Financial, Real Estate, Stock Markets Trends and Current Affairs

Worsening end market demand and continuous reduction in the dealer inventory have led a steeper than anticipated decline of 41% (y-o-y) in the CAT’s revenues to $7.98 bn in 2Q09 from $13.62 bn in 2Q08. Total machine sales and engine sales declined 49% and 32%, respectively, while the revenues from financial products declined 13%. Decline in machine and engine sales was primarily volume driven and was across all geographies. Machine sales in North America, EAME (Europe, Middle East and Africa), Asia Pacific and Latin America declined a significant 51%, 61%, 25% and 47%, respectively. Engine sales in North America, EAME, Asia Pacific and Latin America declined 30%, 36%, 26% and 31%, respectively. The weak demand scenario propelled by cut in residential and non-residential construction spending is reflected in the company’s recent financial results.

The bottom line was severely hit by the sharp drop in the top line along with margin contraction. The increase in SG&A and R&D expenses as percentage of revenues offset the improvement in gross margin achieved through drastic workforce reduction. While the cost of goods sold (material and labor cost) as percentage of revenues declined to 72.1% in 2Q09 from 73.7% in 2Q08, the SG&A costs as percentage of revenues increased to 11.5% in 2Q09 from 7.9% in 2Q08 and the R&D costs as percentage of revenues increased to 4.4% in 2Q09 from 3.0% in 2Q08.

Operating profit (excl redundancy costs of $85 mn) declined 71.7% to $401 mn in 2Q09 from $1,525 mn in 2Q08. However, the sharp decline in operating results was moderated by $93 mn of favorable currency impact included in other income (expense) and lower effective tax rate which was about 10.0% in 2Q09 against 28.2% in 2Q08. Consequently, net income declined 66.5% to $371 mn in 2Q09 from $1,106 in 2Q08. EPS was $0.60 in 2Q09 against $1.74 in 2Q08.

 Wells Fargo reports Q2-09 results today. As I have been preaching for two years now, and as the mainstream financial media and sell side community are finally starting to focus on, credit deterioration trumps one time (or two time) quarterly windfall profits in mortgage refinancing and trading profits. Many banks truly have a large amount of trash on their balance sheets, levered up and collateralized by assets that have dropped nearly 50% in value, and this is off of a valuation base that was grossly exaggerated and overestimated in the first place.

Question: Can extreme purchase accounting wherein Wells Fargo aggressively marks down their Wachovia loan portfolio acquisition overcome the losses that we expect from WFC's loan portfolio in the optimistic and base cases?

Answer: The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible. The advantage of purchase accounting is after you mark down your assets, you accrete them back in. Popular opinion is that those highly discounted transactions such as JPM's purchase of WaMu or Well's purchase of Wachovia should be favorable over the long run.

At first glance, this accounting treatment will in fact have a positive impact on WFC's books. Of the $122 billion in option ARM's, WFC had already marked down these loans by 37% with an estimated cash flows of around $90 billion in due course. However, based on our assumptions on the bank's loan losses (professional subscribers, please refer to the "SCAP" in the WFC forensic analysis - See WFC Investment Note 22 May 09 - Pro), even under the optimistic case scenario, loan losses will be well over $132.4 billion which will create a void (loss) of nearly $40 billion.

Therefore, it remains unlikely that the change in purchase accounting will lead to WFC overcoming the loan losses that we have estimated under the base and optimistic case scenarios.

Worsening end market demand and continuous reduction in the dealer inventory have led a steeper than anticipated decline of 41% (y-o-y) in the CAT’s revenues to $7.98 bn in 2Q09 from $13.62 bn in 2Q08. Total machine sales and engine sales declined 49% and 32%, respectively, while the revenues from financial products declined 13%. Decline in machine and engine sales was primarily volume driven and was across all geographies. Machine sales in North America, EAME (Europe, Middle East and Africa), Asia Pacific and Latin America declined a significant 51%, 61%, 25% and 47%, respectively. Engine sales in North America, EAME, Asia Pacific and Latin America declined 30%, 36%, 26% and 31%, respectively. The weak demand scenario propelled by cut in residential and non-residential construction spending is reflected in the company’s recent financial results.

The bottom line was severely hit by the sharp drop in the top line along with margin contraction. The increase in SG&A and R&D expenses as percentage of revenues offset the improvement in gross margin achieved through drastic workforce reduction. While the cost of goods sold (material and labor cost) as percentage of revenues declined to 72.1% in 2Q09 from 73.7% in 2Q08, the SG&A costs as percentage of revenues increased to 11.5% in 2Q09 from 7.9% in 2Q08 and the R&D costs as percentage of revenues increased to 4.4% in 2Q09 from 3.0% in 2Q08.

Operating profit (excl redundancy costs of $85 mn) declined 71.7% to $401 mn in 2Q09 from $1,525 mn in 2Q08. However, the sharp decline in operating results was moderated by $93 mn of favorable currency impact included in other income (expense) and lower effective tax rate which was about 10.0% in 2Q09 against 28.2% in 2Q08. Consequently, net income declined 66.5% to $371 mn in 2Q09 from $1,106 in 2Q08. EPS was $0.60 in 2Q09 against $1.74 in 2Q08.

