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A Pending Consumer Slowdown

Second quarter earnings reports are flooding in. This gives us an opportunity to observe how the economy is doing through the eyes of companies at the micro level. Reading earnings reports from multiple and diverse companies gives better insight than economists can get by looking at aggregate data. Most of the attention is focused on technology and trying to find an upturn in business. While it is early into second quarter earnings season, it appears the real story surfacing, is the first hints of slowing consumer spending.

Makers of "big boy toys" seem to be an exception, which can be partly explained by the boom in refinancing and cash-outs. Last week the Mortgage Bankers Association refinance index jumped 4% to level not seen since the beginning of the year. No doubt some of the refinancing activity helped some consumers acquire their "toys." Harley-Davidson posted another record quarter, growing revenue by 16.1% and EPS by 25.4%. The move to more conservative accounting continues. Harley announced that it "adjusted its long-term expected return on pension assets from 10.5% to 8.5% as a result of projected market conditions." Harley also included a cash flow statement along with its earnings release. Hopefully, this is another trend that companies will follow. Polaris, manufacture of jet-skis, snowmobiles and ATVs, also posted record revenue. Second quarter sales increased 2.3%, with earnings jumping 15%.

One main topic we have been discussing for several months, if not longer, is the perilous state of non-residential real estate and the expected progression from commercial real estate to residential real estate. Everyone now knows that commercial real estate is flat on its back. Hotels are an unfolding problem, but Wall Street still wants to believe that the turnaround is just around the corner.

The past week I briefly discussed Starwood Hotels and an analyst's upgrade of the stock. Marriott reported earnings last week and announced flat earnings on a 5% increase in revenue. The principle driver for Marriott was its timeshare sales, which were up 21%. They, however, failed to add to profits due to higher marketing cost. Extended-stay revenues fell 8.4%, probably explained by lower business travel. Marriott reported that during the second-quarter average room rates dropped 6.6% and occupancy declined to 73.2%. This led to RevPAR dropping 8.0%. Marriott's full service brands experienced a larger drop in RevPAR (down 8.8%) than its select-service and extended-stay brands (down 6.7%). Going forward, Marriott lowered its guidance for third and fourth-quarter RevPAR. For the third quarter Marriott now forecasts RevPAR declining 4% to 6%, lower than the previous 2% to 4% decline.

Moreover, the recent data from Smith Travel revealed that last week's increase in RevPAR was not the beginning of a trend. Industry-wide RevPAR declined 7.8% last year, which was according to Jason Aler, analyst for Bear Sterns, "meaningfully softer than what we had expected." The upper-upscale segment continues to lag the other segments. Its RerPAR declined 13.1% last week, with several large markets posting larger declines.

Scrolling through the earnings headlines, I noticed BRE Properties, owner and operator of apartments. Apartments have started feeling the affects of the slowing real estate market and the results of BRE Properties reflected the weakness. Revenue was flat with last years results. The company also commented that "average market level rents in the same-store portfolio decreased 4%" and occupancy levels dropped one percent to 94% compared to last year. The company's largest exposure is in San Francisco, accounting for 28% of operating income. Not surprisingly, apartment rents in San Francisco continue to decline. During the second quarter the company experienced a 1% sequential drop. Apartment rents have dropped 21% in San Francisco since 2000.

Elsewhere, J.B. Hunt Transport Services reported second quarter revenues 7% ahead of last year. One line in the press release was interesting. According to the company, "load volumes appear to be in line with expectations suggesting that a significant number of loads were not shifted into the second quarter in anticipation of a possible work stoppage or slowdown by port workers on the West Coast." This is interesting since quite a few large retailers have publicly stated that they have stockpiled inventory in anticipation of a strike by dock workers.

Just two weeks ago Dow Jones Newswires carried a story in which Union Pacific said its pre-shipping of intermodal containers were up 12% in the second quarter. The company could not quantify how much of this increase was due to the possibility of a strike. The same article mentioned container shipments at the Ports of LA and Long Beach increased 16.5% in May over last year. The Port of Long Beach has yet to publish June data, but the Port of LA experienced a 26% jump in container shipments. A spokesman for the Port of Long Beach was quoted saying, "we will see a big drop-off in our numbers in July because so much inventory was shipped early this year." While, J.B. Hunt does not think its shipments were benefited by an inventory buildup in anticipation of a strike, there does seem to be quite a bit of evidence that extra shipments were made. If shipment were accelerated in anticipation of a strike, there should be a noticeable decline in the third quarter.

Maytag and Whirlpool both announced earnings this week and both beat estimates. But, both also said the second half would not be as strong as the first half of the year. While the just ended quarter benefited from "a favorable mix of higher margin Maytag laundry and Jenn-Air products," investors keyed in on the lower guidance going forward. Maytag noted that "the major appliance industry has been surprisingly strong in the first half of this year, but I think the industry growth rate will taper off in the months ahead."

Also in the housing sector, Mohawk Industries reported record second quarter earnings. However, warned that second half growth would likely be only 2% to 5%. This is far short of the mid-teen growth rate analysts were projecting.

Caterpillar might have been my most highlighted earnings report. A few bullet points from Cat's press release: Revenue fell by 3.6%, with profit falling by 26.2%. Looking forward, Caterpillar said, "While overall economic indicators have been positive, the anticipated recovery in capital spending has yet to materialize." Additionally, "Full-year 2002 sales and revenues to be down slightly from 2001. Full-year profit is expected to be about 15 percent lower than last year."

While the story unfolding centers on the consumer. There is not a lot of evidence that the technology sector is improving. Kulicke & Soffa, a semiconductor equipment maker, reported that its third quarter revenue was flat with last year's level, while its loss doubled to $18.1 million. C. Scott Kulicke, chairman and CEO, commented, "Our expectation for this cycle is that it will be characterized by relatively small quarter-to-quarter revenue gains. The natural consequence of this is that we need to continue to whittle down the company's expense base, both by continuing to shift manufacturing operations to China, and by further reducing headcount throughout all parts of the Company."

The market continues to react violently to negative surprises. Mohawk Industries fell 15% after lowering guidance for the rest of the year. Maytag and Whirlpool fell 17% and 10% respectively after guiding the rest of the year lower. These companies are still forecasting growth. At some point, reported results will be below year ago levels. The market is definitely signaling that consumer oriented companies are in for a tough market. It continues to appear that credit conditions will be a major issue. Today's announcement by Capital One and the degree that investors unloaded the stock is very ominous of the unfolding problems. Once companies are unable to sell receivables in the credit markets, and consumers are not able to get that extra Capital One credit card, there will be quite a few retailers and manufactures that will experience disappointing sales and sinking profits.

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