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Rising Costs Start to Pressure Earnings

There have been 280 S&P 500 companies that have reported third quarter, 65% have exceeded estimates and 20.4% have missed. Analysts have focused on rising costs, specifically for energy and raw materials, and how companies are responding to them. Rising energy costs are forcing companies to think of ways to reduce costs or dependence on a single source of energy.

We have discussed that it will be important to understand companies' hedging strategies during this period of rising energy and raw materials. Mohawk, the leading carpet manufacturer, said that the majority of their hedges run out by the first quarter of 2006. It was trying to time the natural gas market this fall. It said that historically, a low point is reached in September. Instead of reaching a low point, two hurricanes damaged most of the infrastructure and prices almost doubled. This could be a real dilemma for companies. Kimberly Clark said that 70% of its hedges run out by March 2006. Mohawk also commented that consumers are altering their purchasing decisions. It thinks that discretionary spending is being limited and when homeowners do a remodeling project, the flooring does not have to be replaced and thinks that the flooring is being postponed.

3M's experience is almost directly opposite. During the conference call, Patrick Campbell, CFO, said "I thought I was a fool, when we hedged natural gas at that level [50% hedged] with natural gas prices at $5." 3M also experienced much stronger sales in Asia (14.2%) and weakness in Europe (+2%). It also said that it has not seen any softening of its end markets caused by the hurricanes. 3M also said that it maintains hedges equal to 40% to 60% of its exposure. That includes price escalation agreements for products that have a high percentage of commodity exposure. Another interesting comment from 3M was that Europe was a much more private label market, which is causing margins to be thinner than in the US.

We have heard that higher energy prices will pressure margins and have caused companies to find new ways to cut costs, especially energy costs. Packaging Corp. of America laid out an example of how the higher natural gas prices affect it. It is lucky that most of its mills use coal, but have the ability to use natural gas as well. First of all, in order to make a ton of paper it needs to boil about 20 tons of water. It said that it could sustain production of just over 1,000 tons of paper just using its coal boilers, but that is where it maxes out. If production had to increase to 1,100 tons it would need to use gas. Its cost on the incremental volume jumps from under $30 per ton to over $200 per ton. At that level its cost is more than the selling price. With that steep of a cost curve it should come to no surprise that their driving focus is to avoid using natural gas during the fourth quarter. The company said that means they will "shift our operational strategy to be able to do that, take risks in areas that protect energy." Commenting on the strength of the economy, Packing Corp. it said that corrugated box volume rose in September. That was the first increase since March.

Potlatch, another paper company, said that, "An unusually large portion of our capital spending next year will be aimed at further energy reduction processes." It also discussed shifting transportation methods from truck to rail. Shipping by rail is less expensive but takes 10 to 14 days compared to truck, which is only 2 or 3 days.

Steel was the commodity that was frequently discussed before energy prices soared. After dropping through most of the year, steel prices have stabilized and on some products have starting rising again. AK Steel reported that spot market prices increased during the latter part of the quarter and that was the first increase this year. It also expects its average selling price to increase 3%-4% during the current quarter compared to the third quarter. AK Steel is another company that needs to find ways to take natural gas out of the cost equation; apparently it takes quite a bit to melt steel.

Analysts were less then thrilled with Caterpillar's third quarter earnings. The company earned $0.94 per share, lower than the $1.06 Wall Street expected. Revenues met estimates, but production bottlenecks caused earnings to be lower. In a bit of defensive commentary the company highlighted how strong the global economy has been over the past two years. Sales for the first nine-months of 2005 are up about 64% from the first nine-months of 2003. The company also said that some of its plants have ramped up production by 80% or more over the past two years. Caterpillar also said that its price increases have offset its raw material increases.

Geographically, the global economy retained the same dynamic that has existed for several quarters. Europe remains weak, while Asia and the emerging markets are much stronger. Of course, China leads the pack. One of the problems of China's growth is the government can essentially turn off certain types of projects. Ingersoll-Rand's major product in China is used for building roads. The company said that its sales were down "significant double-digits" and that will continue next year because the government has reduced activity and not provided financing to the contractors to purchase equipment. Caterpillar also commented that growth in China will be in "fits and starts" based on how the government tries to manage the country's growth.

The increase in global liquidity has benefited McGraw-Hill, which owns Standard & Poor's. The strength has been in residential mortgages. According the McGraw-Hill, new dollar volume issuance increased 27% in the third quarter, and has increased 41.4% during the first nine-months of the year. We have discussed the rebound in commercial construction on several occasions and McGraw-Hill said that new dollar volume issuance for commercial mortgage-backed securities jumped 96.9% in the third quarter and is up 79.5% during the first three quarters of the year. The CDO market is running even hotter. New dollar volume issuance for Collateralized Debt Obligations rose 120.6% during the third quarter pushing the gain for the year-to-date to 113.1%. The company also said that the Mortgage Bankers Association recently increased its fourth quarter mortgage obligation forecast to $639 billion from $595 billion. McGraw-Hill also owns BusinessWeek. We have heard from the newspapers that the advertising environment has been difficult, and it has been at BusinessWeek as well. The company said the positive was that the rate of decline has improved. Advertising pages were down 11.5% in the first quarter, 9.2% in the second and down 8.3% in the third.

Cost cutting is popular in corporate America right now. UPS noted that its Saver product, which delivers the package later in the day, was growing faster than its morning delivery service. The Saver product costs 10%-15% less, one simple way to reduce costs. When asked about the health of the economy the company said that there was a "little bit of a pick up in September" and were amazed at the resiliency of the economy. The company said it had "no reason not to kind of go along with consensus and say that the economy is going to be okay." By talking to its customers, it thinks it will be an okay Christmas. Most of its customers are optimistic about the holiday season. They acknowledge that there are challenges facing the consumer and the energy crunch is stretching their dollar.

Consumer prices have not come under as mush pressure as producer prices, but consumer inflation is staring to heat up. While several economists have dismissed higher consumer inflation because it is mostly the "core" rate that is rising, higher producer prices will spill over into higher consumer prices. While it might take time for prices to work though supply chains, it remains likely that inflation will continue to rise into 2006. One recent example is that Corn Products, one of the leading manufacturers of high fructose corn syrup, said it plans to raise prices by 20%. Oh yeah, that will only increase food costs, so I guess that is not real inflation.

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