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Thursday May 27, 2004 Daily MarketWrap

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U.S. stocks rose, sending the Standard & Poor's 500 Index to its longest rally in nine months. Retailers including Costco, Michaels Stores and Dollar Tree Stores gained after earnings surpassed estimates. Stocks were also helped by a drop in oil prices and a government report that showed the biggest increase in corporate profits in two decades and faster first-quarter economic growth than earlier reported. The S&P 500 added 6 points (+0.6%) to 1,121. The benchmark had its sixth consecutive increase, the longest streak since September. The DJIA advanced 95 points (+0.9%) to 10,205, led by a gain in Boeing Co. The Nasdaq Composite rose 8 points (+0.4%) to 1,984, for its first five-day gain since January. More than two stocks rose for every one that fell on the New York Stock Exchange, the eighth day in a row that advancing issues beat declining shares on the Big Board. That's the first time that's happened since December. Some 1.45 billion shares changed hands, in line with the three-month daily average.

Strong Sectors: internet, semiconductor, communications services, consumer, drug, steel, chemical, retail, gold

Weak Sectors: oil & gas services

Top Stories . . . The U.S. economy grew at a 4.4 percent annual pace from January through March, faster than estimated last month, as businesses replenished inventories, government spending rose and home construction accelerated.

The dollar fell to the lowest in almost two months against the euro after U.S. unemployment- benefit claims were more than expected. It weakened against all 16 major currencies.

Costco Wholesale, the largest U.S. warehouse-club chain, said third-quarter earnings beat analysts' forecast, rising 29 percent because of increased sales of gasoline and food.

Citigroup, the world's biggest financial-services company, plans to sell its remaining shares in Samba Financial Group, ending its presence in Saudi Arabia after almost half a century.

Donald Trump's Trump Hotels & Casino Resorts made a $73.1 million interest payment due on $1.3 billion in debt, just days before the company would have been in default.

Gurus . . . Prudential Economist Dick Rippe says U.S. corporations are incredibly profitable. He says that in 2003, we had reached the fourth highest level of return on capital. If he is right about 2004, we will likely make an all-time high in the return on capital. He is estimating an 8.0% return. After considering all of the years in which the return on capital has been over 6.0%, the stock market returned 16.0% on average during those years. Capital spending expanded during those periods, and good growth in employment developed.

Investors Intelligence says optimism among financial newsletters fell to a 14-month low on concern about rising inflation and oil prices. Of course, greater concern is viewed as a positive, since complacency is the enemy of the bull.

Financials . . . Wells Fargo agreed to buy most of the assets of Strong Financial, the Wisconsin-based asset management firm whose founder, namesake and former CEO was accused of benefiting personally from rapid trading in the firm’s mutual funds. This is a sensible acquisition for Wells Fargo, adding distribution channels as well as $34 billion in assets under management. If the price of $700 million reported by the press is correct, the equivalent of 2% of assets under management seems reasonable for a well-known but tarnished brand name in the asset management business. The reported transaction structure, including a multi-year earn-out period for a substantial part of the purchase price, is consistent with WFC's past money-management acquisitions. Wells Fargo is purchasing assets, not the company, to minimize liabilities; the purchase will increase equity funds to 31% of WFC's mutual fund assets from 21%, and WFC will gain entry into distribution by four major retail securities firms. The transaction is expected to close in early 2005.

