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Wednesday, June 23, 2004 6:15:34 PM
U.S. stocks rose, led by computer- related shares such as Cisco Systems Inc. and energy shares including Amerada Hess Corp. FedEx Corp. gained after the company boosted its earnings forecast. The S&P 500 Index reversed direction nine times in the first hour of trading as investors weighed the impact of an expected increase in borrowing costs by the Federal Reserve on June 30. The Nasdaq Composite moved from losses to gains for a second day. The S&P 500 added 9 points (+0.9%) to 1,144. An index of energy shares had the biggest gain among the benchmark's 10 industry groups. The Nasdaq rose 26 points (+1.4%) to 2,020. The DJIA increased 84 points (+0.8%) to 10,479. All three benchmarks had their biggest one-day gains since June 7. Almost seven stocks rose for every three that fell on the New York Stock Exchange. Some 1.4 billion shares changed hands on the Big Board, the 18th day in the last 19 that trading has lagged this year's daily average. Economists expect the central bank to lift its overnight lending rate by 0.25 percentage point from a 46-year low of 1 percent when policy makers meet June 29-30. That's according to the median estimate in a Bloomberg News survey. The handoff of Iraqi sovereignty also occurs June 30.
Strong Sectors: tobacco, homebuilding, oil & gas, communication equiptment, iron & steel, computer storage
Weak Sectors: gold & silver, discount retail, food processing & distribution
Top Stories . . . FedEx, the world's largest overnight package-delivery company, said fiscal fourth-quarter earnings rose 47 percent as a strengthening global economy boosted demand for its services.
The U.S. Securities and Exchange Commission is reviewing whether brokers who help set interest rates on $204 billion of corporate and municipal bonds misled investors and issuers.
Career Education, a for-profit education company, said it received a formal order of investigation from the Securities and Exchange Commission.
Mylan Laboratories, the largest U.S. maker of generic drugs, withdrew its earnings forecast and filed a lawsuit against the U.S. Food and Drug Administration after the agency delayed introduction of Mylan's version of the Duragesic pain-relief skin patch.
AT&T, the largest U.S. long- distance telephone carrier, said it will stop competing for residential customers in seven states after losing an attempt to revive rules that gave it discount rates when renting local-phone lines.
Quotes of Note . . . ``Earnings will continue to be strong, but share prices reflect that,'' ``I don't see significant gains in the markets in the coming months.'' Alison Porter, head of U.S. equities at Britannic Asset Management which manages $1 billion. Porter has been buying Motorola Inc., the world's No. 2 maker of mobile phones.
Gurus . . . Ken Perkins, research analyst for Thomson First Call says the outlook for second-quarter earnings is fabulous. He says S&P 500 companies in the second quarter will likely boost their third straight quarter of at least 25% profit growth. Year-over-year earnings improved 28% in the fourth quarter and 27% in the first quarter. Demand has been rising and firms have enjoyed the leverage that comes from cost cutting during the bad times. Analysts expect S&P firms’ profits will rise 20% in the second quarter, but Perkins says that given recent trends, he feels comfortable they will be up 26% when fully reported.
Ed Hyman of ISI concurs. His regression model is projecting second-quarter growth up 29%, and he is plus-20% for the third quarter. He says analyst projections are just too low.
As for technology, Alberto Vilar, who runs Amerindo Investment, says his success this year stems from his concentrated portfolio and his bets on eBay, Yahoo, Expedia, and Imclone. He would not be buying Google if the market cap exceeds 40 billion at the offering. He recently bought Eyetech Pharma and has been adding to Juniper and XM Satellite.
And on his radio show last evening, Jim Cramer says he is buying the neglected cable, radio and satellite stocks like Clear Channel, Emmis, Echostar, and Comcast. He would be selling Eight By Eight and Conexant on strength.
Barron's Online highlights an interview with Bernie Schaeffer, a Chairman and CEO of Schaeffer's Investment Research, for his stock pick's. Over the last 12 months, he says that his all-equity "master portfolio" is up 18.3% percent, beating the S&P's 500 index by almost 5 percentage points during that period. Right now, he's bearish, but is long on particular sectors, including auto makers, leading Internet companies, and several gold stocks. He also suggests that investors keep as much as 25% of their assets in cash. Mr Schaeffer currently likes Ford, General Motors, eBay, Kmart, SBC Comm., Hershey Foods, Yahoo and HOLDRs, including UTH, HHH and OIH. Mr Schaeffer currently doesn't like Microsoft. He says that of the 26 analysts that cover the stock, 25 have [Buy recommendations]. Microsoft can only minimally benefit from analyst upgrades, whereas Ford can benefit tremendously through upgrades. And short interest on Microsoft is negligible. "This stock is a prototype of a blue chip stock that I don't see having much fire power to the upside."
