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Stocks fell after a decline in consumer sentiment stoked worries that spending may not be as robust as expected in the coming months. The data sent benchmark Treasury yields to fresh 45-year lows. The DJIA dropped 79 points (-0.9%) to 9,117. The Nasdaq Composite fell 27 points (-1.6%) to 1,626. The S&P 500 lost 10 points (-1.0%) to 988. Treasuries raced higher as the latest round of economic news reinforced hopes for a Fed rate cut. The 10-year Treasury note climbed 15/32 to yield 3.11 percent, while the 30-year government bond ascended 25/32 to yield 4.175 percent. Volume was active, with about 1.26 billion shares changing hands on the NYSE and about 1.82 billion traded on Nasdaq. Decliners outnumbered advancers by about 2 to 1 in both markets.

Strong Sectors: casinos & gaming, leisure prods, gold

Weak Sectors: auto manufacturers & equipment, apparel & accessories, semis, oil & gas services, tobacco, paper, wireless, aluminum

Top Stories . . . U.S. consumer confidence unexpectedly dropped in June by the most in eight months as a weak job market contributed to doubts about stronger growth in the second half.

Treasuries rose in New York trading, sending the five-year note toward a sixth weekly gain, as reports showing declines in producer prices and consumer confidence added to speculation that the Federal Reserve will cut interest rates.

American Express, the fourth- largest credit card issuer, may acquire Threadneedle, a London- based money management company, for about 340 million pounds ($567 million), people familiar with the situation said.

General Motors, the most indebted carmaker with $200 billion in borrowings, had its credit rating lowered by Moody's Investors Service because increasing discounts are hurting profit and its ability to cover pension costs.

Eco Speak . . . Consumer sentiment in the United States weakened in June after two months of solid gains. The University of Michigan's consumer sentiment index fell to 87.2 from 92.1 in May, according to media reports. Economists expected a slight improvement to 93.7. Consumers have been nervous about the labor market.

U.S. producer prices declined 0.3 percent in May. The core price, minus the volatile food and energy components nosed up 0.1 percent. Finished energy goods prices dropped 2.6 percent, as wholesalers continue to adjust prices after a run-up ahead of the Iraq war. Food prices rose 0.1 percent. Mens clothing prices fell 0.9 percent and heavy truck prices were down 0.8 percent, while car prices rose 0.2 percent and communication equipment rose 0.6 percent. Looking back in earlier stages of production, intermediate goods prices slumped 0.8 percent, largely on energy. Still, core intermediate goods prices were soft, down 0.1 percent last month. Prices on goods in their crudest stage of production rose 1.7 percent, largely on a jump in natural gas prices. Core crude prices fell 1.9 percent, the biggest decline for one month in more than two years.

The U.S. trade deficit contracted 2% to $42 billion in April from March's record $42.9 billion as foreign trade in goods and services slowed. Exports sank 2.2% to $81 billion in April, the lowest level in a year. Imports eased by 2.1% to $123 billion, mostly as the result of plunging crude oil prices. In April, U.S. producers sold fewer capital equipment, industrial supplies, foods and feeds, consumer goods, and services. The persistent trade surplus in services dropped to its lowest level in 10 years. U.S. businesses and consumers bought fewer industrial supplies, autos and consumer goods in April. They bought more capital goods and foods and feeds.

Bad Boy Honor Roll . . . The Wall Street Journal is reporting that the Securities and Exchange Commission delivered Wells notices to two former executives Lucent Technologies, indicating their intention for possible civil charges for the executives alleged role in aggressive sales practices in 2000.

Fund Flow . . . AMG Data Services is reporting that equity mutual funds took in slightly more than $2-billion over the past week, but taxable bond funds remained in the pole position, getting $2.4-billion in fresh cash. $914-million flowed out of money market.

Trim Tabs estimated that all equity funds saw inflows of $3.5 billion during the week ended June 11, compared with inflows of $1.4 billion in the prior week.

Equity funds that invest primarily in U.S. stocks had inflows of $3.2 billion vs. inflows of $3.3 billion in the previous week. And bond funds had inflows of $2.1 billion vs. an infusion of $2.2 billion the prior week.

Financials . . . Stephen East at A.G. Edwards downgraded General Electric to "hold" from "buy" due primarily to valuation, given the "strong price performance" in the stock over the past few months in the face of "questionable" economic fundamentals. The stock is slipping 63 cents, or 2 percent, to $30.44, but is up 27 percent since the end of February. "The shares are quickly approaching our price objective and rather than chase them up, we feel it is prudent to wait on the sidelines until more visibility is available," East said in a note to clients. Longer-term, however, he expects strong earnings growth to continue.

IPayment issued its first earnings guidance since going public on May 12 at $16 per share. The payment processing firm said its long-term goal for annual growth in revenue is 20 percent, with 10-15 percent growth excluding acquisitions. The company's target annual range for its operating margin is 10-15 percent of revenue, with gradual improvement each year. For fiscal 2003, IPayment is comfortable with revenue of $200 million to $210 million, excluding any significant acquisitions, and an operating margin of approximately 11.5-12.5 percent.

Ameritrade and Knight Trading said trading volumes rose sharply in May.

