Economy on a knife edge


September was a bad month for the big-box chains as analyst number crunching continues to paint a bleak picture.
Consumers, whose spending accounts for roughly 70 percent of the economy, are becoming wary of dipping into their pay packets which in turn triggers the countdown clock on the recession timebomb.
Office Depot’s share value has plunged dramatically recently after the company admitted its earnings were likely to drop year-on-year as small business customers cut back on their spending in response to the financial slowdown.
And Staples’ CEO Ron Sargent openly described the state of the US economy at a recent conference as "lousy".
Office Depot is also feeling the pressure. CFO Patricia McKay revealed to analysts: "Our small-business customers have changed their buying habits as a result of this environment, and traffic remains slower than normal in our retail stores."
And the prospects for margins appear grim. "If small-business spending in the US remains soft in the fourth quarter, it could be affected similarly as in the third quarter," McKay warned.
At the Goldman Sachs retailer conference in New York last month, McKay announced the market slowdown had caused the retailer to trim down its plans for new store openings, and it now expects to open 100 stores in 2007, down from an earlier 150. For 2008, it now expects to open 125 to 150 stores, down from an orginal scheduled 200.
And the gloomy message was repeated by Staples’ Sargent, who addressed the same conference with a warning that his company needed to improve its same-store sales, which fell two percent in the second quarter.
Same-store sales, or sales at stores open at least a year, is a key indicator of a retailer’s performance as it measures growth at existing stores rather than newly opened ones.
"We’ve got to get them up, it’s a little embarrassing to have negative comps for the first time in five and a half years," said a candid Sargent.
He partly blamed the slowdown on the weaker economy, but said he is seeing a greater decline in spending from consumers than small businesses.
"I think the lousy economy is affecting our retail business, but we’re not seeing anything of a kind of slowdown on the business side," he said.

Industry reaction
Staples insists that despite the gathering storm clouds, it will continue with ambitious new initiatives such as the M by Staples line of high-end office products, like leather portfolios, which will begin to roll out later this autumn with a bigger launch in 2008. It also plans to open 100 stores next year across North America.
The doom and gloom sent many industry commentators into a spin as forecasts were slashed and report warnings were thrown out like confetti.
In one research note, Goldman Sachs analyst Matthew Fassler wrote: "The macro backdrop is no doubt presenting some headwinds, though given ongoing industrial production and GDP growth, we are surprised by the magnitude of spillover to the office products retail segment."
He added: "Depot seems to be bearing more than its fair share of the fallout."
A report by Citigroup offered some crumbs of comfort for the Delray Beach-based company: "We don’t believe Office Depot is losing significant market share and don’t believe there are long-term structural flaws in the industry.
"While we don’t think an investment today will generate a significant return in the next three to six months, we do believe that Office Depot’s shares will meaningfully rebound over a longer-term horizon."
But will the economic malaise and uncertainty spread around the world and across the entire OP industry?


Global economy
Trying to understand the undercurrents in the economies around the world is desperately complicated. The most recent outlook released by the International Monetary Fund (IMF) in April forecasted global GDP growth in 2007 at just below five percent. This is slightly down from approximately 5.5 percent in 2006, but that was the fastest growth for over 30 years.
Between regions, there are some critical divergences under way. Europe has been enjoying an acceleration in economic activity, recording the strongest results since the beginning of this decade.
This resurgence has been led by Germany, which after several years of inconsistent performance has emerged more efficient, competitive and confident. Headed by the remarkable pace in China, growth in Asia remains strong.
But a big question mark currently hangs over the US economy, which has slowed down over the past year and is seen by many as the lightning conductor for the global economy.
The big unanswered question is whether spluttering US growth will trigger decline elsewhere, or whether other regions are big enough and internally vibrant enough to carry on growing reasonably well in the face of the US slowdown?
The so-called ‘credit crunch’, caused by a crisis in the US sub-prime mortgage market, has already been transmitted over the Atlantic and caused a mini-meltdown within the UK financial market.
But was the sight of long queues of people outside branches of Northern Rock, one of the UK’s leading mortgage lenders, anxious to withdraw their money an ominous sign of things to come?
Many commentators believe the global fallout will depend on how widely the slowdown extends within the US economy itself, and how long it lasts. To date, it has been largely confined to a reduction, albeit a pretty large one, in home construction, after a period of unusually strong activity in that crucial measure of a sector. A decline in US credit standards during 2006, as lenders sought to keep business growing in the face of the slowing demand for loans and a change in trend in house prices, has since resulted in a rise in loan arrears. In turn, this has resulted in a blowout in spreads on the low-rated tranches of the securities issued by some of the US lenders active in this market, and a number of loan companies in the sub-prime market went out of business.
This sequence of events has created an expectation that US lenders could withdraw from the housing sector, which in turn would deepen the downturn in construction. In addition, the current re-assessment of risk could lead to a tightening in credit across the US economy, subsequently dampening growth more generally.


