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Consumption Junction

Retailers started reporting second quarter earnings this week. From the limited sample that have already reported, the results appear favorable as margins have held up and inventory levels have improved. July retail sales from the Census Bureau also showed that consumers didn't disappoint economists. Consumption has not stopped with merchandise as retailing stocks have been bid up to 52-week highs. The best performing retail stocks this year consists of a wide variety; Best Buy (+104%), Sears (+81%), Dollar General (+60%), Tiffany (+56%). Most of the weaker retailers are confined to department stores; J.C. Penny (-22%) and Dillard's (-4%). As a group the S&P 500 Retailing Index up over 30% year-to-date, and up 42% off its low set in March.

The Census Bureau reported that retail sales grew 1.4% in July, which was the fastest pace since March 2003 and ahead of the 1.0% increase economists had predicted. Not only were July sales strong, but sales growth for May and June were revised up by 0.4% and 0.5% respectively. Year-over-year growth was even more impressive, jumping to 6.5% on a non-adjusted basis. This was the strongest month on a year-over-year basis since July last year. Retail sales excluding autos increased 0.8%, also ahead of expectations and rose 5.9% on a year-over-year basis. The strength was broad based as vehicles & parts, furniture, electronics stores, building materials, health stores, clothing stores, general merchandise, and eating & drinking retailers all showed year-over-year growth greater than 6%.

Sales at discount retailers continue to do very well. Wal-Mart grew revenues by 11% in the second quarter. Higher end retailers also captured consumers' dollars. Sales at AnnTaylor increased 13.7% in the second quarter, helped by a 5.3% increase in comparable store sales. While gross margins declined 90 basis points, cost cutting helped increase operating margin by 20 basis points. AnnTaylor also lowered inventory days of sales to 93 from 112 in the previous quarter.

Tiffany & Co. reported a 14% increase in U.S. sales. Tiffany's was another company that reported that the quarter got progressively better. U.S. same store sales increased only 3% in May, but jumped to 9% in June before rising 18% in July. For the quarter Tiffany's U.S. same store sales growth increased 9%. The luxury jeweler reported that growth was "geographically broad based." Additionally, it saw "significant sales growth in jewelry in the $10,000 to $50,000 range, as well as a continuation of healthy sales activity in jewelry transactions above $50,000." Internationally, sales increased 9% on a constant currency basis.

Federated was one of the lone retailers to report that second quarter sales declined from last year. The company blamed lean inventory levels for the 1.5% drop in sales, as it ran out of merchandise. We find that excuse interesting as inventory days of sales going into the quarter were not abnormally low and at the end of the quarter were actually a little higher.

There is little question that consumer spending has benefited from the hot housing market, either through refinancing, home equity loans, or capital gains. In a research report earlier this month, CSFB wrote that there has been $215 billion of equity liquefied just thought refinancing since the beginning of 2002. According to the latest GDP report, personal expenditures have increased $125 billion over the same time frame. While the two numbers are hard to compare due to economists trying to seasonalize GDP data, it clearly shows that consumers have had a gale force wind at there back.

This gale force wind is starting to die down. The MBA Refinance Index dropped 20% last week to the lowest level since July 2002. Equally concerning is that the percent of adjustable rate mortgages also rose 0.8% to 22.5%. Home buyers are not worried about getting ARMs now since they intend to sell the house before the mortgage starts adjusting. The problem with this is if too many homeowners are doing this and rates rise, it's likely that there will be an increasing number of homes coming on the market at the same time. Purchase applications fell 10.3%, which was the largest drop since early February. It remains premature to call for the demise of the mortgage boom, especially since bankers continue to report large volumes of home equity loans, but the wind is defiantly spilling out of the consumers' sail.

We have anticipated this recent surge in the economy, but we do not expect it to be sustainable or even healthy. A far majority of market participants think the bubble has popped based on NASDAQ falling over 75% at the low point in October. Unfortunately, substantial economic imbalances not only continue, but have been continually been further inflated since the decline in technology and telecom stocks. These imbalances are now fueling the consumer buying binge through record monetization of home equity. Homes have become the asset of choice and the rush of homebuyers has caused demand to outstrip supply. The laws of economics dictate that home prices rise. This home inflation allows others to extract the inflated equity out of their house to be used for consumption. While this buying binge might last for the rest of the year, the recent stress in the credit markets may indicate that time is running out.

There have been signs that corporate spending is perking up and economists are lining up to argue that this will carry the economy if personal spending falters. For the past couple of years, economists were hoping consumers would support the economy until business started to invest again. The fact the personal consumption accounts for almost 70% of the economy poses a significant problem with this scenario. Since business spending accounts for just 17% of GDP, there is close to zero chance of the economy growing if consumers cut back their spending.

I want to thank our summer intern, Ryan Bend, for his work this summer. I hope you have enjoyed reading the analysis he has provided for the Mid-Week Analysis. This week, he looked inside the earnings of Applied Materials.

Last night, semiconductor equipment manufacturer Applied Materials reported its fiscal third quarter earnings. Investors greeted the stock with enthusiasm today as AMAT rose over 3% while the NASDAQ was flat. Applied Materials did manage to beat Wall Street estimates (before charges) of 6 cents per share in recording a gain of 5 cents per share, yet the stock still appears rich by any sane valuation metric. AMAT's stock price has added almost 70% since the low in March, and now trades at about 7 times sales.

Sales declined 25% from the year ago period and gross margins excluding discontinued operations declined by 1.5%. Management guided that fourth quarter revenues will be flat sequentially. In the most recent quarter a high percentages of sales came from DRAM producers (47%). This reliance on DRAM producers in the future could be particularly challenging since DRAM is known for its wild cyclical gyrations. Another area of concern is the $230 million decrease in backlog orders from the second quarter. Finally, new orders have declined a remarkable 41% from the third quarter last year, yet the stock had risen 40% over this same period.

Applied Materials has substantially trimmed costs as sales have fallen. With research and development declining 23% and sales and marketing down 25%, does that really bode well for future sales? It is clear that the only way AMAT will be able to increase earnings in the near term will be to continue to trim expenses. Top line growth is just not there for the rest of 2003, and is very questionable for 2004. In the third quarter, AMAT recorded a $164 million pre-tax realignment charge for inventory write offs, workforce reduction and facility consolidation. Management also announced that there will be further charges of between $75 million and $100 million in the fourth quarter.

With AMAT shares hitting a one year high this past week, this stock seems priced to perfection. Backlog orders are down, revenues are falling, charges continue to pile up, and the only traction in the business is coming from cost cutting.

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