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Monday May 17, 2004 Daily MarketWrap

http://www.robblack.com/rb_marketwrap.shtml

The market took a step back based on worsening geopolitics, record high oil prices, and threats of rising rates. A bomb killed the leader of Iraq's governing council and the price of petroleum threatens to slow growth in the world's biggest economy. Benchmark indexes closed at their lowest this year. Transportation stocks declined, led by Continental Airlines, on concern higher oil prices will crimp profit. Shares of retailers, including Federated Department Stores, fell on the prospect that a rise in gasoline prices and an expected increase in interest rates will cause shoppers to spend less. The S&P 500 Index dropped 11 points (-1.1%) to 1084. The DJIA slid 105 points (-1.1%) to 9906. The Nasdaq shed 27 points (-1.5%) to 1876. More than two stocks fell for every one that rose on the NYSE. Some 1.4 billion shares changed hands on the Big Board, 3.6 percent less than the three-month daily average. The S&P 500 has posted three consecutive weeks of losses and has declined 6.4 percent from its 2004 high on Feb. 11. The Nasdaq has dropped in five of the past six weeks and has retreated 13 percent from this year's high on Jan. 26.

Strong Sectors: none
Weak Sectors: hardware, internet, networking, semiconductor, software, telecom, biotech, banking, insurance, transportation, broker/dealer

Top Stories . . . Manufacturing in New York state expanded for a 13th consecutive month in May as companies added workers to meet increased demand and shipments rose, a Federal Reserve survey of factories showed. A measure of prices manufacturers received for their goods increased to a record.

The dollar tumbled against the euro, yen and 10 other major currencies after Izzedine Salim, head of the interim governing council in Iraq, was killed in a car bomb attack in Baghdad.

U.S. Treasury notes rose after bombings in Iraq and Turkey boosted demand for the safety of government debt. A government report showing foreign purchases of Treasuries increased also pushed prices higher, helping the 10- year note to its biggest two-day gain in more than two months.

Lowe's, the world's No. 2 home- improvement chain, said first-quarter earnings rose 8.1 percent as the company expanded into metropolitan areas and sales exceeded analyst forecasts.

International investors increased their holdings of U.S. government debt, corporate bonds and stocks by a net $78.6 billion in March, the smallest increase since December.

Sherwin-Williams, the largest U.S. paint seller, agreed to buy Duron, a coatings company, for about $253 million to gain 231 stores and increase its manufacturing capacity.

Lucent, the largest U.S. maker of telephone equipment, will pay a $25 million fine for failing to cooperate with a federal probe into the company's improper booking of revenue.

Quotes of Note . . . ``People are wondering what these factors will do to the pace of the recovery and what it will do to consumer spending. There will be some bumps along the way.'' said Bernie Myszkowski, who oversees $2.5 billion as chief equity officer for ABN Amro Asset.

Gurus . . . On the Nightly Business Report, money manager Bruce Steinberg recommended General Electric, Alcoa, JetBlue, and Intel. On the Rukeyser Show, recommendations on Intel, Johnson & Johnson, Amgen, Radian, Kohl's, Xerox, and Capital One. Guest Gene Hensler stressed Pepsi, Target, Pfizer, and Bank Of America.

Mike Santoli of Barron's underscores the growing use of exotic program and index trading by brokers and hedge funds, which claim an increasing level of day-to-day activity. The proliferation of hedge funds has added to the volatility. On Friday, Alexis Glick of CNBC indicated record short selling activity in these instruments.

The WSJ's "Ahead of the Tape" column discusses stocks to buy in a rising interest-rate environment. Since 2nd quarter began, only the health-care and energy sectors, according to Baseline, are up, and all the other sectors are down. The playbook is to buy consumer staples and pharmaceuticals, defensive stocks that do well in a slowing economy. According to the column, it isn't hard to figure out what won't do well. Banks that have been generating earnings by playing the steep yield curve and buying mortgage-backed securities and auto makers that have financed their customers to the breaking point must top the list. The best investors, and those who aspire to be, give the same answer they would in any environment: Buy good company's that have competitive advantages and make real, honest money. That is, besides Microsoft, which is relatively inexpensive and has Himalayan cash and underappreciated growth prospects. Something will do well. Merrill Lynch's Rich Bernstein has been arguing for some time that there is a larger secular growth story with energy stocks, based on concerns about supply. Within that larger secular growth period, there will be cycles of stronger and weaker earnings. He points out that he has never argued that energy companies aren't cyclical. A top in the latest cycle may be on the horizon. In that case, he contends investors should be moving into the higher-quality, less-speculative energy companies: the integrated giants. Exxon Mobil trades at 15.6x the earnings estimate for this year. It isn't wildly cheap, but that is a discount to the market.

The WSJ's "Heard on the Street" column discusses hedge-fund related problems. During the past year, riskier investments around the globe became investment darlings for hedge funds eagerly hunting higher returns in a low-rate environment. After such a good run across so many asset classes last year, Boston-based hedge fund Baupost Group's president Seth Klarman wrote to clients in his year-end letter: "Could virtually all asset classes be overvalued?" Hedge funds play a bigger role than ever in terms of global capital flows. More than 7K hedge funds now prowl global markets in search of investments. And these private investment partnerships, which often copy one another's strategies and move in and out of investments and regions with alacrity, are an X factor as analysts try to gauge the impact of rising rates. "In the past, [a rate increase] has been a source of instability," warns the most recent Global Data Watch from J.P. Morgan Securities. "Moves in private capital flows can be sudden and severe." Hedge funds now have about $860 bln in capital from investors. But that figure understates the magnitude of their influence, since hedge funds usually use borrowed funds to amplify their investment strategies. When rates are low, the use of leverage expands. Along with using similar strategies, many funds are using the same risk models, as are the proprietary trading desks of banks, securities firms and even some central banks. But since nearly everyone uses the same models, the probability that most funds move at the same time and in the same direction is greater. Such a phenomenon can create pile-ups at the exit door, diminishing liquidity and creating difficulties in financial markets.

