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Kissing Your Sister


Earnings season is half over. As of Wednesday morning 250 S&P 500 companies have reported second quarter earnings. Companies continued to outpace analysts' estimates, and maintain third and fourth quarter guidance. Of the 250 S&P 500 companies that have reported second half results 65.1% have beaten estimates, while only 11.6% missed earnings expectations. Furthermore, companies have eclipsed estimates by 6%, more than twice the historical average. However, in this market it has only been as good as "kissing your sister." Since earnings season started, the market has been locked in a trading range, with a slight downward bias. Obviously, investors were hoping that companies would be more optimistic regarding the second half and increased earnings guidance. This has not happened and the market had already priced in the current spate of positive earnings. Reaching third quarter earnings will be tough. Third quarter earnings estimates forecast 13.5% year-over-year growth, with fourth quarter earnings jumping 21.3% for the S&P 500 companies. This is on top of hefty comparisons from last year. S&P 500 earnings were up 16.6% and 19.9% for the third and fourth quarters respectively in 2002.

The manufacturing sector remains the most lackluster part of the economy. Rockwell Automation stated in its earnings release that, "The timing and pace of improvement in the global economy remain difficult to predict. During the past quarter, we saw some softening in demand in the U.S. and Europe, but on balance there is no discernable trend of further weakness. We are assuming that our business will remain at the current run rate for the remainder of the fiscal year."

Swift Transportation, the nation's largest truckload fleet operator, reported that second quarter revenues increased 10.7% from the year ago period, fuel surcharge revenue accounted for about 25% of the growth. Loaded miles increased 5.9% and revenue per loaded mile increased 2.5%.

Revenues increased 2% at Honeywell. However, 4% was due to currency translation, so revenue on a constant currency basis fell 2%. Profit margins deteriorated to 8.8% from 12.2% last year due to increased pension costs and production declines in commercial aerospace and increased product development. The one bright spot in Honeywell's business was its turbocharger sales.

Unisys was another company that was assisted by a weaker dollar. Second quarter revenues for the IT services company increased 5%, but only 1% after excluding currency gains. Last quarter, Unisys reported strong revenue from the Federal government. The trend continued in the second quarter; "Revenue growth in the quarter was driven primarily by growth in the company's U.S. Federal government business." Unisys' second quarter income statement reveals that EPS growth of 23% is likely unsustainable. While revenue increased 5%, gross profit fell 4% and operating profit fell by 11%. Net income only increased due to a large expense recorded in the year ago period that helped other income reverse from a loss of $16 million to a gain of $10.6 million. This reverse accounted for more than the $15.3 million growth in pre tax income.

IBM increased second quarter revenues by 10%, but currency accounted for more than half. On a constant currency basis, total revenues only increased 3% (all further sales growth results are on a constant currency basis). IBM's service segment provided most of the growth, up 14%. Most other segments experienced declining revenue. Hardware sales fell 6%, Software fell 2% and Global Financing was down 24% - perhaps the only financing division in the country to post lower revenues.

The trend in photography is evident in the results of Kodak and Sandisk. Kodak, the leading film company, experienced flat sales in the second quarter, but were down 6% excluding foreign exchange. The Photography segment declined 2%, but film sales fell 8%. Conversely, revenues at Sandisk, the world's largest supplier of flash memory data storage products, grew 84% from a year ago and 34% from just the first quarter this year. Unit growth exceeded 100%.

Commodity prices have increased throughout the economy. Rock-Tenn, a leading packaging solutions company, said paper prices increased 6.5% year-over-year and 3.9% from the previous quarter. However, it faced higher input prices as gross margins declined from 21% to 18% last year.

Interestingly, Georgia-Pacific said that "the industry's growing inventories and reduced demand from Asia, pulp prices are trending downward." Georgia-Pacific also said that "the fundamentals in almost all of our businesses were weaker than a year ago, impacting performance in every segment." In its packaging business prices were flat, but shipments dropped 2% year-over-year. Its bleached pulp and paper segment is faring worse with shipments down 4%.

Obviously oil prices are higher than a year ago and oil is a major raw material component, especially for chemical companies. Several companies commented that their raw material costs have escalated. Lubrizol, a specialty chemical company, noted its average raw material costs for its fluid technologies for transportation (FTT) segment rose 13%. Revenues fell 3%, but currency added 5% in the FTT segment. Overall revenues increased 5% in the second quarter. Management does not see any relief in the near future. The company stated, "Looking ahead we believe the challenges of a weak economy and high raw materials cost will continue." It also appears that it will be passing along the higher input prices. The company continued by saying, "In response, we are controlling expenses and we are prepared to continue pursuing the pricing we need to address higher raw material costs."

Higher commodity prices even impacted consumption of cookies according to Kraft. Kraft also noted that the softer economy caused on cheese consumption to decline along with coffee and cold cuts. Sounds like Kraft just needs to come up with the C-Diet, where dieters can only eat items that start with the letter C.

