Industry Roundup: All indications point to a rough 2008

RT, NATIONWIDE REPORT —Hope springs eternal this time of year, which is a good thing for a retail industry that has an opportunity to exceed low expectations of sales growth if consumers can push aside waning confidence in the economy, depressing news about the housing market and the wide-ranging impact of high oil prices.

There are some encouraging signs in the form of low unemployment, low interest rates, consumers who experienced wage growth throughout 2007 and the fact that the busiest days of the holiday shopping season still lay ahead. Beyond that, the bar has also been set very low as retailers early this fall began lowering their expectations for third-quarter sales and profits. When actual results were released in November, it became apparent that the bar hadn’t been set low enough, as some of the biggest names in the industry saw weak sales growth, came up short on profit targets and sounded a cautionary tone for the holiday season.

Even with this scenario facing the industry, consumer research from the National Retail Federation conducted in early October suggests average household expenditures this holiday season would increase 3.7% to $923. Another forecast for a more narrowly defined holiday season released by the Conference Board calls for average household expenditures to increase 5% to $471 million. That is despite the fact that consumer confidence continued to sink throughout the second half of the year and hit a two-year low in November, as measured by the Conference Board’s monthly index based on a survey of 5,000 U.S. households.

“Consumers’ apprehension about the short-term outlook is being fueled by volatility in financial markets, rising prices at the pump and the likelihood of larger home heating bills this winter,” said Lynn Franco, director of the Conference Board’s consumer research center. “Despite this rather bleak outlook, consumers have not lost their holiday spirit and anticipate spending more on gifts this season than they did last Christmas.”

Most analysts who follow the retail industry have a more guarded view of the consumer and their willingness to spend—a view reflected in the share prices of most retailers, which are trading at or near their 52-week low, since it remains unclear whether the housing market has hit bottom. “The wretched U.S. housing downturn is getting worse, and if oil prices stay at current levels for long or keep rising, the [U.S. economy’s] fragile expansion could come to an untimely end,” according to economic consulting firm Global Insight.

The key issue is that consumers have seen value evaporate from their personal balance sheets as credit tightened, home prices declined and inventory levels rose. The nation now finds itself sitting on a supply of existing homes for sale that will take nearly 11 months to liquidate, based on the rate of sales that took place during October, according to the most recent data from the National Association of Realtors. The inventory of existing homes for sale has risen steadily since 2004 when the nation had a 4.3-month supply. In reality, the inventory of homes is higher than the Realtor group’s data indicates, because it excludes the homes for sale directly from builders in new developments.

That’s a key reason why expectations are so bleak for retail sales growth during the first half of 2008, and virtually every retailer who reported third-quarter results during November expressed concern about the challenging macroeconomic environment. This was especially true at The Home Depot and Lowe’s, where both companies reported a decline in third-quarter profits, weak same-store sales, lowered their fourth-quarter outlook and sounded a cautionary tone for 2008.

“Pressures on our industry are likely to continue well into 2008, but we remain committed to our goal of providing great products and unmatched customer service, and capitalizing on opportunities to ensure we gain profitable market share regardless of the level of industry growth,” said Lowe’s chairman and ceo Robert Niblock.

Even retailers with less direct exposure to the housing market experienced weak 3Q sales and pressure on profits. Target uncharacteristically missed analysts’ earnings estimates, while Wal-Mart managed to exceed estimates largely because it aggressively guided expectations down throughout the year and benefitted from pricing initiatives that aided margins.

Other companies, such as Dick’s Sporting Goods, also exceeded analysts’ profit targets, but did so largely as a result of tight expense control and sales of higher-margin goods, rather than top-line growth. Dick’s Sporting Goods posted a 2.5% decline in third-quarter same-store sales while Staples posted a 3% decline.

While much of the weakness in sales is attributable to the housing market, there is also the psychological factor weighing on consumers who perceive their homes are worth less. According to Richard Gaylord, a RE/MAX agent in Long Beach, Calif., who serves as president of the Realtors’ association, some of the data regarding home prices has been distorted. “Keep in mind that home prices are up in 93 of our 150 metro areas and there is a lot of confusion in the market from reports about national data,” Gaylord said. “Broadly speaking, home prices in most areas are up modestly or fairly stable.”

The problem is it doesn’t feel that way to consumers who are also feeling the pinch of rising fuel costs at the pump and in the form of food price inflation. The upshot for the retail industry is the uncertainty surrounding the housing market, and bleak forecasts from economic experts regarding 2008 growth could lead to a period of consolidation.

Leading retailers with profitable operations and strong balance sheets are paring back capital spending, budgeting tightly on expenses and making conservative assumptions about sales growth for 2008, enabling them to maintain financial flexibility. For operators who had difficulty achieving success even when consumer spending benefitted from surging home prices and easy access to credit, the exploration of strategic alternatives looms as a possibility if challenging market conditions linger well into 2008.