Earnings: A Clearer Picture Emerges

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Financial guaranty, or monoline, insurers (which are part of the property-casualty group) are expected to have a very challenging operating environment in 2008, as the downward spiral in the housing market continues to exert pressure on the credit quality of the bonds and structured finance securities they guarantee.

Industrials are expected to increase earnings a little more than 8% in 2008. In general most traditional Industrials companies have seen a slowdown in domestic growth, especially those with exposure to housing, automotive, and heavy trucks. At the same time international growth appears healthy overall, with currency gains continuing to add to sales growth. Europe is starting to soften somewhat, in our view, especially in the area of nonresidential construction. However developing markets such as China, India, Eastern Europe, and the Middle East have been robust and seem likely to continue to be so for an extended period. The areas with strong EPS growth projections are involved with infrastructure (mainly buildouts in emerging markets), oil and gas, mining, aerospace, and industrial automation, mostly related to overseas capital spending.

Earnings advances for the Information Technology sector are expected to be led by Semiconductors (+43%), Electronic Manufacturing Services (+35%), Electronic Equipment Manufacturers (+24%), Application Software (+23%) and Computer Storage & Peripherals (+20%) subindustries. Our technology analysts have concerns about S&P Economics' consumer growth expectations for 2008, as well as the lack of major new product introductions this year. However we think enterprise spending will likely improve as companies look to increase productivity.

Diversified chemical companies—the biggest subcomponent of the Materials sector—should see EPS pressure this year, as we expect 2008 production to be limited by downturns in housing construction and auto markets, while feedstock (e.g., petroleum and natural gas) costs should remain high. The outlook for metals is mixed. With housing starts expected to drop in 2008, aluminum consumption is likely to decline and it doubtful that growth outside the U.S. will be sufficient to match the 10% growth in consumption seen in 2007. Steel companies could benefit, however, from a small rebound in auto production and a rebuilding of inventories, as well as from another drop in imports. This group has little direct exposure to the housing industry, as nearly all steel goes for nonresidential construction. For copper we expect lower average selling prices in 2008, due to reduced Chinese demand and a drop in U.S. consumption. We are positive on the price of gold and see it rising to $970 per ounce by the end of 2008 vs the 2007 yearend price of $833.

We expect the Telecommunications Services sector to increase operating earnings by more than 36% in 2008. The Integrated Telecom Services group (which accounts for 88% of the sector's market cap) should see a 38% rise in earnings, followed by an 11% advance in the wireless category. There are only eight companies in the entire sector, with AT&T (T) being the largest by far. Benefits from merger synergies in the group are largely seen as the overwhelming reason for the strong year-over-year EPS growth expectations. Revenue growth is expected to slow in 2008, however, due to increasing competitive pressure from cable companies in voice services.

In general we think it should be a decent year for the Utilities sector, as we see operating earnings rising 10%. Most of the largely distribution utilities should benefit from normal customer growth, while others will benefit from anticipated rate increases and/or a full year of rate increases implemented in 2007. Those companies with significant wholesale power operations should continue to benefit from the replacement of expiring power contracts with new higher-margined contracts. We see EPS growth of 6% each for the Electric and Gas subindustries, but double-digit increases for the Independent Power Producers, Multi-Utilities and Water Utilities subindustries.

There you have it.