Raymond James maintains Underperform on Knight Trading after the company announced that May trading volume showed a sharp increase month over month; while firm views the increase in volumes favorably, mgmt indicated that the co was unable to translate the increase in volumes to an increase in revenue capture per share. The firm is unsure of what the impact to the bottom line will be and remains skeptical on the long-term profit potential in the market-making business.

Freddie Mac upped to Buy from Sell at Sandler O'Neill. Price target $60.

Sovereign Bancorp announced an agreement to acquire First Essex Bancorp for $400 million in cash and stock. The bid represents an approximate 29 percent premium to First Essex's closing price on Thursday ($37.25), and a 23 percent premium to the 52-week high.

Fannie Mae senior vice president Chuck Greener said Friday the company has strictly complied with its financial reporting requirements as required by the Securities and Exchange Commission. Greener, responding to criticism of Fannie and sister company Freddie Mac. "We do not believe Congress will take action to change our status, or in any way impair our mission or operations in serving the US housing finance system," Greener said.

Despite a lackluster economy for the past two years, most Mid-Cap Banks have maintained strong credit quality metrics, and Mid-Cap Bank price out-performance-even against an onerous interest rate backdrop-has been driven, at least in part, by generally superior credit risk management. The Mid-Cap Banks' credit quality success can be attributed to 1) a focus on relationship-based retail and middle market lending (with strong collateral support), 2) senior management oversight and participation in the credit approval and review processes, and 3) general avoidance of higher-risk loan segments including syndicated, sub-prime, credit card, and foreign lending.

However, most Mid-Cap Banks have been posting significant growth in consumer lending-especially in home equity lending where median growth was 23% last year. Concurrently, several macro trends led us to anticipate somewhat higher consumer loan losses. For example, consumer debt continues to escalate, unemployment has risen, and home prices seem to be leveling off, which could lead to less "collateral cushion." The "seasoning" of last year's rapid home equity loan growth could lead to higher losses.

Another potential area of weakness is indirect auto lending due to deflating new and used car prices. However, positively, the major Mid-Cap Bank players in this business appear to have raised their underwriting standards. Charter One and Commerce Bancorp, appear well positioned-even assuming a "worst case" outlook for credit losses. There are also opportunities for positive earnings leverage from credit quality recovery at First Tennessee, Union Planters, and UnionBanCal. “Stressed" analysis indicates that Provident Financial, Huntington, and AmSouth could still have significant embedded credit risk, especially in certain consumer segments.

Many of the companies under coverage in Specialty Finance have spent the past 2 years strengthening their balance sheets and are now becoming strong generators of excess capital. This excess capital generation should create long-term value for shareholders because it gives the companies considerable strategic and financial flexibility - e.g., to increase dividends, repurchase stock, make acquisitions. MBNA, Freddie Mac, and Fannie Mae are the top generators of excess capital and will have the most potential to increase dividends and/or share repurchases over the next few years.

Sallie Mae would also have been a top candidate for an additional return of excess capital had the company not recently announced (5/29/03) that it will double its dividend from $1.00 (annualized) to $2.04 per share. The catalyst for this decision was the signing of the new tax bill on 5/28/03; but clearly the company is generating enough excess capital such that it can increase the dividend without reducing share repurchases or the timing of the GSE wind-down. SLM's announcement makes us hopeful that other companies may follow suit.

CIT should also be strong a generator of capital through 2004. However, we believe the company will retain some of its excess capital to enhance its standing with bond investors and rating agencies instead of returning it to shareholders. This strategy could potentially improve CIT's relatively high funding costs. We also think the company would prefer to use some excess capital for opportunistic acquisitions instead of increasing its dividend or repurchasing shares.

Capital One could easily achieve better asset growth than we have modeled if competition abates somewhat. So although COF should be a good capital generator in 2003 and 2004, the company would rather use it to grow receivables and/or build a greater capital cushion than return it to shareholders yet.

American Express has used it excess capital to increase dividends and repurchase shares for some time. The company should continue to be a strong generator of excess capital through 2004; but like COF and CIT, we believe AXP would rather retain this capital to growth the core business once the economy improves than return more of it to shareholders.

Oil & Gas . . . The federal appeals court in Miami upheld a verdict against the former Exxon Corp. worth up to $1.2 billion on behalf of service-station dealers. At trial in 2001, a jury found that Exxon overcharged its dealers for wholesale motor fuel and then "fraudulently concealed the overcharge." Exxon is now part of ExxonMobil.

A.G. Edwards cut the ratings on eight energy stocks, including ConocoPhillips and Burlington Resources. Others getting the ratings ax were Newfield Exploration, XTO Energy, El Paso Corp., Atmos Energy Corp., EOG Resources, and Talisman Energy.

Energy . . . Credit Lyonnais analyst Gordon Howald said: "Several companies have stated to us that Mirant has been, and continues to be, very good about posting collateral (which is done on a daily basis). The key point is that Mirant is currently not acting like a company on the verge of a Chapter 11 reorganization filing."

