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  In retail, we know why the caged bird sings

BENJ GALLANDER and BEN STADELMANN

Friday, June 8, 2007

For the past several years American consumers have carried on like superheroes. Y2K, the tech blowout, 911 and Katrina were villains that some thought would get the better of the free-spending populace, but each was vanquished in succession. However, that streak looks to be broken now, as a new pair of scoundrels — the housing slump and high gasoline prices — have the champion on the mat.

The key metric for retail chains is same-store sales, which zeroes in on stores that have been open a least a year and compares the total sales generated over the month against the performance in the same period a year ago. Bear in mind that, unlike many government statistics, this measure is not adjusted for inflation. So, with prices rising by about 2.5 percent due to inflation, a retailer reporting a same store sales increase of say, 1.5 percent, is actually losing ground.

For many of the majors, April's same-store sales numbers were horrible. Wal-Mart's decreased 3.5 percent, the largest drop since the world's number one retailer began reporting same-store sales results in 1979. For The Gap, America's biggest clothing vendor, sales plunged by 16 percent. Also off sharply were the two largest hardware chains — The Home Depot by 7.6 percent, Lowe's by 6.3 percent.

Many other leading players suffered double-digit losses, including Ann Taylor, Dillard's and American Eagle Outfitters. The International Council of Shopping Centers, which tracks 53 U.S. retail chains, said the average April decline was the worst since it started keeping records in 1970.

Analysts offered various explanations for the poor showing, from cold weather to the timing of the Easter weekend, and suggested that the numbers would bounce back sharply for May. That data was rolling in this week, and although the numbers are better than April's for the most part, they aren't exactly healthy.

Wal-Mart managed to increase sales by 1.1 percent, but, as mentioned, that's still a loss when accounting for inflation. The Gap was down again, by 3.0 percent. On the bright side, sales for higher-end retailer Nordstrom rose 6.3 percent, while Saks jumped by 37.5 percent. It appears that those who are benefiting from the current merger-and-acquisition boom have been busy spending some of their new-found wealth on baubles and trinkets. For those of more modest means, it's a different story.

The deterioration of the housing market is deepening as billions of dollars in mortgages are turned over from those low, low introductory rates to interest rates that more accurately incorporate the risk of a loan that approximates the full value of the underlying asset. Credit card delinquencies and personal bankruptcies are rising, even as unemployment levels hover at historic lows. With negative household savings rates for the past couple of years, consumers have little to fall back on to maintain their pattern of spending.

This is a big deal because retail sales are the proverbial canary in the coal mine for the U.S. economy. It was the resiliency of the consumer during past difficult periods that encouraged corporations to maintain their spending and hire workers. If the trend in retail sales continues down, we will surely see companies moving to a more cautious posture.

With the prices of many retailing stocks under pressure, people wonder if we, as contrarians, are buying them. No way. There is not a single retailing stock in the portfolio, and it will likely stay that way for quite some time. There are a couple areas of tepid interest — such as home furnishing, which has been hit harder and longer — but in our view this is the beginning of a cyclic change, and our aim is to buy beat-up stocks when the next up cycle is on the horizon.

More important to us, then, is what the consumer canary is saying about the state of the overall U.S. economy and, by extension, what that implies for Canadian industry. The Contra the Heard portfolio currently contains 15 names, the fewest in its history. That pretty much encapsulates our response to the feeble flapping of the poor yellow birdie.


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