SB: Monday Morning Musings: Back to the Future For Earnings

06:18pm EDT 11-Apr-03 Smith Barney Citigroup  (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings: Back to the Future For Earnings

April 11, 2003                 SUMMARY

* We believe investors are beginning to look

Tobias M. Levkovich              beyond the war and are seeking an "economy

rally"  and a reinvigoration of earnings.

                 * We highlight the reasons why we believe

earnings can improve going forward including

inventory building, moderate increases in

captail spending, cost reductions, and a weaker

dollar.

* Leading inflation indices also suggest better

margins lie ahead.

* We continue to believe the consumer will

exhibit resilience given lower energy prices

and likely tax relief.

* Semiconductors could provide earnings relief as

                          might some select other areas.

* Large cap company earnings also seem to be on

the mend, which might support continued

outperformance vs. smaller cap peers.

OPINION

Please see PDF version of this document.

Given powerful images from Baghdad of U.S. forces controlling the Iraqi capital

and the seemingly clear and relatively quick downfall of Saddam Hussein's

regime, investors arguably are looking beyond the "war rally" and have begun

seeking the subsequent "economy rally" that could reinvigorate earnings.  As we

have pointed out various times over the past two years, earnings (and

expectations thereof) historically have been the key driver for stock price

appreciation given very high historical correlation.  Moreover, given that

further P/E multiple expansion may be limited in view of the likelihood that

interest rates may have bottomed, earnings (the critical "E" of our "PULSE"

market driver acronym) will need to climb to sustain further equity market

recovery.

In our opinion, there is basis to believe that earnings can improve going

forward, propelled by a variety of factors:

*   Moderate increases in capital spending;

*   Inventory building, assisted by continued consumer spending;

*   Renewed semiconductor industry pricing strength;

*   Cost cutting; and,

*   A weaker dollar

Indeed, as can be determined from Figure 1, U.S. margins are still well below

their 2000 highs and are hovering near recession lows similar to 1990-91.  Yet,

as demonstrated in Figure 2, aftertax NIPA profits have improved sequentially

for the past four quarters and should do so again in 1Q03, propelled by energy

sector profit recovery.

Figure 1:

Source:  BEA and Smith Barney

Figure 2:

Source:  BEA and Smith Barney

Moreover, if one looks at the table in Figure 3, it becomes fairly obvious that

the decline in S&P 500 operating earnings (in absolute dollar terms) of roughly

$54 billion from 2000 highs to the 2001 low, was highly concentrated in the

Information Technology, Telecommunication Services and Materials sectors.  To be

fair, the Utilities sector was hit in 2002.  Nonetheless, the earnings collapses

were even more specific, as the Technology Hardware & Equipment industry group's

operating profits fell nearly $43 billion from 2000 highs.  Indeed, within the

latter industry group, the Semiconductor industry's profits dropped the most

sharply (almost $18 billion) and seem poised for recovery due to what appears to

be higher DRAM prices of late.  Indeed, our more positive view of the

Semiconductor industry over the past two weeks remains in place.  We believe

pricing (the most important determinant to industry profitability) is likely to

be bolstered further as new capacity additions stall over the next couple of

quarters given restrained industry participants' capital spending intentions.

The other group that experienced an earnings collapse within the IT sector was

Communications Equipment (down almost $15.5 billion since 2000), but we have

been hearing that capital spending is stabilizing of late.  Thus, the decline

may be pretty much over.

Figure 3:

Source: Smith Barney

Furthermore, as we have shown previously, leading inflation indices also suggest

better corporate margins in the future (Figure 4), alongside corporate cost

reductions, especially in light of more than two million jobs having been lost

since 2000.  Given that many companies suggest that each job costs them roughly

$50,000-$60,000 (including benefits), the job losses have trimmed corporate cost

structures by $100-$120 billion, with productivity factors likely to provide

some efficiencies as demand recovers.  Furthermore, a weaker dollar should

assist overseas profits' translation.  As a reminder, more than 20% of S&P 500

companies' sales come from outside the U.S.

Figure 4:

Source:  ECRI, BEA and Smith Barney

While many worry about the consumer, we would note that the pullback in energy

prices removes the recent drag on consumer spending, while likely tax cuts

(primarily bringing forward 2004 and 2006 tax cuts as well as child care tax

credits) should sustain consumer demand.  Indeed, retail sales for March came in

ahead of expectations, and, despite the deep concerns about consumer debt

levels, delinquency rates on consumer loans has dipped over the past two years

(Figure 5).

Figure 5:

Source: Federal Reserve and Smith Barney

Fascinatingly, as we outline every Friday in our PULSE Monitor, S&P 500 forward

12-month EPS estimates have been improving month-to-month since October, albeit

unevenly (Figure 6), underpinning the notion that the market trough may have

been achieved last autumn, alongside weaker forward earnings revisions.

Figure 6:

Source:  Quest and Smith Barney

In our opinion, there has been some deferral of consumer and corporate spending

as a result of the military conflict in Iraq with a decent level of probability

that some demand catch-up can be expected in the next several months.  In our

view, low inventory/sales ratios (Figure 7) should require some production

pickup and as that occurs, overhead cost absorption variance should bolster

profits.  As we have pointed out in the past, another way to discuss overhead

absorption is to consider capacity utilization with profits generally being a

function of capacity utilization (Figure 8).  Thus, the combination of fixed

cost coverage, cost cutting, some modest capex revival, a weaker dollar and

improved pricing all should benefit profits in the future.  Accordingly, the

outlook for earnings seems far from moribund, barring extreme circumstances.

Figure 7:

Source: SB Economic and Market Analysis

Figure 8:

Source:  BEA, Federal Reserve and Smith Barney

Interestingly, when we review the earnings trend by market capitalization of the

S&P 1500 Super Composite, we find that the recovery has broadened out, with

bigger cap names having shifted in terms of much improved income year over year

since 2002 (Figure 9), which may explain why big caps have taken some market

leadership away from small and mid-cap names (Figure 10).  In fact, given that

the P/E valuation discrepancy between big cap and small cap has narrowed

meaningfully, it seems likely that larger cap names may benefit more in trading

rallies in view of liquidity issues and greater research coverage given research

department budget cuts on Wall Street.

Figure 9:

Source: FactSet and Smith Barney

Figure 10:

Source: FactSet and Smith Barney

In conclusion, despite the seemingly great worries about earnings trends, we

would stress that things already were getting better and quite likely can

continue to do so for the aforementioned reasons.  In our opinion, the

semiconductor industry looks more attractive given supply growth constraints and

some underperforming industries (travel, leisure and media) also could do

better.  Furthermore, select industrials might benefit from a Rebuild Iraq

opportunity.  With recent data on retail sales activity and consumer confidence,

plus oil price declines, the "economic rally" might be waiting in the wings even

though most investors seem rather skeptical, as we see it.

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ANALYST CERTIFICATION

I, Tobias Levkovich, hereby certify that the views expressed in this research

report accurately reflect my personal views.  I also certify that I have not

been, am not, and will not be receiving direct or indirect compensation in

exchange for specific choices made in industry or sector selections.

IMPORTANT DISCLOSURES

Analysts' compensation is determined based upon activities and services intended

to benefit the investor clients of Citigroup Global Markets Inc. and its

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that is impacted by overall firm profitability, which includes revenues from,

among other business units, the Private Client Division, Institutional Equities,

and Investment Banking.

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