Defense . . . Merrill Lynch analyst Byron K. Callan downgraded shares of General Dynamics to "neutral" from "buy" because shares of the defense contracting giant are now within range of his price objective. "The last several days of trading have brought the stock price to within range of our price objective where a Buy opinion is no longer appropriate," he said. He said he's "not comfortable raising our price objective at this point in time."

Northrop Grumman confirmed its 2003 guidance for earnings from continuing operations of $3.80 and $4.20 per share. A survey of Wall Street analysts is forecasting 2003 earnings of $4.01 per share for the Los Angeles defense contractor. Operating margin is expected to be in the mid-7 percent range on estimated sales of $25 billion to $26 billion vs. the $25.5 billion target on Wall Street. Sales in 2004 are expected to be $28 billion to $29 billion, and in 2005, revenue is expected to range between $30 billion and $32 billion.

Transports . . . Delphi lowered its second-quarter financial expectations citing a weakening market this year and legal costs. The automotive components and parts giant now expects revenue in a range of $7 billion to $7.1 billion, narrower than the earlier $7 billion to $7.3 billion range. The per-share earnings outlook has been sliced to 15 cents to 17 cents a share versus the estimate of 31 cents. For the year, the company said it expects more economic issues.

Harley-Davidson may trade up on industry sales data. UBS believes that motorcycle industry sales data for May be released as early as Monday, and firm believes Harley may trade up on the news given the easy comparisons for that industry figure.

Moody's Investors Service lowered General Motors long-term rating to "Baa1" from "A3." Moody's also cut its rating on General Motors Acceptance Corp. to "A3" from "A2." Moody's said the downgrade reflects expectations that the intensifying competitive environment in North America -- in combination with large pension obligations -- will result in weak earnings and cash generation at the automaker through 2003.

Monaco Coach (motor home maker) are under pressure after peer Winnebago missed Wall Street expectations with its third-quarter results. Monaco reported its first-quarter earnings of $4.3 million, or 15 cents per share, on April 23, falling 2 cents short of the average estimate of analysts. For the second quarter, Wall Street is looking for a profit of 15 cents per share from Monaco Coach.

Food & Beverage . . . ConAgra Poultry is recalling 129,000 pounds of chicken because it may contain glass, the Agriculture Department.. Earlier this week, Pilgrim's Pride said it would buy ConAgra's chicken operations in a deal valued at $590 million.

The Japanese soft drink industry experienced an estimated volume growth of 3% in May. This compares favorably to declines of 1% and 3% in March and April, respectively. The industry benefited from good weather in the first half of May as well as numerous new product introductions. Coca-Cola bottlers continue to underperform the industry (as they have done in the last year). In May, Coke’s bottler volumes were about flat, similar to the flat growth experienced in May 2002 though significantly improved from a decline of 6% in April. (In 1st quarter 2003, Coca-Cola bottlers averaged a volume decline of 2%, compared to 6% growth in 1st quarter 2002.) While this suggests that Coke is losing share to other soft drink companies, of greater importance is the fact that the company is increasingly focused on margins and profits rather than just volume and share. This is positive. As we highlighted in our May 13 report titled" Expect Asian Profit Growth to Accelerate”, bottler focus on profitability may come at the expense of volume growth. In other words, this share trend is pretty much as we anticipated. Forecast for Coke Japan’s volume growth in 2003 is for 1%, following growth of 2% in 2002. While volumes declined by 2% in 1Q03 and may experience declines of a similar magnitude in 2Q03, the company faces easier quarterly comparisons in 2nd half 2003.

Retail . . . Linda Kristiansen at UBS Investment Research is recommended a "pairs trade" -- buying Federated Department Stores and selling May Department Stores -- given that the companies' strategies and execution "are diverging to a greater extent that we can ever recall." Kristiansen upgraded Federated to "buy" from "neutral" and lifted her price target to $44 from $30, citing increasing confidence in the company's relative growth rate, and belief that Federated will continue to gain market share at the expense of May and others. She also downgraded May to "reduce" from "neutral" and cut her price target to $18 from $20 on expected sales underperformance and margin pressures. The stock is sliding $1.08, or 4.7 percent, to $22. She noted that May was implementing a more "clearance-driven" strategy, while Federated was "dialing down" promotional activity.

Healthcare . . . Tenet Healthcare said it would reduce its billing and collection workforce by 300 employees, or 9.4 percent amid a consolidation of its hospital business and patient billing offices. The company plans to reduce the number of business offices from the current 56 to eight regional offices over the next three years, leading to annual savings of $75 million. The hospital operator said it expects invest $275 million in the consolidation, including $100 million of currently budgeted capital expenditures and $175 million in expenses for training, installation and other implementation costs.

Medical Devices . . . First Albany lowered its rating on Interpore to "buy" from "strong buy" due to valuation.

Bob Hopkins at Lehman Brothers recommended buying Guidant's stock given that the guilty plea to 10 federal felony counts and agreement to pay $92 million "effectively puts the issue behind Guidant. The only lingering risk that we see is that there are eleven product liability lawsuits outstanding, but insurance should cover any damages," Hopkins said. He reiterated his "overweight" rating.

Drugs . . . Teva Pharmaceutical and other generic drugmakers surged after President Bush vowed to remove obstacles to quick approval of cheap generic versions of prescription drugs.

