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Is Sears a Blue Light Special?

Retailers have been in the spotlight this week. Several large retailers reported earnings this week, but it was the announcement that K-Mart will purchase Sears that captured everyone's attention. Besides being ailing retailers, both companies share Ed Lampert as their largest shareholder. There has been speculation that Lampert would turn K-Mart into the next Berkshire Hathaway and use the excess cash to purchase other companies. Analysts are mixed on almost every aspect of the merger. By some, it is being viewed as a way to compete with Wal-Mart by becoming a larger force in retailing by allowing it to ask for more price concessions from suppliers. Others view it as a real estate transaction arguing that by putting together two bad retailers, you don't get one good one. The truth probably lies somewhere in between. Investors wasted no time assuming that any company associated with Lampert, K-Mart, or Sears would benefit. AutoNation and Autozone, both companies that Lampert is the largest shareholder, rose about 1.5%. Companies that supply Sears and K-Mart also jumped on the assumption that this would increase the market they sell into. Whirlpool jumped 4.5% and Martha Stewart rose 6.2%. It might not be that easy. If this was put together to rival Wal-Mart, it is likely that the company will demand price concessions from its suppliers. Whirlpool might find it more difficult to implement its price increase planed for the beginning of the year. For those looking at the real estate angle, the company planes to convert several of the existing K-Mart locations to Sears and plans on vacating several of its mall-based locations. Investors were quick to assume that these mall-based stores were worth more than previously thought and extrapolated that across other retailers that own real estate. Dillard's has long been valued based partly on its real estate holdings. It has jumped 23% since Vornado announced it bought a 4.3% position in Sears last week. If Sears anticipates moving out of malls, this will result in an increase of the supply of mall anchor space. This could diminish the attractiveness of Dillard's anchor space. In a recent research note, UBS reminds investors that recent real estate divestitures at May, Saks, and JC Penney have resulted in substantial charges as opposed to hidden upside and that it will take two to three years for May to unload 34 Lord & Taylor stores.

Retail sales in October came in stronger than expected. Sales increased 0.1% and 0.9% excluding autos. Economists were expecting 0.1% and 0.5% respectively. Additionally September sales were revised upward. Retail sales excluding auto sales were the strongest since May when they were up 0.9% as well. Year-over-year growth has rebounded over the past two months to 8.5%, and is on top of a 6.5% gain last year.

We have discussed the rise in raw material prices that manufacturers have been facing this year. These increases have been causing producer prices to increase dramatically. In October, producer prices jumped 1.7%. Not only was this 110 basis points higher than economists forecasted, it was the largest increase since January 1990. This pushed the year-over-year increase to 4.4% and is the second largest increase January 2001. While manufacturers have experienced price increases for inputs, they have not been able to pass along price increases. This appears to be starting to change. The consumer price index also rose more than economists forecasted in October. On a month-over-month basis CPI rose 0.6% and increased 3.2% from last year. Over the past five years there has been four other months when the monthly increase has been 0.6%, which was also the largest increase over the same period. Additionally, several companies have commented that they will be instituting price increases.

Industrial Production rose 0.7% in October from September; this was the largest increase in three months. On a year-over-year basis, industrial production is up 5.2%. Capacity utilization increased 50 basis points to 77.7%. This was the highest utilization since May 2001.

Lowe's reported that third quarter sales rose 16% helped by a 5.2% gain in same store sales. Earnings were $0.66 per share, beating estimates by one penny. The 5.2% increase in same store sales combined with the 12.2% growth during the third quarter of 2003, made this the best two-year performance since the first quarter 1995. Outdoor power equipment along with cabinets and countertops posted double-digit sales gains. Lowe's noted that appliance sales were improving with sales up high single-digits in October. Sales benefited from increasing traffic, up 10%, along with higher transactions, up 5.7%. During the conference call the company mentioned that steel and resin costs are the two main drivers for vendors to ask for price increases. The company expects fourth quarter same store sales to moderate from the third quarter and be up 4% to 5%. Additionally, the company guided fourth quarter earnings to be $0.58 to $0.60 per share, lower than the $0.60 analysts were forecasting.

Home Depot also beat analysts' expectations. Earnings per share rose 20% on a 13% increase in revenue. Same store sales advanced 4.5% on top of a 7.8% gain last year. Lumber, building materials, and hardware were strong nationally. Higher lumber prices contributed 90 basis points to same store sales growth. Average ticket increased 6.6%, while the number of transactions rose 3.5%. While sales were boosted by the hurricanes that hit Florida, the company said that because of higher expenses associated with freight, store damage and employee expense, there was no earnings benefit. During the conference call the company broke out monthly same store sales that showed a deceleration in October. Same store sales were 6% in August and September and declined to 2% in October. The company was quick to point out that it was against a difficult comparison last year and it was actually ahead of their plan. They also said that for the fourth quarter they are running ahead of how they exited the third quarter.

We have discussed that this economy, while showing strong growth, is not healthy. The strong growth is actually exacerbating the imbalances. A good example of this comes from ArvinMeritor. The vehicle parts manufacturer reported fourth quarter earnings this week that showed the dichotomy between light and commercial vehicle sales. Its light vehicle sales were up 3% during the quarter and operating income dove 67%. Commercial sales were up 46% with operating income up 50%. This is expected to continue. The company expects North American light vehicle sales to be flat next year, while commercial sales are predicted to increase 17%. Steel prices continue to plague manufacturers. ArvinMeritor spent $100 million more for steel than last year, of which it was able to recapture about 50%. Thus, earnings were negatively affected by about $50 million. The company is disappointed with the low level of recoveries from its light vehicle customers. Next year, the company anticipates that earnings will be impacted by $90 million.

Wal-Mart reported third quarter earnings that matched analysts' expectations and were up 16% from last year. Sales grew 9.7% with same store sales up only 1.7% from last year's strong 6.1% increase. Higher expenses caused operating income to grow slower than sales. This was only the second of the past ten quarters that this has happened. The company cited higher costs of labor, utilities, fuel, and accidents Rising healthcare costs are also a concern for the retailer. Food sales increased high single-digits on a same store sales basis with total sales up 20% in its Supercenters.

Over the past year, higher end retailers have generally performed better than the lower end. Another indication of this comes from Zale's latest conference call. The jeweler reported that its same store sales were down 0.9%. The Bailey, Banks & Biddle division, which is higher end, had mid single digit gains. Additionally, average transaction size at Zales and Gordon's declined 4.6% and 2.5% respectively. The average transaction at Bailey, Banks & Biddle increased 4.3% to $1,346, which is about three times higher than the average transaction at the other two stores. The results at Saks showed similar differences. Its Saks Fifth Avenue stores generated a 4.3% increase in same store sales, while the department store division saw same store sales slip 2.6%. Furthermore, spending by Saks Fifth Avenue's top tier clients is up over 20% year-to-date.

Personal consumption grew faster than overall GDP in 17 of the 23 quarters from September 1997 until March 2003. This was fueled by an ever diminishing savings rate along with rapid personal debt growth. Retailers reacted by aggressively expanding. Does the K-Mart / Sears merger mark the end of this expansion? Will other retailers start consolidating as growth opportunities diminish? Time will tell, but it seems improbable that the current trend can be sustained for another five years.

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