Consumer Bulls Take Lumps

Best Buy's troubling guidance raises questions about the Christmas retail season.
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Tuesday's disappointment from

Best Buy

(BBY) - Get Report

threw another log on Wall Street's burning concerns about consumer spending. They have already been stoked by soaring gas and energy prices, real estate speculation, rampant debt, rising interest rates and a slew of bad earnings forecasts from retailers for the rest of 2005.

Best Buy, long a Wall Street favorite for its best-in-breed operational prowess, posted a 25% jump in second-quarter earnings, along with a respectable 3.5% gain in same-store sales for the quarter. The gains mainly reflected ongoing strength in demand for flat-screen televisions and digital music players, but the results still fell short of forecasts as other categories, like DVD and video-game sales, appeared to stagnate.

The company's earnings guidance for the rest of the year also disappointed, adding to similar shortfalls from other retailing titans, like

Wal-Mart

(WMT) - Get Report

. Even before the strains put on gas prices by Hurricane Katrina, a growing chorus of analysts had concluded that the monster crude oil rally of the last two years was already starting to eat into consumers' budgets. Now, a full-blown slowdown that could threaten the economic recovery seems all the more plausible.

Best Buy posted earnings of $188 million, or 37 cents a share, in the quarter compared with $127 million, or 26 cents a share, a year ago. Analysts surveyed by Thomson First Call were forecasting earnings of 38 cents a share in the quarter on sales of $6.75 billion.

Looking ahead, the company expects third-quarter earnings of 28 cents to 32 cents a share on a same-store sales growth of 3% to 5%. The Wall Street consensus estimate for the third quarter is for earnings of 34 cents a share.

"This seems like confirmation that consumer spending over this holiday season is probably not going to be as great as people had hoped for," says Harris Nesbitt analyst Rick Weinhart. "If you thought you could do 4% to 5% sales growth on a comparable basis before these increases in gas prices, it's only reasonable to think you're going to do less than that."

Elsewhere, Banc of America Securities Chief Investment Strategist Thomas McManus reiterated his underweight rating on the consumer discretionary sector. He says inflationary forces are broadening throughout the economy, and "the combination of rising interest rates and high fuel costs

will begin to squeeze an increasing number of consumers from the bottom up," referring to low-income spenders as opposed to the affluent.

While gasoline costs eat up a larger chunk of the spending power for low-end consumers, McManus also notes that poorer people are more likely to be renters, which means they have missed out on the gains in the housing market that have powered middle- and upper-class spending.

"Indeed, renters are not much more confident as a group than they were at the market lows," McManus said in a research note. "Meanwhile, homeowners have enjoyed substantial improvement in their consumption attitudes and behavior, largely because of the wealth appreciation from their homes and financial investments since 2002."

While market bulls wait for the recent gains in the housing and financial markets to trickle down to the low end in the form of employment and wage growth, bears worry that the problems facing the low end will start creeping up to the middle and high end as inflation increases, interest rates go higher, housing prices decline and shoppers start saving their money. McManus noted that just such a phenomenon has taken place in the British economy.

"We believe that eventually in the U.S., as well, higher energy prices and interest rates will cause an increasing number of consumers to find their budgets strained and unable to stretch to manage big-ticket durable purchases," he said.

While some market watchers taking part in the post-hurricane rally were betting the

Federal Reserve

would take a pause after 10 months into its rate-tightening campaign, others have pointed out that inflationary pressures, only exacerbated by the disaster, are more likely to inspire rate hikes.

On Tuesday, the government reported that its producer price index, a gauge on wholesale prices, jumped 0.6% in August following a bigger 1% increase in July. Energy prices jumped 3.7% in August, led by a 9.5% rise in gasoline costs. The core rate of inflation, excluding energy and food costs, was flat for the month.

That data reflect conditions before Hurricane Katrina struck in early September. Since then, there are signs that higher energy prices are starting to ripple through the economy. On Monday, the No. 2 U.S. chemical maker,

DuPont

(DD) - Get Report

, said it is planning price increases for all its products due to the rising costs of energy and feedstocks. The company cited the impacts of Hurricane Katrina on commodity costs as a major factor in its decision.

"We are facing the unfortunate reality that the world has truly changed and energy prices are not receding, nor do we see signs of lower energy costs in the near future," said DuPont Chief Marketing and Sales Officer Diane H. Gulyas. "This supply shock has affected all of our operations and requires a comprehensive strategy that includes this price initiative coupled with our ongoing productivity improvements and energy conservation efforts."

Concerns about the effects of higher inflation and interest rates spread throughout the retail sector after Best Buy's report. Wal-Mart shed 75 cents, or 1.6%, to $45.14.

Target

(TGT) - Get Report

lost 93 cents, or 1.7%, to $54.49.

Sears Holdings

(SHLD)

dipped 85 cents, or 0.6%, to $130.28.

Home Depot

(HD) - Get Report

declined 57 cents, or 1.4%, to $40.76; and

Lowe's

(LOW) - Get Report

fell 73 cents or 1.1%, to $68.08.