Defensive . . . Barron's highlights few defensive stocks that are worth to pick up. If money flow doesn't do it for you, consider some fundamental factors pointing in the same direction. Morgan Stanley equity strategist Teun Draaisma predicts upward earnings revisions will likely top out in the next two to three months, seasonally the most sanguine time for upgrades. Actual European corporate profits won't reach a cyclical summit until the fourth quarter, but a crest in estimate revisions typically leads reported results by two quarters. A peak in the profits expectations is the "classic signal" to sell cyclicals, like metals, mining and technology stocks and buy defensives, he argues. Some of his favorite defensive picks include oil co Total, Nestle, and drugmaker AstraZeneca. Last year, just taking the Total stock dividend yield plus share buybacks produced a 7% return, he notes. It trades at a relatively undemanding P/E multiple of 14x 2004 earnings estimates, "as if oil were $20 per barrel not $40," he says. Both the Swiss food giant and the Anglo-Swedish pharmaceutical co were recently added to the Morgan Stanley recommended portfolio. AstraZeneca, meanwhile, saw 1st quarter earnings drop and is spending buckets to promote its cholesterol fighter, Crestor, but, says Draaisma, pharma remains an unloved sector and AstraZeneca has a good drug pipeline.

Barron's highlights financially strong company's that should head higher over the next 12 months. Also called Barron's 500, a unique stock ranking system, which grades how well the 500 biggest publicly traded U.S. and Canadian company's (measured by sales) have performed for investors. Barron's sixth annual survey relies on calculations made by CSFB Holt. This year's top honor goes to Boston Scientific, maker of medical devices, that earned a perfect 4.0. Placing second is Countrywide Financial, a mortgage broker, which also earned a 4.0, but for which Holt estimated a slightly lower growth rate for '04 CFROI. In third place, with a 3.75 grade, is L-3 Communications, which sells secure and specialized communications systems, many with military applications. Nos. 4 and 5, respectively, homebuilder D.R. Horton and Omnicare, a provider of pharmacy-management services, also received a 3.75 grade, but Horton had a slightly higher forecasted CFROI. Sun Microsystems, which makes computer workstations and servers, bears the dubious distinction of ranking last in this year's survey, after years of ranking near the bottom. The company's annual rev has declined in each of the past two years, and one-time profits have turned to losses. Other bottom-dwellers include grocer Winn-Dixie Stores, AT&T, Qwest Communications and El Paso, a natural-gas pipeline operator.

IPO . . . Barron's highlights Blue Nile, the online purveyor of diamonds and jewelry that hopes to dazzle investors with its IPO this week. In business only since 1999, the co has won a loyal following by selling diamonds at below-market prices, and, as an Internet vendor, not charging sales tax outside its home state of Washington. Blue Nile doesn't carry loose diamonds in its inventory. Suppliers ship stones to the co the day after a customer makes a purchase, and Blue Nile assembles and ships the end-product. The co also sells non-diamond jewelry and watches, and offers a much wider variety than any neighborhood merchant. Blue Nile's financials have grown more brilliant over its brief history. Sales swelled to $128.9 mln last year, from $48.7 mln in 2001. Operating income jumped to $11.3 mln, from a loss of $5.3 mln two years earlier. A plus: the co has no debt. In the IPO, the co will sell 2 mln shares, and existing shareholders will sell another 1.74 mln. On a positive note, senior management won't be selling. Slated for Wednesday, the offering will be sold through investment banks led by Merrill Lynch. Shares are expected to price between $17.50 and $19.50. "I will buy Blue Nile [if shares are priced in the current range] and pair it against my Zale short," says Doug Kass of Seabreeze Partners, a Palm Beach hedge fund. Kass is short the bricks-and-mortar jeweler because he expects margins to be squeezed by online competition. Kass estimates Blue Nile will earn 52 cents this year and 70- to- 75 cents in '05. Its shares, if priced within the indicated range, would sell for 25x '05 estimates. That's well above Zale's P/E multiple of 12, based on F05 ests, and Tiffany's P/E of 18, but below Amazon.com's 31. Kass believes Blue Nile's valuation is warranted because earnings could rise 40%.

Japanese . . . Japan is a primary beneficiary of the shift in the global environment from deflation to inflation. It is being pushed out of its deflation by the decline in the super-strong (deflationary) dollar of 2000, the U.S. expansion, and the increase in the U.S. inflation rate. Analysts are raising forecast for Japan’s full-year 2004 GDP to 3.4% (was 2.2%), up from 2.7% in 2003.

Inflation . . . Expect only a mild inflation in coming years. This assessment is a key variable in the outlook for a durable expansion, with strong growth in employment and corporate profits. Analysts recognize risk to this outlook if inflation spikes. For several months, the outlook will be somewhat at the mercy of the inflation data. The U.S. is the first country ever to exit a deflation while maintaining a floating exchange rate, so the inflation behavior is new territory.

• Financial markets have reacted sharply in belated recognition of the inflation problem. The Fed is probably encouraged by the smoothness of the transition. Short-term interest rates have priced in substantial rate hikes, with the Fed funds rate now expected to reach 2.5% in mid-2005 and 3% near the end of 2005. This prospect strengthened the dollar, raised bond yields and caused sharp declines in the prices of gold, commodities, equities and emerging market assets, in effect reversing much of the inflation trade of late 2003 and early 2004.

Why an inflation?

Inflation is primarily a currency phenomenon brought about when the value of a currency falls substantially.

• Prices have to adjust across borders, whether goods are readily traded or not. The arbitrage is relatively thorough, though it operates with a lag. In a floating exchange-rate environment, money supply growth rates or analyses of the slackness in the economy are not very helpful in anticipating inflation.

• The dollar weakened substantially after 9/11, reacting to negative real U.S. interest rates and concerns about U.S. growth. This created a reflation process and then, as the accommodative monetary policy continued, an inflation process

• The evidence of an inflation problem now is similar to the evidence of the deflation problem in the late 1990s. The price of gold is as far above its moving average as it was below in 1999. This indicates dollar weakness and upward pressure on dollar prices.

