Connecting the Dots

By: Tony Sagami | Wed, Aug 31, 2005
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ATI Technologiesslashes Q3 outlook
Disappointing profits at Electronics Boutique
Hutchison drops forecast because of weak demand
Finish Line suffers from weak demand
The disappearing middle class

The damage from Hurricane Katrina wasn't as bad as previously feared, but the damage to our country's energy infrastructure is worse than feared.

According to the U.S. Minerals Management Service, a federal agency, nearly all of the oil and natural gas operations in the Gulf of Mexico have been shut down. 615 of 819 offshore rigs in the Gulf have been evacuated. The result is a 92% drop in oil and an 83% decline in natural gas production in the Gulf of Mexico.

No surprise -- the price of energy surged. A barrel of oil soared by $2.61 To $69.81 and the wholesale price of unleaded gas hit a new all-time high and jumped by more than 20%.

20% in a single day!

The bulls, however, aren't very worried. The market was down, but not by anything nearly what it should have given the energy situation. The Dow Jones dropped but only by 50 points.

The bulls will tell brag about how well the market "acted," but all I see is a massive disconnect between reality and the play money the Wall Street crowd thinks it is playing with.

The longer this blindness to risk lasts, the more painful the reckoning will be. Like Alan Greenspan said last week, "History has not dealt kindly with the aftermath of protracted periods of low risk premiums."

If you haven't put your portfolio through a hypothetical stress test and made the appropriate defensive adjustments, I suggest you do so pretty darn fast.

ATI Technologies slashes Q3 outlook. ATI Technologies makes the high-speed graphic chips that kids need to play graphically rich video games. The trouble it isn't selling very many of those gaming chips.

ATI warned that Q3 sales and profits will fall far short of forecasts because of slower-than-expected sales of its desktop PC chips and a massive inventory write-off.

CEO David Orton said:

"This has clearly been a challenging and disappointing quarter for ATI."

How challenging?

==> Instead of $550 to $580 of sales ATI only expect $465 to $480 million instead. The fact that a company can watch its business crumble by $100 million of sales in a matter of weeks tells you how quickly business can deteriorate.

==> Not only did the company sell fewer numbers of chips than expected, the average selling price of its chips was lower than ATI expected. I've talked many times about this shrinking profit margins, falling prices, and profitless prosperity that are killing the tech world.

==> ATI is writing off $60 million to $70 million in inventory. In the old days, write-offs used to signal obsolete equipment. These days, inventory write-offs are a way to boost the profits on the next couple quarters. After all, the profit margin on inventory that has been written off is 100%. This move smells very fishy to me.

I say that because this is the second time that ATI has taken down its Q3 forecasts. The reality is that business is crashing and ATI is a sinking ship.

Either rival Nvidia (NVDA) is eating ATI's lunch or the entire industry is doing poorly. I can tell you with confidence that you're looking at an industry-wide problem. I say that because of what Electronic Boutique had to say.

Disappointing profits at Electronics Boutique. Video game sales Electronic Boutique is one of the largest sellers of new and used video games in the country. Come October when it merges with GameStope, it will become the elephant of the industry.

Apparently, serving America's little video addicts isn't as profitable as it used to be.

Electronic Boutique reported 14 cents of PRO FORMA profits, which is not only down from the 16 cents it made last year, but also below the 17 cents that Wall Street was expecting.

Video games are the end of the same food chain that ATI Technologies lives in. A simple game of connecting the dots tells you that this is one industry that you need to stay away from.

Hutchison drops forecast because of weak demand. Hutchison Technology makes suspension assemblies for PC disk drives and warned Wall Street to expect lower sales and lower profits this quarter.

For the quarter ending September 25, Hutchison now expects to make 5 to 20 cents on $150 to $165 million of sales. That's way below the 59 cents of profits on $174.9 million of sales that Wall Street was expecting.

The problem is twofold:

  1. Overall demand is down. Hutchison previously said it would ship 190 million to 200 million units this quarter. It now only expects to sell 170 to 180 million units instead.

  2. What is selling are its lower cost, lower profit margin products. Hutchison says it profit margins will drop from 28-30% to 19-23% instead.

For those of you playing connect the dots at home, Hutchison's five largest customers are Western Digital, TDK, Alps Electric, Innovex, and Fujitsu.

Hey, this isn't very good news for Dell, Gateway, Intel or the rest of the PC food chain either.

