Evidence Of A Slowdown Mounts
Sorry for any inconvenience resulting from the delay in publishing this weeks Mid-Week analysis. Next week's will also be published on Thursday.
Evidence pointing to a recovery is getting scarce. Economic data released this week generally pointed to continued weakness, plus companies continue to lower earnings guidance for the third quarter. On Monday, the Conference Board released its index of leading economic indicators, which fell 0.2 to 111.8 in August. On Tuesday, the Conference Board said consumer confidence is at a 10-month low. The widely followed index fell 1.2 points to 93.3 in September. The present situation component fell to 88.5, which is the lowest since 1994. The most interesting aspect of the survey was the results of the "Plans to buy" questions. Only 3.3% plan to buy a home in the next 6-months, which is the lowest percent since last November. Additionally, in the next six months, only 6.8% expect to purchase a car and 25.8% anticipate buying a major appliance. These are the lowest results since June 2001 and October 1997 respectively. Just last month 4.5% planned to buy a house, 7.4%, a car and 31.3% an appliance. While survey results have varied from what consumers have actually done recently, it does show increased trepidation in consumers and increases the probability that zero interest financing pulled forward future sales. This is even more interesting since the biggest refinancing wave is happening right now. As preposterous as it sounds, there is a chance consumers will start saving again and pare down their historic debt burden.
Monday, Moody's Investor Service said junk bond defaults set a record in 2002. So far this year $139.5 billion worth of bonds have defaulted, compared to $135 billion for all of 2001, which was the previous record. The default rate has climbed to 9.6% and Moody's expects it to reach 9.8% at the end of the year. Just last month, Moody's expected the default rate would end 2002 at 8.8%. At the beginning of the year, Moody's expected the default rate to be 6.8%
Besides the economic data, companies have been busy lowering estimates for the third quarter. According to FirstCall, S&P 500 earnings are expected to grow 8.5%, down from 11.2% three weeks ago. Chuck Hill, director of research at FirstCall, expects growth estimates to drop all the way to 6%, with actual growth coming in at 8%, beating the lowered estimate. With a couple more weeks for analysts to lower estimates, the 6% growth estimate is a good possibility. But, will the actual results be better?
Companies have been providing valuable insight as they lower guidance or release earnings. Listening to what companies are saying is more important than watching the economic data. Especially now, with the direction of the economy being so vital and uncertain. Several companies warned that earnings or revenue or both would be lower than previously expected.
JDS Uniphase continues to slash costs, and jobs, to reduce its breakeven point. Earlier this week, the optical components maker, warned it would not meet is previous revenue estimates due to cancelled contracts. Obviously, the canceling of contracts does not bode well for the telecom industry. As I'm editing thion Thursday afternoon, SBC Communications announced it is cutting another 11,000jobs and is cutting a billion out of its 2003 capx budget. Out of the 11,000 job cuts, 9,000 will happen during the fourth quarter. One-third of the cuts will be management level positions. SBC already eliminated 10,000 jobs this year.
Peregrine Systems announced it put two more of its buildings up for lease. After building a five building campus complete with auditorium, conferencing center, restaurant, and gym, the newly bankrupt company is now utilizing one building. Speaking of bankrupt companies, the Enron "E" fetched $44,000 at Enron's auction on Wednesday.
Roadway, one of the largest trucking firms, announced earnings this week that met lowered estimates. The company said in it press release, "the economic recovery slowed and that negatively affected our business levels." The company added a bit more detail, "After a slow January, the first half of the year saw continued improvement in freight volumes. Early in the third quarter that trend continued, but within a few weeks began to deteriorate. July and August saw lower tonnage levels than anticipated." Roadway's prospects for the rest of the year increased along with everyone else in the industry after Consolidated Freightways declared bankruptcy earlier this month. Previously, the trucking sector has been a good indicator for the economy, but due to the bankruptcy of one of the biggest firms, the anecdotal evidence will not be as meaningful. Interestingly, on the conference call, the company mentioned that its insurance costs have increased.
On a conference call hosted by Bank of America, Sam Zell, president of Equity Office Inc., said their insurance costs have doubled and several in the industy have tripled. Zell pointed out that they are able to pass through the higher cost to tenants. But these higher cost are being borne by businesses right when they are supposed to increase their spending to help get the economy going.