• Expect a piece-by-piece inflation process, the mirror image of the piece-by-piece deflation in 1997-2001. The inflation rotation has proceeded from dollar weakness to higher gold prices, negative real interest rates, higher commodity prices, inflation signs in China, and an extreme in the ISM prices paid index. Pipeline inflation pressures are already evident.

• According to the ISM index, the prevalence of price increases to manufacturers is at its highest level since 1979 (when inflation was rampant.)

• Price increases are spreading further up the inflation “food chain.” Core CPI inflation, normally the last to be hit, rose 0.3% in April, bringing year-over-year inflation to 1.8%. Combined with the 0.2% reading in February and 0.4% in March, the three-month annualized inflation rate is now 3.3%.

Why is inflation mild, but persistent?

The dollar has weakened to the point of causing a mild inflation. The graph below shows the deviation of the price of gold from its ten-year moving average since leaving the gold standard. In effect, this measures bouts of dollar weakness or dollar strength. Assuming a steady $375 gold price going forward, the upward pressure on prices should persist for several years but not be too pronounced.

Factors adding to inflation:

• With inflation now rising, real interest rates are likely to remain negative well into 2005 when the Fed funds rate will finally overtake the inflation rate.

• Expect the Fed to raise its interest rate target to 1.25% from 1% at its June 30 meeting, beginning the long process of raising interest rates to neutral. Recall that the Bank of England has its rate at 4.25%, even though it has slower growth and lower inflation than the U.S. The Fed’s most recent statement said that “policy accommodation can be removed at a pace that is likely to be measured.” This means policy will remain loose for several more quarters.

• Consequently, we expect the rebound in inflation, while modest, to be persistent. Factors holding down inflation:

• U.S. consumer price inflation didn’t slow much in the deflation process (though dollar-linked China’s did). The U.S. CPI basket is clearly sticky. We think memories of the deflation and recession will hold down price increases during the inflation. Reinforcing this, some of the excess capacity built in the late 1990s is still economically viable.

• While we think inflation will encourage higher inventory levels, the 20-year experience with disinflation will retard the transition, spreading the demand (and probably price) impact over several years. This same logic will probably keep Japan’s demand growth somewhat restrained.

• The diffusion index of items in the CPI basket shows that the dispersion of price increases is spreading but is still below the pre-deflation norm. With 70% of items rising in price in an average month, the impact on overall CPI is mild rather than pronounced.

Small Caps . . . The WSJ discusses small stocks profits, which are pegged to surge and could drive stock prices higher as the year progresses, especially if concerns about interest rates, oil prices and Iraq can subside. But, according to the paper, further out a potential problem looms. Since this year's profit growth is expected to be so high, company's will have hard time beating or even meeting those growth rates next year, and the poorer comparisons could be viewed negatively. "The outlook for this year's earnings is quite good and that should help stocks in 2004," said Bob Davidson, co-manager of Touchstone Small-Cap Growth Fund. "But there is no question earnings will slow and especially the weaker competitors could fall by the wayside in 2005." As for vastly outpacing analysts' ests, the percentage leader on the S&P 600 is NYSE-traded Ryerson Tull. The metals processor turned a profit of 46 cents a share when Wall Street was expecting 2 cents. Next up is Park Electrochemical that posted earnings of 20 cents a share compared with the 4 cents that analysts expected. The biggest miss on a percentage basis is OshKosh B'Gosh, a children's clothing and accessories retailer that lost 16 cents a share when an earnings gain of 6 cents was expected. Next is Concord Communications, a software provider that posted a loss of two cents a share when Wall Street projected earnings of one cent. According to the article, basic-materials company's, like chemicals, paper products and metals, are shining most, with earnings growth of 240% as a result of easy comparisons from last year's 1st quarter and improved global demand. The same factors are driving tech company's, the second-best performers, with earnings having grown 161%. The poorest performers are telecom company's, with 3% growth, utilities up 7% and financials up 8%.

Financials . . . Barron's cover story highlights Fannie Mae, which presents to the outside world a face of consistent earnings growth and transcendent social mission. However, the article suggests this compelling story line has frayed of late. A Barron's analysis of Fannie's accounting methods finds that, while legal, they obfuscate rather than illuminate Fannie's true financial condition, allowing billions of dollars of derivative-related losses not to be reflected on its income statement. As a result, Fannie's capital strength is less robust than the company's many fans on Wall Street and on Capitol Hill would contend. The Bush administration, meanwhile, has mounted a frontal assault on Fannie and its smaller sibling, Freddie Mac, contending that the company's high-balling growth in the residential housing market potentially threatens the financial safety of the U.S. and the global financial system. The Bush administration has failed over the past 2 years to force legislation through Congress to rein in Fannie and Freddie. According to the article, Fannie is now feeling the heat, too. Two weeks ago, Ofheo announced that the probe had uncovered evidence that Fannie had failed to follow proper GAAP in determining the size of impairment charges and rev recognition on investment holdings in manufactured- housing and aircraft-lease securities in prior fiscal quarters. Fannie subsequently argued it had done nothing wrong and will be able to avoid any restatements that, given the size of $8 bln in its manufactured-housing securities and reported $300 million in aircraft-lease paper, could be substantial.

REITs . . . El Paso Corporation has advised Crescent Realty it is planning to move all personnel from Crescent's Greenway Plaza complex, located in Buffalo Speedway submarket of Houston, to El Paso's existing headquarters in downtown Houston. As of March 31, 2004, three El Paso subsidiaries leased a combined total of 912,000 square feet in Greenway Plaza which, under current terms, which translates into 4.6% of Crescent's total annual office revenue. El Paso's move is expected to be complete by year end 2004.

