Not Bad By Farr

The second quarter earnings season is unfolding better than expected. However, our well-voiced concerns over revenue shortfalls are proving well-founded. Currency headwinds and a contracting economy are providing a difficult operating environment for many public companies. The good news is that bottom-line earnings are coming in ahead of expectations. While this may initially seem counter-intuitive, the answer is cost cutting and expense reductions.

Management teams finally appear to be grasping the severity of this economic downturn. In prior quarters, management teams had flocked to the confession rail, quarter after quarter, to explain why earnings came up short after the economy proved to be surprisingly difficult. It is true that much of the positive 2Q earnings surprises thus far are no doubt the result of sandbagging (ie, dropping the bar so low that it is easy to hurdle). However, that companies have finally started aggressively cutting overhead and headcount strikes us a responsible and healthy.

Companies are getting leaner and meaner, and balance sheets (especially within financials) are actively being fortified to withstand further demand weakness to come. When top-line growth returns, these companies will be superbly positioned to bring maximum dollars to the bottom line. Growth will return; don’t lose faith. Don’t get impatient either; there are an awful lot of things working through the economy.

The investment banks posted very strong underwriting fees for both debt and equity in the second quarter, which reflects the urgent demand to strengthen balance sheets. We expect continued strength in underwriting activity based on higher stock prices and the continued need to fortify balance sheets. Banks that do not have underwriting fees or trading revenues have not fared as well, and we expect this trend to continue. Consumer and commercial loan losses will continue to mount, and most bank appear to be behind the ball with regard to loan loss provisioning.

While we do not believe a strong economic recovery is imminent, we do believe that any incremental recovery in revenue growth could ultimately translate into sharp bottom line increases as a result of all of the cost cutting that has taken place. Moreover, year-over-year comparisons are beginning to represent a low bar for most to easily meet or exceed.

We continue to believe we are in the midst of a protracted period of consumer de-leveraging, which means higher savings rates and less consumer demand. In this environment, companies are likely to remain lean and mean, and any reversal of unemployment rates is likely to be very tepid.

We are actively seeking companies that were early to recognize the severity of the downturn, and have consequently adjusted their businesses to strengthen balance sheets, protect earnings, and take market share in this environment. There are many such companies in our client portfolios that fit this description.

Positive signs are unfolding. They are real. They will build the foundation for the ultimate climb higher and recovery. A recovery will happen but it will take time.

Hang in there!

Peace,

Michael