ML initiated coverage of 5 new generic stocks: TEVA, Mylan, Taro, and Pharmaceutical Resources with Buy ratings and American Pharmaceutical Partners with a Neutral rating. In addition to the new companies, our generic/hybrids coverage also includes Alpharma, Andrx, Barr Labs, IVAX, SICOR, and Watson.

Despite the strong run generic stocks have had year-to-date, the stocks can perform well over the intermediate term. In addition to strong fundamentals, three important drivers to consider are (1) scarcity value, (2) historical valuation, and (3) political and regulatory reform. Scarcity Value. Investors should recognize that the market cap for the generics in our coverage universe is approximately $43 billion. That compares to U.S. major pharma companies' total market cap of over $600 billion. So we expect supply/demand dynamics to remain favorable for some time even if we see some issuance activity (which investors should expect). In looking back at forward P/E's for the generic industry since 1990, the current multiple of 23-24x forward EPS is actually in line with the group's average over that time period. While one could argue that the generic industry is stronger than ever and could command a premium to the historical average, ML is not currently making any such assumption in our price targets. The group's 12% P/E premium relative to the DRG's P/E is modestly above the 8% premium historical average since 1990. Political/regulatory reform. The FDA finalized a proposed rule change that would, among other things, limit branded companies to one thirty month stay per drug regardless of how many patents they list in the Orange Book. And on the political front, Senators Gregg and Schumer, along with Kennedy and McCain, recently sponsored a bill that could be complementary to the FDA proposed rule change. The most important part of this bill for the generic industry would relate to what triggers the start of the 6-month exclusivity bill. It is unclear whether the bill will be introduced as a stand-alone bill or as part of a broader Medicare drug benefit bill. While these changes are not earth shattering, they could further bolster generic sentiment this year.

Media . . . Netflix was defended by Piper Jaffray who says they would be opportunistic buyers of NFLX following today's insider-sales weakness. The firm believes that venture investor LVMH's sale of 2.3 million NFLX shares was part of a broader Internet investment strategy, rather than specifically being strategic to either NFLX or LVMH, and that the 2.3 million shares represents all of LVMH's position; in addition, firm says the company's business fundamentals remain compelling and they expect the growth momentum in its subscriber base over the next couple quarters to remain strong.

Telecom . . . Sanford Bernstein analyst Jeffrey Halpern reiterated his "outperform" rating and $25 price target on AT&T's stock, saying he believes it is a "compelling investment" given that the stock is "significantly undervalued" relative to its peers, and that the sustainability of the company's cash flow power is underestimated. He added that the company offers the "greatest leverage" to a recovery in the industry. The stock is down 79 cents, or 3.7 percent, to $20.74, hurt by a downgrade by Jefferies & Co.'s Richard Klugman to "underperform" from "hold" due to valuation. He has a $18 price target.

Billionaire buyout expert Carl Icahn stepped up pressure on Global Crossing investors, saying he's ready to launch an immediate big for the bankrupt global long-haul communications carrier. Icahn made an unsolicited offer last month in a bid to derail a plan by Asian-based Singapore Technologies. Icahn is offering $472 million for outstanding Global Crossing bonds along with cash for a total bid of $700 million. Singapore Technologies has tentatively agreed to invest $250 million in Global Crossing and give creditors a 39 percent stake in the newly emerged company as well as $200 million in new debt. Icahn wants to combine the company with another carrier, XO Communications, that he bought in bankruptcy proceedings. He said his offer, contingent on the termination of the Singapore bid, would enable Global Crossing to quickly emerge from bankruptcy court and put an end to its financial uncertainty.

Storage . . . In lining up Dell and HPQ, Sun Microsystems said they had made strides in reversing the effects of Microsoft's moves. H-P said it plans to ship Java with all desktop and portable PCs it sells with Windows, for both commercial and consumer markets. Dell spokesman said the company will make Java a standard feature when users order any machine with Windows or Linux. These, and potentially other, agreements with systems vendors counterbalance the "must carry" dispute with MSFT but, otherwise, in our opinion, have no material effect on Sun.

Network Equipment . . . Disappointing June Quarter’s for Nokia, Motorola, Texas Instruments coupled with existing excess inventory suggest the Asian inventory problem will take several Quarter’s to resolve. QCOM likely to see the effects one quarter later. QCOM has longer lead times for its chips, so we expect the weakness witnessed by other OEM's will likely not have an impact until the September Quarter. Lowering estimates for chip shipments for 4th quarter from 24 million to 20 million and 2004 from 103 million chipsets to 100 million (flat Year/Year) with most of the reduction coming in 1st quarter 2004 (Dec). 2003 revenue decreased by $82 million and 2004 rev decreases by $61 million. The September pro-forma EPS ests. decline from $0.30 to $0.28 and F04 from $1.32 to $1.30, both below consensus. QCOM faces increased competition from NOK and TXN that we believe will be more pronounced in 2004.