Barron's Online highlights Wells Fargo, which has risen about 27% since the publication last wrote favorably about it a year ago. According to the article, low mortgage rates in recent years have helped Wells report 11 consecutive quarters of earnings growth, but as interest rates rise, Wells Fargo will likely see earnings growth slow. Plus, the stock isn't much of a bargain now. First of all, it's hard for a bank of Wells' size, nearly $400 billion in assets, to grow quickly. "The co is becoming increasingly large and complex, meaning it will be harder to keep up its track record" of consistent earnings results, says John McDonald, an analyst with BofA. Also in 1st quarter, Wells' home mortgage rev was down 50%. Wells cited an increase in home mortgage rates in late 2003 as the prime culprit for this decline. That could be a taste of things to come: The Mortgage Bankers Association expects U.S. mortgage originations to drop by roughly 27.5% this year from 2003 and refinancings to fall by almost 60%. John Leo, director of growth equities for Northern Trust, calls Wells a "good, high-quality banking organization." But he says the threat of higher rates prompted Northern to pare its position in Wells and other potentially interest-rate-sensitive financial stocks such as Lehman Brothers and Legg Mason. According to the article, the valuation of Wells' stock shows no sign of falling, Wells fetches a healthy 2.8x book value, well ahead of financial behemoths such as Citigroup, at 2.3x book value, and JP Morgan Chase, going for 1.6x book.

American Express is enjoying considerable success, management appears focused on further strengthening the business. It seems unlikely that company will become complacent as happened in the 1980s when it was similarly successful for a time. The company’s increased flexibility and scale are significant advantages. This flexibility now enables the company to formulate a range of plans in anticipation of a variety of market conditions and competitive factors. These plans can now be executed quickly to take exploit opportunities that arise. The company’s decision to sharply increase marketing spending in early 2002 which many competitors had reduced their marketing spending is an example. The company seeks to be a “market mover” in each of its businesses. The company appears to focusing even more intensively on further differentiating itself from competitors in each of its businesses. This is to be accomplished in part by devoting more attention to the forces and factors that influence customer behavior. Over time, the company has become better and better at understanding and measuring how different actions and factors affect customers’ experience, satisfaction, and behavior. Customers’ experience builds and strengthens the brand, advertising doesn’t. At a recent meeting of 160 senior managers, several other companies’ successes were examined and reviewed as examples. To improve the performance of its various businesses and operating units, the company is seeking to better align performance goals and measures with overall customer behavior and business results. For example, providing superior customer service is no longer sufficient. Improvements in customer service must lead to higher customer spending and higher earnings to be of value and to justify increased compensation. This increased attention to the impact various actions and investments have in terms of business benefits is likely to continue the transformation of the company that the focus on flexibility and efficiency over the past several years began. American Express seeks to build on its premium value positioning with an even greater focus on the high spenders that make its spend centric model work. Network services agreements with US banks (beginning with MBNA) are expected to increase American Express’ dominance of the high spending segment of the market. Network agreements are a logical extension of the company’s ongoing efforts to capture an increased share of customers’ spending (and at AEFA, an increased share of customers’ assets). Over a period of years, migrating only a small portion of a bankcard issuers’ charge volume to American Express’ network could generate meaningful charge volume, revenue, and profit given the low incremental investment needed to handle additional network volume. Earnings growth still seems dependent on market performance, but over time, the company expects to generate earnings growth by increasing its market share. There seem to be few opportunities to increase profit margins, but given the significant operating leverage that exists (and limited additional capital required as the business grows), the opportunity for increased earnings is significant if assets under management and fee generating businesses grow in size. Improving the linkage between the card business and AEFA and developing market segmentation skills and strategies similar to those used in the card business are increasingly important elements in the company’s strategy for AEFA. The company is to introduce a GOLD account in about two months (focus on customers with $100, 000 of investible assets) which will complement the previously introduced PLATINUM account which was targeted at customers with at least $500,000 of investible assets.

