4 big retailers fight the inflation economy
Inflation is changing consumer behavior and the rules of engagement for many big retailers. Here's what it means for Wal-Mart, Costco, Target and Tiffany.
By Jim Jubak
Inflation is reshaping the economy. And since this is an odd kind of now-you-see-it, now-you-don't inflation, the changes in the economy are far-reaching but subtle.
You can see the shape of the new inflation economy in the tales of four retailers, all of which have released sales numbers recently.
If you're wealthy, you probably aren't feeling the current bout of inflation at all -- and you certainly aren't changing your buying habits.
Tiffany (TIF, news, msgs) is doing just fine, thank you.
If you belong to the lower half of the economic pyramid, higher inflation mostly takes the form of higher energy prices -- even though those aren't a part of the official inflation core. Stretching that paycheck to the end of the month is a challenge in the best of times and, since these aren't the best of times, you're hunting even harder for bargains. When you can't find them, you're cutting back on what you buy, period. Wal-Mart Stores (WMT, news, msgs) feels your pain at its cash registers.
And the middle-middle to upper-middle class? We're showing the most interesting and far-reaching changes in purchasing behavior of all. Although the overall rate of inflation is modest, inflation in the big-ticket service expenses, such as tuition and health care, that eat up a huge chunk of middle-class income is soaring at near double-digit rates.
But even though we may be strapped for cash, the middle class doesn't easily give up its aspirations to luxury. In our buying, we're looking to goods that combine low price with quality design to feed our appetite for luxury. And thanks to falling prices for goods, the middle class is finding it possible to buy luxury at bargain prices at stores such as Target (TGT, news, msgs) and Costco Wholesale (COST, news, msgs) that have cracked the code.
No inflation and double-digit inflation
It's all a result of the very peculiar nature of current inflation.
On the one hand, there is no inflation.
For example, I recently went shopping for a 5,000 BTU window air conditioner for my son's room to replace his very noisy and very energy inefficient seven-year-old unit. A year ago we paid $229 for a similar air conditioner for my daughter's room, so my wife and I were pleasantly surprised to find a new Panasonic 5,000 BTU, the updated version of the model we bought last year, selling for $179 at our local appliance store.
That's a huge 22% drop in the air-conditioner inflation index in a year.
On the other hand, there's double-digit inflation.
Private-school tuition for my two kids will pop 9% and 11%, respectively, for the 2006-07 academic year. That's above the national average of a 7.5% increase in college tuition for 2005, according to the U.S. Bureau of Labor Statistics. But it's near the 9.5% increase in the national average in 2004 and the 8.4% increase in 2003.
Painful hikes in service costs
And tuition bills aren't the only thing going up at close to double-digit rates. In the first quarter of 2006, for example, health-care costs rose at an annualized rate of 8% to 10% (depending on whether you get your health care through an HMO or a individual physician), according to the Arlen Group, an employee-benefits consulting company.
What explains this now-you-see-it, now-you-don't inflation pattern?
The breakdown is pretty simple. If you're looking at the cost of a manufactured product, the price is likely to be steady or even falling. If you're looking at the cost of a service, the price is likely to be climbing and maybe even climbing fast.
According to the Consumer Price Index (CPI) for the three months that ended in April 2006, the annual inflation rate for personal-care products was -2%, for footwear -1.6%, and for new cars -0.3%. Meanwhile, the annual inflation rate for personal-care services was 4.1%, for tuition 5.4%, for hospital services 10.6%.
Stunned by gas prices
In short, any product facing the intense pressure of the global economy -- and the vast new manufacturing supply added to that global economy by China, India and other developing countries -- is likely to be showing very small price increases, despite the rise in the cost of raw materials such as oil, iron and copper. Any service that is domestically produced and that can't easily be outsourced to cheaper service providers overseas, such as hospital care, is rising in price -- often at a rate substantially above the official rate of inflation.
Energy is the huge exception to this pattern. The surge in gasoline prices in the first part of 2006 took the annualized inflation rate for the three months ending in April to 55%. That's a stunning number. It will come down as the gasoline-price spike of early 2006 yields to a more gradual increase in the price of gasoline. But as distorted as the number is by short-term volatility, it is a good indicator of the kind of pain that everybody who drives is feeling right now.
These inflation trends play out differently, however, depending on where you stand on the income pyramid. For lower-income consumers, the pain of higher energy prices trumps all else. The top income levels aren't yet seeing any reason to rein in their luxury buying. And the middle income levels, squeezed disproportionately by the huge inflation in services, are busy shifting costs.
