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Preannouncements Take Center Stage

Last week kicked off the pre-announcement period. Honeywell was one the first to announce it would not meet analysts' earnings estimates. During the conference call, David Cote, CEO, said, "The recovery is not there the way we anticipated it. It seems to be going the other way." Cote added, "I don't expect Honeywell will be the last company to put out a warning for the second half." He was right, there has been a flood of pre-announcements this week. Also on the conference call was an interesting question from a buy-side analyst regarding taking a charge. Here is the exchange:

Question: You indicated that [the] economy seems to be slowing or at least there is no material pickup. With the pressure on your businesses, why can't you take a big charge towards the end of the year and kind of clean out and make the changes you want to do? What is your thinking on that?

Answer: Obviously, I am not a big fan of big charges just for the sake of big charges. If there is something that has occurred where we have to do it, I will face into it when the time comes, but I just think it is not generally a good practice unless there is a good reason for it. If one arises, we would handle it the right way and if it doesn't, we won't.

Just when I started to think financial analysts were figuring out that taking charges really are meaningful and not an easy way to push a bad investment or decision under the rug. Wishful hoping I guess. Also last week, Lucent said sales would fall 25% sequentially and expects its loss to be 45 cents per share, almost three times the loss analysts expected. Can anyone remember the last time Lucent didn't issue an earnings warning?

Right now it seems everything we have been discussing over the past several months is coming to a head. Retailers are starting to experience lower sales, over-leveraged consumers are starting to buckle, companies are reining in their expansion plans. When companies hold their earnings conference calls, or pre-announcement calls, we should see how companies are navigating this confusing economic situation.

Best Buy's earnings conference call held on Tuesday provided an excellent example of what we can expect to hear from other companies. In its press release and conference call, Best Buy provided quite a bit of information detailing what is happening in the economy and what companies are doing to navigate through this difficult economic environment. First of all, Best Buy reiterated, that its "earnings decrease reflects the significant slowdown in comparable store sales gains since July, as well as the challenges of rapidly reducing expenses in our existing cost structure." Best Buy said same store sales are expected to be flat for the third and fourth quarter as well as its earnings. Second half earnings will be helped by "reductions in SG&A expense, such as outside services, discretionary advertising and corporate overhead." Best Buy also noted that raising health care costs were adding to its cost structure. When companies cut costs, they are essentially taking away money that someone else used to receive, either employees or service providers. We have been pointing out that the aggressive expansion plans retailers have pursued would halt. Best Buy noted that, it is "First of all, we took some things that we had been working on off the table like international expansion, acquisitions, and a series of smaller other kinds of initiatives. There were expenses related to those, and those will be structurally going away for the balance of the year. We also looked at things that were either more speculative, things we were doing with consulting services, or secondary in terms of they're sort of more questionable and pulled those things out of the plan."

Another indication of a weakening consumer came from NCO Group, which is the largest accounts receivable collection service company in the world. Tuesday, the company said it will earn between 28 and 33 cents per share, quite a bit lower than the 41 cents analysts' had been estimating. In the press release the company said:

 "During the first half of the third quarter, we have seen a further deceleration of consumer payment patterns. While we have adjusted our spending to adapt to the current levels, we have not executed material changes to our expense structure given the fact that our client volumes are beginning to increase. While the planned increases in client volumes could signal an improving operating environment for our company, we are approaching the next several months cautiously. We will control expenses wherever possible, and spend incremental costs only when necessary to accommodate client growth."

On Wednesday, EDS announced one of the bigger surprises so far. Instead of earning $0.74 per share this quarter, EDS expects to report EPS of 12 to 15 cents. Asset writedowns comprise of about 22 cents of the miss, the rest is based due to "reduced discretionary spending on existing contracts as well as fewer new sales" and "a decision to increase investment in sales pursuits and processes to leverage an increased business pipeline." The company also noted weakness in contracts in Europe. EDS expects the market softness to continue into next year. Revenue will be down 2-5% instead of up 4-6%.

There is no pick up in technology yet. Charted Semiconductor, the third largest contract chipmaker, warned it would miss its sales target. The company added, "based on reduced demand projections from a number of our customers...this is no longer achievable". Also, Oracle announced it will miss analysts' estimates and said the corporate IT environment remains weak. Previously, Oracle expected modest revenue growth in fiscal 2003 (year ends in May), however, CFO Henley said this week he was "less optimistic" and flat revenue would be more likely. Larry Ellison, Oracle's CEO, expects fiscal year earnings to be flat as well.

Over the past couple months there have been several media related companies indicating advertising is picking back up. Looking at the situation with a jaundice eye and in light of the Best Buy conference call, companies, assuming there was going to be a second half recover, might have tried to get ahead of the curve and started advertising campaigns. It has just been recently that doubt was cast on the second half recovery, and most economists continue to believe the odds of the economy contracting are extremely small. Additionally, automakers comprise an extremely large portion of adverting. After the incentive spurred boom ends, the automakers might decide to pull in the purse strings and reduce it advertising spending.

Another interesting tidbit was gleaned from the Circuit City conference call. Circuit City owns a large amount of Carmax. During the conference call the company said that zero percent financing drives traffic, but "It's a marketing tool but almost nobody takes it. Nobody who needs the loan can take that loan." Most people assumed this, but it is nice to see confirmation. It shows the precarious financial situation the majority of consumers are in if they have to assume a longer, higher interest loan simply because of a lower monthly payment.

Elsewhere in the news, health care costs continue to be a thorn for business owners and workers alike. A survey by the Kaiser Family Foundation found that health care premiums rose 12.7% last year, which was the biggest increase in 12 years. Just as Best Buy noted, health care is starting to increase labor costs. To help ease their burden, more employers are passing along more of the cost to employees. Some employers are deciding to drop coverage all together, the number of small businesses offering health insurance dropped to 61% from 65% last year.

This week, outplacement firm, Challenger, Gray & Christmas issued a report saying that white-collar workers comprise 48% of the long-term unemployed (out of work longer than 27 weeks) up dramatically from 38% last year. Additionally, the number of long-term unemployed jumped 81% to 1.5 million workers. Commenting on the report, John Challenger said, "the continuation of prolonged joblessness may be the straw that finally breaks the back of consumer spending."

The refinance boom is the big variable for the economy. With backlogs throughout the process it now takes about 60 days to complete. Economists are encouraged that this will coincide with the start of the holiday shopping season. There is an outside chance that the consumer will do an about face and use the proceeds from refinancing to pay down other debt or save it. If this happens, any hopes of a consumer led recovery go right out the window.

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