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July 21, 2005

Will Earnings Finally Disappoint?
by Chad Hudson

Last week, we discussed June same store sales results from the retailers. On Thursday last week, the Commerce Department released its retail sales report. Retail sales jumped 9.6% from last year. Sales at general merchandise stores increased 9.8% from a year ago, the strongest growth since February 2004 when the comparison was against the beginning of the Iraq war. June also marked the largest gain in auto sales since October 2001, when the domestic automakers kicked-off the zero-percent interest financing promotion. Clothing stores also had the best month since April 2004.

Late last week, the Federal Reserve reported that industrial production jumped 0.9% in June, the largest month-over-month increase since February 2004. Production increased 3.9% on a year-over-year basis. Capacity utilization increased 0.6% to 80.0%, the highest since December 2000. Confirming that the industrial sector has rebounded, AMB Property Corp., an owner and operator of industrial real estate, reported that second quarter earnings jumped 90% from a year ago and surpassing analysts' estimates by over 50%. During the conference call the company commented that it estimates that there was 60 million square feet of net absorption during the second quarter. This would be "robust by any standard and levels not seen since the boom year of 2000." They are still experiencing negative rents as contracts that were signed during the boom roll off. The largest contributor to lower rents is San Francisco. The company did note that it saw some weakness in May, but is unclear if it amounts to a turnaround, but was worth noting.

American Standard and Eaton also commented that commercial construction has picked up. American Standard reported that residential and commercial air conditioning sales increased 5%. Eaton's electrical business was up 12.5% and power business up 13%, which led the company to say, "non-residential construction spending in North America is starting to pick up." Eaton also said that the heavy duty truck market was strong. Its comparable sales were up 36% and it estimates that the market grew 23%.

The financial companies have posted lackluster second quarter results. For the first time in three years, Citigroup missed analysts' estimates. The flattening yield curve caused "one of the worse" market environments for fixed income trading. Fixed-income trading revenue dropped 28%. Additionally, there was a rush of bankruptcy filing before the new bankruptcy legislation becomes effective. This added about $175 million to its credit costs for its credit cards.

The gradual improvement in the labor market has benefited the employment agencies. However, Manpower seemed more guarded than in the past few quarters. Its US businesses was down 2.1%, mostly due to a divestiture, but even accounting for that, revenue would have been flat. Light industrial has been the weaker area and the company said it was more of a pause as its customers are waiting to get product through the channel before ramping up again.

Trucking companies have benefited from strong economic growth. JB Hunt reported second quarter earnings that were 20% better than last year, but missed analysts' forecasts. Revenue increased 12% helped by a 6.9% increase in rates. The biggest challenge to the industry continued to be finding drivers. During the earnings conference call the company commented on the current environment; "While the general freight economy slowed in the second quarter from its robust pace of 2004, there appears to be no indication that freight demand is headed into a significant downturn. In fact, demand picked up toward the end of the quarter."

The two most notable earnings disappointments so far have been Intel and Yahoo. Both actually met analysts' estimates as well. Investors were concerned that Intel's gross margins dropped to 56.4%. Plus, investors have learned from parsing Greenspan's comments and didn't like the change in guidance for full year margins from "59%, plus or minus a few points" to "59%, plus or minus a couple points." Since investors were expecting an increase in gross margin, this singled that margin expansion might me lower than anticipated. Additionally, Even though most in the industry are not forecasting rapid growth for 2006, Intel still plans to add capacity. This could also crimp margins as well as the company might not be able to run its plants at full capacity. Nevertheless, Wall Street raised earnings estimates for the rest of the year and for 2006.

Yahoo! met earnings estimates, but investors focused on lower than expected revenue and a reduction of third quarter guidance. Earnings per share were $0.13, up 62.5% from last year, but the internet company lowered third quarter earnings and revenue guidance. Most of the reduction in guidance is due to a $20 million negative impact from the dollar strengthening. The company did raise the midpoint for its full year guidance for both revenue and EBITDA. Wall Street was more skeptical as most analysts lowered full year estimates for revenue and earnings.

Ford reported that second quarter earnings were down over 20% from a year ago, but beat analysts' forecasts by more than 40%. Ford was more of a bank than an automaker. Selling cars in North America resulted in a $764 million loss, while financing those purchases earned the company $740 million. International automotive operations earned $347 million.

While Ford was able to earn a profit during the second quarter, General Motors lost $286 million, or $0.51 per share. Analysts expected the carmaker to post a profit of three cents per share. Sales jumped 8.5% in the second quarter. June accounted for all the increase when buyers were able to buy vehicles at the same price as employees. GM's automotive operations lost $948 million and its financing operations earned $816 million. Adding injury to insult, CSM Worldwide lowered its forecasts for second half sales of GM's full-size SUVs. The consulting group now forecasts that sales of GM's full-size SUVs will drop 30% from last year compared to it previous forecast of an 18% drop. Since its SUVs are more profitable, this will hamper any efforts to turn around the automotive operations.

As of last Friday, second quarter earnings were expected to increase 8.1% from last year. This is below the 8.8% growth expected at the beginning of the quarter. If earnings fail to grow by at least 8.8%, it would be the first time in eight quarters that earnings growth was less than expected. Of the 141 companies in the S&P 500, almost 70% have exceeded analysts' estimates. Only 15.6% have not achieved the level of earnings analysts had forecasted. Earnings growth was strong even among some of the companies that disappointed investors. The S&P 500 has advanced over 50% since early 2003 and the Russell 2000 has almost doubled (up 93%) since then. While the economy is obviously expanding, investors may have grown too complacent during this boom. Earnings growth has been extremely strong over the past two years as the economy rebounded from the recession. The rising tide was able to lift all boats and now that much more moderate growth is likely, companies will become more differentiated and will have a higher degree of earnings risk. As the economy continues to expand, interest rates will rise at some point adding a large degree of systemic risk to the markets.

Chad Hudson
Mid-Week Analysis
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