Evidence at Wal-Mart
Higher energy prices have so much impact on lower-income consumers because these aren't exactly boom times for these folks to begin with. Real hourly wages for blue-collar manufacturing workers and non-managerial service workers were up, as of April 2006, 0.1% from April 2005. And, thanks to longer hours worked, weekly wages were up 0.4%, according to the Bureau of Labor Statistics. The cost of gasoline is up about 20% in that same period, according to the bureau.
That's some squeeze. And Wal-Mart felt it. On May 30, the company reported that same-store sales for May had climbed by just 2.3%, near the lower end of the 2% to 4% range that the company had projected. The company told investors and analysts: "As discussed in our first-quarter earnings call, we continue to see higher gasoline and utility prices impacting our customers. As a result, we have seen more pronounced paycheck cycles." In other words, thanks to higher gasoline prices, Wal-Mart's customers are running out of money before it's time for their next biweekly or monthly paycheck to arrive.
Even with falling prices for goods, these lower- to middle-income consumers can't make ends meet. They're already shopping at Wal-Mart because it offers the lowest prices they can find, so this group doesn't have a big opportunity to save a buck by changing its shopping habits. They simply shop less.
Who cares about price?
The high end of the market, the luxury end that Tiffany calls home, couldn't be more different. On May 31, Tiffany reported earnings of 30 cents a share for its quarter ended in April 2006. U.S. same-store sales actually fell by 1%, leading to disappointing 5.8% revenue growth for the quarter. But the company was able to increase its gross profit margin by almost 2 percentage points even as prices for its raw materials (gold, silver, and diamonds) pressed upward. Tiffany made up for those higher costs and then some by improving its product mix and raising prices. The rich, and those not-so-rich who look for a luxury fling at Tiffany, just aren't very price-sensitive.
And the middle and upper-middle classes? Their behavior is a volatile mix.
Unlike the rich and near-rich, these consumers feel the pain of energy inflation and the huge surge in inflation in education, health care and other services.
There isn't a whole lot that these consumers can do to avoid inflation in the services they consume -- services which represent a huge portion of the fixed costs of many middle-class and upper-middle-class families. But they can try to take advantage of falling prices for manufactured goods. Unlike the lower-income consumer who already shops the bargains at Wal-Mart, the lowest-cost store, most middle-class consumers can cut costs by bargain hunting. And that's what they seem to be doing, if the recent results from Target and Costco are an indication.
Middle-class consumers still chase luxury
On May 31, Costco reported huge numbers for the first quarter and for May. Same-store sales climbed 7% in the first quarter and increased by 10% in May. Those numbers were even better than the 5.1% same-store growth reported by Target for the first quarter and the 6% same-store growth analysts were projecting for May.
Why the big difference between results at Wal-Mart, on the one hand, and Costco and Target on the other? Because although middle- and upper-middle-class consumers want to save money, they're not yet willing to give up on their aspirations to luxury. At Target, these consumers feel they can find fashion, design, brand names and quality at prices that are lower than the specialty store or the anchor store at the mall -- even if the prices aren't the lowest. Costco, with its ever-changing mix of merchandise, almost always offers something for this quality-conscious consumer. (My upstairs neighbor, for example, makes regular Costco runs to buy lamb.)
For this cost-shifting middle- or upper-middle-class consumer, the price is right at Wal-Mart but the quality isn't. Wal-Mart knows this all too well. That's why the company has launched an effort to upgrade its store brands (taking a page from Target's book) and to renovate 1,800 stores to attract middle-income shoppers.
New tricks, new competition
I think this describes the battle for the middle- and upper-middle-class consumer that is still heating up. As inflation in services squeezes this consumer, the challenge to retailers will be to offer the right price point to attract this customer while also providing the kind of quality that this consumer demands. The signs of the battle are all around us.
Some companies will have to learn new tricks. Here in New York City, for example, Whole Foods Market (WFMI, news, msgs) faces new competition on quality and price from Trader Joe's. Whole Foods, which has built its growth on quality at any price, has suddenly started arguing in advertisements that its prices aren't as high as everyone thinks. (Good luck with that one.)
Other companies, such as Coach (COH, news, msgs) and Luxottica (LUX, news, msgs) will face the challenge of fine-tuning quality and price in a volatile economy.
And, of course, never count Wal-Mart out.
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