What Can A HOG Teach Us About Consumer Spending?

July 21, 2011
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The economic recovery is stalling…  Unemployment stats are no longer declining and actually ticked higher in June.  Consumer sentiment is dropping.  And retailers are resorting to aggressive discounting and promotions to move inventory off their shelves…

But don’t tell that to Harley-Davidson (HOG) – whose shares hit a new recovery high this week.  The company reported a surprisingly strong second quarter, beating expectations and increasing forecasts for the second half.  From Bloomberg:

Harley-Davidson Inc. (HOG), the biggest U.S. motorcycle maker, said profit rose after it boosted sales in its home market for the first time in almost five years. The company said it will ship more bikes than previously planned. Shares jumped the most in nine months.

Harley said it now expects to ship 228,000 to 235,000 motorcycles, an increase of 8 percent to 12 percent from last year. It had said in April that it planned to ship 215,000 to 228,000.

Harley Davidson isn’t the only well known consumer-discretionary retailer reporting strong performance.  Polaris Industries Inc. (PII) – the ATV and snowmobile maker also impressed investors with a positive earnings report.

For the second quarter, the company reported earnings of $1.37 – nearly double last year’s figure on revenue that was 41% higher.  The EPS figure beat expectations of $1.18 and management increased guidance for the full year.

So what’s going on with the US consumer?  Higher unemployment should lead to lower discretionary spending right?  So why are the high-end retailers making a killing and what’s up with premium retail stocks hitting new highs?

A Bi-Polar Consumer Environment

Question:

Is the US consumer experiencing a healthy, economic expansion – with the ability to increase spending and splurge on discretionary purchases?

OR

Is the US consumer struggling with employment, debt, and inflation; unable to keep up with day-to-day expenses?

The answer is YES! Both statements are true…

In today’s market, there is an increasing difference between the “have’s and the have-not’s.”  For individuals who are lucky (or prepared) enough to have stable employment in high-demand areas, the environment is just fine.  But for those who are struggling with unemployment (or underemployment), negative housing equity, and tapped out savings accounts, the picture is much different.

The most recent University of Michigan Consumer confidence report hit an index level of 63.8 – the lowest level seen since March of 2009.  For reference, any reading below 100 represents pessimism – or negative confidence.  This month, the “future expectations” component was particularly bad with an increasing number of workers expecting income to drop over the next several months.

This forward expectation reading is key because it is a major clue as to how consumers will be spending over the next several months.  Shoppers who are worried about their jobs are a much tougher sell than shoppers who are confident that their income will keep rolling in.

The headline number may actually be a bit deceiving.  The key is not necessarily in what the average spending is expecting – but in what the high-income consumer believe will happen.  Like it or not, these are the consumers that actually drive the commerce engine.

The Wall Street Journal had an interesting take on this difference today…

When massive job losses hit in early 2009, all income groups turned equally pessimistic about the economy, as shown by confidence indexes constructed from the Conference Board’s indexes divided by income groups, along with Census Bureau household income data.

Confidence among households earning less than $50,000 a year improved in 2009, but has stayed weak over the past two years, while consumers earning more than $50,000 have registered a large increase in confidence.

The article points out that there are three key distinguishing factors between healthy consumers likely to be spending robustly, and those that are hunkering down and spending only for necessities.  The three factors were income stability, positive home equity, and funded savings / retirement accounts…

  • Consumers with stable incomes are more willing to splurge on non-necessary big ticket items.  This sentiment could be especially strong for workers who are required to pick up the slack (productivity) for companies with reduced workforces.  A 60 or 70 hour work week leaves high-income earners feeling like they “deserve” to spend a extra on enjoyable purchases.
  • Positive home equity does wonders for sentiment.  One of the major issues holding consumers back is a negative equity position on real estate.  If you’re in a place where you owe more than your house is worth, and you have any reservations about your current job, that negative equity can be a spending albatross.  If you believe you might have to move to find a job in the next few years, any additional capital should be used to plug the equity gap.On the other hand, consumers with flat or positive home equity are one step ahead of their competing consumers.  While consumers are still less likely to pull equity out of their homes for discretionary spending, the fact that one has a positive asset in terms of home value can be a sentiment lifter and encourage more spending with discretionary cash flow.
  • Funded retirement account or emergency savings accounts leaves more bandwidth for spending. For consumers with little or no savings – who may have tapped out retirement accounts to pay for expenses, even an increase in earnings will not result in additional spending.  These consumers must make up for lost time, and replenish a non-existent capital buffer.But for consumers who have remained employed and were able to manage through the recession without tapping their savings, the picture is much different.  Additional income can be immediately spent – and this creates a widening gap between the two increasingly distinguishable consumer classes

Consumers with stable earnings, positive home equity, and retirement savings are supporting the businesses of high-end retailers.  Whether buying big ticket items, apparel and accessories, or even just eating out, well-off consumers are spending money at retailers that offer premium products and services.

You can see the effects of this spending by looking at some of the more “discretionary” retailers which continue to make new highs.

The lesson learned from these charts is to not be too quick to write off high-end retailers.  Although it is tempting to take short positions based on expanded earnings multiples and weakening consumer statistics, remember that these companies don’t serve the “average” consumer.  Instead, they cater primarily to the affluent – who currently live by a different set of spending rules.

On the other hand, use caution when trading retailers that are more sensitive to the lower-income consumer.  These retailers face more risk in terms of unemployment levels, rising debt crisis and an economic double dip.

Just as there is a widening gap between the consumers who are hopeful and enjoy a healthy income, there is a significant divergence between consumer stocks serving different segments of our risk-laden economy.


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