All about REITs . . . Better than anticipated earnings were the theme for REITs this quarter. Although fundamentals are still weak, they are improving. In contrast, REIT stocks have tumbled as bond yields backed up on positive job growth reports in March and April. A good managers inclination is to favor those sectors with the best earnings growth propsects and total return potential.

Quarterly FFO Performance. The whole REIT coverage universe reported an average year-over-year FFO per share decline of 4.2% in 1st quarter 2004 (after adding back non-cash charges) due primarily to fundamental weakness in the multifamily and office segments. Within the REIT universe, shopping centers (FFO/sh up 7.0%), regional malls (up 5.6%), and specialty finance (up 7.4%) were the top performers.

Full Year 2004 Projections. For full year 2004, FFO per share is expected to increase a modest 0.5% for coverage universe. Anticipate that the best performance will be delivered from shopping centers (up 7.4%), industrial (5.2%), specialty finance (4.8%) and regional malls (3.9%). Multifamily and office are projected to show declines but not as significant as 2003.

REIT Bear Market. REIT stock prices climbed 13.2% but are now down 6.0% year-to-date. Given strength in the economy, it appears as though higher interest rates are on the horizon, which leads to the question whether REIT fundamentals can outpace the effects of higher interest rates on valuations. They will but not until later in the year.

Sector-Specific Trends. Within each of the REIT sectors, there were unique takeaway points gathered from the first quarter results which are explored in more detail later.

Office Trends. During the earnings season, office companies reported continued weak conditions in their markets but modestly increased activity. According to REIS, 33 of the 61 largest U.S. office markets reported negative absorption in 1st quarter 2004, (up from 19 markets in 4th quarter 2003), but positive net absorption for the nation in total, for the second consecutive quarter. With modest new deliveries, the overall national vacancy decreased 10 bps to 16.8%, the first quarterly decline since 2000, according to REIS. Effective rents fell in 46 markets, 0.7% on average to $20.29 per sq. ft. Management teams seemed encouraged by the increase in net absorption in their markets, and feel that rents are unlikely to fall much further, perhaps with the exception of select tech-oriented markets. However, most do not expect rents to rise until a fair amount of positive absorption takes place (i.e., 2005-2006). Assuming a modest economic recovery in 2004, office REITs expect occupancy to remain stable and potentially increase later in the year. With respect to rents, office REIT managers were less sanguine, and continue to expect no increase in pricing power in 2004.

Multifamily. The nine multifamily companies that covered generated an FFO per share decline of 6.0% in the first quarter of 2004 versus 1st quarter 2003, using Operating FFO as defined above. Heading into earnings season, we were expecting an average decline of 9.6%, so the results were ahead of projections. That outperformance, for the most part, can be explained by a significant variance for both Archstone-Smith and Camden, which realized unexpected non-recurring income in the quarter. In Archstone-Smith’s case, year over year FFO would have been negative if not for the non-recurring income, while Camden’s FFO grew year over year (by 4.0%) even after subtracting out the non-recurring contributions; additionally, Home Properties had year over year FFO per share growth of 3.3%. The entire apartment universe, including seven companies we do not cover, saw FFO per share decline by 4.0% in 1st quarter 2004 versus 1st quarter 2003. In addition to those companies mentioned above, Amli, Associated Estates, and Mid-America had positive year over year FFO per share growth, while United Dominion was flat. The worst performers in the quarter all come from within our coverage universe: AIMCO (negative 25.6%), Gables (negative 18.5%) and Post (negative 14.8%). Using operating FFO, analyst are projecting a more modest FFO per share decline of 2.4% in 2nd quarter 2004; analyst are calling for a 1.7% decline for full year 2004 over 2003. Heading into earnings season, we were projecting a 0.9% FFO per share decline in 2004 over 2003 coverage universe; reduced guidance in several cases led to the modest 80 basis point reduction. Looking at the multifamily universe as a whole, FFO is expected to decline by 1.5% in 2004 versus 2003.

Industrial. FFO per share for the three industrial names we cover increased 1.3% in 1st quarter 2004, versus our estimate of a 2.1% increase, which included PLD (-7.3%), AMB (-10.2%) and Keystone (+21.2%). The results were aided by easy comparisons for Keystone. Our revised 2004 FFO estimates for our coverage universe now represent a 5.2% increase over 2003, in line with prior estimate of a 5.2% increase. In comparison, FFO per share is expected to rise 8.0% for full year 2004 for the six industrial companies that we track. Revised 2004 CAD estimates reflect a 1.0% increase from 2003 for our coverage universe.

Retail. The three shopping center companies that we cover reported an FFO per share increase of 7.0% in the first quarter of 2004, which was ahead of the 1.6% that we were projecting. Kimco

outperformed, followed by New Plan. Kimco’s strong results may be attributed to solid leasing activity and occupancy gains as well as acquisitions. New Plan reported healthy rental rate growth and acquisitions outpaced expectations. This was the first quarter of same property NOI growth since 3rd quarter 2001. Equity One performed in line with our estimates as leasing was robust and the level of acquisitions were high. The 11 shopping center REITs that we track posted FFO per share growth of 9.1% in the quarter. The top performers in terms of FFO per share growth were Kimco, up 19.2%, Developers Diversified, up 16.4%, and Weingarten, up 10.7%. The two laggards were Acadia Realty, down 11.1%, and Heritage Property Trust, off 1.4%. For the full year 2004, the three shopping center REITs covered are expected to post 7.4% growth versus 8.2% for the group overall. In 2005, the expectation is for 7.5% growth for our coverage universe and 7.4% for the 11 shopping centers that we track. The nine regional mall REITs that we track posted 10.0% FFO per share growth in first quarter 2004. The outperformance was driven by Pennsylvania REIT, up 34.9%, followed by Taubman Centers, up 34.2%, and General Growth Properties, up 22.4%. CBL & Associates gained 3.4% and Simon

Property Group achieved 7.9% growth. For the two regional mall REITs in our coverage universe, we estimate 3.9% growth in FFO per share in 2004, and for the nine mall REITs, the expectation is for 7.9% in 2004 and 9.2% in 2005.

