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January 19, 2007

Earnings Growth Decelerates
by Chad Hudson

Earnings season is upon us once again. Over the past two weeks, analysts have lowered their estimates for fourth quarter earnings growth. Analysts now forecast earnings for the S&P 500 to have increased 9.1% last quarter compared to 10% growth expected on January 1. This would mark the first quarter since the second quarter of 2003 that earnings failed to grow at a double-digit rate. If companies end up exceeding current estimates and post double-digit gains, it would be 14 consecutive quarter of double-digit earnings growth and beat the previous record of 13 quarters set between the fourth quarter 1992 and the fourth quarter 1995. The financial sector is the major driver for S&P 500 earnings for the fourth quarter. Financial earnings are expected to have grown 34% last quarter. If the financial sector is excluded, the rest of the S&P 500 is expected to have increased earnings by 1.9%. Earnings growth for financial companies are expected to slow to single digits for 2007 and the expected earnings growth for the S&P 500 is similarly muted. Earnings growth is expected to slow to 7.7% and 6.1% for the first and second quarters respectively.

JPMorgan Chase was one of the first financial companies to report fourth quarter earnings, and its results confirm that financials will likely post significant earnings gains. Earnings per share jumped 48%, led by a 51% increase in investment banking. Results from banks without investment banking and trading operations will likely be more muted. Wells Fargo's earnings growth was much less impressive, only 12%. Commercial loans increased 11% and its mortgage operations saw a 64% increase in profits.

Analysts expect the technology sector to be a drag on fourth quarter earnings growth. Analysts' estimates call for earnings to be flat with last year's level. Last week, AMD announced that its fourth quarter sales would be about 3% higher than the $1.33 billion reported in the third quarter and operating income would be lower than in the third quarter, but higher than last year, due lower average selling prices. Analysts were expecting a 12% sequential increase in revenue. On Tuesday, Intel announced that its gross margin is also suffering from the competitive landscape. Its gross margin contracted to 49.6% in the fourth quarter, down from 61.8% last year. Since 2003, gross margin has dropped from 58% to 51.5% for 2006. Additionally, the company said gross margins will drop to about 50% for 2007. The result of gross margin pressure was a 39% drop in earnings per share in the fourth quarter and earnings are expected to fall another 3% this quarter, which is on top of a 34% drop last year.

Lennar reported fourth quarter earnings of $0.74 per share, excluding inventory writedowns and other charges that totaled $1.98 per share. Revenue dropped 14% driven by a 4% decline in closings coupled with a 10% drop in it average price. Lennar has been the leader in the strategy of lowering prices to clear inventory. Incentives averaged 13.5% of the price, compared to 3.0% last year and 10.1% last quarter. Higher incentives pushed gross margins down to 15.9%, from 28.3% last year and 20.9% last quarter. Due to lower revenues, SG&A expenses deleveraged by 190 basis points and helped push operating margin to 3.8%. As bad as the current conditions remain, Lennar was able to put a positive spin on the future. The company said that "if the current environment of strong employment, low interest rates and a healthy economy continues, and the market for new home sales demonstrates traditional, seasonal improvement, we will meet or exceed our 2006 earnings of $3.69 per share." But, Lennar admits that it is mostly a guess and even said that it is "a goal at this point, and not guidance." It followed up on its conference call that "market conditions have continued to be difficult...we have not seen an improvement in market conditions to date." Also during the conference call, Lennar laid out its plan to achieve its earnings goal. It expects deliveries to decline 20% for the full year, but margin improvement should make up for the expected revenue shortfall. It expects deliveries to gradually increase from 8,500 in the first quarter to 10,500 by the fourth quarter. Along with the increase in deliveries the company forecasts that the average selling price will gradually improve from $300,000 in the first quarter to average $310,000 for the full year. The average price last year was $315,000. It would appear aggressive to suggest that margin improvement would be able to overcome a 20% decline in units combined with a drop in selling price, but that is exactly what Lennar expects to be able to do. While homebuilders have gotten a bit more optimistic, there remains more pessimism then optimism. The National Association of Home Builders released its Optimism Index rose 2 points in January to 35. A reading under 50 indicates more home builders view market conditions as poor.

Fourth quarter results from Parker Hannifin reveals that the manufacturing sector has moderated, but with pockets of strength. While North American core sales only increased 1% and the company said that they are "moderating...and when I say moderating, that's coming down". Aerospace sales increased 16%. Additionally, international core sales increased 12%. These two segments are expected to drive earnings growth this year even as its automotive, heavy-truck and residential air conditioning sales are expected to slow further in the second half of 2007.

Consumer spending showed mixed results in December. Overall retail sales increased 0.9% in December, the strongest month-over-month since July, according to the retail report published by the Census Bureau. The year-over-year comparison painted a much different picture. The 3.6% increase was the smallest gain since August 2004. Building materials sales dropped 4.3%, the first year-over-year decline since February 2002. Sales at electronics stores surged 13.7% compared to last year, which was the largest year-over-year increase since April 2004. Flat panel televisions were the hot item this Christmas, but how profitable they were for retailers' remains to be seen. The larger question is whether or not the drop in energy prices will spur consumer so spend the "savings" from lower energy prices. The National Federation of Retails expects retail sales growth to decelerate to 4.8% in 2007. This would be the smallest increase in five years.

The Federal Reserve's Beige Book reported that "economic activity expanded at a modest pace since the last report." The only blemish that appeared in this compilation, besides the common reference that residential housing was weak along with auto sales, was that "labor markets as tightening and cited examples of some businesses having difficulty finding qualified workers." The report quickly added that even with a tighter labor market, wages only showed "relatively moderate gains." In a speech today, San Francisco Federal Reserve Bank President, Janet Yellen said that while she views the "labor-market tightness as transitory, I do take it as a serious risk."

Chad Hudson
Mid-Week Analysis
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