Eventually, spending on telecommunications equipment should show growth. How will this impact the financial performance of the vendors? Earlier this year, analysts felt that Alcatel, Lucent and Nortel presented the best values, while Ciena provided the least. Analysts saw limited upside from our other mid-tier stocks as they already reflected a recovery. Given the recent rally, it would be useful to revisit this analysis. Although we are not prepared to predict the timing for a recovery, wanted to see how the current valuations reflect our scenarios. Consider this a useful tool to compare the equipment stocks. With the stocks running so much, consider what could stem the momentum. From a technical perspective, the group may have more upside; however, the fundamentals remain unchanged. Although the stabilization is positive, it does not represent industry growth. Investors could face disappointments as carrier budgets get cut again during second quarter reporting season and vendors forecast little improvement from the bottom.

What does wonderland look like? Assume that companies complete restructuring by 4th quarter 2003, so measure the earnings power of companies, by assuming some revenue growth (versus 2003 revenue estimates), while keeping the expenses flat versus the 4th quarter 2003 base. Consider several growth scenarios. For large diversified companies (Lucent, Nortel and Alcatel), examine the valuation under three growth scenarios: 10%, 15% and 20%. Make higher growth assumptions for smaller companies (ADC, Tellabs, Advanced Fiber Communications) of 15%, 20% and 25%. On a dollar basis this higher growth seems reasonable. For Ciena make an exception to the rule and examine the valuation under very aggressive growth scenarios of 50%, 75% and 100% (under lower revenue growth estimates Ciena is not profitable). Also model modest gross margin improvement from the higher sales volume. Finally, fully tax income for all of the models to better illustrate the normalized earnings.

Through this scenario, all of the companies become profitable, but we see variation when we consider valuation. The diversified incumbents (Lucent, Nortel and Alcatel) and access pure play Advanced Fibre appear to have a more attractive valuation level. However, the valuation of mid-tier players, ADC Telecom, Ciena and Tellabs appear to reflect a more robust recovery than have modeled, and present risk even after factoring an aggressive 25% (for Ciena 100%) revenue growth scenario.

Alcatel was the least expensive stock as it currently trades at less than 13xr wonderland EPS of $0.76 when we model 15% top-line growth versus 2003; however, see such a scenario as highly unlikely. Our current forecast has Alcatel’s sales declining 10% in 2004, well below expectations for flat capital spending. Ciena stands out as the most expensive stock in the group as it currently trades at about 43x our fictitious EPS after modeling 100% topline growth versus 2003 coupled with 41% cut in operating expenses (the only company we have modeled further cost cuts beyond 2003).

ADC Telecom will have a tough time achieving a recovery scenario. In the past, the company’s challenges have been in obtaining growth. There is value in the balance sheet, yet continue to struggle with envisioning growth. There is only modest upside from the current price, and see risk if the spending environment should deteriorate further.

ADC’s sales level and operating margin in 1998 exceeded levels that could be achieved in a recovery. In 1998, sales nearly reached $2 billion, while in our recovery scenarios, a 15% rise from CY03 sales yields $871 million, and growth of 25% gets it to $947 million. It is hard to see operating margin reaching 1998’s 17% on the lower volume; rather with operating expenses held steady and gross margin at about 40%, we have modeled only 5%-10% in our recovery scenario. This is below management’s stated long-term goal for operating margin of 15%-20%. In addition to the lower sales level, the product mix has changed since 1998. High margin connectivity products contributed a greater portion of sales in 1998 than we would expect in a recovery. In the optimistic case, one could argue that the higher software and services contributions in a recovery or acquiring a connectivity competitor could propel operating margins. On the other hand, lower volume and low margin transmission products could pull down operating margin. Even without a recovery scenario, ADC returns to profitability; however, consider the valuation in a recovery. The stock currently trades at about 32–70x recovery scenario earnings suggesting that the stock presents risk should sentiment about the sector shift. ADC’s balance sheet appears healthy in our current model. In the April quarter, the company had $377 million in cash (about $0.47 per share). Following the recent convertible note issuance, expect ADC to end 2003 with $788 million cash or about $0.97 per share. The balance sheet is healthy, and feel that this provides the stock with a solid foundation, as the company should be cash flow positive for the foreseeable future. ADC reflects the core of the industry, and management’s outlook suggests that we could be a long way from a recovery yet near stabilization. ADC is an industry litmus test, so regard it as an important company to monitor to signal industry trends. This is base assessment on ADC’s diverse customer base and product line.

Advanced Fibre’s recovery scenario is within the realm of possibility. There are opportunities stemming from the combination of existing customers (Sprint, Alltel, Verizon and rural carriers) along with increases from SBC. In the intermediate term, analysts are concerned that sales to Verizon have slowed and the market has yet to see evidence of a pick up from SBC. In recovery scenarios, where we grow sales 15% - 25% from 2003 estimates, you can see operating margin exceed 1998 levels. With sales of $380 million and gross margin of 50%, derive an operating margin of 17%, and on the high end with sales of $413 million and gross margin at 52%, you derive an operating margin of 20% versus 12% in 1998. Although consider the top line growth achievable, would be surprised to see the operating margin exceed the pre-bubble levels by so much. Suspect that in reality costs would rise somewhat with the higher sales. Recent staff cuts highlight the company’s cost consciousness.

