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Negative Earnings Momentum

Today’s release of preliminary GDP data indicated the economy was not as weak as economists expected in the third quarter. This was followed by the better than expected Chicago PMI report. Even thought these two better than expected pieces of bad news gave investors a ray of hope, it is important to remember that the economic situation is getting worse. Merrill Lynch is expecting fourth quarter GDP to decline by 1.5%. Yesterday, consumer confidence fell much more than expected. The Conference Board’s index of consumer confidence fell to 85.5 in October, down from 97 in September. Analysts expected a much smaller decline to 95.5. Both components of the index notice dramatic declines. The current component fell to 107.6 from 125.4, while expectations fell to 70.8 from 78.1. Confidence is no doubt being shaken by bombardment of layoff announcements and anthrax scares. Layoff announcements are painting a grim outlook for future job prospects. Respondents to the survey that believe jobs are hard to find rose to 20.7%, up from 18.8% last month. Additionally, those that see jobs being plentiful plummeted to 21%, from 27.1% in September. This should lead consumers to retrench, cooling the spending spree of the last four years. And consumers are at least saying they are. The Consumer Confidence Index also showed a decrease in the number of consumers planning to buy a house or major appliance. Not only is the economic picture getting grimmer, but also earnings actually look worse.

Third quarter results are coming to a close and according to FirstCall, S&P 500 earnings are poised to decline about 22% from last year. And those are pro-forma results. FirstCall estimates that the terrorist attacks knocked about 5% off earnings, so even without the attacks earnings would have been down on the order of 17%. These results are far below the expectations at the beginning of the quarter. On July 1, S&P 500 earnings were expected to decline 6.2%. Estimates had already been lowered prior to the attacks to a decline of 14.7%. After the attack, estimates plunged to down 22.8%. FirstCall’s biggest concern is the rate that fourth quarter warnings are already being announced. From Oct 1 to Oct 26, 283 companies have pre-announced earnings shortfalls. This pace is way ahead of the previous quarter’s. Based on the level of fourth quarter earnings warnings, FirstCall expects "more slashing for at least 4Q01 and 1Q02 estimates in the coming weeks." Firstcall forecast that fourth quarter S&P earnings will be down 22% as well. A 22% decline in the fourth quarter will be much worse than the 22% decline in the third quarter. Insurance losses account for about 3% of the decline that will not be present in the fourth quarter and the comparisons are on a much easier year ago period. FirstCall is not expecting the first quarter of 2002 to show a sequential increase, and is not ruling out that the second quarter will fail to increase sequentially. Revisions to 2002 earnings should be coming shortly, according to FirstCall.

The inventory glut continues to pressure margins. In Thursday’s edition, the Nihon Keizai Shimbun is reporting that the DRAM spot price has declined to under a buck. The article quotes a spokesperson for a major Japanese chipmaker, "We cannot turn a profit unless the price trebles from what it is now." The price of DRAM has been in free fall for at least a year, falling 90% from the year ago levels. Prices fell 10% in just the past week, which is the late stage of the procurement for holiday season. Now that the holiday buying season has ended the prices of DRAM is expected to continue its slide.

In addition to the inventory glut, over capacity continues to plague technology companies. UMC released third quarter earnings this week and revealed that revenue declined almost 60%. UMC is hoping that "consumer electronics and PC orders" will boost sales 10% next quarter. UMC did note that "wireless and wire-line orders show no sign of increasing." The dramatic fall in consumer confidence will likely spill over into pocketbooks. If this happens it is unlikely that the fourth quarter will provide any needed relief. Wall Street analysts are already calling for a 3% decline for the important holiday season. But I digress. UMC also slashed its capital spending to $1.1 billion, down from a previous revision of $1.5 billion. UMC’s original forecast called for $2.8 billion.

Cingular Wireless announced its decision not to develop a full 3G-wireless network. A year ago, 3G was believed to be the catalyst for the next wave of upgrades and a rebound in the technology sector. This will severely put a damper on the prospects of a 3G build-out in the US or in Europe. Not only will this squelch the handset upgrade cycle, but it will leave wireless carriers holding basically worthless licenses that they overpaid for.

