Hewlett-Packard derailed the technology train, at least for a couple of hours this morning. One year following the historic merger of HP and Compaq, it appears that HP is still having digestive problems. Whether or not its difficulties are due to integration issues, its clear that they involve more than simply weak demand. HP put part of the blame for its earnings shortfall on its aggressive pricing during the quarter, especially on desktop computers. Even Dell addressed HP's aggressive pricing during its conference call last week. It is interesting to note that Dell was able to increase revenues by 16% and unit shipments by 27%. I don't recall Dell resorting to aggressive pricing for its results. HP continued the pattern of multi-nationals with currency gains contributing to revenue growth. In HP's case it accounted for more than all of it. Favorable currency translation accounted for 7% of HP's revenue growth, outpacing the 5% growth that was reported.
Another market commentator dismissed concerns that earnings growth has been derived from currency gains and cost cutting. He claimed that nobody grossed up revenue growth to account for the strong dollar. He also praised companies for the insight to cut costs when needed and said that this shows that management is doing its job. While I agree with this, it avoids the real question earnings quality raises - will earnings growth be sustainable? Investor's desire earnings growth derived from increasing business rather than cost cutting since cost cutting cannot happen in perpetuity. Additionally, declines in discretionary spending often lead to diminished sales in the future. Two of the easiest cost reductions to implement are research & development and advertising. It should be obvious that sustained cuts in either of these can cause future sales to fall. If cost cutting is the predominate source for earnings growth, the sustainability has to be questioned. Referring back to Hewlett-Packard shows that not only did it miss earnings estimates; it benefited from a couple of cuts in discretionary items. Using HP's own pro-forma financial statements, earnings increased by 64%. HP benefited from a $106 million reduction in R&D along with a 470 basis point reduction in its tax rate. Had these factors been the same as they were in 2002, earnings growth would have dropped to 37.7%. It is interesting that HP was able to reduce R&D by such a large amount, over 10% from last year, since just a few days ago HP announced its 150 new digital products. I know several engineers and they always seem to work a lot of overtime prior to project deadlines.
Refinance applications continue to fall. The 15% drop marked the seventh consecutive decline. The index has not experienced seven weeks of lower activity since the end of the boom at the end of 2001. While the purchase index fell 5% on top of last week's 10% drop, it remains at elevated levels. Solidifying the data on the housing boom, the Commerce Department reported that housing starts rose to the highest level since December 1985. Several economists expect housing to surge if interest rates continue to climb as buyers rush to take advantage of the low rates. The popularity of adjustable rate mortgages and interest only loans shows that buyers will simply switch to a product that offers the lowest possible rate. The New York Times reported that Wells Fargo said its "applications for interest-only mortgages worth $200,000 or more jumped 28 percent in July and have increased 11 percent so far this month."
The growth in mortgage debt is worrisome as personal bankruptcies continue to rise. This week, the Administrative Office of the U.S. Courts reported that personal bankruptcies jumped 10% to 1.61 million fillings for the year ending June 30, 2003, a nine year high. Homeowners have had personal finance experts telling them to replace high interest rate debt with lower interest-bearing home loans or refinancing. While this is sound advice, this is usually only a Band-Aid solution. Spending habits have to change and consumers often find themselves back in a position of high credit card balances. Only now a large portion of their debt is secured by their house instead of unsecured.
Before our intern Ryan Bend goes back to finish off his MBA at Indiana University, we caught him long enough to offer a few comments on the home improvement retailers that reported this week. While we are sorry to see Ryan go, we understand that a greater purpose calls him. Yes education and learning are nice, but more importantly a man has few opportunities to relive his youth, and this is his last chance.
"This week it was a tale of two home improvement retailers, as we had Lowe's report earnings on Monday and Home Depot yesterday. While there were some common themes in both releases and conference calls, it is clear that Lowe's is executing better than its larger competitor. On Monday, Lowe's released great second quarter earnings, highlighted by same stores sales growth of 6.9%. The stock has responded, moving upward by 9% thus far this week. The story was a little different for rival Home Depot, as the larger retailer reported same store sales growth of 2.2% for its second fiscal quarter. In spite of the fact that analysts were expecting just 2% comparable store growth from Home Depot, Lowe's had set the bar with its excellent numbers on Monday. The market punished Home Depot on Tuesday, sending the stock down over 5%. It rebounded slightly today, gaining a per cent.
Lowe's second quarter earnings increased 28% and revenue rose 17% from the second quarter in 2002. Sales strength was broad based, with comparable growth in almost all categories and witnessed in all geographic locations. The company also cited weather improvement as a sales catalyst as nice weather in the second quarter meant more projects outside the home could be undertaken. Strong comparables came understandably from outdoor power tools, paint and nursery, making the weather story seem all the more plausible. Usually companies use weather as a reason why they did not meet earnings forecasts, finally a company that actually gives weather credit for helping it out.
An interesting demographic fact that Lowe's seems to be taking advantage of is that we presently have the largest homeowner rate in the history if the United States. This has been, of course, buoyed by record low interest rates that have recently been increasing of late, in unison with domestic treasury notes. Additionally, aging baby boomers seem to like these home improvement tasks. And while some investors view Lowe's and Home Depot as plays on record levels of housing starts, when building inevitably dies down and rates go up, there still should be plenty of baby boomers doing projects on their houses. The big question is, "Why they will be doing all these home improvements?". Is it because they enjoy the outdoors and like the idea of getting out of the office and building something with their own hands? Or is it because at age 50 they financed their $400,000 home with a 30 year mortgage and now whey can't get rid of the property?
The week went significantly less well for Home Depot. With over 1,600 stores, Home Depot continues to cannibalize its own business with expansion. Lowe's is more nimble, with roughly half as many locations (900). And hence Home Depot CEO Rob Nardelli, has a tougher job. Home Depot did show nice comparable store sales growth momentum, rising to 3% in July from 2.3% in June and 0.8% in March. And their initiative to move more salespeople to the floor through installing automated checkouts makes sense. However, inventory rose 20% from the quarter a year ago while sales growth was just 10%. This raises a red flag, in spite of Nardelli explaining that he wanted to keep more inventory around as sales increased.
What to do with the $5 billion of cash on the balance sheet is another question for Home Depot management. From the conference call, it appears the only thing management can think of to do is repurchase shares and increase the dividend. Not a bad idea, especially as finding places to put these home improvement stores will only get increasingly difficult. Not to mention what could happen if the baby boomers get fed up with rebuilding the deck or watering the flowers.
