Raw Materials Rubbing Companies Raw

By: Chad Hudson | Thu, Oct 21, 2004
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Third quarter earnings season got in full force this week. There are 179 of the S&P 500 that report earnings this week, and 136 next week. As of Wednesday afternoon, 172 S&P 500 companies have reported third quarter results and 107 earned more than analysts expected and 33 failed to meet forecasts. By combining actual results for those that have reported and estimates for the others, earnings are expected to increase 14.5% compared to 15.7% last Friday. Over the past several months we have discussed the rise in raw materials, mainly steel and oil. While this is boosting earnings for energy and materials companies, it is negatively impacting most other industries.

Several companies in the auto sector reported earnings over the past week and have guided earnings estimates lower for the fourth quarter. The central theme from all the companies is summed up by Michael Burns, CEO of Dana, "The magnitude of the raw material increases, coupled with a decrease in light-vehicle production volumes, hit us harder than expected." Delphi, the largest auto parts maker, said it will cut an additional 1,500 jobs to 8,000 cuts already announced as the company fights to regain profitability that it lost in the third quarter.

The automakers continued their reliance on financing. General Motors' earned $656 million from GMAC, while it lost $116 million from making automobiles. GM also benefited from reducing its product liability reserve by $250 million. The company stated that it decided to reduce what it reserves from the high-end of the range of estimates to a more "appropriate estimate within that range." This alone added 44 cents to EPS. Health care is also eating into the automakers bottom line. Early in the year it was experience an 8.5% increase in health care costs. Currently, it is running in the low double digits and they expect this increase in continue into next year. And adding insult to injury S&P downgraded its debt to BBB-. Any lower and its debt falls to junk status.

United Technologies is benefiting from the current boom in manufacturing. Sales increased 17%, but only increased earnings by 13%. Again, higher raw materials cost pressured margins. For the full year, higher commodity prices will cost the company $150 million. The maker of Carrier air-conditioning systems noted that there has been a pick-up in commercial office construction, but is reluctant to call it a recovery. Sales at the Carrier unit advanced 9% from last year's depressed levels. The company noted that the mild summer impacted sales.

Whirlpool reported that third quarter sales increased 6.6%, but net income declined by 3.8%. A lower share count resulted in earnings per share rising almost 5%. Similar to scores of other companies, Whirlpool cited rising raw material costs as the main factor for earnings to decline. The company said that higher raw material and logistical costs added about $60 million to its cost structure. The company also said that it experienced shortages and longer lead times for supplies, which is forcing it maintain higher inventory levels. Inventories increased 23% from the previous year. Furthermore, the company expects that costs will continue to escalate into the fourth quarter by about $50 million. In order to offset these cost pressures, the company announced it will increase prices by an average of 10% starting January 2. Unfortunately for the company, it is a lot easier to announce a price increase than it is for it to stick. Increasing competition from Asian manufactures will complicate Whirlpool's planed price increase. According the Nick Heymann, analysts at Prudential, GE was only able to capture a 1% price increase. The company also has significant exposure to Sears, which has been having problems with appliance sales.

Countrywide Financial reported that third quarter earnings per share were less than half the amount as last year. The company also fell short of Wall Street estimates by about 7%. Analysts didn't expect the company to increase earnings during the third quarter since last year the company posted a 343% earnings increase on the heals of the record refinance activity that occurred in 2003. The conference call yielded several interesting statistics for those keeping tabs on the housing and mortgage market. Adjustable rate mortgages comprised of 61% of its total volume. Twenty-one percent of their volume during the quarter was for interest only loans. In California, 36% of volume in interest only and 13% in the Pay Option ARM (this can be a negatively amortizing loan).

3M reported that third quarter sales rose 7.6% while EPS grew 17%. Analysts were surprised by the company's full year guidance that will be $3.74 to $3.75 per share, which was two to three cents lower than the consensus estimate. Sales of optical film, which is used to manufacture LCD displays, was the main cause of concern. Several companies have said recently that there is a glut of LCD displays in the market. This would obviously reduce the number of displays that have to be made during the fourth quarter. This holiday season will be very important for the LCD market. There have been several companies that have leveraged themselves to the high-end television market.

Consumers' healthy appetite for imported goods has proved a boon for the railroads. Sales at Norfolk Southern rose 16%. Car loads increased 10.6%, driven by a 21% gain in intermodal. This strength has continued into October. Loadings through October 10 set a new 52-week high, while the week following was the second strongest on record. The company attributes its strong demand on four factors: higher consumer spending, higher industrial production, international trade, constrained trucking capacity.

The strained trucking capacity has led to a surge in class 8 trucks (semis). Cummins has benefited from this surge, posting sales growth of 34% and earning growth of 200% (excluding a tax benefit and an inventory revaluation). This surge in earnings was after accounting $0.65 per share, just over one-third of earnings, for higher raw material and operational inefficiencies due to the significant volume ramp. Theodore Solso, CEO, said that he sees no sign of lower commodity prices ahead.

The two large toymakers reported that third quarter sales fell for both companies. The 2.2% drop in revenues at Mattel led to profits falling 5.2%. Hasbro was able to cut costs, which enabled the company to post a nominal increase in earnings of 3.3% (excludes a charge taken in the year ago period).

The price of steel has started to decline from the peak reached during the third quarter. According to Steel Dynamics, this is a typical pattern. Companies typically build up inventory during the third quarter and work it down during the fourth quarter. This lessens the demand during the fourth quarter for steel products, which lowers the price. Companies do this because most steel supply agreements are negotiated during the end of the year.


 

Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis
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