Freddie Mac's April data showed that its retained portfolio declined at a 7.8% annualized rate, slightly faster than in March. This was the sixth month in a row the portfolio has shrunk. Purchases were slightly higher than in March, but liquidations and sales increased more. With purchase commitments relatively flat in April ($20.3 billion vs. $20.6 billion in April) we don't expect the retained portfolio to grow if May either, even if liquidations decline somewhat. PCs outstanding also declined in April (at a -4.9% annualized). New PC issuance was higher than in March, but liquidations spiked to a 44% annualized rate, restricting growth. Freddie Mac's market share of new issuance was an estimated 40% and more "normal", but the liquidation rate on its portfolio suggests that its securities are still more prepayment sensitive than Fannie's. Credit quality overall remains very good. Delinquencies on non-credit business totaled just 30 bps vs. 29 bps a year ago. Delinquencies on credit-enhanced (riskier) business totaled 1.62%. This was the second month in a row that they didn't increase. Lack of portfolio growth should lead to an increase in surplus capital, creating an even greater cushion relative to the OFHEO's mandated 30% surplus. The company should be well positioned to take advantage of an improvement in market conditions when one occurs.

Transports . . . General Motors advanced hybrid technology will be used on transit buses in the Seattle area beginning next month, eventually creating the nation's largest fleet of diesel-electric hybrid buses. King County leaders were scheduled to take delivery of the first of 235 buses Thursday at Seahawks Stadium. The 60-foot mass-transit vehicles, which are more expensive than standard diesel buses, deliver up to 60 percent greater fuel economy and can reduce emissions by as much as 90 percent, GM said.

Defense & Aerospace . . . Google news reports through several media channels that there is a huge bullet shortage in Iraq. According to several media channels, American soldiers are firing so much ammunition that the military's largest supplier of bullets can't keep up. Tanks that log 800 miles a year in peacetime are grinding through that many miles in a month, wearing out their treads. Dan Murphy, CEO at bullet supplier Alliant Techsystems, said the company's Army ammunition plant in Missouri has gone through its fastest increase in production since the Vietnam war. It has hired 1,000 workers and some production lines are running around the clock. "There's no question that on many of the items that are being consumed rapidly in Iraq, like tank treads, like body armor, like small-caliber ammunition, the Army is beginning to run out, and the Army is becoming worried about its stockpile," said Loren Thompson, a defense analyst with the Lexington Institute. Alliant Techsystems is churning out 1.2 billion bullets a year at the Army-owned plant it runs in Independence, Mo., but it's already working 24 hours a day. So the Army has given contracts for 70 million rounds each to Israel Military Industries and the Winchester unit of Olin Corp., said Lt. Col. Matthew Butler, who buys bullets for all branches of the armed forces through the Army. He said the first deliveries on the new contracts are expected next month.

Consumer Products . . . CSFB notes that Gilette's M3 Power was launched in the U.S. this week; despite M3 Power's 67% price premium to Mach3 Turbo, firm does not believe the razor (handle) carries a higher margin, and they expect the negative margin impact of greater razor versus blade sales to be amplified. However, firm says their new earnings model incorporates the base-case scenario for 2004, which they believe appropriately reflects the profitability pattern of a new system launch and incorporates last year's Mach 3 Turbo launch in Europe and this year's launch of Venus Divine and Sensor3. Firm raises their 2004 EPS estimate to $1.64 from $1.61 and raises their 2005 estimate to $1.83 from $1.82. While the First Call consensus for 2004 is $1.61. The firm believes the market consensus is somewhat higher, and despite the likelihood of upward earnings revisions, they believe the stock is already pricing in EPS expectations in the $1.65 range.

Food & Beverage . . . UBS upgrades Coca-Cola to Buy from Neutral and raises their target to $60 from $55 based on their belief that the company's new marketing and innovation strategies clearly hit on the major opportunities. Firm believes it is quite possible that Steven Heyer will stay and they are becoming more comfortable with Neville Isdell as CEO. Firm says that KO's unveiling of its mid-calorie cola C2 in the US and Japan, as well as KO's new ads for Diet Coke/Sprite, gives them confidence that high-margin CSDs (88% of volume) will return to growth in 2H04 and beyond.