New Tech . . . The WSJ highlights the ShotSpotter, which can detect gunshots within about 2 miles and notify police within seconds, giving them the precise location where the gun went off. ShotSpotter listens for gunshots with acoustic sensors that can be affixed to trees, telephone poles and other structures. Once a gunshot is detected, ShotSpotter calculates the position where the gun was fired and sends the data over phone lines to a central server accessible by law-enforcement agencies. Because it uses computer software to analyze sounds, ShotSpotter is precise enough to ignore fireworks, backfiring cars and other noises that could be mistaken for gunfire. To address those concerns, ShotSpotter is developing a wireless system that can be moved on the fly. By the third quarter, the co expects to be producing a device that communicates wirelessly through a set of radio frequencies that send data to the central server. "You can have a complete wireless-sensor network up in an hour," says James Beldock, CEO and president of ShotSpotter. ShotSpotter's capacity to pinpoint the source of a gunshot within a few feet doesn't come cheap. Law-enforcement agencies have to pony up $180K, which buys a license to use ShotSpotter software and eight sensors. Each additional fixed sensor costs $2,640 and each additional wireless sensor will cost about $5K. Looking ahead, ShotSpotter is teaming up with Xybernaut , a maker of wearable computers, to develop a gunshot-detection device that can be worn on the body. The wearable ShotSpotter could be sewn into jackets or mounted on bullet-proof vests or patrol cars. These sensors could send gunshot data to a PDA, cellphone or other type of digital display, letting the person know in seconds where shots are coming from and the type of gun being fired. ShotSpotter says it's currently in talks with the military on applications for the device.
Mortgages . . . Mortgage applications edged higher 0.1% in the week of June 18 as 30-year mortgage rates fell 13 bp to 6.21% and 1-year adjustable rates remain attractive at 4.10%. Refinancing showed its 6th decline of the last 7 weeks (-1.7%) as purchases rose 1.1%. The purchase index has remained strong despite the rise in long term rates as May reached a record high which should be reflected in tomorrow's release of new home sales.
New Trading Rules . . . The WSJ reports the SEC is expected to approve a pilot program today that will lift short-selling restrictions on about 1,000 actively traded stocks for a one-year period, allowing investors to more easily bet against some large stocks. But the agency is abandoning, at least for now, an earlier plan that would have allowed short-sales only at prices at least one cent above the best national bid. It now plans to expand the pilot to 1,000 companies from the 300 it proposed in October and shorten the time period to one year instead of two. The SEC will also lift restrictions for a year on some after-hours short-sales, allowing unrestricted short-selling from about 6:30 p.m.
IPO . . . Salesforce.com’s IPO priced at $11, above the expected range of $9-$10, which was raised earlier in the day from $7.50-$8.50. The company is the largest provider, based on market share, of application services that allow organizations to easily share customer information on demand. It provides customer relationship management, or CRM, service to businesses of all sizes. Providing applications that are delivered through a standard Web browser, the co substantially reduces many of the traditional expenses of enterprise software implementations. From its introduction in Feb 2000, its customer base has grown to 9,800. According to a study, the market for on-demand application services is projected to grow from $425 million in 2002 to $2.6 billion in 2007. The company posted sales of $96 million last year, up 88% year over year. The company posted its first profit last year. The co planned to go public last month, but delayed the deal to allow a cooling-off period following comments in the press by its CEO. It's not Google, but this deal has generated a lot of interest as it has been an aggressive and successful player in the CRM space. It probably would have been even more warmly received had it listed on the Nasdaq rather than the NYSE. This is a 10 mln share deal, led by Morgan Stanley and begins trading this morning.
Economic Comments . . . The government periodically divides GDP into industries. The data continues to show several well-established trends. The output of the biggest industry, financial services, continued its steady growth as a share of GDP, reaching 20% in 2003. Manufacturing and agricultural output continued to decline as a share of overall GDP.
