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January 26, 2006

Earnings Cause Concern
by Chad Hudson

Existing home sales dropped to 6.6 million units. This was much weaker than the 6.87 million units economists were expecting and was the lowest selling rate since March 2004. Existing homes sales are recorded when contracts are closed and are typically signed a month or two earlier. This corresponds to the run up in mortgage rates that peaked in early November. New home sales are recorded when contracts are signed, which makes them more coincident. Last month, new home sales had the largest drop since January 1994. December new home sales will be announced on Friday. Typically, home sales have been quick to rebound once interest rates declined.

The homebuilders have reported earnings that have met expectations, but guidance for the first quarter has been weak. This week, Ryland Group reported that fourth quarter revenue jumped 23% to $1.53 billion. Closings increased 11% and the average price increased 13% to $286,000. The higher selling price pushed gross margins up to 26.3% compared to 22.5% last year. With the help of higher margins, earnings soared 53% to $3.32, beating estimates by about twenty cents. However, investors focused on the 5% drop in orders. And more importantly orders dropped 34% in the West and 13% in the North. Orders increased 27% in Texas and 4% in the Southeast. Margins in Texas are lower than the company average. Because of this, the company expects margins to decline 100 basis points in 2006. The company blamed to drop in orders on delays in opening subdivisions in Phoenix and Las Vegas. These communities have since opened and the company expects orders to rebound. Investors were also lukewarm to comments made by D.R. Horton. While the company also exceeded analysts earnings estimates, management said that the average sale price on new orders dropped in three of its five regions and expects the average selling price to decrease sequentially though 2006. Analysts were also concerned about the drop in operating margin at Beazer Homes. Its average price increased only 2% which was the lowest since early 2003. After several quarters of gangbuster results, success has finally caught up with them and it will prove difficult to maintain the stellar results of the past few years.

Eaton's conference call to discuss its quarterly results usually provides very good insight to the manufacturing sector. The industrial company thinks the early cycle businesses such as residential real estate are beginning to weaken and the later cycle businesses are strengthening, such as commercial construction and aerospace. Eaton has been calling for a slowdown in residential real estate about as long as anyone has, but is sticking with it and thinks it will be this year. Eaton anticipates that new vehicle sales will slow slightly to 16.6 million units in 2006. This would be the slowest pace of vehicle sales since 1998. Eaton's economic forecast expects "at least two, maybe three, maybe four interest rate increases." They "expect to see commodities stay relatively high. We do not buy into the scenario that says that commodities are backing off at this point, because we think demand is still pretty darn high....And we think that's why we're a little cautious about the interest rate environment and our own feeling is we're going to continue to see the Fed increases interest rates, and why we believe H2 [second half] will have substantially lower growth rates, GDP, than H1 [first half]."

Texas Instruments reported earnings that were a penny better than estimates, but revenue was slightly lower than consensus estimates. The company said that revenue missed estimates because of factory constraints and bottlenecks. Similar to several other technology companies it warned that revenue and earnings would likely be lower than current estimates. The company said revenue would be $3.11 billion to $3.38 billion, well below the $3.46 billion analysts were predicting. While this is lower than analysts are forecasting, it still represents 10% revenue growth, which is difficult to describe it as weak.

Transportation companies have reporting stellar results as the economy has rebounded. Burlington Northern reported that fourth quarter revenues increased 18%. The 18% gain was comprised of 3% unit growth, 6% price and 9% fuel surcharge. Much of the growth has been due to increased trade coming in through the West Coast ports. Burlington expects this trend to continue, it said that it expects "trade growth via the West Coast to be exponential to GDP growth." To help handle the growth the company will increase its capital spending by 10% to $2.4 billion and it increased its workforce by 5% last year. Union Pacific also reported earnings this week. It noted strength in lumber, steel and construction products. Its intermodal segment was up 5%.

Along with rail companies, trucking companies have also prospered during the past few years. CNF Inc. reported that fourth quarter revenue increased 12% and earnings jumped 30%. Investors were spooked by the 1.6% drop in yields as it might prove an indication that pricing is getting more competitive. The truckload carriers have fared better. Swift reported that revenue per mile excluding fuel charge increased 4.4%. It also said that activity has recently slowed. According to the company, the first week of January was good, but the last two were not as good as last year. The trucking industry largest challenge is finding and keeping drivers. Swift said its turnover was under 100%, but was definitely higher than 2004. It also said that "from an industry standpoint, if we are going to be able to do something about this driver shortage, it's going to have to come with increased wages."

Ford announced its restructuring plan this week. Over the next six years, Ford will close 14 manufacturing plants and reduce its workforce by 30,000 employees. This will reduce its capacity by 26%. These measures will help cut $6 billion in annual costs by 2010. The company will quit issuing any earnings guidance and said that they will be profitable by 2008. Healthcare costs increased to $3.5 billion, up from $3.1 billion last year. This translates to $1,100 per vehicle sold.

Steel Dynamics is looking for a more normalized environment this year. Average selling price in the fourth quarter was $596 a ton, up from $514 in the third quarter. Capital expenditures are expected to rise by 54% to $98 million in 2006. The steel industry uses a huge amount of natural gas. Steel Dynamics, like a lot of others were caught off guard by an increase last year. In order to stem further price escalations it started hedging the price on natural gas. Those hedges are now below the market price of natural gas. Speaking of its end markets, it said that any slack in the passenger vehicle market has been nicely replaced by a robust construction marketplace.

There have been several companies that have either missed analysts' earnings estimates or announced that its first quarter results would be lower than analysts were forecasting. While results at these companies were lower than expectations, it does not necessarily mean that results were weak. It is clear that the economy is slowing, but again slowing does not translate into weak. It appears that investors were over optimistic regarding earnings growth. If earnings continue to disappoint, stock prices will likely undergo a significant correction, especially if economic data continues to show strong economic growth, which will put pressure on interest rates.

Chad Hudson
Mid-Week Analysis
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