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Ford Needs More Than Magic

This week started the flurry of corporate earnings reports. While still too early to draw conclusions, companies have reported better than expected earnings. First Call reported that for S&P 500 companies that have reported earnings, 68% beat expectations, while only 15% missed analysts' estimates. Additionally, earnings were 6.2% better on average; this is more than twice the historical average that companies beat estimates by. Most of the strength is in the technology, which have beaten estimates by 22%. Companies are also maintaining guidance for the third and fourth quarters. According to First Call, analysts have increased their estimates for third quarter earnings growth by 0.2% to 12.9% since the beginning of the month. Fourth quarter growth estimates have been lowered by 0.2% to 21.1%. We have expected companies to maintain guidance for the second half of the year since the economy has been showing signs of improvement. It will be important to watch how the market reacts to these positive reports. So far, the overall market is trading lower. While it is still early, it appears that investors were expecting better than expected results (I just had to say that after years of reading Wall Street reports making similar statements).

In order for third quarter estimates to be met, earnings will have to grow 7.4% sequentially. This will be quite a leap considering the strongest third quarter sequential growth over the past 15 years was only 6.7% in 1991. The average third quarter sequential earnings growth over this time frame is actually a decline of 1%.

Advertising remains a mixed picture. Most newspapers have reported strength in advertising, but limited results so far. Several newspapers are reporting lower circulation, but higher revenue from circulation thanks to price increases. Newspapers have also expressed that there is softness in help-wanted and retail. The New York Times said its advertising results "improved considerably toward the end of the quarter with our Newspaper Group experiencing a 4.6% year-over-year gain in June ad revenues." Knight Ridder, which provides the most detail by segments, reported that "drug stores, furniture and general merchandise were strong… and department stores were generally flat for the quarter (and trending down toward quarter's end); groceries down in the low teens and home electronics were down 4.9%." The second-largest newspaper publisher also said, "telecom, pharmaceutical and automotive were strong. Computers and high tech were up slightly versus the prior year. Travel was weak, although June gave evidence of increased activity from cruise lines and airlines." Help wanted advertising is still suffering, down as much as 45.7% in San Jose. But real estate is "the one outstanding performer." The best markets were Miami (+22.7%), Philadelphia (+22.7%), Kansas City (+15.0%), Fort Worth (+14.8%). The two exceptions were San Jose (-13.9%) and Charlotte (-10.5%).

Also commenting on the labor markets was Cintas, the leading uniform provider. In its earnings release it said, "our customers continue to pare back their employment levels, which reflects the sluggishness they see in their business and the overall economy."

Commercial real estate continues to feel the affects of the weak labor markets. Moody's Investor Service, in its quarterly report on the outlook for commercial real estate, lowered the score for the overall commercial real estate market by 7 points to 59 (on a 1 to 100 scale, with 100 being the highest). This was the lowest score since the third quarter of 2001, when it was 54. Multifamily and retail scored the highest at 66 and the office market was the lowest, scoring 45. Geographically, the best markets were: Honolulu, Los Angeles, New York, Riverside and Oakland. Conversely, the worst conditions exist in: Denver, Dallas, Indianapolis, Stamford, and Albuquerque.

A few homebuilders reported earnings this week. This quote from M.D.C. summed up the current state of the industry; "Our operating results in the 2003 second quarter are among the strongest for any quarter in our history. Home closing, revenues, and homebuilding and financial services operating profits reached new second quarter highs….In addition, we received more home orders during the last three months than for any quarter in our history, contributing to our record backlog." Instead of the jump in stock price following previous earnings announcements, the stock prices of the homebuilders have been muted this quarter. The huge jump in interest rates is mostly to blame, and will be interesting to watch if rates continue their upward march.

The closer a company is connected to consumers and finance the better the company's performance. Two of the best performing stocks this week have been Harley-Davidson and Polaris. Both are not strangers to this column and both companies beat analysts' expectations by considerable margins. Harley sales increased 22%, and more importantly retail sales increased 14% as Harley's "dealer network sold more motorcycles in this quarter than in any other quarter in [its] 100-year history." Polaris reported a 24% increase in ATV sales in the second quarter compared to last year. Sales of Victory motorcycles and Personal Watercraft jumped 124% and 157% respectively, although most of the gain in the Personal Watercraft was due to the timing of shipments. For the year-to-date period, sales are up 16%.

The manufacturing sector of the economy continued to lag in the second quarter. Eaton reported that its end markets shrank by 5%, but was able to outpace the market by 5%. Furthermore, the company stated that, "For the second half, we do not anticipate any significant growth in our end markets." The pockets of strength that the company sees are in the residential market, but "the commercial markets - particularly the office construction markets - have weakened further," as well as the automotive sector.

Several companies have reported that international sales are better than domestic sales. Gentex, maker of automatic dimming mirrors for vehicles, reported that domestic sales increased 7% while foreign sales jumped 17%.

Last Friday, our best (and only) intern commented on the increased percentage of General Electric's earnings coming from its financing arm, GE Capital. Today, Ryan Bend picks on Ford Motor and the fact that it sells cars on the side.

"The automaker reported today that more than 99% ($715 million out of $718 million) of its second quarter pre-tax income came from its Financial Services division.

We can only assume that owners of Ford stock are finding that reading the Automotive business detail is becoming increasingly painful. This past quarter saw worldwide Automotive revenue drop 3% while North American sales declined 10%. Automotive operating margin for the quarter rounds to 0% due to rising costs of sales on a percentage basis coupled with increased marketing activities. Compared to Q2 2002, lower net interest income/ expense of $70 million and higher equity in net income of affiliates of $91 million increased the reported Q2 2003 net income before tax by $161 million. Without the benefit of those non-operating items, Automotive would have lost $158 million before tax instead of the $3 million gain that was reported.

Analysts are rightly questioning the earnings stability of Ford Credit. The financial services arm continued to benefit from lower interest and depreciation costs. Earnings growth from Credit is just not sustainable in our opinion. At Ford Credit, quarterly income before tax grew $115 million to $715 from $600 million in 2002. In spite of Financial Services debt increasing to $155 billion in Q2 2003 from $151 billion a year ago, interest expense fell by $287 million in the second quarter compared to the year ago period. Subtract the $287 million interest cost decline at Credit and the aforementioned $161 million at Automotive from the $718 million pre-tax income Ford reported, and we get pre-tax income of $273 million, or a 73% decline from the Q2 2002 pre-tax income of $1.0 billion.

To borrow Ford Vice Chairman Allan Gilmour's words today in the earnings release, "It's a tough old world."

Ford is a great example of a company in tough times that is being propped up by the accommodative policies of the Federal Reserve. With the recent action in the credit business one could wonder, "What is Ford worth without Ford Credit?". Goldman Sachs investment bankers are not allowed to respond."

Perhaps the best explanation for the how the stock market has traded this year comes from south of the border. The Tequila Regulation Council reported that exports of tequila increased 20% from last year.

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