By Brian Nelson, CFA
Simply put, the United States is not going to default on its debt. In other words, we think any market action resulting from the debt-ceiling issue will be irrelevant in coming months, and resolve itself in due time -- as it has with any other crisis. Further, we remain unconvinced that this topic is a legitimate concern for long-term equity investors. The fact that America has a large national debt (and a problem with entitlement programs) is well documented in every history and social-studies textbook in grammar schools across the country; how can this be something that will blindside the markets? We're not talking about derivatives on complex mortgage instruments here.
The debt-ceiling deadline is purely a political issue, one that we believe will be sorted out, and not in the way the government sorted out Lehman (by letting it fail), which sent the markets into free fall at the time. We know that the current adminstration is well aware of the implications for the markets if America defaults, and it is inconceivable that policy-makers will willingly put further pressure on the nascent domestic economic recovery. But even if polticians make a big mistake and fail to meet the August 2 deadline to raise the $14.3 trillion borrowing limit on America, any market reaction will be temporary. Look at how far the markets have recovered since the Lehman debacle: The S&P is now less than 12% from peak 2007 levels, with many constituents making new all-time highs this year. We view the possibility of an American default as practically nil and think the media is blowing things out of proportion. Turn off the political news regarding this issue. America's national debt is a long-term problem, not one that will shock the markets and keep them lower permanently because of what happens this week or next.
We have been quite impressed with the outlook for corporate earnings thus far, pretty much across the board, First, let's talk about technology. Apple's (AAPL) second-quarter results were phenomenol, with the company once again blowing past the highest-of-high whisper numbers. Sales of the iPhone were up over 140%, while unit sales of the iPad nearly tripled. Though some of this strength has come at the expense of Research in Motion (RIMM), the consumer continues to buy the best mobile equipment out there, and Apple's results speak to this. Apple remains on our Best Ideas List, and we expect further strength in the firm's equity.
International Business Machines (IBM) put out some great second-quarter numbers and raised its full year earnings guidance. The firm's backlog continues to expand, and noted that services backlog is up over 50% in markets it considers as growth. The firm's software division showed nice sales growth due to its Websphere family of products (which increased 55% from last year's quarter), while hardware also showed strong expansion (revenue from System z mainframe server products jumped over 60% compared with last year's quarter). The firm also expects cloud revenue to double this year.
Microsoft's (MSFT) fiscal fourth-quarter results were also strong, with solid sales growth achieved in its Server & Tools segment, Microsoft Office 2010, and its Xbox 360 entertainment platform. It estimated that PC sales expanded roughly 1% to 3% in the quarter, not bad given that netbooks declined over 40% in the period (explained by Apple's outperformance). We were less than impressed regarding its profitability at Bing, and Yahoo's (YHOO) top-line results spoke to some display advertising issues, but we view weakness here as being more than offset by significant strenghth at Google (GOOG) and Facebook.
Let's dig a little deeper into the health of the consumer. Coke's (KO) second-quarter revealed worldwide volume growth of 6%. Coke Zero, Powerade, NOS Energy, and Fanta also delivered strong expansion in the period. Impressively, demand for its brand Coke product expanded 24% in China and 17% in Russia, revealing its ongoing and tremendous international market opportunity. And while Coke's results were robust, McDonald's (MCD) performance was fabulous in its second quarter. The firm posted sales growth of 16%, with same-store-sales expanding 5.6% globally (with particular strength in China). In June, comparable store sales jumped 7.7%, the highest since November 2008.
Achieving fundamental performance not seen in years has been a common theme this earnings season, especially in the industrials sector. United Technologies (UTX) achieved growth in all six of its divisions for the first time since mid-2008. Order rates at Otis were up 23% thanks to strong demand from Asia and China, while order rates for commercial HVAC new equipment at Carrier jumped 13%. Commercial spares at Pratt & Whitney’s large jet-engine business and at Hamilton Sundstrand advanced over 20% and 25%, respectively.
General Electric's (GE) performance was not too shabby either, despite concerns regarding reported industrial revenue in the period. The company noted that infrastructure orders were up 24%, with equipment and services orders increasing 33% and 16%, respectively -- backlog reached a new all-time high of $189 billion at the end of the quarter (it had been $177 billion in the first quarter). GE indicated that industrial earnings should improve in the second half of this year, with expectations for the cycle to accelerate in 2012.
Harley-Davidson (HOG) posted perhaps one of the more surprising second quarters, in our opinion. Sales of motorcycles and related products advanced 18% as US dealers sold 7.5% more new Harley-Davidson motorcycles in the period compared to last year’s quarter, marking the first year-over-year jump in the metric since the fourth quarter of 2006. Harley also upped its shipment forecast for 2011 and now expects to ship as many as 228,000 to 235,000 motorcycles during the year (was 215,000 to 228,000), a 12% increase from last year at the high end of the range. Order and shipment stength at United Technologies, GE, and Harley speak to a stronger-than-expected corporate earnings environment in coming periods, in our opinion.
In terms of weakness, Caterpillar's (CAT) results were less than impressive, and has been one of the few companies mentioning the political environment in the US and potential softening growth in China in its report. We view the name as an outlier in the context of the strong performance from other names, however. And Caterpillar did raise its earnings guidance (ex Bucyrus) for the year, so we think the intent behind the firm's language is to temper the street's enthusiasm or prepare us for a disappointment in coming periods (whether it be Bucyrus-related or other).
Another area of weakness we've seen has been in the airline space, as majors continue to suffer from rising jet fuel prices. Ironically, however, American Airlines' (AMR) recent large order for as many as 460 narrowbodies speaks to sustainable strength in the aerospace supply chain in coming periods. Honeywell's (HON) beat-and-raise second-quarter performance further suports our a strong commercial aerospace outlook. We outline our bullish position on the aerospace supply chain in the July edition of our Best Ideas Newsletter.
In all, we think the market should pay less attention to the debt-ceiling issue and more to corporate earnings, which have been pretty strong almost across the board. Our outlook on the market is positive, and the goal with our Best Ideas Newsletter is to continue to build on our outperformance relative to the S&P 500 in future periods. We think the S&P 500 has more room to run higher before the year is up.