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Costs Are Pressuring Margins


The second week of earnings season is dominating investors interest. Companies have been beating earnings estimates. By Wednesday night, 196 S&P 500 companies had reported fourth quarter earnings. Earnings are beating analysts' estimates by an average of 2.2% with 66% of the companies beating estimates and 17% failing to meet Wall Street expectations. As we have noted previously, energy companies were expected to be one of the strongest groups, but the results so far are blowing away estimates. On average, the 9 of the 28 S&P energy companies have reported earnings that are 115% higher than last year. While fourth quarter earnings have been better than anticipated, analysts have slightly lowered estimates for the first quarter. As of last Friday, fourth quarter earnings growth estimates increased to 16.5% from 15.1% last week, while first quarter estimates slipped to 7.3% from 7.7%.

The strong economy has benefited box makers. Packaging Corporation of America reported that volumes increased 6.7% during the fourth quarter. This was on top of 7.5% increase last year. Volumes increased in December. Volume was up 4.5% in October and November, and jumped 10% (excluding an acquisition) in December. This strength has continued into 2005 with volume up about 10% on an adjusted basis. Cost, however, were higher than expected and the company failed to meet analysts' estimates, even though operating income increased 60% from last year. Transportation issues were discussed on the conference call. The company said that shipping cost the company $0.03 per share, or about 8% of what it earned. The higher transportation costs are influencing business decisions. The company said it is carrying ten percent morn inventory because "the cost of carrying that inventory is very small v. the additional transportation expense you run into if you don't have that buffer. We went on to say he "would be surprised if I am the only on affected by this."

DuPont earned $0.37 per share, 28% higher than last year and four cents better than Wall Street expected. The chemical company experienced 14% revenue growth in its five core segments. In addition to strong volume growth of 5% in the quarter, it was able to raise prices by 4%. For the full year prices increased 3%, which was characterized as "the strongest quarterly and annual price gains that we've seen in 15 years." Moreover, during the fourth quarter, DuPont has been able to increase prices more than its input prices have increased. Its initial price increases during the first half of 2004 only offset about half of the impact from higher input prices. By the third quarter it, totally offset the higher prices and even added a penny to earnings per share. In the fourth quarter the higher prices added eight cents to earnings, or about a fourth of overall earnings were due to higher prices. The company expects its "positive pricing momentum will carry into 2005."

Higher food cost had a bigger affect on Kraft. Earnings per share dropped 26% even as revenue increased 7%. Higher food costs pressured margins by 140 basis points. Cheese was about 20% above its long-term average. While it expects dairy prices to moderate, it expects to raise prices on several other items this year. The company mentioned: coffee, nuts & cereal in the US, and ready-to-drink beverages. The company tempered expectations by saying that its noticed that consumers have become more "value-conscious" in recent years. Analysts lowered earnings estimates by about six cents. Sara Lee said its earnings for the year ending in June would be lower this year by $0.15 due to higher commodity costs and sluggish European sales.

Restaurants also had to contend with higher food costs. Chili's increased same store sales by 3.2% with almost all the increase coming from higher prices. In fact, there was a 1.3% decrease in traffic, which was offset by a 1.5% increase in mix. Even with the price increase, gross margin declined as commodity prices increased. The company specifically mentioned: dairy, ribs, burger meat, chicken and produce. It expects higher prices to continue to weigh on margins during current quarter.

Newspaper advertising remained in the doldrums in the fourth quarter. The New York Times Company reported that fourth quarter earnings rose 4%, with advertising revenue advancing only 2.4% and circulation flat. The company said that local advertising was better than national, which decreased 1.4% due to declines in: entertainment, travel, financial, and technology. Weakness in those categories offset gains in: telecommunications, healthcare, pharmaceuticals, and banking. Classified advertising grew 2.9% helped by help wanted and real estate, with automotive advertising declining. It was noted that help wanted advertising improved in all its newspaper properties. Its costs increased by 4.6% driven by investments made at the International Herald Tribune. Additionally, the company said newsprint prices increased 7.5%. Gannett echoed that local advertising and classified were stronger than national. It also saw strength in help-wanted advertising, up 22%, with 80% of its papers reporting a year-over-year increase.

All the financial companies have reported strong results for their mortgage operations. During its conference call, Washington Mutual revealed why the Option ARMs have grown to be popular. We have discussed the Option ARM mortgages for the past several months. During its conference call, Washington Mutual let everyone know why its popular when it answered this question: ...how much higher was the gain on sale in option ARMs than the gain on sale on fixed-rate loans?

Well, pretty significantly. I think as we've told you in the past, that's why we've been pushing the option ARMs as high as we have. Our total ARM production was, you know, over two-thirds this quarter. And that's a higher margin product for us...So I am feeling -- you know, we're going to continue to push that option ARM as hard as we can.... So, that will be a continued focus for us.

While earnings are strong, cost pressures are escalating rapidly. Most commodities increased during the second half of 2004 and have remained at high levels. This will pressure the year-over-year comparisons over the next couple of quarters. Plus, since most companies procure supplies on long-term contracts, cost pressure will continue to escalate as contracts are rewritten at higher prices. AK Steel said that it was able to get double-digit price increases on the contracts that were renewed. With the new prices agreements the company expects revenue to be at least $600 million higher than in 2004. These higher prices for inputs will either lower earnings for companies that use these commodities or end prices will have to increase causing inflation to increase.

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