Industry data continues to show several well-established trends.
• The output of the biggest industry, financial services, topped $2.2 trillion (all data is nominal). The industry continued its steady growth as a share of GDP, reaching 20% in 2003.
• Financial services includes two major subdivisions. Finance and insurance make up 7.9% of GDP, while real estate and rental activity make up 12.4% of GDP.
• Manufacturing output continued to decline as a share of overall GDP, falling to 13% in 2003. In 1947, manufacturing output was $65.8 billion out of a $244 billion total GDP, roughly 27%.
• Agricultural output continued its long-term downtrend as a share of GDP. At $112 billion, it produces roughly 1% of GDP. In 1947, agricultural output was $20.7 billion out of a total GDP of $244 billion (in nominal 1947 dollars.) The uptick in the early 1970s was related to a definitional change in the data at that time.
• Mining (consisting mostly of oil and gas extraction) continues to be a relatively minor share of overall GDP, at 1% ($125 billion) of GDP in 2003. It was the fastest-growing industry in 2003, up 18.3%, due to the strength in oil and metals prices. The bulge in this industry’s share of GDP in the late 1970s as the dollar weakened, inflation rose, and equities in this sector surged.
Market Comment . . . Economic data releases continue to bring surprises to the upside. Indeed, last week’s release of industrial production for the month of May and the Philadelphia Fed Index for the month of June demonstrated that the economy is still delivering robust results. Nevertheless, all this positive news on the economic front has done little to revive market volume. In fact, in recent weeks we have begun to see typical summer season trading patterns emerge as volume on the averages has started coming in on the soft side. This probably marks the beginning of what is often a very dull season for the markets . . . summer.
Market Comment . . . June marked the beginning of what is typically the slowest season for market volumes. The common complaint is about the lack of liquidity in the market. Undoubtedly, vacation season lies just around the corner and investors are unlikely to make big commitments ahead of it. June historically represents 8.1% of total annual NYSE trading volume. July tends to be even slower, with about 7.9% of total volume, and August typically marks the depth of this cycle with an average of 7.6% of the total annual volume.
Summer rarely offers much excitement as far as volumes are concerned, and, unfortunately, this dull trend seems to seep into market performance as well. The summer months have typically been associated with some of the worst market episodes of the past 50 years! All in all, the combination of seasonal headwinds and a lackluster technical backdrop, as evidenced by the neutral reading on our MIBS composite (Momentum- Intensity-Bullish Sentiment) of oversold/overbought conditions, seem to suggest that significant market upside in the near term is unlikely.
The economy continues to show signs that it is firing on all cylinders, demonstrating some of the most robust growth we have seen in decades. The unavoidable consequence of such a strong economy is that inflationary concerns have begun to mount. As such, it is looking more and more likely that the Fed will raise rates at its next FOMC meeting at the end of the month. Indeed, in an interview this past week, Fed governor J. Alfred Broaddus, Jr. stated that “we’re clear that we need for rates to move up . . . We have a
credibility for low inflation, and we aren’t about to give it up.” Language from other Fed governors has been equally strong in recent weeks.
The Fed’s approach to monetary policy has been somewhat predictable over the years, since it is largely based on the concept of excess capacity. Essentially, the Fed waits for the economy to absorb excess capacity before moving the fed funds rate higher. We have a total economy capacity utilization rate that incorporates both the manufacturing and services sectors (the latter consisting of the portion of unused labor in the economy). Excess capacity is quickly being absorbed, and the utilization rate is nearing levels that are typically associated with the beginning of a tightening cycle.
The economy is currently running at 87.2% of total capacity, a level that is close to past levels associated with the beginning of monetary tightening cycles. Indeed, the utilization rate has risen significantly in the past two months, bringing us closer to the first Fed rate hike. At this pace, by the time the June economic data are figured in, the Fed should have the conditions it has historically viewed as necessary in order to begin raising rates.
The beginning of tighter monetary policy does not have to be a dire outcome for the equity market since at least a portion of the adjustment has already been discounted. Indeed, the backup in bond yields suggests that a large part of the tightening cycle is already being priced into the market, at least when it comes to the forward market multiples. The fact that the yield curve is currently sitting at a 50-year high suggests that the long end of the curve may not have to rise as much as the fed funds rate over the tightening cycle.