Finish Line suffers from weak demand. Every time my children need new tennis shoes, we go through a wrestling match. They want the newest, coolest tennis shoes that often cost $100 while I prefer to shop at the bargain bin.

Heck, even $30 seems like a lot for tennis shoes that my kids will either wear out or outgrow in 3 to 6 months.

Finish Line is a chain of mall-based retailer of brand name athletic shoes. They sell the kind of shoes my boys want to buy.

Well, either a lot more parents feel just like me or the typical American consumer or me is feeling so strapped by rising energy costs that he is cutting back on discretionary spending...like $100 tennis shoes.

==> Finish Line told Wall Street to lower its expectations for this quarter from 48 to 50 cents to 37 to 39 cents instead. The problem is that same-store sales dropped by 2% in June, July, and August.

==> Q4 isn't looking so hot either. Finish Line now expects to lose 1 to 3 cents, well below the 5 to 7 cents it previously promised.

==> For the year, Finish Line expects to report $1.16 to $1.21 of profits instead of the $1.47 Wall Street was expecting.

The problem is very simple: Americans are cutting back.

"Although we started the quarter with sales on plan for most of June, sales from late June thru the remainder of Q2 were disappointing."

This is not new news. As we've reported in this column, the list of retailers that have lowered their Q3 and Q4 guidance is very long: Wal-Mart, Hot Topic, Barnes & Noble, Limited Brands, New York & Co., Bombay Company, GameStop, Claire's, The Gap, Aeropostale, Bebe Stores, and Gymboree are all retail stocks that I've highlighted in the last two weeks.

While it seems ultra-obvious to you and me, Wall Street has yet to connect rising energy and rising interest costs to slumping consumer demand.

I think the reason that Wall Street is so oblivious is that the most of the jobs reports coming out of Washington D.C. show an economy that is creating new jobs. What those knuckleheads don't get is that most of those new jobs are low paying, zero-to-few benefits, service jobs.

The disappearing middle class. One of the themes we keep re-circulating in this column is the opinion that most of the new jobs being created are either good paying, white-collar jobs or low-wage, low-benefits service jobs.

Unfortunately, America's high-quality, high-benefit, good-paying blue-collar jobs are leaving the country. A new survey from the AFL-CIO confirms that.

==> 53% of the workers surveyed said their income is not keeping up with rising health care and gasoline prices.

==> 70% said wages weren't rising fast enough to keep up with the higher cost of living.

==> 43% said they were confident about achieving their financial goals, down from 70% in 1999.

What I see is an America where the middle class is slowing becoming an endangered species. An America that is slowing becoming a country of haves and have-nots.

Long term, that wide disparity of income is a destructive force. I see it every day in the beautiful, western Montana resort town that I live in.

My children go to class with children who parents live in 10,000 square foot log-home mansions, have closets filled with designer clothes, and travel to warm, exotic spots every Christmas vacation.

My children also go to class with kids who wear the same clothes to school day after day, live in ramshackle trailer homes, and look forward to the free, hot lunch they get at school because it is the best meal they'll get that day.

Sadly, the two groups look at each other with contempt.

Worse yet, I fear that same dynamic is playing itself out all across America and that is a very troublesome, long-term economic millstone that will ultimately drag our economy down.


 

Tony Sagami

Author: Tony Sagami

Tony Sagami
Harvest Advisors.

Tony Sagami

Tony Sagami is the owner and founder of Harvest Advisors, an investment research and money management company. Sagami has been managing money for more than 20 years and is one of the early pioneers in the application of technical and quantitative analysis to mutual funds and stocks.

Tony is a man that wears several hats. In addition to Harvest Advisors, he has launched several successful technology companies. Tony is the owner of Monocle Systems, a popular investment analytical software program that has been used by thousands of professional money managers and sophisticated individual investors. Tony is also co-owner of AdvisorSquare, one of the largest web design and hosting companies in the world.

Tony is a frequently quoted expert, appreciated for his frank and unconventional view. Tony has appeared in publications such as the Wall Street Jouranl, Barrons, Kiplingers, Smart Money, Business Week, New York Times, Washington Post, Investors Business Daily, Bloomberg, Financial Planning Times, Mutual Funds Magazine, Chicago Tribune, LA Times, and many others.

A graduate of the University of Washington, Tony enjoys coaching youth sports, serving his community as an active Rotarian, and exploring the all the beauty that Montana has to offer. Tony is a Paul Harris Fellow, an Eagle Scout, and married to his first-and-only wife and father of 4 wonderful kids.

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