Specialty Finance. The specialty finance coverage is focused primarily on commercial mortgage REITs, which typically underwrite credit risk, not interest rate risk. For this reason, concerns over rising interest rates appear to be overblown. Fundamentals in this industry continue to be solid because origination opportunities remain strong, and there are positive spreads to be made over current capital costs. Long-term real estate debt securitization trends have created a huge playing field; while the volatile interest rate environment may reduce overall investment opportunities, it is conceivable that spreads will widen making those opportunities more attractive. Given the better than average dividend yields in the specialty finance sector, especially after the interest rate related sell-off of the past 45 days, these stocks offer solid potential total returns.

Oil & Gas . . . BJ Services upped to Strong Buy from Outperform at Raymond James based on the recent 10-15% pullback in the stock has created an attractive entry point for investors, as firm believes the fundamentals continue to support solid earnings growth. Price target $55 (25x 2005 estimate), suggesting 34% upside.

JP Morgan upgrades Noble Drilling to Overweight from Neutral, saying the combination of strong free cash flow and 9.4 million shares remaining on its repurchase authorization provides good downside support; given current inflation fears and a seemingly unstoppable oil price. The firm believes that pairing NE against Global Santa Fe or Diamond Offshore looks particularly appealing, as NE has underperformed both of these peers meaningfully YTD, but both the fundamentals and relative valuation now favor NE. Also, earnings are expected to grow 122% between 2Q04 and 4Q04. Importantly, essentially all of this gain is attributable to better asset utilization and is not at all dependent upon improvements in global day rates.

Transports . . . Prudential lowers their view of the Automakers sector to Unfavorable from Neutral, saying Fed Funds rate increases have historically had a negative impact on shares of the domestic OEMs. While firm is not convinced that upcoming moves by the Fed will materially hurt the earnings of the automakers, they believe that investors will at least initially react as they have (negatively) to prior rate increases by paying less for those earnings. Firm downgrades General Motors to Neutral-Weight from Overweight, and downgrades Ford and Daimler Chrysler to Underweight from Neutral-Weight. Firm also upgrades Toyota, as they believe the Japanese OEMs will provide a relative haven to auto industry investors in a rising Fed Funds environment.

Retail . . . Lehman upgrades Tiffany to Equal-Weight from Underweight based on valuation. The firm says that any incremental improvement in sales in Japan, while not likely to materialize until 2nd half 2004, could provide a catalyst for the stock. The firm sees the opportunity for substantial efficiencies in sourcing and distribution in 2004 and after via internal manufacturing and new facilities; U.S. sales remain robust, and current trends remain on plan thus far in 2nd quarter, making the stock more compelling from a risk/reward standpoint. Firm also notes that TIF trades at 20.5x their 2004 EPS estimate, a 27% discount to its historical median forward P/E.

Lowe's reported earnings of $0.57 per share, $0.03 better than the consensus of $0.54. Revenues rose 22.0% year/year to $8.68 billion versus the $8.49 billion consensus. The comapny expects 2nd quarter EPS of $0.89-$0.91 versus consensus of $0.88.

Limited reports earnings of $0.13 per share, in line with the consensus of $0.13. Revenues rose 7.4% year/year to $1.98 billion versus the $1.96 billion consensus. The company sees 2nd quarter EPS of $0.23-0.26 versus the consensus of $0.24. The company also announced that it has authorized a $100 million share repurchase plan. This additional repurchase plan follows the successful completion of its March 2004 tender offer to repurchase $1billion of its common stock.

Healthcare . . . Barron's highlights company's that may benefit from an e-prescription system that may finally supplant the paper prescription pad. In speeches this year by President Bush and his Medicare boss, Dr. Mark McClellan, electronic prescribing topped their lists of technology fixes for America's health-care hassles. Congress included e-prescribing pilot projects when legislating Medicare's new drug benefit. Health insurers are starting to pay doctors to install electronic prescribing systems. By the end of the summer, about 75% of the nation's pharmacies should be wired into an e-prescribing network built by the drugstore industry. If e-prescribing's time has at long last come, that is, according to the article, welcome news for little firms like Allscripts Healthcare Solutions, health insurers and prescription benefit managers, like CareMark Rx, Express Scripts and Medco Health Solutions. "A lot of people go to a retail pharmacy because we like the relationship there," says Dr. Mark Frisse, an e-prescribing expert at First Consulting Group. "But there will be a lot more going to mail order." Medicare-funded drug plans will ultimately favor mail order, predicts Dr. Frisse. A few weeks ago, the health maintenance organization WellPoint said it would pay $40 million in startup costs for 19K doctors to start using software from Allscripts or its Dallas-based rival Zix. The P/E multiple of 32x next year's EPS places Allscripts at the high end of the range for the medical software stocks like Cerner, Eclipsys or IDX Systems. But Allscripts CEO Glen Tullman sees tremendous upside, with a deal like WellPoint's suddenly giving Allscripts a chance to add some of the HMO's 19K-affiliated doctors to the 15K-20K doctors that it took Allscripts 5 years to sign.

On Thursday, May 13, HCA held its annual investor day at its headquarters in Nashville, TN. Overall, sensed a slightly more cautious outlook than last year’s guardedly optimistic tone, although we believe the company’s long-term business model and growth expectations remain intact. Most of the conference focused on the uninsured and bad debt trends, with the conclusion that HCA is not looking for improvements yet, it is still focused on stopping the bleeding at this point. To that end, the company has continued to refine how it calculates bad debt and is devoting significant efforts to improve collections. Besides bad debt, other business trends appear rather mixed, with consolidated volumes likely to remain uncertain in the near-term, and improved labor and insurance costs being offset by higher supply expense. Pricing trends appear to be holding up well, with strong Medicare and managed care increases expected. While analysts were somewhat expecting the company to announce a new share buyback program, with only $225 million left on its prior program as of the end of the first quarter. Rather, HCA reiterated is goal of reducing debt and lowering its debt to capital ratio from 55% to the low 50s by mid-to-late 2005. Overall, HCA’s current share valuation is somewhat reasonable, but not cheap. Given uncertainty over potentially worsening uninsured and bad debt trends and the subsequent impact on margins and earnings growth, analyst would like to see either a more attractive valuation multiple or a stabilization in operating trends before becoming more positive on the shares. To this point we note that our current model suggest 18% EPS growth in 2005 (off of a down year in 2004), as comparisons ease. However, we have somewhat optimistically assumed a 50bp improvement in bad debt trends and if 2005 bad debt is at 2004 levels, then 2005 EPS growth would shrink to approximately 10%.