Among the group, Advanced Fibre has one of the better opportunities to achieve the hypothetical scenarios. Even without winning new customers or growing new product sales, we could envision customers like SBC and Verizon becoming more active in upgrading Digital Loop Carriers to increase penetration of broadband services. Given Advanced Fibre’s position with both of these carriers (2000 deployed but lightly equipped chassis), an additional $50 million in sales looks to be a possibility.

The challenge in valuing Advanced Fibre is accounting for the large net cash position, which will be about $9.35 per share by the end of 2003. To make comparisons, also consider the price to earnings multiples which exclude this net cash from the share price and exclude $0.11 of interest income from the EPS. Under a scenario of high growth, there would appear plenty of upside left at Advance Fibre. The company is trading at 20-26x (8-10x excluding cash) recovery earnings, which implies upside under a high growth assumption. Advanced Fibre has a healthy balance sheet and no long-term debt. The published model forecasts 2004 cash at $10.14 per share.

Alcatel faces challenges as its traditional customers continue trimming spending. However, Alcatel still appears fairly interesting under this scenario. However, seeing such a growth scenario is highly unlikely. Our current forecast has Alcatel’s sales declining 10% in 2004, well below expectations for flat capital spending; hence expect Alcatel’s market share could erode. The company remains strong in access, but other segments appear vulnerable.

With the higher sales level (10% - 20%), adjust gross margin into the mid-thirties. Under our assumptions, Although expect Alcatel to face a challenging 2003, recovery analysis suggests that the stock presents an attractive valuation. Alcatel yields a range of operating margin from 6% to 11%, which is above its 5% achieved in 1998, and consistent with Nortel and Lucent in a recovery. In reality, Alcatel could continue to lag Lucent and Nortel in operating margin because the company has been somewhat less aggressive in restructuring. Under our growth scenario, Alcatel would earn $0.54 - $0.98 per share, which equates to earnings multiples of 10 – 18x.

Alcatel’s balance sheet has shown steady improvement, and net cash has turned positive. Expect Alcatel to continue to reduce debt and we see the company generating nearly $1 billion from operations in 2004. S&P rates Alcatel’s credit as B+/Negative.

Even with a robust recovery scenario, Ciena’s stock still appears expensive. even provided an extra push on the sales level and grew the top line 50% - 100% versus 2003 estimates. Even in the most optimistic scenario, only arrive at $620 million in sales, which is still dwarfed by 2001 sales of $1.4 billion. Ciena has cut costs since our last recovery analysis, however, the sales outlook has come down too. Under our scenario, Ciena loses ($0.07) with 50% growth and earns $0.13 per share with sales growth of 100%. Assume that gross margin can improve from 2003E of 25% to 35% - 45% on the higher volumes.

But doubling revenues and improving margin was not enough to bring Ciena to profitability in our model unlike all of the other companies. Also had to cut the operating expenses by over 40% versus the expected level in 2003, which leads us to question the validity of this exercise on Ciena. However, at least it provides a “maximum” valuation mark for the company, Ciena’s valuation is so high that it even surpasses this level set by our hypothetical model. The operating margin ranges from –8% to 13%. The 13% level seems slightly stretched given that in 1998 the company reported a 10% operating margin level. Considering our most optimistic case, Ciena currently trades at a multiple of 44x EPS of $0.13. If we consider the valuation excluding current net cash of about $2.51 per share, get a 26x multiple. Only under a case where we double growth and nearly halve expenses does Ciena look fairly valued. This exercise reaffirms our valuation concerns with Ciena.

Believe two things need to happen for Ciena to improve its prospects. The company must achieve major improvements in sales, which appear stuck below $100 million per quarter (even if the company wins its total addressable opportunity of $250 million from the Dept. of Defense GIG BE project), and secondly, the company needs further restructuring to lower operating expenses and raise gross margin. Analysts have mixed feelings about Ciena’s sales prospects. The company has a complete suite of optical transport solutions, and with Wavesmith, it sells into the healthier carrier data networking market. However, today, Ciena faces increased competition and carriers are driven less by technology leadership and more by pricing and packaging than in the bubble days.

Despite continued cash burn in our model, Ciena maintains a decent cash position. Net cash will be nearly $900 million or $1.89 share by the end of 2004. Ciena has about $728 million long-term debt. Most of the remaining long-term debt is a 3.75% convertible that raised $690 million and was issued in February 2001 and are due in 2008. S&P rates Ciena’s credit as B/Negative.

Lucent provides limited upside, under a recovery assumption. Lucent, like Alcatel and Nortel, should benefit from an eventual recovery as even a modest 10% revenue growth assumption brings Lucent back to its historical 7% operating margin level. A recovery scenario assumes a 8% dilution ( increased the share count by 300,000), Lucent could issue shares to satisfy the 7.75% redeemable convertible preferred note and possibly to settle the class action suit. Running scenarios with sales growth of 10% - 20% from 2003E. Assumed gross margin would range from 37%-40% on the higher volume. With operating expenses held at YE03 levels, we derive an operating margin range from 7% to 12%. Compare this to Lucent’s 14% operating margin from 1998. Under these scenarios, Lucent earns $0.07 - $0.18 fully taxed. This equates to P/E multiples of 12-32x.

