S&P 500 price targets 1,500 for year-end and 1,550 twelve months out. This implies that the growth rate will be 10% next year. I guess this is the reason why Cohen increased the multiple to 28 times earning from 26 times. While I think these projections will prove to be too lofty, Cohen's analysis does not match the insanity of others such as James Glassman. In his book, Dow 36,000, Glassman argues since long-term returns of equities are better than returns on bonds, stocks are less risky and deserve the same, or lower discount rate as a long-term bond. I have long thought the academic community has done little to help the investment community, and in most cases have hindered it by moving the focus from security analysis to mathematical modeling, ala LTCM. At least academics have to have their idea subject to peer-review. Instead, Glassman peddled a book by preying on neophyte investors that were blinded by a raging bull market.

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