Retail . . . At 21.7x 2004 estimate of $2.15, Kohl’s shares are trading at a 47% discount to the five-year average 12-month forward P/E of 41x, and at 1.2x the forward multiple accorded the S&P 500, below the historical rate of 1.8x. Although the stock may appear inexpensive compared to historical levels, we note that the shares have traded down due to inventory problems, resulting slower sales and earnings misses. Although the worst of the inventory issues appear to be behind them, Kohl’s has not yet experienced a pick-up in same store sales. Kohl’s is still sorting out its merchandise content and marketing strategy. In addition, the competitive landscape has become more dynamic as traditional department stores revitalize their assortments, J.C. Penney continues its turnaround, and off the mall retailers such as Old Navy and Target strengthen their apparel offering. It is critical for KSS to start consistently meeting its earnings guidance and look for Kohl’s to hit its planned net income growth of 25%-30% in 2004, (vs. a decline of 8.1% in 2003). Should the launch of several new apparel brands in the Fall as well as the launch of the new Estee Lauder cosmetic brands at KSS be successful, there could be upside to our 2004 EPS estimate of $2.15.

Medical Devices . . . Merrill Lynch downgrades Guidant to Neutral from Buy after the co announced that issues related to its Champion stainless steel stent could result in a delay of its lead drug eluting stent program. Firm says that a simple manufacturing sequence change may influence performance and could be implemented in a timely fashion, allowing GDT to still get CE Mark by early 2005 and to start its pivotal U.S. study this summer; however, even if this benign outcome materializes, firm says that process scale-up issues could still delay full enrollment in FUTURE IV (U.S. pivotal study) by six months. Alternatively, a stainless steel redesign may be necessary, which could delay the program by at least 6-9 months. Firm says a more draconian scenario would put the program back to square one, in which case the SPIRIT, a Vision stent coated with a durable polymer and everolimus, would likely become GDT's lead program, which would delay a U.S. launch until 2007.

Media . . . Piper Jaffray says the international launches of Napster are happening sooner than expected. Napster has gone live in both the UK and Canada within the last week. The firm had been expecting both services to be launched in mid-to-late summer. The firm now has a higher degree of confidence that the co will hit June Quarter Napster estimate of $7 million. The launches are positive, given the co beat competitors, such as Apple and Real Networks, to these geographies. Applying average multiples to Roxio's respective software and Napster business equates to a $14 stock. While clearly this is too aggressive given the turnaround nature of the Roxio story, this valuation exercise demonstrates that the stock is trading at a deep discount to its peer group.

The WSJ reports that Yahoo! plans to announce today the availability of a new antispyware service through its toolbar software. The new service will allow registered Yahoo users to scan for spyware, monitor Web surfing and other computer activities, and carry out other orders. The Yahoo! users can then have the service remove the spyware from their computers. They need to have installed Yahoo's free toolbar software, which works with a web browser and allows users quickly to access other services such as Web search. Antispyware software "is the number one thing we're hearing from our users in terms of the security tools and services they wanted to see delivered from Yahoo," said Julie Herendeen, VP for network products at Yahoo!. Yahoo's! new service uses technology from PestPatrol Inc., a closely held maker of antispyware software.

Storage . . . Bank of America out with a negative call on disk drive stocks saying they believe investors have bid up the drive stocks in anticipation that numbers have bottomed and major restructurings will be announced. The firm believes that the June Quarter has been slightly weaker than anticipated for all drive companies and that fundamentals haven't improved much, if at all. All of the disk drive stocks have rallied in the last week. Since 5/18, Seagate has increased by 10%, Maxtor by 1% and Western Digital by 14%. According to BofA, the month of April was weak, May was on plan, and they don't yet know what June will look like, though they note that white box demand in Europe still seems weak. Drive companies will do 40%-50% of the June Quarter revenues in the month of June. In addition, pricing is still very difficult. They have heard comments that desktop pricing is still down 5% quarter/quarter, whereas the firm has assumed down 10% year/year in their long-term model. They believe that both MXO and STX will announce restructurings in the next few months. Analysts do not know if STX will be in the position to announce its proposed restructuring on the conference call next week; it may have to wait until the July conference call. They think that many investors are expecting a 10% headcount reduction, and suspect it may be smaller. BofA is currently not making any changes to estimates.