Lucent has the right customer base to benefit in a spending recovery. Lucent’s historical strength has come from the RBOCs, PTTs, and largest CDMA-based wireless carriers, and currently this appears to provide better exposure. The risk to Lucent, which is possible, would be for the carriers to not only increase spending, but to also leap ahead to next generation products (e.g., softswitches, Internet Protocol-based switches and routers). In its efforts to reduce costs, Lucent cut back on a number of its products that seemed too far off to generate meaningful sales. There are concerns that Lucent has lagged in data networking and access products. However, Lucent is addressing the data-networking gap at least in part by partnering with Cisco and Juniper. Lucent’s balance sheet has shown strong improvement, yet remains a work in progress. Based on latest information, Lucent’s long-term debt stands at $3.2 billion, the company has $1.2 billion 7.75% convertible debt and about $1.0 billion in the convertible trust preferred. Lucent has about $1 billion in notes due in July 2006. Estimate Lucent’s cash bottoms at the end of 2003 at about $2.6 billion. Even without our recovery scenario, believe Lucent will generate cash in 2004. S&P rates Lucent’s credit as B-/Watch Negative.

Nortel provides a potential attractive valuation with a similar P/E to Lucent. With its recent return to profitability, Nortel seems to have decent leverage in a recovery. Nortel ran scenarios with sales growth of 10% - 20% from 2003E. Assumed gross margin would range from 42%-44% on the higher volume. With operating expenses held at 2003 levels, derive an operating margin range from 6% to 10%. Compare this to Nortel’s 10% operating margin from 1998. Under these scenarios, Nortel earns $0.09 - $0.19 fully taxed. This equates to P/E multiples of 17-36x.

Nortel has the right product mix to benefit in a spending recovery. Nortel’s finances have been managed well without having the company exit too many businesses. Nortel continues to sell products to enterprises, wireless carriers and wireline carriers. Nortel’s diversity makes it easier to benefit from a spending recovery earlier than others, particularly given its enterprise products. Nortel’s next generation solutions in optical, softswitch and wireless position the company better than Alcatel and Lucent for network upgrades. The biggest challenge for Nortel may be penetrating the RBOCs and certain PTTs, many of which are traditional Lucent or Alcatel customers. Contrary to competitors, Nortel has not pushed to promote an independent services business. If services turn into growth engines for competitors as carriers outsource to lower operating expenses, Nortel could lag. This as a potential long-term issue.

Liquidity concerns have faded away from the minds of investors, and in our opinion rightfully so. Currently modeling the company exiting 2003 with over $3.4B in cash, sufficiently funded. Beyond that, believe the company can achieve positive cash flow. There is no major debt repayment until 2006 giving Nortel some breathing room. Remind investors, however, that historically our cash flow models have been prone to a high degree of variance and liquidity should continually be monitored. S&P rates Nortel’s credit as B with a negative outlook.

Tellabs will have a tough time achieving recovery scenario. See value in the balance sheet, yet continue to struggle with envisioning growth. See only modest upside from the current price, and see risk if the spending environment should deteriorate further. Tellabs’ valuation, like other mid-tier vendors ADC and Ciena, appears to reflect an overly optimistic recovery. Believe achieving the recovery assumptions could be a stretch for Tellabs, and suggest that further restructuring might be in its future. The addition of Vivace offers potential for growth with a carrier data networking product, but have felt that way about Tellabs new product efforts in the past, and we were disappointed.

In recovery scenarios, where you grow sales 15% - 25% from 2003 estimates, you can see operating margin well below the 1998 level of 31.1%. With sales and gross margin ranging from $1.13 - $1.22 billion and 48% - 50% respectively, derive operating margin ranging from 3% to 9%. Tellabs has become a very different company and find it hard to create a scenario to return to historical operating margin. In 1998, the markets for Tellabs primary product, digital cross-connects, was growing rapidly, and the company generated an operating margin over 30%. Even through the 1990’s, Tellabs maintained operating margin over 20%. However, given the maturity of the product line, a more realistic operating margin target should be consistent with other mid-tier suppliers, in the low teens. Tellabs has several paths to achieve the recovery scenario. The key route comes through new products [6400 (Ocular), 6500 (big next generation cross-connect), 7100 (metro DWDM), 6300 (international next generation SDH system) 7200 (Internationally focused metro WDM), 3600 (next generation echo control system), multi-services switches from Vivace acquisition]. The second route requires improvements in the mature 5500 product sales. Although this seems less likely, if carriers see growth in access lines, or an increase in access deployments as a result of deregulation, the 5500 dominates the market for managing this new traffic in the network. Under three growth and margin scenarios, Tellabs earns $0.12 - $0.24 fully taxed. This equates to P/E multiples of 32-65x, which implies limited upside potential Telecommunications Equipment – 12 June 2003 even under these aggressive scenarios. Even if you exclude cash for other, the range of multiples remains high at 26-64x.

Tellabs has a healthy balance sheet with no long-term debt and cash in the last quarter of about $1 billion or $2.44 per share. The current model has Tellabs generating cash in both 2003 and 2004. Their most optimistic recovery scenario generates $100 million in net income, $70 million greater than our published 2004model.