We have discussed the inflation in healthcare over the past year or so. It seems more and more companies have mentioned these increases. This week, Administaff said that they, "lost money in the first half of the year, primarily because health-insurance costs swelled." The human resource service provider, "changed its pricing policy to pass on more of the costs to its clients." The company also said it "is trimming costs and capital expenditures."
Sprint PCS lowered its guidance for the third quarter because subscribers growth was below plan. Instead of the 1.7 million additions, the company now expects to lose around 25,000. It seems that after Sprint lowered its credit standards in 2001, problems are now surfacing, "a larger percentage of these newly added customers failed to pay for services or engaged in fraudulent payments that led to deactivation of their accounts."
Maytag, the nation's third largest appliance maker, lowered earnings guidance by about a dime. Instead of the $0.79 per share analysts were expecting, Maytag forecasts earnings to be in the range of 65 to 70 cents. Just last June, Maytag revised upward its guidance based on stronger that expected sales of higher margin products. The about-face was caused by an environment that is "more challenging than expected." The company said sluggish sales combined with the delayed launch of a new washer caused the revision.
You know you're in a bad business when you experience a 30% sequential decline in pricing and you are able to point to a benefit. Micron Technology did just this. It also proved you cannot make up negative gross margins by increasing volume. While sales were up56%, actually ahead of estimates, Micron experienced gross margins of negative 4.5%, which obviously caused Micron to post a loss for the quarter. And to get into this business you have to build a multi-billion dollar plant.
As the third quarter winds down, analysts and economists are looking forward to the easy comparisons in the fourth quarter. But, the year-over-year comparisons for the third quarter were just as easy. Last year, S&P 500 earnings fell 21.5% in the fourth quarter from the previous year, but third quarter earnings were down 21.6%. Now analysts are expecting third quarter earnings to grow 8%, but miraculously grow 15% in the fourth quarter. Actually, the 15% growth is what FirstCall expects estimates to drift down to. Currently fourth quarter earnings are expected to grow 21.3%. There is little indication of any sequential pick up in the economy, if the base for the third and fourth quarters are the same, it is doubtful earnings growth will hit double digits in the fourth quarter. As I mentioned last week, the refinancing boom will be the billion dollar question. The bullish economists keep pointing to the refinance boom as something that will pull the economy through the slowdown. The refinance boom is a one-time shock, okay, a one-time shock that has been happening over and over again. But it has to end. I highly doubt two years from now Fannie Mae will be paying homeowners for the privilege of holding their mortgage. Then again…
Wal-Mart started off the week by saying same store sales would be near the low end of expectations for September. Federated added that it might not make its 3% to 5% same store sales target. CSFB visited with management at May Department stores earlier this week. According to their research note, "The near term tone of business was characterized as 'timid'." The company said consumers are, "waiting the store out for the next markdowns." The Bank of Tokyo-Mitsubishi & UBS Warburg US chain store sales index fell 1.7% last week. It looks like the blimp in retail sales over the past couple weeks, was just a blimp.
Two companies that service the employment sector reported earnings this week, Paychex and Cintas. Both reported lower than expected earnings. The conference calls from both these companies provided a glimpse at the status of the employment sector. Here are a few excerpts:
"Payroll service revenues were negatively impacted by a 2.1 percent year-over-year decline in checks per client. The declining check volume trend peaked in the third quarter if fiscal 2002 and began to improve in the fourth quarter of fiscal 2002. The year-over-year reductions in checks per client for the first through fourth quarters of fiscal 2002 respectively were 2.6 percent, 4.3 percent, 4.8 percent, and 3.0 percent in the fourth quarter."
"So, if I had anything to say about what I see in the economy right now -- it is stuck. It is not going up; not going down. New sales activity is okay, retention is okay, losses its -- we are kind of where we are and that is why you'll note that we do our forecast and our forward-looking statements based on current business conditions. And if you look at what we're saying is going to happen at the end of the year compared to what we said three months ago, it's almost identical except for a slight improvement on the human resource sales, where we got off to a little bit better start than we anticipated."
"We're happy we saw the slight improvement down to 2.1 percent decline from 3.6 but I will tell you, I wouldn't take anything more than that to the bank."