Network Equipment . . . Bear Stearns believes that Juniper may have lost major core switch upgrade opportunities worth $300-$400 million at two North American RBOCs (likely to be Verizon and SBC). Despite JNPR's alliance with Lucent, the incumbent switch vendor, firm says these RBOCs chose Alcatel's 7670, a next-gen routing switch which allows the carriers to better preserve their ATM/FR data service revenue. Firm sees competitive pressure mounting in the core IP routing space with the introduction of Cisco's CRS-1, which could potentially limit the growth rate of JNPR's router rev over the next 12-18 months. In the near term, firm believes that JNPR's revenue outlook remains strong, and they think the company will likely beat its own guidance and consensus for 2nd quarter and 2004. However, firm says the stock is fully priced at 39x their 2005 EPS estimate. Reiterates Peer Perform rating.

Semiconductors . . . Intel will be using NVIDIA's top-to-bottom family of PCI Express graphics processing units (GPU), as part of Intel's PCI Express-enabled chipset launch programs. Intel has purchased several thousand NVIDIA PCI Express enabled GPUs which Intel will be using for: platform level testing; software development kits; channel seed kits; technical solutions training; and various demo systems.

Intel is scheduled to provide its mid-quarter update after the close on 6/3. Analysts are maintaining revenue estimates for 2nd quarter at $8.0 billion (down 1.1% Quarter over Quarter), above the mid-point of the April guidance range of $7.6-$8.2bn (-6.1% to +1.3% Quarter over Quarter), and EPS estimate at $0.27. Intel is likely to tighten its revenue guidance to the higher

end of the prior range – expect a range of $7.9-$8.1bn. PC builds in 2nd quarter 2004 are in line with normal seasonality, with overall business conditions tracking expectations at the start of the quarter. On the desktop side, though we estimate Taiwan motherboard shipments to decline 12% Quarter over Quarter in 2nd quarter 2004, which is below normal seasonality, this data only partially captures Intel's motherboard ramp in 2nd quarter 2004 and thus does not provide an accurate picture of PC builds. As is customary with any chipset launch, Intel is ramping its own motherboard production ahead of the Grantsdale and Alderwood launches in June, and believe overall motherboard shipments are tracking normal seasonality. Recall that when Springdale was launched in 2nd quarter 2003, there was a similar disconnect between Taiwan shipments (down 7% Quarter over Quarter), and Intel motherboard shipments (up Quarter over Quarter) and revenues (up 1.0% Quarter over Quarter). Taiwan notebook shipments meanwhile are expected to see a healthy 10% Quarter over Quarter increase in 2nd quarter, at the high end of normal seasonality. Gross margin estimate for the quarter, at 62.2%, is also at the high end of the guidance range of 60% +/- a couple of points. The 60% mid-point is on the conservative side, given 1) our estimate for revenues to decline by only 1.1% Quarter over Quarter, 2) expect startup costs for 65nm development to be minimal, 3) gross margin should see a positive contribution from the shift in processor mix toward notebooks, and 4) the continued migration to 300mm/90nm production. However think there is a good chance Intel may leave the mid-point unchanged at 60% in its mid-quarter update, tightening the range to 60% +/- 1%, given the company’s tendency in recent quarters to be conservative in its margin guidance. Catalysts for the stock include: the ongoing shift toward mobile computing, recovery in the flash business, and the gross margin story playing out in upcoming quarters. A heavyweight PC semiconductor oriented stock like Intel will be one of the early outperformers in our space leading into and in 2nd half 2004, as we should soon start to see incremental PC builds for a seasonally firm 2nd half 2004, which should also serve as a catalyst for the stock.

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