Semiconductors . . . Lattice Semiconductor expects second-quarter sales to remain flat with the previous quarter, consistent with previous goals.

Latest XBox rumor just a rumor according to Pacific Growth. In reaction to rumor that ATI Tech had been picked for the XBox 2, Pacific Growth says that the speculation over this has been going on since mid-January, and firm would expect it to continue through the fall. Pac Grow does not expect the final design decision to be made until late 2003. While ATYT and NVDA are in the running, firm believes it is way too early to assume one or the other will win out. Recalling the events that led up to the original XBox design, believes it would be incredibly risky to assume one company or another has an advantage. Pac Grow continues to rate both stocks Over Weight.

Ben Lynch at Deutsche Bank downgraded Intel to "hold" from "buy" due primarily to valuation, as the stock has achieved his $22 price target. Lynch said he did not see a positive near-term catalyst, and added that consensus forecasts for the second half of 2003 for the sector are more subject to downside risk than upside potential. "Following a strong performance for semiconductor stocks over the past four months, we expect a period of retrenchment, or at least consolidation, through the slower summer months," Lynch said in a note to clients.

Boxmakers . . . Hewlett-Packard said it's under investigation by the Department of Justice and other federal agencies for allegedly selling computers to the government the company knew to contain defective parts, according to the computer firm's most recent quarterly report filed with the Securities and Exchange Commission. The federal investigation claims that HP "made or caused to be made false claims for payment to the United States" for computers known by the company to have had floppy disk controller errors. The company also said in the filing that it continues to provide information to state attorneys general in California and Illinois in response to similar inquiries. "HP is fully cooperating with these inquiries," the company said in the filing.

Software . . . MusicNet, the online music venture owned by several major recording companies, said it has begun to offer songs in Microsoft's audio format, a setback to Real Networks. MusicNet said it has converted most of the 350,000 songs in the music library it makes available over the Internet into Windows Media 9. Macrovision and MSFT are working together to release a CD Audio solution combining Windows Media9 and MVSN's SafeAudio, which should become commercially available in July. Wider industry support for Windows Media9 underscores the importance of the MVSN/MSFT collaboration.

Adobe Systems earned $64.2 million in the second quarter, up from $54.3 million in the same period a year ago. Excluding certain items, Adobe said it earned $66.7 million, or 28 cents per share, 2 cents better than the consensus estimate. Adobe also grew revenue to $320 million from $317 million last year. Analysts expected the maker of publishing software to post $312 million in sales.

Electronic Arts target raised to $90 from $75 at Wedbush Morgan.

Adam Holt at J.P. Morgan cut its second-quarter earnings and revenue estimates for PeopleSoft due to evidence that the company's customers are delaying signing deals "given the Oracle-J.D. Edwards machinations." Holt also said there were signs that PeopleSoft's competitors have begun benefiting from the customer disruption. "As Oracle overtures will likely continue, it is likely this disruption will as well," Holt said. Oracle launched a hostile takeover bid for PeopleSoft last week, just days after PeopleSoft entered into an agreement to acquire J.D Edwards. He now expects the business software company to earn 10 cents a share on revenue of $444.6 million, versus prior projections of 12 cents and $464.8 million, respectively.

SonicWALL was cut to Neutral at B. Riley on valuation. Price target $5.29.

Oracle beat its fiscal-fourth quarter profit target with net income that rose 31 percent from last year. The software maker, which is bidding $5.1 billion to take over rival PeopleSoft, earned $858 million, or 16 cents a share, vs. $656 million, or 12 cents a share in the same period last year. Analysts had been expecting Oracle to earn 14 cents a share, on average. The year-ago earnings would have been 14 cents a share, excluding a $104 million in write-offs for its investment in Liberate Technologies. Fourth-quarter sales rose 2 percent to $2.83 billion. Oracle shares rose 6 cents to close at $13.33 in Nasdaq trading. Ellison says things are getting worse at Peoplesoft, not better, and that the ORCL win rate this quarter versus PSFT suggests as much... on the face of things, says PSFT's claim that it has unanimous support of customers is not true; ORCL points to the business it won from Merrill Lynch, which was a PSFT customer.

J.D. Edwards filed suit in Colorado against Oracle seeking $1.7 billion in compensatory damages for what it said was Oracle's interference with its proposed merger with PeopleSoft. J.D. Edwards also field suit in California state court charging Oracle, its CEO, Larry Ellison, and executive vice president Chuck Phillips with engaging in wrongful conduct and unfair business practices.

Oracle spokesman Jim Finn said the company believes two lawsuits filed against the company by J.D. Edwards are frivolous. "Clearly PeopleSoft and J.D. Edwards prefer to fight in the courts than let shareholders decide. We believe that this case has no merit whatsoever," Finn said. After the market closed, J.D. Edwards filed suits in Colorado and California charging Oracle, its CEO Larry Ellison, and executive vice president Chuck Phillips with engaging in wrongful conduct and unfair business practices. J.D. Edwards is seeking $1.7 billion in damages as well as an end to Oracle's $5.1 billion hostile bid for PeopleSoft.