Medical Devices . . . Oppenheimer out on St. Jude Medical following news from last Friday that the EPIC-HF, a cardiac resynchronization therapy system, would not be cleared by the FDA in May. However, the company still expects to receive product approval by the end of the current quarter. According to the firm, the delay could be significant, as it pushes back STJ's US launch of a CRT system, the lack of which has cost the company some US market share losses to Medtronic and Guidant, both of which introduced CRT systems in the US around two years ago. They are not making and changes to their full-year EPS estimate of $2.23 but note that there could be downside to earnings projection for this year if the delay in the EPIC-HF's clearance extends well into the third quarter. Firm also notes that with the stock trading 34x 2004 EPS estimate on Friday, the valuation was fully factoring in this year's gains from a successful 2nd quarter or 3rd quarter launch of CRT systems thus, the stock might weaken today. Firm maintains their Neutral rating.

Drugs . . . Prudential is out on Eli Lilly saying that the odds of company losing its Zyprexa challenge now appear to be higher than previously thought. One of the generic companies' arguments supporting patent invalidity has centered around a legal doctrine known as "public use", but this appeared to be a non-issue because of prior court precedent, further affirmed by a lower court ruling in 2003 on a different patent dispute between GlaxoSmithKline and Apotex related to Paxil (depression). LLY even cited this lower court ruling as support for its Zyprexa patent. Recently, however, the Court of Appeals for the Federal Circuit reviewed the lower court Paxil findings and issued an opinion that overturns the lower court's findings on "public use" - this creates a potentially dangerous legal precedent for LLY. According to the firm, the odds now appear higher that the way in which LLY conducted some of its Zyprexa clinical trials could indeed lead to invalidation of the patent based on "public use". They note that when the odds of a win were previously 90/10 in favor of LLY, then maybe it is now 75/25. Prudential does not believe current LLY share price fully reflects this new, increased risk.

Biotech . . . Protein Design Labs reported that its humanized antibody, daclizumab, did not meet the primary endpoint in a Phase II clinical trial in patients with moderate or severe ulcerative colitis. Steven Benner Chief Medical Officer said, "We are disappointed that daclizumab did not demonstrate a clinical benefit in this setting. Based on these findings, we do not plan to further develop daclizumab as a treatment for ulcerative colitis."

Hotel & Leisure . . . Roth upgrades Century Casinos to Strong Buy from Buy after the co reported in-line 1st quarter results. The firm believes that Womacks' casino revenue will stabilize in 2nd half 2004, they expect the co to be recommended for approval by the Alberta Gaming and Liquor Commission to be awarded a casino license in Edmonton, Alberta in the next 3-5 months, and they think that potential upside exists from a positive ruling on the company's Johannesburg casino license, which is currently being contested by the Gauteng Gambling Board in the South African Supreme Court.

CSFB upgrades Mandalay Resort to Outperform from Neutral, saying recent multiple compression (-17% off 52-wk high) and continued fundamental momentum combine to create an attractive trading opportunity; firm says that multiple Las Vegas operating momentum drivers are likely to remain in place for the next several quarters: lengthening booking curve, favorable convention and FIT mix shift, reduced third-party distributor dependency, close-to-home consumer mentality, positive currency effects, and relatively low airfares. Target is $62.

Media . . . The Financial Times reports that Viacom is in talks to buy Viva Media, the struggling German broadcasting company, in a move that would strengthen the US media group's grip on music television in Europe. People close to the talks said to the paper that Viacom was conducting due diligence on Viva Media with a view to making an offer that would value it at about 300 million. They said to the paper that discussions were at a fragile stage and there was no assurance of agreement. The talks come as Viva Media is struggling with declining ratings at its two music TV channels in Germany, which are facing intense competition from MTV.

Interesting Note from Bear Stearns on radio stocks . . . Rough "C" #1 & #2: Contrast/Cancellations. A year ago, radio was enjoying a burst of activity with the image of President Bush declaring the end of the heavier military aspects of Mission Iraqi Freedom. This year's image is Fallujah and prison abuse. This may have led to some rotation of business to June from May, especially for national advertisers. Rough "C" #3/#4: Comparables/Context. In 1st quarter 2004, companies provided guidance above their current 1st quarter pacings, expecting 1st quarter would improve. March's 10% growth brought 1st quarter above consensus; most public companies did better. In 2nd quarter 2004, companies gave guidance below internal pacings and see higher sell-outs and rates. Weekly pacing data often comes without context, which makes pacing hard to interpret. Rough "C" #5: Capitulation from Core Investors? On average, since January 1, 2001, radio stocks have seen double-digit upward/downward returns every 47 days. How many "core" investors are now unable/disinterested in the group due to its incessant volatility. Radio's weekly pacing data versus newspapers (monthly) and TV (quarterly) may contribute to the problem. Rough "C" #5: Contraction. During the last two weeks, radio stock valuations have taken a beating, down on average 16%. Multiples have contracted to those levels the industry faced in the worst of times and radio's free cash flow multiples have slipped below those of the newspaper business. Radio Can Ride the Rough "C's"! TV Should Not Suffer By Association. Radio stocks are very attractive right now. While pacing data could weaken again this week, as "comps" suggest, 3rd quarter in TV is brewing to be very big. Radio should not be left behind. TV stocks should not suffer by association with radio. BS likes the broadcast group right now.