A different way to analyze what is currently being discounted in the market is to look at the term structure of the futures market. The fed fund futures are already pricing in more than a 125-basis-point fed funds rate increase by the end of this year, in a relatively linear, gradual path. Furthermore, investors are currently expecting the fed funds to continue on this gradual path into early 2005.
The conclusion to be drawn from the fed funds futures market and the bond market is that the first few rate hikes could be somewhat easier to digest than in prior cycles and that market multiples don’t have to be drastically affected since much of the outcome is already priced in. The uncertainty remains in how the tightening cycle will affect earnings, since rising rates tend to dampen the growth outlook. In short, while rising interest rates are never a positive for the market, the effect may not be as dire as some are
predicting in the current cycle.
The current monetary policy cycle has a number of elements that are similar to the policy cycle of the early 1990s. Indeed, in both the easing cycles of the early 1990s and that of the past three years, the fed funds rate dropped by about 500 basis points. Furthermore, the time period over which the rate cuts took place is also turning out to be quite similar. Both scenarios experienced less than a year-and-a-half between the last rate cut and the first rate hike (assuming the Fed in fact raises rates later this month). Thus, in terms of magnitude and duration, there are a lot of similarities between the two cycles.
Indeed, similarities certainly exist between the two episodes with respect to the amount of time in which the easing policy occurred as well as the magnitude of the rate cuts. Rates declined 525-550 basis points in each easing cycle, after which troughs in the monetary cycle (i.e., the period between the last rate cut and the first rate hike) lasted about a year to a year and a half. Furthermore, six months after the first rate hike in 1994, rates had risen 125 basis points — the exact same increase the fed funds futures are currently projecting for the end of this year (or six months from now).
Most investors seem inclined to focus on the similarities between the current cycle and that of the 1990s and are therefore ignoring the differences that exist this time around. In our view, what will be most helpful for portfolio positioning this year is to concentrate on the differences rather than the similarities to the early 1990s. At the heart of these differences is the pattern we have seen in leading indicators of the economy, which, of course, was influenced by the stimulating tax package in the recent cycle, causing leading
indicators to accelerate more intensely than in the earlier episode. Indeed, this difference is extremely important in regard to how the market will likely react to the Fed cycle this time around, in our opinion.
The biggest difference between the current backdrop and that of the 1990s is the pattern of leading economic indicators and the timing surrounding their respective peaks. For instance, at this juncture, it appears that leading indicators may have already seen a peak in momentum, whereas in 1994 they did not peak until nine months past the first rate hike. This difference has implications for sector positioning — in 1994, it meant that cyclicals maintained leadership despite the Fed raising rates (because leading indicators were still accelerating). Indeed, it is the direction of leading indicators that drives the relationship between cyclical and noncyclical sectors.
Another useful longer-term leading indicator is the momentum in global short-term interest rates, which tends to lead many indicators by about six months. The recent increase in the momentum of global rates suggests that leading indicators, like the ISM, may have already seen their peaks for the cycle and could soon begin to lose momentum. Even if global short-term rates remained flat, the index line would trend toward zero, suggesting that other leading indicators could soon follow suit, somewhat earlier than they did in the 1990s scenario.
While there are typical aspects to the equity market’s response to a tightening in monetary policy, understanding the dynamic of these leading indicators gives the best reading of what is likely to happen, in our opinion. While we cannot predict exactly how the market will react when the Fed raises rates, we can attempt to understand past patterns in market activity following a first rate hike to get a better sense of what is likely in store for the months ahead. However, the conclusion at the market level has not been as completely consistent over the years as it has been at the sector level. Indeed, sector leadership during a tightening cycle has been overwhelmingly dominated by noncyclical leadership — a theme we think will be key for portfolio positioning for the remainder of the year.
In a typical cycle, the equity market begins to lose some momentum heading into a tightening cycle. We have found that, on average, the S&P 500 typically loses steam about three months prior to the first Fed rate hike. In fact, the overall index rarely makes significant headway in these last few months leading up to a change in monetary policy. On average, the equity market has only managed to gain about 2%-3% in the 50-day period preceding an initial rate hike.
In addition, the S&P 500 on average has been down 3.5% from its intra-period (i.e., between the last rate cut and first rate hike) peak at the time of the first Fed rate hike. With that in mind, the S&P 500 reached 1158 in February, marking the high point for the current cycle. This suggests that the market should close at around 1125 on the day the Fed first raises rates if this were to play out as a perfectly typical cycle. As such, the current market level seems to be right where it should be, indicating that it is on cue for a Fed rate
hike.
