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October 26, 2006

Manufacturing Slows, Earnings Remain Strong
by Chad Hudson

There have been some indications that economic growth has sputtered over the past several months. Over the summer, consumers balked as energy prices soared. Just as consumers started regaining their footing the manufacturing sector started to experience slower business activity or forecasted business to weaken. Residential construction is the most often cited area of weakness followed by the domestic automakers. There is also the expectation of a significant decline in the number of class 8 trucks that will be produced next year that has caused manufacturing companies to have a cautious view of 2007.

Considering that the manufacturing sector plays a limited factor in the economy, it is difficult to determine if these pockets of weakness will be enough to significantly alter economic growth. It is quite likely that consumers will be much more unconstrained during the holiday season, as was predicted just three months ago. The two major forces that were working against the consumer for most of the year have recently reversed. Energy prices have retreated lately and interest rates have come down offering homeowners stuck in ARMs that were about to reset a chance for a much more favorable alternative. The housing market remains the area of biggest contention. The statement from the FOMC meeting on Wednesday noted that "economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market." It's easy to forecast that consumer spending will weaken since customers will not be able to tap into their home values to subsidize their spending. Plus the multiplier effect of home purchases is usually considered quite large. Unfortunately, this has not quite panned out. Bank of America reported that its home equity loan balance increased 21% in the third quarter and the refinance index from the Mortgage Bankers Association has climbed from the 1400 level in July to 1800 now, and hit 1970 last month.

The Richmond Fed survey dropped eleven points to -2. This was much worse than the one point drop economists expected and the lowest level since January. Every segment dropped in October. Shipments fell the most, dropping from 9 to -7. Respondents noted that pricing pressures have started to ease. Prices paid increased 2.73% from the prior month, compared to 3.7% in September. Prices received only increased 1.8%, which was the lowest increase since March. The weakness in the Richmond survey corroborated the weaker than expected results from the Philadelphia Fed survey. While the Philadelphia survey only fell 0.3 points to -0.7, economists were expecting the survey to rebound to 7.0. There were a few components that increased, namely, new orders (+14.7 to 13.4) and shipments (from -6.8 to 5.3). The outlook for the next six months is much more promising. The index measuring expectations for the next six months rose by 16.9 points to 16.7. This is the highest its been since May this year. New orders jumped 20.8 points to 29.2. The number of employees also rose to 13.1 from 5.7 last month.

Existing home sales dropped 1.9% in September to 6.18 million annualized units. The median price dropped 2.2% from last year, matching the decline last month. The number of homes on the market dropped for the second consecutive month, but the number of months of supply remained 7.3 for the third consecutive month. The condo market was softer than single family homes. Sales of condos fell 3.2% and the months supply rose to 8.6 months.

M.D.C. Holdings reported that its third-quarter earnings fell 60%. Revenue dropped 7.6%. Net new orders dropped 40%, largely due to the cancellation rate jumping to 48.5%. Similar to other home builders, M.D.C. has had to lower prices and increase incentives to sell homes. Gross margins were negatively impacted by over 600 basis points, dropping to 22.7%. Additionally, SG&A costs increased to 12.9% of sales from 10.4% last year.

Last week, the earnings report from Caterpillar received a lot of focus. While Caterpillar reported a 30% increase in third quarter earnings, the heavy equipment maker said that 2007 earning would be about twenty cents lower than previous projections. Prior to its earnings release, analysts were much more bullish than the company was. While Caterpillar lowered earnings guidance range by twenty cents to $5.05 to $5.30, consensus estimates was $6.25. The company blamed weaker residential market and the anticipated drop in its diesel engine business for the more cautious outlook. Industry analysts are expecting class 8 truck orders to be down 25-40% next year as trucking firms bought trucks ahead of the emissions change. Cummins, a supplier to engine makers is planning on a drop of 40%. It's curious why analysts were so positive on Caterpillar in light of these known headwinds.

The new emission standards that will be implemented next year has caused trucking firms to boost orders in 2006. Because truckers are leery of the new engines, there are questions about the reliability and fuel economy, firms would rater buy trucks this year and not incur the risk. This increase in the number of trucks on the road might have altered the industry in the short-run. Monitoring the results of trucking firms is a good way to judge the strength of the economy. As we have discussed, by most accounts the economy hit a soft patch during the summer and has since gained traction. However, the trucking firms have not experienced the same dynamic. Most firms have reported that business conditions were weakest in September and thus far in October. The segments often cited were autos and residential construction. Since trucks are fungible, any weakness in one sector can result in an oversupply of trucks available to service other clients. The fact that firms have been buying in front of the emissions change has likely exacerbated the situation. Plus, last year Hurricane Katrina caused havoc with the transportation system. Not only were trucks called in to support recovery efforts, but with operations at the Port of New Orleans crippled for several months, goods had to be diverted to other ports and hauled a longer distance. This makes the comparison to the year ago level much more difficult. All these factors have combined to make the current environment very difficult for the trucking industry. Is the trucking sector foreshadowing a slower economy or are these mitigating events causing the trucking sector to issue a false positive?

Third quarter earnings have continued to beat analysts' estimates. Just over half of the S&P 500 has reported third-quarter earnings and 73% have exceeded estimates and only 12.5% have missed estimates. Thirty percent of the companies that have beat estimates have done so by 10% or more. Earnings are now expected to increase by 16.7% compared to last year. At the beginning of the quarter, analysts were expecting earnings growth of 15.3%. However, fourth quarter earnings growth estimates have declined. As of last Friday, analysts were forecasting fourth quarter earnings to increase 11.4%, substantially lower than the 12.8% growth predicted just three weeks ago. Additionally, estimates called for 14.7% growth at the beginning of the third quarter.

The current economic environment is offering everyone enough data points to hang their hats on or hang themselves. With the economy driven mostly by consumer spending and the resiliency consumers have shown over the past decade (remember consumer spending didn't contract during the latest recession), the benefit of the doubt has to go to stronger growth. Tight labor markets combined with decent wage growth only confirms that the economy could surprise on the upside. It will remain a fluid situation and it wouldn't take much to tilt the balance the other way.

Chad Hudson
Mid-Week Analysis
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