 Wells Fargo reports Q2-09 results today. As I have been preaching for two years now, and as the mainstream financial media and sell side community are finally starting to focus on, credit deterioration trumps one time (or two time) quarterly windfall profits in mortgage refinancing and trading profits. Many banks truly have a large amount of trash on their balance sheets, levered up and collateralized by assets that have dropped nearly 50% in value, and this is off of a valuation base that was grossly exaggerated and overestimated in the first place.

Question: Can extreme purchase accounting wherein Wells Fargo aggressively marks down their Wachovia loan portfolio acquisition overcome the losses that we expect from WFC's loan portfolio in the optimistic and base cases?

Answer: The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible. The advantage of purchase accounting is after you mark down your assets, you accrete them back in. Popular opinion is that those highly discounted transactions such as JPM's purchase of WaMu or Well's purchase of Wachovia should be favorable over the long run.

At first glance, this accounting treatment will in fact have a positive impact on WFC's books. Of the $122 billion in option ARM's, WFC had already marked down these loans by 37% with an estimated cash flows of around $90 billion in due course. However, based on our assumptions on the bank's loan losses (professional subscribers, please refer to the "SCAP" in the WFC forensic analysis - See WFC Investment Note 22 May 09 - Pro), even under the optimistic case scenario, loan losses will be well over $132.4 billion which will create a void (loss) of nearly $40 billion.

Therefore, it remains unlikely that the change in purchase accounting will lead to WFC overcoming the loan losses that we have estimated under the base and optimistic case scenarios.

Worsening end market demand and continuous reduction in the dealer inventory have led a steeper than anticipated decline of 41% (y-o-y) in the CAT’s revenues to $7.98 bn in 2Q09 from $13.62 bn in 2Q08. Total machine sales and engine sales declined 49% and 32%, respectively, while the revenues from financial products declined 13%. Decline in machine and engine sales was primarily volume driven and was across all geographies. Machine sales in North America, EAME (Europe, Middle East and Africa), Asia Pacific and Latin America declined a significant 51%, 61%, 25% and 47%, respectively. Engine sales in North America, EAME, Asia Pacific and Latin America declined 30%, 36%, 26% and 31%, respectively. The weak demand scenario propelled by cut in residential and non-residential construction spending is reflected in the company’s recent financial results.

The bottom line was severely hit by the sharp drop in the top line along with margin contraction. The increase in SG&A and R&D expenses as percentage of revenues offset the improvement in gross margin achieved through drastic workforce reduction. While the cost of goods sold (material and labor cost) as percentage of revenues declined to 72.1% in 2Q09 from 73.7% in 2Q08, the SG&A costs as percentage of revenues increased to 11.5% in 2Q09 from 7.9% in 2Q08 and the R&D costs as percentage of revenues increased to 4.4% in 2Q09 from 3.0% in 2Q08.

Operating profit (excl redundancy costs of $85 mn) declined 71.7% to $401 mn in 2Q09 from $1,525 mn in 2Q08. However, the sharp decline in operating results was moderated by $93 mn of favorable currency impact included in other income (expense) and lower effective tax rate which was about 10.0% in 2Q09 against 28.2% in 2Q08. Consequently, net income declined 66.5% to $371 mn in 2Q09 from $1,106 in 2Q08. EPS was $0.60 in 2Q09 against $1.74 in 2Q08.

Caterpillar has released revenue and EPS figures for 2Q09. Although the reported revenues of $7.97 bn is lower than the consensus estimates of $8.86 bn and our even more opitmistic estimates of $9.2 bn, the reported earnings per share of $0.60 per share stands higher than the consensus estimates of 0.22 per share and our (even more optimistic) estimate of $0.29 per share.

The results have beaten the expectations of the Street and our calculations primarily due to better than expected margins which it seems has been achieved through higher than expected (and apparently drastic) cut in workforce as well as a lower tax rate. From Bloomberg.com: "[Caterpillar] has eliminated about 17,100 full-time jobs since December. More than 17,000 contract and temporary workers also were cut." We will be able to ascertain the reasons for margin expansion after analyzing the full results when they become available.

For professional subscribers, if you recall, we had highlighted the sensitivity of the stock's valuation to the change in margin and highlighted it in the forensic report. Higher-than-expected margins have propelled the earnings for the company, though revenue of the company still remain significantly subdued, declining a significant 41% y-on-y in 2Q09. It is my belief, that cost cutting can only go but so far. If they are not able to raise revenues next quarter, a profit surprise is highly unlikely unless they cut imprudently deep into overhead and expenses.

Caterpillar has released revenue and EPS figures for 2Q09. Although the reported revenues of $7.97 bn is lower than the consensus estimates of $8.86 bn and our even more opitmistic estimates of $9.2 bn, the reported earnings per share of $0.60 per share stands higher than the consensus estimates of 0.22 per share and our (even more optimistic) estimate of $0.29 per share.

