Kass: Don't Buy Big-Caps' Big Move Up
By Doug Kass
Street Insight Contributor
4/30/2007 1:35 PM EDT
As I've discussed, the trend in better-than-expected first-quarter corporate profits has clearly been the main contributor to the market's amazing skein this month -- 18 out of the last 19 trading days have been up.
A bear's glib response might be that this achievement was accomplished against lowball guidance. To be sure, that has been the case, but even more important is that an analysis of the quality and composition of the better-than-expected rise in revenue and profit suggests that there was less than meets the eye to these returns. (Markets are definitely in an unskeptical mode, as both good and bad news is interpreted favorably.)
As such, more aggressive buybacks -- the rapidity of which should drop as corporations contend with higher stock prices -- and the impact of nonrecurring currency gains have clearly not impacted valuations negatively, but in the fullness of time they might.
We know by now that the U.S. end markets have weakened in the first quarter, even as international markets, particularly in Asia, have remained strong. It is a tale of two different economies.
As an example, I have written about about the opposite ends of demand for Graco (GGG - Cramer's Take - Stockpickr - Rating), which manufactures equipment to apply paint and other coatings on automobiles, appliances and furniture. Graco missed consensus earnings expectations and had its first profit decline in six years.
But more interesting was the mix of business growth and direction. The company's North American volumes dropped by 9%, while its international sales grew 23%. The company's aggregate organic growth was negative 2% (Americas, -13%; Europe, +16%; Asia, +35%). Analysts had previously estimated overall organic growth to increase by 5%.
However, that outstanding overseas growth could be coming to an end.
We all know by now that the Achilles' heel of the domestic economy has been housing. The bulls suggest housing might be stabilizing, that the contagion to other parts of the economy has been contained.
The bears, like myself, suggest that housing is in the process of undergoing another leg down, and that the multiplier effect of the accumulated downturn is just beginning to be felt on construction job growth and personal consumption growth.
What is interesting to me is that there are now signs that foreign housing markets might today be where the domestic residential market was one and a half to two years ago: primed for a fall.
As evidence of the potential for a nondomestic bubble bursting, I recently commented on last Monday's and Tuesday's 50% slide in the shares of one of Spain's largest developers, Valencia-based Astroc Mediterraneo. (Other Spanish-based developers, Fomento de Construcciones & Contratas, Acciona and Grupo Immocaral, also faltered.)
The speculation in property development and bank stocks in Spain is symptomatic of the overenthusiasm and bubblelike conditions in many emerging markets, and could spell trouble ahead.
Foreign Exchange Benefits
Last week I spent some time on the telephone with CNBC's Steve Liesman analyzing the composition of first-quarter profits, stripping out the foreign exchange benefits. Specifically, we both did separate analyses of the role that a weakening U.S. dollar had on the positive translation of revenue and profits in the first quarter.
As of early last week, 18 Dow components had reported. Of these, two companies reported no impact from currency, one company reported a slightly negative impact and two did not reference foreign exchange -- 13 reported a positive impact of first-quarter results.
Of those 13 companies reporting a favorable foreign exchange translation benefit, on average currency benefits contributed more than 25% to the growth in sales year over year.
Currency gains/sales growth were as low as 7% of the revenue growth at American Express (AXP - Cramer's Take - Stockpickr - Rating), and more than 30% of the revenue growth at IBM (IBM - Cramer's Take - Stockpickr - Rating), Altria (MO - Cramer's Take - Stockpickr - Rating), DuPont (DD - Cramer's Take - Stockpickr - Rating) and Pfizer (PFE - Cramer's Take - Stockpickr - Rating). (Of all 18 reporting Dow components, foreign exchange contributed about 15% to quarterly sales growth.)
In the aggregate, the 18 companies reported a 9% rise in revenue from $231 billion in the first quarter of 2006 to $252.5 billion in the first quarter of 2007. That year-over-year gain of 9%, or $21.2 billion, beat analysts' consensus by $8.7 billion. However, a lower U.S. dollar produced a positive foreign exchange translation contribution of $3.45 billion to the sales growth, representing a sizable 40% of the $8.7 billion revenue beat. (Without the benefit of the lower U.S. dollar, sales growth would have been shaved by about 1.5% -- and would have recorded a 7.5% rate of growth.)
Given that foreign exchange gains contributed to nearly 40% of the upside revenue surprise in the first quarter, to what degree did foreign exchange translation contribute to first-quarter earnings surprises?
Unfortunately, many companies don't spell out the boost. But in light of the fact that (1) the share of internationally based profits is rising and (2) that the effective tax rate for non-U.S. generated earnings is lower than the domestic corporate tax rate, there is reason to suspect that the foreign exchange translation of profits could have provided an even larger percentage contribution than it did to first-quarter year-over-year sales growth.
For now, earnings quality (especially in a background of such a pronounced market ramp) seems to be something less than a mildly interesting statistic to most investors.
Although the U.S. dollar hit another low last week, no one even's considering the impact if the dollar eventually rallies. Nor are many other concerns being considered -- such as non-U.S. central banks' tightening aimed at slowing economic growth -- as the crowds continue to outsmart the remnant.
