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September 22, 2005

Third Quarter Earnings Come Under Pressure
by Chad Hudson

The Federal Reserve hiked interest rates 25 basis points for the eleventh consecutive meeting. The Fed said that the "widespread devastation in the gulf region, and the associated dislocation of economic activity, and the boost to energy prices imply that spending, production and employment will be set back in the near term. It is the committee's view that they do not pose a more persistent threat." Besides adding the commentary on the effects of Hurricane Katrina, the statement from the Fed didn't change much from the previous meeting last month. Last month, the fed said inflation was "well contained." Now inflation is only "contained." The Fed did add that, "Higher energy and other costs have the potential to add inflation pressures."

Economists were surprised that the Fed left the policy paragraph unchanged, including saying that it will be "measured." Traders took that to mean that there is a slight chance for rate hike above 4.0%. It is unanimous that there is one more hike this year, either in November or December and there is about a 50% chance of another 25 basis point hike at the January 31, 2006 meeting.

American Eagle, the popular teen retailer, announced that it its earnings will be lower than previously articulated because of "lower-than-expected business trends." Same store sales were up 11% through September 19. This was below management's plan and analyst's forecasts. Analysts are worried about lower sales because the company came into the quarter with elevated inventory levels. This has led to higher markdowns, which when combined with the slower traffic results in lower earnings. This is exactly the scenario we discussed last month.

Swift Transportation, the nation's largest truckload carrier, said it will miss its third quarter earnings estimates. The company said that higher fuel costs along with weak shipping demand was the reason. Considering that Wal-Mart is Swift's largest customer, this news gives more evidence that Wal-Mart is experiencing a difficult market and the lower-income consumer is bearing the brunt of higher energy costs. However, the weakness in the transportation sector might be more widespread. Last week, Yellow Roadway said that its earnings would not meet analyst's estimates and Werner Enterprises said higher fuel prices will reduce its third quarter earning more than previously forecasted. Neither company commented on demand, which could be taken as a positive or negative, but it seems that when companies announce bad news, they usually like to soften it up by including some good news. So if volumes were strong, it is likely that they would have mentioned it.

Estee Lauder announced that fiscal first quarter sales will be lower than expected due to, "soft sales primarily in the Americas, where the Company has recently been impacted by weakness at certain retailers, the general consumer response to higher oil and gas prices, softness in the Southeast region due to the effects of Hurricane Katrina and lower than expected sales from promotional programs." This is one of the first indications that middle-class consumers have reduced spending. This could also be the first indication that department store sales have experienced slower sales. Avon Products also said that its results would be lower than previously forecasted.

Brunswick lowered its forecast for the full year because of "the combined effects of high fuel prices, lower consumer confidence and Hurricane Katrina." While the company said "retail demand for our marine products has remained robust," the company anticipates wholesale dealers will be more cautious during the off season and believes it is best to be proactive in managing the product pipeline and will cut production to ensure inventories are not bloated during the off season. This could be an interesting development. Over the past decade, the companies that have been the most aggressive have been rewarded. There could be wide-ranging ramifications if companies start becoming more cautious.

Lennar attempted to rally the bulls on Wednesday by announcing that it earned more than $2.00 per share during the quarter that ended August 31. The company is scheduled to release earnings next week, but the company said results were released early because of "market volatility." This volatility was an 8% drop, which was the largest drop in its stock prices since August 2002 on the prior day.

Cott Beverage, the largest manufacture of private label soft drinks, said results will be "substantially below" forecasts. The company attributed the shortfall to "continued carbonated soft drink volume softness in the U.S., product mix shift towards lower margin bottled water and escalating raw material costs," particularly for resin. On Monday, Eastman Chemical announced that it will boost resin prices by about 40%. The company said that customers that refuse to pay that surcharge will not get any more resin. "Soft drink volumes across the U.S. continue their erosion." Sales are off 3.1% this year.

This week, several companies warned that third quarter earnings would fall short of previous guidance. Higher energy prices and the impact from Hurricane Katrina were the primary reasons cited. Investors have been quick to react to the downward revisions. In fact, the "short retail, long energy" has become the most talked about trade among equity traders. With energy prices soaring and companies warning of earnings shortfalls, I was reminded of one observation discussed after reviewing first quarter earnings. Several companies mentioned that the cost of hedging had increased and the attractiveness of hedging when oil had already moved to $55 was not as enticing. If that proves accurate, several other industries will come under pressure. If Hurricane Rita maintains its current forecasted path and intensity, it could get much worse before there is any relief.

Chad Hudson
Mid-Week Analysis
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