"The reason for the revenue reduction is primarily driven by two things. One, our results for the first quarter were in revenue were not as high as we had originally expected primarily again due to the sluggish economy, in fact totally due to the sluggish economy. What is impacting our customers is they reduce their workforce, they shut down operations, reduce shifts, etc. Of course any revenue we lose in the first quarter it tends to remain lost throughout the year until the economy starts picking up.
"As we look at the economic situation we don't see any substantial improvement happening in the near-term. Therefore I would say our revenue guidance adjustment is to reflect a more pessimistic view of the economy for our fisca year ending May 31, 2003."
"There is no question we are seeing higher costs in the medical field and we're having to figure out how to absorb those costs into our system."
"Unfortunately I don't think we are seeing any improvement but we're really not seeing any deterioration. We're seeing the same sluggishness that we saw in the first quarter."
"In our rental business I would say there still seems to be a weakness among manufacturing type customers. Most of ou customers are more in the service industries and we just don't see a lot of exciting things going on there other than attracting new business. Existing customers just seem to be doing what Cintas is doing and kind of being cautious because there's just not really a lot of great news sitting out there."
Wall Street published a few interesting comments this week. Merrill Lynch's chief strategist, Richard Bernstein, expects the employment situation to stay weaker longer than most expect. In a research note published he noted that "corporations will attempt to restore profitability via layoffs." Also on the labor front, Bernstein said, "Real wage growth, perhaps the prime driver of the strength of the consumer sector, is slowing, and we expect it will slow significantly more than most currently expect." Interestingly, perhaps Mr. Bernstein has been reading our own Doug Noland, as he is "wary of consumer finance companies…. credit risk is potentially being under-priced."
Also out of Merrill this week was an update on the commercial office market. The first sentence sums up the situation pretty well, "We've searched the horizon for a rebound in the nation's office markets and found none. In fact, we believe that US office markets are likely to trace a very long bottom and that it will take four-to-five years for the vacancy rate to recede to 10%....The problem bedeviling a recovery is not supply. Rather, it is a complete absence of demand. Net absorption shrank 29 msf [million square feet] during 1H02 which follows an astounding 96 msf negative net absorption during calendar 2001." The national vacancy rate has climbed from 15% at the beginning of the year to 17.2% at the end of June. Obviously with the vacancy rate approaching 20% across the nation, office vacancies are widespread. Merrill tracks 86 markets and now half are on its list of "distressed" markets. The problem is not confined to the larger markets either. About a month ago, a reader sent me an article from the Omaha World Herald discussing Omaha's soaring vacancy rate. By the end of the year real estate experts are expecting the vacancy rate to climb to 34%, up from just 11% at the beginning of the year.
It still amazes me how a topic that has been known about for years without fanfare can all of a sudden matter to investors. Pension plans fit that mold. It has not been a secret that companies have been benefiting from pension gains and plans useing unrealistic return assumptions, but now all that seems to matter. According to Merrill Lynch, 98% of the 346 S&P 500 companies that offer defined benefit plans will be underfunded at the end of 2002. These companies are expected to be underfunded by a cumulative $323 billion, or 69% of the total value of their assets. This is quite a shift as the pension plans were overfunded by $215 billion just two years ago. Even our local business writer, Scott Burns, penned two articles this week discussing a few of the problems with pension plans. Tuesday's article, How IBM pulled a FAS one on pensions, shows how the current pension rules do not convey current situation. Sunday's article, Pension funds: the next crisis?, discusses how stocks are an improper investment for pension funds. The premise is that pensions need to match their assets with their liabilities. Since the liabilities rise and fall inversely to interest rate moves, pension funds would be much better off buying bonds since their value would move correlated with the liabilities.
CSFB reduced 2003 semiconductor capital spending forecasts by over 20%. CSFB now expects only $26 billion. If $26 billion ends up being the magic number, that will be the lowest level of capital spending since 1994.
It is becoming clear that the economy is struggling to gain traction, and is showing signs of slipping back into recession. Companies are continuing to cut costs by reducing capital expenditures and reducing payrolls. Economists are expecting the refinance boom to keep consumer spending up. While the refinance boom will likely extend the spending spree, I think there is some risk to the popular scenario. As the Conference Board survey hinted, consumers may be at their limit and decide to pare down debt. Plus we know delinquencies are at record levels. If this happens the economy will surely slip back into recession.