Consumer confidence
Incidentally, Office Depot last month highlighted two states, Florida and California, which are both susceptible to housing market fluctuations, as regions that were suffering from a "significant slowdown in small-business spending".
The effect of softness within the US economy has now spread to consumer spending. In the US, the barometer of retail sales is the Conference Board Consumer Confidence Index. Despite a surge in July, this gain was wiped out in August.
Lynn Franco, director of The Conference Board Consumer Research Center, said: "A softening in business conditions and labour market conditions has curbed consumers’ confidence. In addition, the volatility in financial markets and continued sub-prime housing woes may have played a role in dampening consumers’ spirits.
"But, despite less favourable conditions and in spite of all the recent turmoil, consumers still remain confident. And current Index levels suggest further economic growth in the months ahead."
Consumer assessment of present-day conditions in August was less upbeat than in July. Those claiming conditions are "good" decreased to 26.4 percent from 28.3 percent, while those saying conditions are "bad" increased to 16.3 percent from 14.5 percent. Consumers were also less positive in their appraisal of the labour market. Those saying jobs are "hard to get" increased to 19.7 percent from 18.7 percent. Those claiming jobs are "plentiful" decreased to 27.5 percent from 30 percent in July.
Consumers, once again, turned cautious in their short-term outlook. Those expecting business conditions to worsen in the next six months rose to 10.6 percent from 8.2 percent, while those anticipating business conditions would improve was virtually unchanged at 15 percent.


Inflation under control
It is also noteworthy, and very important from a global perspective, that underlying US inflation appears to have drifted downward so far this year, having risen slightly through 2006. Low and stable inflation has been a key underpinning of US and global economic expansion for the past decade and a half.
Economic policymakers around the world remain on alert for threats to that stability. If the US authorities continue to turn inflation back down, then the foundations for future growth will have been strengthened. But US policymakers themselves would be the first to admit that the risk of higher inflation has not yet disappeared.
In Asia, Japan is revitalised and growing again, but the fortunes of the region continue to be driven by China. According to the latest available official figures, China’s GDP grew at about 11 percent over the last year. Just about every statistic and measure on the Chinese economy provides a positive picture. However, there remain several areas where the Chinese authorities have expressed concern. Concern surrounds the Chinese asset markets, especially the share market, which has increased by around 50 percent this year. Rises in prices for soft commodities are also finding their way into food prices, which is a pretty big share of the cost of living in China and a number of other like countries.
In response, China has tightened its fiscal policies, and taken taxation measures aimed at dampening speculative excesses in the share market. It would take something extraordinary and unprecedented to knock China off its current path to rapid growth.
In Australia, domestic economic data has signalled a pick-up in the pace of growth in demand and activity. Capacity utilisation is high after a lengthy period of expansion and unemployment continues to decline. Business and household confidence are strong. The demand for finance has strengthened, even apart from the temporary surge in June, particularly in the business sector. These conditions have been accompanied recently by higher-than-expected underlying inflation.
The Australian economy is on the cusp of the 17th year of the expansion which began in the second half of 1991. Currently, there is a high degree of confidence about the future, with share prices near record highs, property markets firming again and high-street borrowing proceeding at a healthy pace.
It is clear that a bigger US slowdown would still be a big deal, if it occurred, and keeping good global growth going would increasingly depend on policy responses in other parts of the world.
But provided the weakness in the US economy remains largely confined to its housing sector, the spill-over effects to the rest of the world through trade and financial channels are likely to remain small. There is some historical evidence in support of this, with other moderate US growth slowdowns in the past having had a relatively modest effect on world growth. This seems to be the most likely outcome as we look forward over the next year or two.


Positive signs
Despite the talk of a retail slowdown and recent jitters on the domestic and world markets, the UK office supplies industry is seeing a mini resurgence, according to leading business analysts Plimsoll.
"Our summary of the market finds 53 percent of companies in the sector in a surprisingly confident mood," says David Pattison, senior analyst at Plimsoll. "This has been fuelled largely by their latest results, but we have identified a group of 30 office product companies that are the driving force behind the resurgence, having increased their sales by 19 percent and lifted their profitability from 4.5 percent last year to 6.2 percent this year.
"We always knew that for many companies 2007 was a make-or-break year, but with all the talk of a slow down in the UK economy the figures from this elite group of companies are really refreshing. A lot of hard work during the past couple of years is finally starting to pay off." Also apparently flying in the face of economic scare stories is the fact that levels of investment are increasing for the first time in five years.
Pattison continues: "Bad publicity in the shape of job losses has led people to believe that the industry is in decline, but this is not the case. Total output from the sector continues to rise, while sales are up one percent. But for many, those sales increases are reaching two percent. Behind all this is increased productivity and capital investment. Successful companies have been chasing new levels of efficiency to compete on the UK stage."


Price wars
Not all the results are good, and the main cause for concern, according to Plimsoll, is the failure of 27 companies in its analysis to cope with these new levels of business performance. Worse still, Pattison warns, some of them will struggle to survive if, as expected, the wider economic picture results in a bumpy ride during the next six months for UK business in general.
But one leading analyst raises the spectre of a potential price war as the big-box retail chains launch ambitious marketing campaigns to stem their declining markets and maintain their customer accounts.
 "That scenario would obviously be the last thing any of them really need," he says. "But desperate times would call for desperate measures. Yet again, it would be the independent dealer that would feel the brunt of the fallout."
 There are certainly worrying times ahead and if the retail commentators are to be believed, it appears the economic future will get worse before it gets better. As ever, OPI will keep you updated on the shape of the future global OP market.