No Fun for Consumer Discretionary Outfits

Consumer discretionary companies knew they were in for a tough recession. As job losses mount, spending on the fun and frivolous is naturally the first to go. But recent corporate results show especially big drops in sales at outfits that cater to consumers' sense of whimsy.

Take Mattel (MAT), one of the world's largest toymakers, which reported earnings on July 17. Mattel's sales fell 12% in the U.S. and, ignoring the impact of currency movements, 16% overseas. The company managed to beat earnings expectations—with earnings per share of 6¢—by slashing costs. But the economy took its toll.

"Throughout the second quarter we saw the continuation of economic malaise on a global basis," Mattel Chairman and Chief Executive Robert Eckert said. "The magnitude of the sales declines surprised me," BMO Capital Markets analyst Gerrick Johnson said in an interview.

Harley's Production Cuts

Toys are an example of a purely discretionary product. If you don't mind nagging kids—a big if perhaps—toys are an easy place to cut purchases for cash-strapped families.

A motorcycle is another purchase that, almost always, doesn't count as a necessity. On July 16, Harley-Davidson (HOG) surprised investors by saying it would only ship 212,000 to 228,000 motorcycles this year. That adds to previous production cuts, and will result in Harley-Davidson shipping 25% to 30% fewer bikes than last year.

Harley is careful not to flood the market with its motorcycles, a key way it tries to protect the value of its well-known brand. "The further declines at retail have led to an intensified imbalance in our supply and demand in the last few months," Harley President and Chief Executive Keith Wandell told analysts.

Drop in Consumer Incomes

Some investors are hoping that a revived economy can spur more consumer spending. Don't count on it. The big problem is that Americans and many others around the world are bringing home less income to spend. That's not a trend that will end soon, warns Keith Hembre, chief economist at First American Funds.

Though the economy slowed in the first half of the year, American incomes got a substantial boost from federal spending and stimulus—increased Social Security payments, a lower tax rate, and expanded unemployment benefits. "The lift those programs had to personal income is pretty much behind us now," Hembre says. Meanwhile, unemployment is high, so companies won't need to raise—and can sometimes cut—employee pay.

Companies like IBM (IBM) have been able to report better-than-expected earnings largely by cutting costs, he notes. Most of those savings come right out of labor costs. These economic trends raise troubling questions about the holiday shopping season, very important for discretionary firms.

Sparse Retailer Inventories

Because there is no built-in, automatic demand for products like motorcycles and toys, sales trends can be very difficult to predict. A company like Mattel must plan manufacturing and marketing for the holidays well in advance. That means making big bets. Asked about this, Mattel's Eckert said: "That's the toy business. Every holiday we're taking a chance."

This year, many consumer discretionary companies are being more conservative and trying to take fewer chances. One reason for Mattel's weak sales numbers is that retailers, cautious about building up too much inventory, are keeping less product on their shelves, execs said. Expect that to continue into the holiday season, BMO's Johnson says. "Retailers would rather run out of product than have too much." For consumers, he adds, that means "things could sell out more quickly and probably won't be replenished."

One source of hope for the holiday season is the possibility of falling gas prices. Lower prices at the pump would at least give consumers a bit more cash to spend, Hembre says. But even if gas prices fall, there may be little to significantly spur consumer spending until companies stop cutting staff and start hiring and raising wages. And that's unlikely to happen before next year.

In the meantime, consumer discretionary outfits—whether they make 99¢ Hot Wheels or $17,000 Harleys—will be on an uncertain track.

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