The most predictable element of tighter monetary policy is the reemergence of noncyclical leadership. Indeed, a higher fed funds rate usually has an impact on the growth outlook, which inherently favors noncyclical, more stable segments of the market. A turning point in the relative performance of the most cyclically-sensitive industries usually occurs an average of 17 weeks before the first rate hike of a Fed tightening cycle — a trend we have seen begin to unfold in the market recently, suggesting that we are already in line with a typical path.
Indeed, we have already seen a shift from cyclical sector leadership to noncyclical leadership, suggesting that the reaction from equities has been typical thus far. We expect the noncyclical trend to continue and to intensify for the foreseeable future. The portfolio implication is clear: a decline in leading indicators and a dampened growth outlook from a higher fed funds rate suggest that investors should be defensively positioned at this stage. We caution investors that a pro-cyclical posture at this juncture has become a riskier venture.
Financials . . . Goldman Sachs upped to Outperform from Market Perform at Wachovia. The upgrade is reflective of a broader call on the brokers as well as Goldman specifically. Broadly, the firm thinks M&A is beginning to pick up again, fixed income is stronger than initially thought, and GS shares are simply becoming more attractive. Wachovia is raising their 2004 and 2005 estimates to $8.90 and $8.56 to reflect better fixed income trading, security service revenue, and modestly lower costs. Firm's full-year 2004 and 2005 ROE is now 20% and 16%, respectively. Valuation range $103 to $108
Education . . . Career Education cut to Peer Perform from Outperform at Bear Stearns.
Merrill Lynch downgraded Career Education to Neutral from Buy following news the company has received a copy of a formal order of investigation from the SEC. As they understand it, the significance of the SEC investigation becoming formal is that they have access to current and former employees and can fine the company if wrongdoing is found. Firm believes that this news, and to a lesser extent, an amended shareholder lawsuit filed against Career Education last Thursday, puts the company under a cloud that could hang over it for some time.
Transports . . . FedEx reported earnings of $1.33 per share, excluding a $0.04 gain and a $0.01 charge, in line with the consensus of $1.33. Revenues rose 20.8% year/year to $7.04 billion versus the $6.8 billion consensus. Company issues upside guidance for 1st quarter (Aug), sees EPS of $0.90-1.00 versus consensus of $0.80; for 2005 sees $4.20-4.40, consensus $4.29.
Tobacco . . . Deutsche Bank upgrades RJ Reynolds to Buy from Hold and raises their target to $75 from $64 after the FTC approved the company's bid to buy British American Tobacco's U.S. assets. The firm cites the speed of approval, steady domestic fundamentals with upside potential to their 2004 estimate, and heightened prospect of a dividend boost this year.
Restaurants . . . Piper Jaffray notes that, despite the upside reported last night from Darden, May same store sales at the two core formats were disappointing. Red Lobster fell 4.5% compared to the firm's 4.0% expectation while Olive Garden struggled with a 1%-2% gain compared to the firm's 6% estimate. The results were aided by stronger-than-expected margins (a phenomena the firm does not expect to continue), a lower-than-expected tax rate, and fewer shares outstanding. Also, management subtly reduced its long-term EPS growth expectations from its most recent "at least 15%" to one of "double-digits."
Darden’s Red Lobster same store sales declined 4-5% in May, slightly above our estimate, with traffic declines of 1-2%. Olive Garden's May comps rose only 1-2%, slightly below our estimate, with traffic declines of 1-2%. Negative May traffic for Olive Garden may raise concern that Olive Garden slows before Red Lobster turns. For the quarter, Red Lobster comps declined 6.4% while Olive Garden was up 5%. Darden repurchased 4.4 million shares of stock in the 4th quarter, which added approximately $0.01 to earnings versus estimates. Margins were lower than expected due primarily to unusually high SG&A costs, partially offset by lower food and beverage and other operating costs. Darden issued 2005 EPS guidance of up 8-12% growth ($1.62-$1.68), based on 50-60 new restaurants and 1-3% same store sales growth. The sales guidance is below DRI's prior historical target of 3-5% comp growth, but seems more realistic and should result in less aggressive advertising and promotion. DRI toned down its long term EPS target to growth in a "double digit range" from 15% or better.