Strength in personal consumption, especially of imported goods is evidenced by the 9.2% growth in intermodal revenues at Burlington Northern. Burlington's results also show the down trend for the domestic automakers as automotive revenues declined by 7.0%. Similar to Lubrizol, higher oil prices are putting pressure on the bottom line. Burlington's fuel costs rose 27% year-over-year. Without the higher fuel cost Burlington would have increased operating income by over 10%, instead operating income fell by 2%.

Several companies announced that sales were picking up later in the quarter. Sears was among them saying that "sales trends generally improved during the quarter." This has led Sears along with the majority of other companies to believe that the second half recovery is on its way. Comparable same store sales declined in the second quarter, but the light in the tunnel gives Sears the optimism that same store sales will be "flat to up low-single digit in the second half."

CDW Corporation, a leading provider of technology solutions, quantified its improvement though the quarter. In its earnings release the company said, "Compared to last year, average daily sales for April 2003 declined 0.9 percent, May grew 1.3 percent, and Jun increased 4.7 percent." Additionally, CDW noted that sales to the public sector increased 18.6%.

West Marine reports that boaters have started to shop more. While comparable store sales fell 4.4% in the second quarter, during the first two weeks of July comparable store sales are up low single-digits.

Travel is not looking any better. AMR passenger revenue fell 5.4%, and revenue passenger miles fell 3.8%. Marriott announced that second quarter REVPAR (revenue per available room) declined by 5.0% due to lower occupancy and lower average room rates. Full service hotels fared worse with REVPAR dropping 6.1%. Lower priced brands and extended-stay hotels fared better with REVPAR declining only 3.6%. Timeshares continue to be the one bright spot for hospitality companies. Timeshare revenue increased 7% with sales in Aruba, Hawaii and St. Thomas the strongest. Marriott does not expect its business to pick up for the rest of this year. In its earnings release the company stated, "we are not yet seen clear indications of a meaningful rebound in REVPAR and profits. We believe the impact of an improving economy on the lodging business is likely to lag by roughly two quarters."

If second quarter results from Kelly Services is any indication of the current labor market, the employment situation is still precarious. Sales in its U.S. Commercial Staffing segment dropped by 0.7% compared to last year, and reversing the 4.9% growth in the first quarter of 2003. Its Professional, Technical, and Staffing Alternatives segment did increase sales by 1.6%, but it too was far below the 6.1% growth rate in the first quarter. The International segment was the only segment to increase revenues faster than in the first quarter, 3% after adjusting for the weaker dollar compared to flat growth in the first quarter. Manpower Inc. reports a similar environment. Its sales increased only 1% after adjusting for currency. Additionally, the largest staffing company said, "in the U.S. we have yet to experience an increase in activity to indicate that we are in the midst of a meaningful upward economic turn."

Is there any need to discuss the homebuilders that have reported over the past week? Here is a quick summary: record orders, record closing, record backlogs, and record mortgage originations.

Last week, Caterpillar reported stellar second quarter results, a fact that was not lost on investors since its now more than 10% higher than before it reported earnings. Investors also tripped over themselves since Caterpillar said, "We are seeing signs that a replacement cycle has begun in our machinery business after a long waiting period. Certainly we saw evidence of this trend in sales to our dealers' rental operations." Many saw this as a sign that the beleaguered manufacturing sectors will emerge from the ashes sooner rater than later.

It does appear the economy is strengthening, but ever so slightly. A large part of revenue growth is coming from the weak dollar, and earnings growth is coming from cost cutting. Obviously these are not quality ways to grow. Consumers remain flush with cash and are starting to benefit from the latest tax bill. The big question is how long will economic upturn last? Earnings estimates are very aggressive for the second half of the year, but with companies feeling the wind at their back they are not about dampen investor optimism.

Lastly, the follow analysis is from Ryan the Intern.

Ask Jeeves, Inc. rose nearly 20% to $17.67 today on strong second quarter earnings news. The internet search provider appears to have found a profitable niche and has shown increasing ability to monetize its search capabilities. Revenue increased 66% year over year and 13% sequentially. Costs appear to remain in check year over year as gross profit margin increased to 80% from 73% and pro forma net income margin rose to 20% this year versus -22% last year.

You have to give Ask Jeeves management some credit. This stock has come back from the dead (it was less than a dollar in April 2001). It presently trades at 8 times sales, 62 times 2003 earnings estimates and 43 times 2004 earnings estimates.

On a more sober note, last Thursday General Motors reported its second quarter results. In an increasingly evident trend we saw deteriorating automotive performance coupled with excellent financing division performance. In Q2 2003, automotive reported a pre-tax loss of $56 million versus a pre-tax net income of $1.5 billion in Q2 2002. Conversely, General Motors Acceptance Corporation reported net income before tax of $1.3 billion in Q2 3002 versus $698 million in the quarter a year ago.

In the conference call last Thursday, CFO John Devine stated, "We have to be profitable in the automotive business. I want to point that out. I'll stress that this is not an easy thing to do."

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