Airlines are starting to report earnings for the third quarter. US Airlines reported a loss of $11.64 per share, which was worse than analysts expected. It has reduced capacity by 23% since the attacks on September 11th. Its load factor climbed to 62 in October from 46 percent following the attacks. These results are typical of the industry. The Air Transport Association reported that industry-wide load factor for October was 64 percent. International flights are even lower. Traffic picked up after the initial decline, but has stabilized at current levels. John Heimlich, economist for the industry trade group, noted that "We haven’t seen very much progress this month… No week stands out." Last year the load factor was about 70 percent. Considering the industry has reduced capacity by about 20% and there are about 23% less people flying domestically now than a year ago. International travel is down 37%. Most of the airlines are not profitable at these load factors. Now that the airlines are discounting tickets to try and spur travel, breakeven points are much higher.

Starwood Hotels is also reeling from the September 11th attacks. Net income for its third quarter fell over 70%, on a 12% decline in sales. Revenue per available room (revpar) declined almost 20% for hotels open for at least a year. During the second half of September revpar dropped a whopping 49%.

The great bull market of the late 90s was helped by several factors. Most of these factors have been neutralized. Stock options played an integral role in propping up company earnings, as companies were able to issue stock options in lieu of salary. This basically deferred a substantial amount of compensations and kept it "below the line." The National Center for Employee Ownership estimates that over 10 million workers have options as a form of compensation. During the boom workers gladly accepted a lower salary for more stock options. Now that stock options have lost their "lottery ticket" status, employees are asking for higher base salaries. In fact, "Nine out of ten take more cash and less equity" says Jana Rich, managing director for Korn/Ferry International. This will put more pressure on companies as they cut costs. Companies have also taken several paths tying to appease workers that have options that are underwater. In the past companies would typically re-price existing options. However, due to accounting changes in 1998 companies now have to take a charge to earnings if they re-price employee stock options. The standard practice now is to simply issue more options at a lower strike. However, this is starting to get the attention of investors. Not only does this dilute existing shareholders, but negates the idea that options are supposed to be a performance-based form of compensation.

Wall Street analysts are starting to pitch "defensive" stocks. Clorox is one example. It was upgraded today by one of the large Wall Street firms. The analyst cited that valuation appears attractive at 23 times 2002 earnings. Clorox has posted negative revenue growth in five of its last eight quarters with negative earnings growth in four of those quarters. Earnings per share for the year ended June 2001 is only 7.8% above 1997 levels and 17.6% below last year’s earnings. The analyst that upgraded Clorox sees the company increasing volume by only "low single digits." I agree with the analyst that Clorox is a defensive name and will not dramatically surprise on the downside, but for a company that is barely growing to be trading at a growth multiple is hardly a safe haven in this market.

The sliding stock market has put a huge damper on the venture capital industry. Nationally, venture capitalists handed out only $7.7 billion, down 73% from last year and down 31% from just the previous quarter. The outlook does not look any better. "We’re not seeing anything to suggest the fourth quarter will be an up quarter," said John Taylor, vice president of the National Venture Capital Association. Investments into venture capital funds have been hit just as hard. During the third quarter venture capital funds raised just $6.2 billion, down 78% from last year and down 37% from the second quarter. Venture capitalists are tightening the reins with 81% of the money going to existing investments.

Credit quality is falling as fast as corporate earnings. S&P expects more than 200 companies to default on about $100 billion, more than double the $42.3 billion defaulted on last year. Likewise Moody’s downgraded 122 companies representing more than $500 billion worth of paper during the third quarter. Moody’s only upgraded 22 companies with $66 billion worth of debt. Both rating agencies are expecting a dramatic rise in the default rate of "junk bonds", with Moody’s expecting a slight worse scenario, 10% default rate compared to S&P’s 9.4%.

The commercial paper market is coming under pressure as credit quality is deteriorating. As a result corporations have not dramatically lowered their borrowing cost. Money market mutual funds are indicating that they are becoming more worried about credit risk, forcing companies to issue longer maturity paper. In an article published in the Financial Times on Monday, Boyce Greer, the market group leader at Fidelity Investments, said "You can’t wait around for a ratings agency to put a company on negative watch. It’s too late by then." Managers have been turning to other forms of short-term paper. Asset-backed has become the most popular alternative, with agency and T-bills securities also gaining popularity. The amount of commercial paper outstanding has declined by almost $200 billion this year to $1,423 billion. Asset-backed securities have experienced a gain of about $40 billion in the last two quarters. The amount of commercial paper held in money market accounts has declined to 34.5% from 36.7%. However, this shift into asset-backed securities is not without its own risks. These securities are highly dependent on just what the assets are. Usually these securities are full of trade receivables, car loans and other type loans. As the economy continues to weaken it will not bode well for the highly leveraged companies and consumers. We know defaults are rising and the question is likely to shift to "when" and not "if" more defaults will affect money market funds.

Have a safe and Happy Halloween.

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