IT Services . . . Goldman Sachs retains its Neutral view of Indian IT Services stocks after last week's surprising elections in India. The local market in India (Sensex) closed down 10% due to three factors: (1) Concerns of increased influence from the communist/left parties in the newly formed coalition govt; (2) Retail margin selling pressure. (3) FII/Hedge funds selling of Indian state owned govt sponsored industries. Assuming a worst case scenario change in taxation, the firm notes a 3-4% change in DCF fair values for Indian IT. Firm expects sector to remain volatile.... CIBC also chimes in on the election. The telecom landscape may see some impact depending on which policies Ms. Gandhi wishes to embark on. Cos from the infrastructure side with exposure to India include ERICY, NOK and UTSI For the handset market, CDMA is an emerging technology and one of the fastest growing regions for QCOM's chip sales. OEMs with exposure in India for/with CDMA or GSM are LG Ericsson, Motorola, Nokia, and Kyocera. Chip suppliers include RF MIcro, Triquint, Sawtek and Anadigics.

Smith Barney upgrades Cognizant Tech to Buy from Hold, saying the latest sell-off related to the Indian election results seems completely unjustified, as they think it is highly unlikely that the new Indian government will take steps that adversely impact the fast-growing IT/BPO industry. In addition, firm notes that the US dollar has strengthened about 4% since late March 2004, which helps the company's gross margins. Target is $56.

Telecom . . . The WSJ reports that AT&T asked the regional Bell company's to agree to a binding arbitration in an effort to resolve the dispute over wholesale rates, but the Bells rebuffed the proposal. A federal appeals court in March struck down FCC competition rules that require the regional Bell phone company's to lease their networks to rivals such as AT&T and MCI at deep discounts. Attempting to avoid industry chaos in the wake of the decision, the FCC asked both sides to reach private agreements on wholesale prices, which the Bells maintain are too low. There has been little progress to date even as the June 15 date for the court order to take effect approaches. AT&T CEO David Dorman on Friday said the company is "frustrated by the lack of progress in negotiations to date," and called for the use of arbitration to break the impasse. Parties to arbitration must abide by the final agreement. Mark Cooper of the Consumer Federation of America backed AT&T's call for arbitration. The group is concerned that higher wholesale rates could raise prices for consumers or price Bell competitors out of the market. "AT&T has realized that the Bells are not interested in a reasonable solution and has upped the ante by proposing binding arbitration," Mr. Cooper said. "This approach can provide the needed breakthrough that levels the playing field among competitors and ensures long-term competition to the benefit of consumers."

The WSJ reports that Vonage Holdings will announce today that it is cutting the price of its unlimited calling plan by 14% to $29.99 from $34.99. Vonage has 155,000 Internet phone lines and is adding 25,000 new phone lines a month. The move comes just six weeks after AT&T launched its Internet calling plan which it plans to roll out to 100 cities by year end. AT&T's unlimited calling plan costs $39.99 a month, though the company is offering it for $19.99 a month for the first six months.

Network Equipment . . . Morgan Stanley out in defense of Lucent saying the SEC is set to close its 3+ year investigation into Lucent's accounting. An already disclosed fine of $25 million is expected to be levied against LU for failing to cooperate with the inquiry. The cooperation issue stems from LU's decision to indemnify employees under investigation, something the SEC disproves of, and has since added provisions against this practice in settlement agreements. According to the firm, today's announcement should not be viewed as new information. The company announced in December 2000, that it had improperly booked approx $679 million in revenue and restated its financials. They do not view today's news as unexpected, and believe it should close the SEC investigation. While the stock may react unfavorably to the news, they do not believe that today's announcement is likely to change any of the previously disclosed information regarding the SEC's investigation.

The WSJ reports that the SEC is coming down hard on Lucent, both to deal with its alleged misdeeds and to send a clear signal that the agency wants nothing less than full cooperation from company's under investigation. The securities watchdog is expected to file civil fraud charges against Lucent as early as today for improperly recognizing $1 billion in rev and to fine it $25 million for failing to cooperate with inquiries. The cooperation issue included disputes over Lucent's indemnifying employees under investigation from some things such as legal fees, fines and penalties, a practice on which the SEC has gotten tougher. The agency will charge at least five former Lucent executives for their alleged roles in the company's accounting problems, people familiar with the matter said to the paper.

Thomas Weisel comments on the N+I 2004 trade show. The firm's main conclusion is that except for a few emerging pockets of growth (security, wireless LANs, voice-over-IP), the networking market is relatively mature and differentiation among vendors is increasingly hard to see -- meaning share gains will be critical to vendor growth. From a stock perspective, the firm comes away more positive on Adtran, Polycom, and to a lesser extent Foundry. The firm continues to be cautious on Extreme Networks and F-Five. Booth chatter reinforced the firm's view that Polycom's business trends are increasingly healthy, both due to the improving economy and the multiple new product introductions. As for ADTN, the firm says its valuation is attractive at 21x our 2005 estimate (versus growth rate of 15% and peer group median of 22x).

The WSJ reports that Nortel gave some top executives millions of dollars in cash bonuses, rather than the usual award of stock, just weeks before the company's shares plunged on a March 10 warning that earnings would have to be restated for a second time. Meanwhile, Nortel said Friday it is the subject of a criminal investigation by the U.S. attorney's office for the Northern District of Texas, Dallas division. Nortel said it received a federal grand jury subpoena to produce financial statements and corporate, personnel and accounting records as far back as Jan. 1, 2000. The Dallas investigation is in addition to ongoing investigations into Nortel's accounting by the U.S. SEC and the Ontario Securities Commission. According to a review of regulatory filings, the bonuses, awarded in Feb, were part of the company's long-term compensation plan. In past years, most recently in July 2003, the award had been granted entirely in the form of restricted stock. According to the article, this time around, when the board's compensation committee voted to award the shares on Jan. 29, it decided to give the executives half of that compensation in cash. Nortel's stock has since fallen nearly 44%, meaning that if the executives had received Nortel stock instead of cash, they would have fared far worse.