The results have beaten the expectations of the Street and our calculations primarily due to better than expected margins which it seems has been achieved through higher than expected (and apparently drastic) cut in workforce as well as a lower tax rate. From Bloomberg.com: "[Caterpillar] has eliminated about 17,100 full-time jobs since December. More than 17,000 contract and temporary workers also were cut." We will be able to ascertain the reasons for margin expansion after analyzing the full results when they become available.

For professional subscribers, if you recall, we had highlighted the sensitivity of the stock's valuation to the change in margin and highlighted it in the forensic report. Higher-than-expected margins have propelled the earnings for the company, though revenue of the company still remain significantly subdued, declining a significant 41% y-on-y in 2Q09. It is my belief, that cost cutting can only go but so far. If they are not able to raise revenues next quarter, a profit surprise is highly unlikely unless they cut imprudently deep into overhead and expenses.

Caterpillar has released revenue and EPS figures for 2Q09. Although the reported revenues of $7.97 bn is lower than the consensus estimates of $8.86 bn and our even more opitmistic estimates of $9.2 bn, the reported earnings per share of $0.60 per share stands higher than the consensus estimates of 0.22 per share and our (even more optimistic) estimate of $0.29 per share.

The results have beaten the expectations of the Street and our calculations primarily due to better than expected margins which it seems has been achieved through higher than expected (and apparently drastic) cut in workforce as well as a lower tax rate. From Bloomberg.com: "[Caterpillar] has eliminated about 17,100 full-time jobs since December. More than 17,000 contract and temporary workers also were cut." We will be able to ascertain the reasons for margin expansion after analyzing the full results when they become available.

For professional subscribers, if you recall, we had highlighted the sensitivity of the stock's valuation to the change in margin and highlighted it in the forensic report. Higher-than-expected margins have propelled the earnings for the company, though revenue of the company still remain significantly subdued, declining a significant 41% y-on-y in 2Q09. It is my belief, that cost cutting can only go but so far. If they are not able to raise revenues next quarter, a profit surprise is highly unlikely unless they cut imprudently deep into overhead and expenses.

For those of you who don't follow me regularly, I find it a travesty that banks insured by taxpayer dollars (ultimately) are allowed to take the risks that they do to chase earnings, then get to keep the profits as we indemnify the losses. This blatant risk taking paid off for Goldman this quarter (well, sort of, unless you actually take the risk into consideration when tabulating profit - risk that was incompletely reported, see The Goldman conspiracy theory is now no longer a theory). It also appeared to pull JP Morgan's fat out of the fire as well. The caveat is that these companies have big, rapidly deteriorating credit issues on their balance sheets, and the investing public is being given a smoke and mirrors routine based on strong, but risky and hyper-volatile trading profits to distract them from what caused the greatest recession of all time (thus far, it may get worse) - and that is credit issues. Fat trading profits are transient, these banks balance sheet holes and credit issues aren't. It's just that simple. And what about the banks that don't have trading arms to hide their negative earnings under??? Now, on to the review of credit issues in the JPM conference call...

Leveraged loans marked 42 cents on the dollar

"First on leverage lending if you recall we started with $43 billion on a pro forma basis with Bear Stearns back in September, 2007 and that's on a notional basis. Now we carry a remaining amount of market value of $3.3 billion and that's carried at roughly $0.42 on the dollar so those are marked down values for what remains."

Now I'm going to be very quick going through the next three slides so I'm just going to make some common points, so the first point is that obviously when you look at home equity prime and sub prime, you're going to see the charge-offs continue to trend higher versus prior periods and in a couple of cases prime and sub prime we up our future guidance but the second point is that across each of these portfolios, so I just want to say it once, they flow into the early delinquency buckets and the dollar value of loans that are sitting in the early delinquency buckets has started to stabilize [this part of the comment seems to be referring to a very short term observation from which they have drawn a positive conclusion that flies in the face of the longer term trend, marked in bold above] .

Like JP Morgan (Anecdotal observations from the JP Morgan Q2-09 conference call), I have never performed a full forensic analysis of Bank if (pun intended) America, but I have made anecdotal observations in the past. See the list of articles at the end of the post for my ruminations on BAC. For now, let's look at the media reports of thier most recent quarter...

From Reuters:

Chief Executive Kenneth Lewis said tough economic conditions will hurt results into 2010. Soaring credit losses may add to pressure on Lewis as the U.S. Congress and regulators increase their scrutiny of the bank, including its ability to manage risk and its controversial January 1 acquisition of Merrill Lynch & Co.

"Growth in charge-offs and non-performing assets still scares the daylights out of me," said Paul Miller, an analyst at FBR Capital Markets. Ya Damn Skippy!

Bank of America set aside $13.38 billion for bad loans for a second straight quarter, and net charge-offs totaled $8.7 billion, up 25 percent from the prior three-month period.

ONE-TIME GAIN HELPS RESULTS

Second-quarter net income applicable to common shareholders fell 25 percent to $2.42 billion, or 33 cents per share, from $3.22 billion, or 72 cents, a year earlier.

Before preferred stock dividends in both periods, profit fell 5 percent to $3.22 billion. Net revenue on a taxable equivalent basis rose 60 percent to $33.09 billion.