Last week, investors became very cautious of retail stocks after the majority of retailers reported lackluster October results. These concerns were short-lived as retailers started reporting third quarter results. The Morgan Stanley Retail Index dropped 3% during the first three days of the month and has since rebounded 4% to within a few points of the all-time high hit late last month.
Wal-Mart reported that total sales were up 12%, driven mostly by new stores as same store sales growth was only 1.5%. Food sales were stronger and general merchandise comps were negative, following flat comps last quarter. Wal-Mart said the hurricanes only had a minor impact. Stores not impacted by the hurricanes last year saw same store sales increase 2.0%. Gross margins expanded by 52 basis points, but a 71 basis point increase in SG&A caused operating margins to contract. Higher utility and Wal-Mart's remodel program were cited for the higher expenses. Wal-Mart has already started lowering prices for the holiday shopping season. For the fourth quarter Wal-Mart said it expects to earn between $0.88 and $0.92 per share compared to $0.86 last year.
The increase in profits Wal-Mart expects was referenced by Target when asked how it felt about the competitive environment given the announcements from Wal-Mart regarding how aggressive it plans to be during the holiday season. "I think probably the best forward-looking statement I heard out of Wal-Mart this morning was that they intended to earn $0.88 to $0.92 in the fourth quarter, which is a very robust level of profitability. So clearly despite all of the rhetoric surrounding rollbacks, they do not intend to have some kind of fundamental profit delivery problem, and therefore neither will we." For the third quarter, Target's revenue increased 11.2% with same store sales faring much better than Wal-Mart's, increasing 4.6%. Most of the increase in same store sales came from an increase in average ticket as traffic increased only 1%. During its conference call, Target's management made a good point regarding the recent strength in the department store sector. It mentioned that that sector has undergone a lot of acquisitions and have benefited from stores closing and picking up the transfer business.
The biggest earnings disappointment among retailers was Home Depot. The leading home improvement retailer reported that third quarter earnings per share of $0.73. This was lower than the $0.75 Wall Street was expecting. Same store sales were weak, declining 5.1%. The trend worsened throughout the quarter. Comp sales were negative 1% in August and fell to -4.3% and -8.7% in September and October respectively. Part of the decline in comp sales was due to a 1% drop in the average ticket amount. The company said that it "saw softness in big ticket items particularly kitchens, soft flooring, and windows. This affected by our transactions and our average ticket. Average ticket was $58.33, down 1% year-over-year." Not only were third quarter results weak, but the company said that fourth quarter earnings would decline 12% to 16% and "comps will be mid-single digit negative." Commenting on the state of the housing market, Robert Nardelli, CEO of Home Depot, said, "it certainly came faster and deeper than we thought... I think that it will continue throughout all of '07. I know there are a lot of points of view out there, but I still think we have deeper to go than we've seen. If you think about just the loss of jobs in the home improvement market, I mean in the home construction business, it's at unprecedented levels."
D.R. Horton reported fourth quarter results this week that were significantly better than analysts were forecasting. Homebuilding revenue dropped 5%. Deliveries fell 7% and average selling price increased 3%. Homebuilding gross margin dropped 830 basis points to 18.2%. Net orders dropped 25%, the cancellation rate was 40% compared to 29% last quarter. The company noted that it started 46% fewer homes during the third quarter than a year ago and the total number of home under construction fell 27% from the previous quarter. While revenue and earnings were better than analysts expected, the company didn't say that the housing market has rebounded. During the conference call, the company commented that, " I would say we are in the early stages of a declining market. And as I said on the Q3 conference call, most of these down turns are longer and deeper than we envision at the beginning. Actually I'm waiting for CNBC to call the bottom of the market but they have not called it yet." Hopefully, there was a bit of humor thrown in there.
Investors now are betting that the bottom of the homebuilding cycle is within sight, with second quarter of 2007 being frequently cited. The cancellation rate has to get substantially better and Wall Street expects it to get better during the fourth quarter of 2006 and the first quarter of 2007. The rational behind this theory is that those are canceling now signed a contract before the housing market started to stumble and those that have signed a contract recently know the market is weak and decided to purchase anyway and therefore are less likely to cancel because of the weak housing market. This obviously assumes that gross orders stabilize. Given the bulging inventory of new and existing homes, this could prove optimistic.
Inflation pressures have faded with the recent drop in energy prices. On Tuesday, it was reported that producer prices fell 1.6% in October, much larger than the 0.5% economists forecasted. Even excluding food and energy, prices dropped 0.9% compared predictions of a 0.1% gain. Consumer prices also fell in October. Headline consumer prices fell 0.5% last month, with core CPI advancing 0.1%. Compared to last year, consumer prices were 1.3% higher and excluding food and energy prices increased 2.7% higher from last year. The ease in consumer prices has been almost entirely due to lower energy prices. It should be concerning that prices other than energy continue advance faster than what is considered the Fed's comfort zone.