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Inflation Fears Slip

Inflation fears eased after the Labor Department reported that producer prices increased only 0.1% in July. Economists were expecting an increase of 0.4%. Additionally, the core rate actually fell 0.3% versus an expected increase of 0.2%. The year-over-year change will likely continue to trend down over the next few months as comparisons will be against the spike in energy prices that occurred following the hurricanes last year. The PPI rose 6.9% on a year-over-year basis last September. Taking a step back it should not be surprising that producer prices have started to moderate. At the end of 2005, producer prices had risen 14.5% over the previous three years. This was the largest increase since early 1991. The larger question is whether or not higher producer prices will seep into consumer prices.

Consumer prices rose more than producer prices in July, rising 0.4% from June and up 4.1% compared to last year. Similar to the past few months, much of the increase was due to an increase in owner's equivalent rent, which has increased 3.7% from last year. Not surprising, fuels and utilities continue to be another driving factor, up 10.2% year-over-year.

Last Friday, the Commerce Department reported that retail sales increased 1.4% in July and rose 1.0% excluding auto sales, which made July the strongest month since January. On a year-over-year basis, retail sales increased 3.9%. This was the weakest year-over-year growth since August 2004. The slow growth is mainly due to the weaker auto sales following last year's employee discount pricing. Auto sales fell 9.5% and excluding auto sales, retail sales were up a healthy 8.4%. Electronics stores were one of the best performing sectors, up 7.6%. Building materials rebounded after a weaker June, up 10.8%. It was interesting that restaurant sales were up 6.2%. There have been several restaurants that have reported weak results for the second quarter.

Last week, we discussed Federated Department Stores second quarter earnings and thought it might be a prelude for the rest of the group. Dillard's certainly followed suit. The department store reported that gross margins expanded by 112 basis points. Margins were helped by lower markdowns along with higher sales of private label merchandise. Dillard's could come under pressure as Federated begins to transition the May Department stores into its Macy's brand. Most of Dillard's stores will be in the same malls as a Macy's and have similar customers.

Abercrombie & Fitch reported that second quarter earnings rose 14% to $0.72 per share, beating analysts' estimates by a penny. Its same store sales were flat and gross margin improved by 90 basis points, but was offset by higher expenses that caused operating margins to fall 30 basis points. The teen retailer had been having troubles with inventory, but managed to get inventory back in line during the quarter. Inventory per square foot increased by 8% compared to a 39% increase last quarter. The ability of Abercrombie to clear out inventory without compromising gross margins provides evidence that consumer spending has some life left.

Kohl's second quarter earnings increased 30% and exceeded analysts' estimates. Most of the better than expected results was due to a 60 basis point increase in gross margins. Gross margins expanded to 37.6%, which was the company's best gross margin in at least 10 years and likely ever. Margins will likely continue to be high as inventory per store fell 2% in the second quarter. Additionally, same store sales increased 5.5%. The number of transactions per store increased 3.3%, and the average ticket rose 2.2%.

Pacific Sunwear was one retailer that was not able to capitalize on strong consumer spending. It reported earnings per share of $0.14%, which was 50% below year ago levels. Same store sales fell 5.5% and the company indicated that the first two weeks of August were also weak. Contrary to most other retailers, gross margin fell about 400 basis points. The weak same store sales caused SG&A to deleverage by 130 basis points resulting in operating margins to drop 600 basis points, the lowest since 2001. Additionally the company said third quarter earnings would be between $0.22 and $0.30 per share, significantly below the consensus estimate of $0.49 per share. This is what can happen to retailers when consumer spending slows and inventory levels start to bulge, although it is more pronounced in the specialty retailers since they are often held hostage to fashion trends.

Wal-Mart also posted lackluster second quarter results. Earnings increased 7.5%, excluding charges for exiting its German operations. This was the weakest earnings growth since the second quarter of 2003. Same store sales increased only 1.7%. Gross margin expanded by 10 basis points, but higher SG&A costs caused operating margin to decrease by 20 basis points to 6.0%. It is likely that costs will continue to pressure Wal-Mart's margins. Higher minimum wage laws have been passed and several communities are passing their own minimum wage laws for big box retailers such as Wal-Mart. During the conference call the company noted that, "customers tell us that they are most concerned about gas prices."

Home Depot reported second quarter earnings that increased 13% from last year due mostly to its acquisition of Hughes Supply. Same store sales fell 0.2% mostly due to a drop in traffic, the average ticket was up 4.2%. The company forecasts that the second half of the year will be "challenging" and its results will be on the "low-end" of its previous guidance. Gross margin declined 100 basis points to 32.2%, but costs didn't increase as rapidly and operating margin only declined by 50 basis points.

The weakening housing sector is likely a major factor in Home Depot's lackluster results and its not likely to reverse soon. According to the Commerce Department, housing starts dropped 4.6% in July from the previous month and dropped by 13% over the past year. The 1.795 million unit rate was the slowest pace of starts since November 2004 and the second slowest in the past three years. Building permits fell 6.5% and have dropped 21% since last year. This was also one of the few months when the number of permits was lower than the number of starts, signaling that future starts will likely be weak. The National Association of Realtors reported that existing home sales declined 7% to an annualized rate of 6.7 million homes in the second quarter. States that experienced the dramatic price increases over the past few years were among the states that had the weakest sales. California, Nevada, Arizona, and Florida all had sales 20% below last year's level. The NAHB index of homebuilder optimism dropped seven points to 32. It marks the lowest level since February 2001. All three components fell; present situation dropped seven points to 36, future sales fell six points to 40, traffic slumped six points to 21. All were to levels not seen since early 2001.


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