Retail . . . Harris Nesbitt downgrades Dick's Sporting Goods to Neutral from Outperform, but raises their target to $35 from $32. The firm believes that the stock's valuation is full and fair, and they have some reservations about the benefits of the recently announced Galyns acquisition. Firm questions whether the returns from the acquired GLYN stores will match the industry-leading returns shareholders have come to expect from DKS, and they believe that the integration process could pose some disruption risk that could impact DKS's steady growth record.
Healthcare . . . UBS downgrades Laboratory Corp to Neutral from Buy based on valuation, as the stock is near their $48 target; also, while free cash flow yield (7%) and the potential for share buybacks are positives, they think year/year price comparisons will continue to be challenging for the reminder of the year.
Barron's Online highlights PacifiCare Health, suggesting its recent sell-off provides an attractive entry point. "It is worth far more than it is trading at," says Joe Pappo, portfolio manager with Lotsoff Capital Mgmt. "We think the stock has upside." Though many insurers abandoned or reduced their Medicare businesses a few years ago, PacifiCare held fast, garnering the biggest market share. That and several new products should give it a leg up if enrollment in Medicare health plans spikes next year, as many expect. Meanwhile, a healthy increase in government reimbursements should bolster PacifiCare's profits, offsetting a possible price war among commercial insurers. "Medicare is not the only driver. But the key to PacifiCare's stock will be success in Medicare," says William McKeever, an analyst with UBS. PacifiCare projects enrollment in its Medicare + Choice program will jump by about 7% to 736K by year-end. Paul Ginsburg, president of the Center for Studying Health System Change, says seniors are becoming more comfortable with this new breed of Medicare health plan, and he expects enrollment in these plans to pick up next year. By the end of 2005, enrollment in PacifiCare's Medicare health plans should reach the company's goal of 787K, according to Scott Fidel, an analyst with J.P. Morgan. By 2006, membership could exceed a million, estimates Christine Arnold, an analyst with Morgan Stanley. According to the article, PacifiCare's stock looks cheap-particularly compared with its peers. At 11.49x projected earnings over the next 4 quarters, the shares fetch an 18% discount to a group of managed care stocks and a 33% discount to the S&P's 500. The stock trades above its historical median of 9.1x projected earnings. Based on projected earnings for 2005, PacifiCare still has the second lowest P/E multiple among the ten largest publicly traded health insurers in the U.S. and its PEG ratio remains attractive.
Medical Devices . . . OraSure Tech gets FDA approval for HIV-1/2 test to detect HIV-2 in oral fluid. With this approval, the OraQuick HIV-1/2 Test is the only rapid, point-of-care test approved by the FDA for use in detecting antibodies to both HIV-1 and HIV-2 in oral fluid, finger stick and venous whole blood, and plasma samples.
Drugs . . . Morgan Stanley upgrades Baxter to Overweight from Equal-Weight, as they believe that the company is in the early stages of a turnaround. The recently announced restructuring efforts and additional actions by new management should improve the company's earnings quality and growth prospects over time. Target is $41. Firm also downgrades BDX to Equal-Weight from Overweight based on valuation, as the stock is approaching their $56 price target.
JP Morgan adds Forest Labs to their Focus List, saying yesterday's weakness is overblown. The firm feels the Celexa controversy in the media is irrelevant, since: 1) Celexa is not approved for adolescents and has never been marketed for such, 2) there was no intent to suppress the data from the failed Lundbeck study, 3) the FDA has had the safety data from both studies and has not raised any concerns, 4) Celexa is going generic, and 5) they find little legal basis for a suit similar to Paxil. Firm also notes that the SSRI mkt growth rate has been declining for over a year, although they think there will be a rebound, especially with Lilly's imminent launch of Cymbalta. At $57, firm notes that the stock is trading at 20x CY05 EPS, which is close to its 2-year trough valuation and below the 28x 2-year avg. Target is $68.
