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Reality Bites


During the past couple months, Wall Street has been hoping the economy will turn around to jump start earnings. Now that earnings warnings are starting to come in, it looks like Wall Street will be in for a reality check. Besides the plethora of negative earnings revisions, the economic data has taken a turn for the worse.

Earnings pre-announcements continue to be center stage and will until companies start reporting earning in earnest starting the week of October 14. As mentioned last week, FirstCall expects earnings growth to drop to 6% by the time companies start announcing earnings. It got a good boost last week, dropping to 7.3% earnings growth from 8.5% last week. Warnings from AMD, Dow Chemical, and an earnings miss from Walgreens will put additional pressure on estimates.

Last week I said fourth quarter estimates were too high. Its nice to have some company, not too much, but enough to let you know your not totally off your rocker. Last week's Barron's ran a story about fourth quarter earnings that quoted Doug Cliggott, chief executive and strategist for Brummer & Partners and former managing director of JP Morgan. "I'd put that number in the 'ain't no way, no how' category," said Cliggott. He added, "Given what looks like very meaningful moderation in the pace of economic activity, we'd be lucky if earnings were flat in the fourth quarter versus the third quarter."

ARM Holdings PLC, the British semiconductor designer, announced that its earnings would be about half what analysts expected. ARM Holdings' warning is even more surprising since it has not missed an estimate since the first quarter of 1999. Chips designed by ARM are used in 70% of the mobile phones and other portable devices. Previously, its' clients, which include most of the leading chipmakers, expected demand to improve during the second half of the year. "Over the past 90 days, they have seen that upturn fail to materialize…and even seen conditions deteriorate," said CEO Warren East. This does seem to contradict some of the comments handset makers have made recently. The company also warned that revenue and earnings will be flat sequentially in the fourth quarter. Traditionally, the fourth quarter is stronger than the third quarter. Mr. East also indicated that the industry is deferring investments.

The longshoremen strike and its pension fund teamed up to cause Burlington Northern to miss earnings estimates for the third quarter. The second-largest railroad company didn't quantify the impact from the strike, but it will incur an additional $11 million in expenses during the third quarter and $4 million in the fourth due to Burlington lowering its assumed rate of return on its pension plan assets to 8.5% from 9.5%.

Dow Chemical announced its third quarter earnings will be about 45% lower than estimates due to higher oil and gas feedstock prices. Analysts were concerned since Dow is well known to be one of the better hedgers in the industry and suspect there might be more to the story. Sanford Bernstein analyst, Graham Copely, said, "it's an industry problem…you are getting an indication oh how competitive this industy is and how lackluster the economy is." Maybe this is another example of a hedging strategy not being as effective as before? Dow's announcement is also concerning since just a couple months ago, it said they "expect overall economic activity to continue its improvement in the third quarter…earnings for the third quarter will be substantially better than the third quarter of last year."

A recent survey from Towers Perrin, an actuarial consulting firm, found that health care cost would raise 15% in 2003. The firm expected the results to reveal a 10% to 12% increase. I wish! I just received a notice that my family's healthcare premium will increase by 28%. This will be the second increase in 14 months. Over that span, my premium has increased over 100%. The survey also found that more companies are passing along the increase to workers.

On Thursday, EMC warned it would lose an additional penny on top of the penny analysts expected EMC to lose. The data storage company also said it would lay off 1,350 employees, on top of the 4,000 shed last year. Commenting on the industry, the company said, "The IT spending environment continues to be brutal. In fact, it got even worse at the very end of the quarter. Our third quarter was on track until late September."

CIO magazine provided more confirmation that there would not be a pick up in technology spending in the near future. "The light at the end of the tunnel in terms of increased spending on IT is not going to appear until 2003, according to Gary Beach, publishers of the magazine that conducts the survey. Beach adds that, "Even then, it's going to be gradual. They're not going to all of a sudden turn the calendar and see massive budget increases."

Even technology companies are not spending money like they used to. The Financial Times looked at the top 30 companies in Silicon Valley and found Research & Development spending dropped 5% during the first half of 2002 compared to last year. Larry Ellison, chairman and CEO of Oracle, was quite to the point during an interview with the FT, "Silicon Valley will never be the same. Those who believed this is merely a cyclical downturn are mad. They cannot see what is happening in front of their eyes. Our industry is going to mature and as something matures, the rate of innovation does slow." Dan Wilson, economist at the Federal Reserve Bank of San Francisco, is also concerned, "This is a worrying development. Corporate R&D spending is very important for innovation and has been shown to be closely correlated to [you guessed it] productivity."

GM's pension fund continues to be one of the most talked about items. John Devine, GM's CFO, said "At 10%, given where the inflation rate is and where returns are, it looks somewhat high." According to a recent Financial Times article, a 1% reduction in the assumed rate of return increases its pension expense by $700 million. Considering 8.5% seems to be the rate companies are switching to, GM's earnings could face severe pressure.

Wal-Mart lowered its same store sales guidance for September to between 3% and 4%, previously Wal-Mart maintained a 4%-6% range. The Instinet Redbook weekly sales report showed same store sales fell 1% compared to the same week last year. Additionally, the Redbook report showed September sales were 0.7% below sales in August. And if I remember correctly, the beginning of the month retailers were starting to see a pick up in demand, so it looks like consumer spending is falling precipitously. Target announced its September sales would be below year ago levels.

The Mitsubishi sales report also showed sales fell a comparable 0.8% from last week

Another indication that shopping mall traffic is down came Aeropostale. The specialty apparel retailer said, "We began the early back to school season with a strong sales trend and posted good results in August and early September despite challenging year-ago comparisons. In mid September, however, we began to experience a significant reduction in our sales activity verses our business plan." It said the weakness was "primarily because of a drop in mall traffic and reduced consumer activity beginning in mid-September."

Other gloomy news this week included, lower ISM report, construction spending, Chicago Purchasing Managers Survey, initial jobless claims remained over 400,000. Even the "good news" was not anything to turn cartwheels over. Factory orders, while beating estimates, still showed no growth. The lackluster earnings from companies and dismal economic data are starting to cause economists to revise GDP estimates for the fourth quarter. Bruce Steinberg, Merrill Lynch's chief economist, dropped his estimate for the fourth quarter a full percentage point to 2.5%. Others will undoubtedly follow shortly.

Lastly, in his October commentary, Bill Gross discusses the implications if capital investment activity fails to increase after the refinance boom ends. Instead of giving Gross an inadequate summary of his latest commentary, please read the commentary if you have not already, Knock, Knock, Knockin' on Heaven's Door.

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