UNEDITED

Revenue growth in the third quarter was up 9.5% for the S&P 500 according to the latest estimate from First Call. This is substantially higher than the 6.5% estimate when earnings season started, but should not be a surprise given the latest economic data. This could be revised even higher since it does not include the results from retailers, which started reporting results this week. So far these results have met or exceeded analysts estimates. As third quarter results were reported better than estimates, analysts have been inching up earnings estimates for the fourth quarter. Analysts are now forecasting earnings growth of 21.7% for the fourth quarter, up 0.8% from the end of the third quarter. Although estimates for the fourth quarter have increased, estimates for the first quarter of 2004 have declined by 40 basis points. In fact, earnings growth estimates for the full year 2004 have declined throughout the year. Since the end of March 2003, full year earnings estimates for the S&P 500 have increased from $52.30 to $54.76 now. But earnings 2004 have only climbed from $61.00 to $61.52. Analysts either expect that the earnings recovery has run its course and expect "normal" growth, or are waiting to increase earnings estimates.

Last week, I mentioned that Ford was having difficulty weaning itself off incentives for its highly anticipated new F-150. This week, Ford announced that it would offer 0.9% financing on the F-150 as well as offer $1,000 rebates to non-Ford owners. With high fixed costs including pension and health care cost, the automakers are stuck in a position where they have to produce as many cars as possible to spread these across as many vehicles as possible. Prior to 1998 there were only a dozen months that auto sales reached the 16 million unit rate. Since then, there have been 58 months when vehicle sales topped the16 million annualized rate. Automakers decided to use incentive to bolster sales once sales tapered off, especially after September 11. Automakers turned to low interest rates besides rebate offers as a way to lower monthly payments for consumers. The incentives along with zero-percent financing plan worked, but the automakers have to keep increasing the incentives to entice new buyers. Unfortunately, at some point lower credit quality customers will be the only avenue to maintain sales growth.

Mitsubishi Motors might prove to be the test case for what happens when financing incentives go awry. The Asian Wall Street Journal carried a story describing how Mitsubishi went from one of the fastest growing car companies to one of the weakest in a few short years. Mitsubishi announced this week that it had a loss of 80.22 billion yen ($740.2 million) for the six-months ending September 31, 2003. This compares to a profit of 9.6 billion yen during the year ago period. The loss results from a combination of lower sales and a charge to cover car-loan defaults. Mitsubishi's reversal stems from rolling out its "zero-zero-zero" marketing plan in late 1999. This allowed buyers to drive off with a new car with no down payment, no interest, and no monthly payments for up to 12-months. Obviously sales took off. In 1998, US sales were 190,515 units, by 2001 sales jumped to 322,292. Sales were up another 7% in 2002 to 345,111 vehicles. Not only was Mitsubishi enjoying fabulous sales growth, but higher profitability as well. The zero-zero-zero was not costing the company as much as previous incentives. According to one economist quoted in the Automotive News in February 2000, Mitsubishi was only spending about $500 per $10,000 of vehicle value, which compared with the industry average of $1,877 per vehicle. The Automotive News story also revealed what Pierre Gagnon, Mitsubishi executive vice president, thought the risk was:

"Gagnon said that only real risk with zero-zero-zero was in discovering a bunch of bankruptcies once the payments start coming due in January. But a pilot zero-payments-until-2000 program last June showed the eligible A-tier customers didn't default at any greater rate"

In June of 2003, S&P cut its rating on Mitsubishi's asset backed securities, due to a rise in defaults. A month later the company announced that it would have to take a 50 billion yen ($419 million) charge to cover the car-loan defaults. In hindsight, not all customers that were approved for the zero-zero-zero plan were A-tier customers, or at least are not now. Initially, the company started out with tight standards only to loosen standard to capture more sales.

The company said that it had to tighten its credit standards, which caused sales to falter. Earlier this year, Mitsubishi announced it was canceling its zero-zero-zero programs and replacing it with traditional cash rebates. While most automakers have reported lower sales this year, Mitsubishi has been at the bottom of the list. During the first ten-months of the year, Mitsubishi has sold 221,481 vehicles, 22% less than the first ten-months last year, and the trend is not favorable as October sales declined 30.5% from October 2002.

What happened to Mitsubishi showed just how much consumers prefer cheap financing as opposed to cash financing and the repercussion that eventually develop. Cheap financing or actually, low monthly payments, has been driving consumption. Data from the Federal Reserve showed that the average maturity for auto loans has increased to 63.2 months. This was the longest maturity ever, which keeps the monthly payment lower. Granted it makes perfect sense for consumer to stretch low interest lows over as long as a period as possible. The problem arises when the economy is based on persuading consumer to continue taking out more and more loans. One anecdote, on my way back from getting dinner tonight, a bus had an ad from KB Home advertising homes for $650 a month. Homebuilders regularly dismiss concerns that a raise in interest rates will affect housing sales. They all claim that homebuyers will just secure an adjustable rate mortgage. There seems to be little concern that these adjustable rate mortgages will actually adjust to a higher interest rate, leaving homeowners in a precarious financial position.

Incidentally, Ford's debt was downgraded by S&P to BBB-, just one notch above junk status. Investors were relieved that the debt was upgraded to "stable outlook" and went on a buying spree as Ford bond spreads narrowed by 50 basis points and the stock price jumped 6% to a 15-month high.