CIBC notes that a posting on the FDA's web site suggests the agency has reversed the approvable status of Mylan's ANDA for generic Duragesic, which is a $1.3 billion transdermal fentanyl product and the most significant near-term event in MYL's pipeline from final to tentative. Firm says they have limited information on details and were unable to reach MYL mgmt, although they believe that the FDA's move, despite mgmt's past proclamations, negates the possibility a launch post patent expiry on 7/23/04 until the expiration of a six-month pediatric exclusivity period. Firm says that Street estimates (2005 consensus is $1.35) almost universally assume a July launch, and they anticipate downward estimate pressure. However, firm thinks that MYL could still hit their $1.31 number, which factors in a Jan 2005 launch, assuming no JNJ-authorized generic and limited additional generics.
Schering-Plough will continue to co-promote INTEGRILIN with Millennium in the United States and retains rights to the product in other territories outside of Europe. Schering-Plough will continue to pay royalties to Millennium on INTEGRILIN sales in other territories outside of the United States. In the United States, Schering-Plough and Millennium co-promote INTEGRILIN and share profits. Financial details of the agreement pertaining to the return of the European rights are not being disclosed.
The FDA plans to extend patent protection for the pain-relief patch Duragesic by six months, Janssen Pharma said, delaying the launch of a generic version. Separately, Mylan announced that it is filing suit against the FDA in the U.S. District Court for the District of Columbia, seeking to restore final approval for its fentanyl transdermal system. "In siding with Janssen and withdrawing Mylan's final approval, the FDA has acted contrary to multiple sections of the Federal Food, Drug, and Cosmetic Act and the Administrative Procedures Act, its published regulations and the legal precedent on point. We view this decision as yet another assault on the generic pharmaceutical industry. Among other problems created by the FDA's decision, this opinion encourages branded pharmaceutical companies to ignore the 45-day timeline to sue and effectively eliminates a generic company's ability to challenge patents that are nearing expiration." Local procedural rules require a hearing in the suit to be held prior to July 23, 2004, and as a result, MYL suspended annual earnings guidance.
Biotech . . . Friedman Billings Ramsey maintains their Outperform on Imclone and raises their target to $93 from $82. The firm is saying recent head and neck cancer data suggests Erbitux potential with radiation therapy in multiple cancer types; firm raises their Erbitux sales estimate for 2nd quarter to $55 million from $31 million (consensus $45-$50 million), and raises 2004 estimate to $232 million from $154 million (consensus $225-$230 million).
Media . . . Jeffries upgrades Ask Jeeves to Buy from Hold and reits $39 target. A 22% pullback in the last 30 days, combined with an expected strong 2nd quarter report, make the stock attractive. The firm also believes that an extension of the Google agreement before the Google IPO is likely.
Electronics . . . Barron's Online highlights PalmOne, which saw its shares pop 36% Tuesday, after the company soundly beat analysts' expectations and boosted revenue for its FY. But, according to the article, PalmOne shares may have had their run. The Treo line could still prove to be a small portion of an industry where larger rivals like Dell loom and PalmOne's core organizer market erodes. The risk continues that once the early adopters have been captured, the Treo will be unable to cross [to mainstream consumers]," wrote Charles Wolf, an analyst at Needham in a note to investors. Despite the popularity of 'smart' phones like the Treo, "there could be a backlash" in the next several years, says Todd Kort, an analyst at Gartner. While the Treo is certainly cool, its price isn't likely to woo the masses. After rebate, a Treo 600 costs about $450 at AT&T Wireless. And most of Treo's impressive demand is coming from PalmOne's organizer customer base, a market in which PalmOne is losing ground. Gartner ests that PalmOne lost 7 percentage points of worldwide organizer market share last year to 35%. Further, organizer demand is stagnant. Gartner expects organizer unit sales to be essentially flat at 11.3 millon organizers by next year from 2003. And the Treo may have a lot more competition very soon. "You're going to see more and more models from more vendors," says Kort. Mr Kort expects Hewlett-Packard and Dell to enter the combination device fray some time next year. According to the article, PalmOne also trades at a lofty 4x its expected long-term annual earnings growth rate and at roughly 40x the consensus for its 2005.
Telecom . . . Smith Barney says that Vodafone's announcement of two mgmt changes in Southern Europe/Italy and Asia Pacific/Japan adds uncertainty to the stock. The firm thinks the former mgmt change is more negative, as the CEO was more involved in day-to-day operations and the business has performed well; maintains Hold rating.
The WSJ reports that Qwest Communication is expected to announce today it will launch a new Internet calling service for business customers in mid-July. The service, which will be available in major cities across the nation this year, will allow users to route calls through the Internet from laptops while on the road and forward voicemails to e-mail. It will also offer standard features such as call waiting and caller identification, 911 service and speed dial. The Internet calling service will run mostly over Qwest's long-haul and local network and comes with unlimited local and long-distance service.
