Connecting the Dots

By: Tony Sagami | Wed, Oct 12, 2005
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"Significantly below" warns Potlatch
Higher energy costs sap Alcoa profits
K2 blames high gas prices for profit shortfall
Shrinking doodad demand Part I
Shrinking doodad demand Part II
Shrinking doodad demand Part III

If you're a bull, you got to be close to crapping your pants.

Q4 has unfolded exactly like we thought it would now that we've made it past the end-of-quarter hanky panky.

Long-term interest rates are rising, gold is trading near an 18-year high, several Fed chiefs are warning that inflation is getting out of control, bank stocks are trading are hitting new 52-week lows, and the momentum has shifted to the downside.

If Q3 earnings continue its negative trend, look for the selling to accelerate.

I think the bulls will be shocked at how fast and how far stocks will fall. I hope you, however, have purchased your stock market armor and insurance.

"Significantly below" warns Potlatch. Potlatch, a lumber and pulp forest company, warned that its Q3 results would be "significantly below" the 50 cents the Wall Street crowd was counting on.

What's the problem? Sky-high energy costs. Potlatch (NYSE:PCH) said that it spent $10 million more for fuel in the Q3 than it did during the same quarter last year.

"The shortfall is largely attributable to the high cost of energy...these costs, which are approximately $10 million higher than third quarter 2004, are impacting almost every aspect of the company's operation from natural gas used at its manufacturing facilities to in-bound and out-bound transportation surcharges."

Those big logging trucks don't run on water. The cost of getting very large and very heavy trees from the forest to sawmills can't be cheap.

A more important point to realize is to understand that transportation costs are going up for everybody...not just Potlatch. It doesn't matter whether you make lumber, milk, cars, toys, shoes, computers, or books...they have to be transported by planes, trains, ships, or trucks.

Energy is an equal opportunity killer of profits.

Higher energy costs sap Alcoa profits. Take a look at Alcoa, who cited the same problem on Monday when it reported its Q3 results. Even though Alcoa managed to beat expectations, profits would have been much higher if not for higher energy costs.

"Higher energy costs affected our results this quarter. We have an aggressive productivity program, but it has not offset the impact of escalating costs in energy and raw materials and the speed at which they are flowing through."

Alcoa managed to escape a profit shortfall in Q3, but I'd be surprised if they were able to conjure up a great Q4.

K2 blames high gas prices for profit shortfall. Sporting goods-maker K2 told Wall Street to crank down its sales and profit expectations.

==> Instead of 77 to 81 cents, K2 now expects to make 66 to 68 cents in 2005 instead.

==> Instead of $1.36 billion of 2005 sales, K2 says it will pull in $1.29 to $1.32 instead.

What's the problem? K2 is blaming weak paintball gun sales. In turn, K2 is blaming high gas prices for the weak paintball gun sales.

"The majority of paintball products are sold through the mass distribution channels, and these consumers have been particularly hard hit by rising energy costs."

There are several takes in this K2 warning:

  1. K2 sells its paintball guns through mass-market distributors (mainly Wal-Mart) so this profit warning is confirmation that stores that cater to the blue collar crowd is indeed suffering from weak end demand.
  2. The Wall Street knuckleheads that brag how well our economy has adapted to $60 oil have zero idea how painful $3 gasoline is killing consumer spending.
  3. I've warned you to stay far away from consumer-centric businesses, such as hotel, retail, consumer electronics, automobiles, furniture, toys, restaurants, homebuilders...and leisure stocks such as K2.

Shrinking doodad demand Part I. SigmaTel (Nasdaq:SGTL) makes chips that go into portable consumer electronic devices: MP3 players, notebook PCs, DVD players, and the red-hot iPod from Apple.

Despite the avalanche of business from Apple, business isn't so hot at SigmaTel. I say that because SigmaTel warned that its Q3 sales and profits would be below expectations.

==> Instead of $78.6 million, SigmaTel says it will only pull in $74.4 million instead.

==> Instead of $78.6 million of sales, SigmaTel expects to pull in $74.4 million of sales.

==> Instead of 30 cents per share of profits, SigmaTel now expects to make 20 cents of profit.

==> Instead of 51% profit margins, SigmaTel now expects

The demand for electronic doodads is shrinking and everybody in the doodad food chain will have to face the painful fight for a shrinking pie.

Shrinking doodad demand Part II. Xilinx is the largest maker of PLD (programmable logic devices) chips, which are chips that are programmed to perform specific functions such as keeping time or holding phone numbers in your cell phone. Just about every electronic doodad in the world needs PLD chips.

Well, Xilinx (Nasdaq:XLNX) hit s new 52-week low on Monday after it warned that its sales would be below expectations.

Xilinx warned that its Q3 sales would fall by 1-2% versus its previous forecast of flat to up 4%. In dollar terms, that means that instead of $405 to $421 million of sales, Xilinix is only going to pull in $397 to $401 million instead.

Since Xilinx sells more than 50% the world's PLD chips, this profit and sales shortfall tells you volumes about the demand for doodads (consumer electronics).

When combined with the SimgaTel warning, you should see the outline of a very troublesome picture for the consumer electronics industry.

For those of you playing connect the dots at home, Xilinx's biggest customers include Lucent and Cisco and its main competitors are Lattice Semiconductor and Altera.

Shrinking doodad demand Part III. International Rectifier makes power systems that help manage switch electricity on and off to supply power to the electronics devices, such as appliances, computers, and cars.

Business, however, isn't so hot.

==> IRF warned that its Q3 sales would be approximately $273 million, which is about 3% lower than Q2 sales of $281.8 million.

==> Profits, at 35 to 37 cents, are well short of the 51 cents the Jack-and-the-Beanstalk crowd was counting on.

==> Profit margins are shrinking too, falling from 43.5% to 40.5% in the last 90 days.

Top customers include Bosch, Cisco, IBM, Lockheed Martin, Maytag, Motorola, and Philips.



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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