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July 19, 2007

Will Earnings Justify Market Rally?
by Chad Hudson

Consumer prices increased 0.2% in June, which was slightly higher than the 0.1% economists were expecting. Compared to last year, prices are 2.7% higher, which was equal to last month. Prices for food and beverage continue to accelerate, up 4.0% year-over-year, which was the fastest pace in at least ten-years. Fuel and utilities jumped from 3.4% year-over-year increase in May to 4.3% in June. While the overall housing component ticked up to 3.4% year-over-year, owner's equivalent rent has decelerated over the past five months, up 3.3% in June, down from 4.3% in January. This has obviously helped offset the surge in food and energy costs. There may be some hope that consumer prices will decelerate in the near future. Producer prices actually fell 0.2% in June, which left a lot of economist scratching their heads. Economists were expecting a gain of 0.2%. On a year-over-year basis, producer prices increased only 3.3%, significantly less than the 4.1% posted last month, but roughly the same as in March and April. Ironically, producer prices were lower due to declines in gasoline prices and food prices.

Last week, retailers reported June same store sales that were in aggregate better than estimates. According to Thomson Financial, same store sales increased 2.4% in June. Analysts were expected growth of only 1.8%. Most of the better than expected results were due to Wal-Mart posting a 2.4%. Estimates called for only a 0.8% increase. Analysts seem to have forgotten that last year's results were relatively weak. According to the ICSC, chain store sales increased 2.4% during June 2006. This simply means that retailers had an easier comparable period this year. Again much of this was due to Wal-Mart, it's same store sales increase was only 1.1% last year. Looking at the two-year stacked growth rate tabulated by the ICSC, same store sales growth was only 4.9% in June, the lowest since November 2003, excluding April 2007 that was influenced by the shift of Easter. Retail sales during the second-half of last year averaged 3.1%. While not stellar results, it was better then July's at 2.4%. If the current pace continues, it's likely that aggregate chain store sales growth will be around 2%. This is usually not enough for retailers to leverage SG&A and would result in lower margins. This doesn't even include the competitive pressure that it appears retailers are facing, which is pressuring price and thus gross margins.

Earnings for the S&P 500 are expected to have increased 4.2% during the second quarter. This is slightly better than when the quarter started and analysts were expecting earnings to advance by 3.9%. The consumer discretionary sector is expected to post earnings that are 10% lower than last year. But this is concentrated in seven stocks. In aggregate, the consumer discretionary sector is expected to have earnings of $16.824 billion during the second quarter, $1.844 lower than last year. The two automakers, Ford and GM, are expected to do just over $1.1 billion and the five homebuilders in the S&P 500 are expected to lose a cumulative $1.65 billion. Without these seven companies, the consumer discretionary sectors earnings is expected to increase 6% and increases the expected growth of the rest of the S&P 500 to 5.8%.

CSX reported that second quarter revenue grew 4.5%. A 6.9% increase in pricing more than offset a 2.4% drop in volumes. The railroad company experienced weakness in its automotive and housing markets. Overall, intermodal volumes declined 1.5%, but the composition of results was quite divergent. International results were off 8.0%, which was offset by a 8.1% increase in domestic traffic. Part of the decline in international volume was due to the closure of one of its facilities. The company noted that domestic volumes were aided by the addition of new short-haul intermodal volume. It's likely that this business has come at the expense of the trucking firms as the price of diesel has remained elevated.

Results from J.B. Hunt also point to rail taking market share from truckers. The transportation and logistics company reported second quarter earnings that met analysts' estimates. Strength in intermodal (revenue up 9.8%) offset weakness in its dedicated (revenue down 1.7%) and truck (revenue down 10.1%) segments. Pricing fell 2%, despite a reduction in its fleet size. EBIT dropped 33% on a 2.1% revenue increase.

United Technologies reported second quarter earnings per share increased 6.4%. Revenues increased 13%, driven by 10% organic growth, which was boosted by 56% growth at Sikorsky (the manufacture of Black Hawk helicopters). Excluding Sikorsky, organic growth was 6%. The company did say that domestic residential HVAC business was worse than expected, commercial, international and refrigeration offset the residential weakness.

The National Association of Home Builders reported that builder optimism fell four points in July to 24. There has only been two months that builders have been more pessimistic, December 1990 and January 1991. Both present sales and future sales components fell five points to 24 and 34 respectively. Traffic fell three points to 19. The release of housing starts and permits provided hard evidence that homebuilders shouldn't be optimistic. The number of homes started in June did increase from May by an annualized rate of 34,000 homes to 1.47 million from the previous month, but May's starts were revised down by 40,000 units. Building permits plunged by almost 100,000 to 1.4 million. While the number of permits issued last month was revised higher, this was 51,000 less than the low of this cycle set in April and removes almost any hope that the new home market will materially improve for the remainder of the year. On Wednesday, Richard Syron, CEO of Freddie Mac, commented that, "Unfortunately I don't think we have hit bottom. I think things are going to get worse."

The weak market continues to force homebuilders to write off land. Pulte announced that it, "anticipated booking second-quarter impairment and land-related charges in the range of $740 million and $770 million." Net new orders fell 20% and closings fell 40% compared to last year's results. It's comments regarding the market reflect the sentiment reflected in the NAHB survey. In its press release it said that the "difficult conditions that plagued the homebuilding industry in the first quarter of 2007 worsened in the second quarter, with increased competitive pricing pressures, elevated levels of new and resale home inventory, and weak consumer sentiment for housing affecting the entire industry."

There has definitely been deceleration in economic growth over the past few months. Retail sales have already dropped to a lackluster pace and it's likely that margins have come under pressure as well. Earnings for the S&P 500 have been boosted by currency gains from the multinational corporations which benefit from the weaker dollar. Earnings are also being boosted by the large amount of stock buybacks. Not only are companies announcing large stock buyback plans, but accelerating those plans by issuing debt to buy the shares. This week, Rohm & Hass announced it will raise $1 billion in debt in order to double its buyback plan. It will use the $1 billion in proceeds to buy back stock during the third quarter and use cash flow to buyback another $1 billion from 2008 to 2010. Its stocks jumped almost 9% on the news, which surly got the attention of other corporate chieftains, especially those that do not want to be part of KKR's empire.

Chad Hudson
Mid-Week Analysis
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