The Earnings Blame Game

With more than half of companies now having reported third-quarter earnings, silver linings seem in short supply.

We all know the culprits for the recent round of disappointing profit news: falling home prices, the subprime mortgage blowup and the ensuing credit crunch. But how wide the swath and how deep it cuts across corporate America have been surprising.

Standard & Poor's expects third-quarter earnings for S&P 500 companies to decline 4%, on average, from the third-quarter of 2006. Estimates for the full-year are falling fast: Thomson Financial says analysts expect S&P 500 earnings to grow 6.3% for all of 2007 -- they expected nearly 8% growth on October 1.

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Merrill Lynch's massive $8 billion subprime-related write-down was stunning, and the list of companies blaming housing, subprime mortgages or the credit crunch for their troubles includes not only homebuilders, banks and financial-services companies, but also car dealers, big-box retailers, semiconductor makers and freight companies.

IBM (IBM), which reported a 6% earnings rise, nonetheless blamed a shortfall in hardware sales on weakness among its financial-services customers. Even Hershey (HSY) blamed the credit crunch for weakness in its candy business, saying that higher interest rates cut into distributors' profits, forcing them to whittle inventories.

In fact, you hear the same excuses in so many earnings releases that it makes you wonder: Are some companies latching onto a convenient scapegoat to camouflage other weaknesses? It wouldn't be the first time.

"We've seen it in happen in the past," says Goldman Sachs strategist Michael Moran. Companies have blamed disappointing results on the weather (El Niño was popular a few years back) and political crises, including the war in Iraq and the September 11 attacks. Some companies have even blamed the Olympics and the O.J. Simpson trial for keeping them from doing their best. This time around it's the triple threat of housing/subprime/credit crunch.

Analyst Doug Freedman at American Technology Research says Microchip Technology (MCHP) may have latched onto a "convenient excuse" in blaming a 24% decline in fiscal second-quarter profits in large part on the housing downturn -- the sector accounts for only 8% of Microchip's sales. Freedman recently downgraded the stock to "hold."

And Robert Olstein, who manages the Olstein All Cap Value fund is skeptical of Hershey's story. "No one gives up their chocolate bars based on interest rates," he says.

But while investors should maintain a healthy skepticism about how companies are accounting for shortcomings in their September-quarter reports, they shouldn't discount the possibility that more companies will run into trouble.

"In this particular case, we think the credit crunch does have a wide reach," says Marc Siegel, head of financial research and analysis at the RiskMetrics Group. For instance, Siegel sees a lot of risk in companies that have traditionally grown by acquisition, relying on debt financing to do so.

In particular, he's watching Affiliated Computer Services (ACS) for signs of stress. Shares of the information-technology-services and business-processing company closed at $50.85, down 0.5%.

Companies with significant near-term financing needs and weak cash flow will be the least attractive to lenders in a stingier credit environment, no matter what the business. That means RiskMetrics is watching Borders Group (BGP), the book retailer, and Asbury Automotive Group (ABG), a car dealer. Borders closed at $15.45, down 1.9%; Asbury ended at $18.12, down 6.8%.

Finally, RiskMetrics is wary of any company late with its Securities and Exchange Commission filings. Why? Because loan agreements stipulate that companies must be current, and although it's rare, creditors can declare late filers in default and demand early repayment. Among the companies Risk Metrics highlights in this group is Bally Technologies (BYI) a gaming-equipment maker whose shares closed at $40, up 2.8%. Bally says it'll file in October -- that doesn't leave much time.

Are there any safe harbors where investors can hide from the third-quarter's triple witching? If you're looking for earnings strongholds, look no further than health care stocks, and in general, tech stocks. Healthcare stocks are on board to report a 12% increase in third-quarter earnings and should log a 17% gain in profits this year and 15% next year, says S&P. Pharmaceutical giant Merck (MRK) closed at $57.86, up 0.2% and within a hair of its 52-week high.

Tech companies are getting a lot of momentum from overseas sales, with some 55% of revenues coming from abroad. S&P is looking for an 11% earnings gain, on average, in the third quarter, a 14% gain for all of 2007 and a 25% gain next year. "They've got the most leverage to the weak dollar because they do much business in yen and euros," says S&P strategist Alec Young.

Tech stocks were certainly bright spots on October 30. Apple (AAPL) rose 1%, to $187.00, after it said it had sold more than 2 million copies of its latest operating system for the Macintosh computer. Google (GOOG) rose 2.3%, to $694.77, on speculation that it will soon bring its g-phone to market soon. And not a word about housing, subprime mortgages or a credit crunch.