Semiconductor Equipment . . . WR Hambrecht reiterates its Hold rating on Applied Materials with a $22 target assuming that the stock should sell at 8x estimated 2005 gross profits of $2.72 per share. The company is scheduled to report its April Quarter results tomorrow afternoon. The firm looks for orders of $2.20 billion, up from $1.68 billion and expects 3rd quarter guidance to call for a 5%-10% increase in orders, 15%-20% revenue growth, and EPS of $0.22. However, the firm believes that Applied's size and large market share will limit its future growth to a rate nearer the equipment industry average of 10%-12% as opposed to its 25% annual growth rate from 1980 to 2000.

Transmeta announced that Svend-Olav Carlsen, the company's chief financial officer, plans to resign in June 2004 in order to accept a new opportunity with a privately held company. The company has initiated a search for a new CFO and is defining its transition plan. The transition date has not yet been established.

Boxmakers . . . The six-week waiting list to get a popular iPod Mini digital music player from Apple Computer is likely to get shorter by the end of the year. Hitachi’s hard disk drive unit said on Sunday that it will spend about $200 million to double the disk drive output of its Thailand factory, including the 1-inch, 4-gigabyte disk drives that are found in the iPod Mini.

Semiconductors . . . SG Cowen out on Lexar Media and Sandisk saying that based on their recent survey suggests SNDK is aggressively leading price cuts, on average about 30% since March (vs. 20% previously announced). LEXR appears to be more selective, but competitive in retailers where both brands are sold. LEXR average pricing declined 11% since March. Firm notes that PNY (a smaller player) was slow to react to price cuts, and on average has shown flat pricing since the end of March. Thus, they see the potential for further market share consolidation for SNDK and LEXR. LEXR is near a 2-year low P/E, but the firm recommends investors await signs of more stable pricing before putting new money to work. Fear of further price declines could depress P/E for some time.

Eastman Kodak forms long-term agreement with Lexar Media, Inc. to gain a larger share of market for removable digital memory products, driven by surging demand from the mass-market adoption of digital cameras, mobile phone cameras, portable music players and other consumer electronics devices. Consumers can expect to see a full suite of KODAK branded memory cards on store shelves in 4th quarter 2004.

Goldman Sachs upgrades AMD to outperform from In-Line and raises their 2005 EPS estimate to $0.99 from $0.70 (consensus $0.72). The firm believes the upside to consensus for AMD in 2004 and 2005 will come from: 1) better ASPs from the impact of 64−bit processors and Intel's less aggressive price cuts, 2) an opportunity Intel has provided AMD to sell 64−bit MPUs before Intel launches its own with Microsoft's 64−bit OS, 3) the likelihood that NOR flash (51% of rev) will contribute upside in 2nd quarter due to tight supply, the low cost architecture of MirrorBit, and aggressive transitions to 110nm and 90nm, 4) long-term improvement in interaction with enterprise customers, and 5) seasonal improvement in 2nd half 2004 PC units.

Goldman Sachs downgrades Sandisk to In-Line from Outperform; while they continue to believe there is some upside left to 2004 estimates, they believe that it is likely too late to be overweight the stock approaching mid−2004, with 2005 coming into view where NAND supply will grow more quickly. Also, firm expects a 4% oversupply environment in DRAM in 2005, which will likely have a spill−over effect on the NAND market. The firm expects that SNDK's 2004 estimates will likely peak out around $1.50, at which point greater bit shipments would likely have to be at lower average ASPs.

ThinkEquity upgrades Anadigics to Overweight from Equal-Weight and raises their target to $10 from $9; firm says recent checks indicate that an improving demand picture for ANAD and the expected strength in the overall wireless handset market could result in substantial upside to ANAD's ests for the 2H04 and beyond. Also, the progress ANAD is making in expanding into new programs with existing customers and its broadening customer base have resulted in a substantially improved long-term outlook for the co.

Software . . . SG Cowen initiates coverage on Red Hat. Having established its initial market presence via low-cost license fees, the company is rapidly shifting to a value-added subscription model that provides high visibility into revs and earnings. Firm expects revs to grow by 50%+ annually to $300 million in 2006, with GAAP EPS more than quadrupling to $0.36. However, firm believes that much of this upbeat outlook is already reflected in the stock, which has more than tripled in the past year and now commands a valuation (16x 2006 rev, 69x 2006 EPS) that leaves little room for disappointment. Firm recommends holding the shares, but would lean towards selling into strength rather than buying into weakness.

JP Morgan in Europe adds SAP to their Focust List, as they expect strong Year over Year license growth and improving operating margins to drive earnings growth, leading to significant stock outperformance.

Bear Stearns upgrades BEA Systems to Peer Perform from Underperform based on valuation; having fallen 23% since its close of $10.78 on May 13, and more than 40% since the beginning of March. The firm now believes that much of the near-term downside in the stock has been captured; in addition, while firm continues to view BEAS as a relatively solid co with a large customer base, they believe strategic issues may haunt BEAS's growth prospects over the next couple of years, and they will be watching the co closely for further signs of sales force execution difficulties and any competitive developments with IBM and Oracle.

PeopleSoft comments on Oracle's revised offer. "Given the significant antitrust obstacles in both the United States and Europe, we do not believe Oracle's bid can be completed at any price. We note that Oracle has timed this announcement on the eve of our annual Leadership Conference, our most significant customer event for senior executives with more than 2,500 attendees. This is one more instance of what we firmly believe is Oracle's ongoing effort to damage our business. Consistent with its fiduciary responsibility, the Board will evaluate the reduced offer at a regularly scheduled board meeting later this month."

Late Friday Oracle revised its cash tender offer to purchase all of the outstanding shares of PeopleSoft to $21 per share, or approximately $7.7 billion. The previous offer was for $26 per share, or approximately $9.4 billion. ORCL extended its previously announced tender offer to midnight EDT on Friday, July 16, 2004.

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