AT&T will stop competing for local and long-distance residential customers in Ohio, Missouri, Washington, Tennessee, Louisiana, Arkansas and New Hampshire (approx population of $38 mln). This action is a result of a 6/9 decision by the Administration and the FCC not to appeal a recent Federal court decision that overturned FCC wholesale rules put in place to introduce competition in local markets. The reversal of local competition policy by the Administration will permit the Bell companies to raise wholesale rates as early as November. The increase in wholesale rates means that T will likely be unable to economically serve customers with the competitive bundles currently available.
SBC announced it will spend $4 billion-$6 billion on a fiber-to-the-node (FTTN) network upgrade over five years, pending the successful completion of video field trials and further
regulatory clarity on network sharing requirements. Estimate about two-thirds of the capital plan represents incremental spending. The FTTN plan will facilitate an IP-based video offering, utilizing Microsoft's IPTV product supported by the Windows Media 9 video codec. With the Microsoft platform, SBC could theoretically deliver four separate video channels (including HDTV), VoIP and several Mbps of broadband data. SBC expects to complete field trials of the
service by 2004 or early 2005. Estimate the $4B-$6B capital plan will cover ~10 million of SBC's in-region homes, equating to ~$500 cost per home passed. The capital plan includes building fiber to remote terminals within ~5,000 feet of each target home and using ADSL2+ access technology for the last mile. The plan does not include CPE or local/in-home network upgrades which may be necessary to support video services. While analysts are cognizant of the possibility that regulatory posturing could be one motivation for today’s announcement, a viable video solution remains a key goals for all of the RBOCs. This plan would likely be dilutive to earnings during the build phase, and possibly for a more protracted period depending on customer take rates. It is increasingly evident that SBC views video as a key component of its product bundle. Expect a spirited battle between the RBOCs and cable competitors as each attempts to enter the other’s core business. The result will be lower margins for all participants.
IT Services . . . IBM and Motorola announced that they plan to work together to promote highly integrated, standards-based computing platform technologies for telecommunications based on IBM's industry leading eServer BladeCenter system.
Network Equipment . . . Lehman cuts their 3Com target to $6.50 from $8 after the company reported solid results. However, firm says the disappointing resale of J.V. products and the unexpected departure of the CFO and COO place the company's long-term story on hold. Maintains Equal-Weight rating.
The WSJ reports SBC Comm. said it will test a new fiber-optic network this summer and could potentially invest as much as $6 billion to roll out the technology to millions of consumers during the next 5 years. SBC's move to invest in fiber reflects increased competition from cable-television company's and Internet start-up businesses that are ramping up the rollout of inexpensive phone services. The new network could allow users to get high-definition TV, super-fast Internet connections and Internet phone calls. Separately, Sprint said it will upgrade its wireless-telephone network to provide data speeds comparable to home digital subscriber line or cable-modem connections.
Semiconductors . . . Janney initiates Zoran with a Buy rating and $21 target. The firm is saying the company offers investors a great opportunity to invest in a growth story specifically focused on consumer electronics that is less than $1 billion in market cap. Firm expects the co to benefit from several emerging market opportunities, including its DVD, DTV, Digital Imaging, Digital Camera, and mobile handset business units. Although they anticipate integration issues and view Zoran's higher cost structure as a disadvantage, they believe these end markets, which are all experiencing growth rates in excess of 20% for the next few years, will permit our earnings growth forecast of 42% from 2004 to 2005.
Banc of America believes that AMD's 2nd quarter is tracking in-line to better than seasonal as a result of strong demand for NOR flash products (~51% of sales) and a better mix of processors (49% of sales) into a seasonal PC mkt. As a result, firm raises their 2nd quarter estimates to $0.11 from $0.09 and raises their 2004 estimate to $0.60 from $0.57, versus consensus of $0.09 and $0.60, respectively. Firm also notes, the recent weakness in shares of AMD presents a buying opportunity, as the recent concerns of Intel regaining share in the NOR Flash market are overblown. The firm thinks that given the tightness in capacity and the continued strength in the handset market, both Intel and AMD can both benefit from the overall strong demand environment. Target $20.
Software . . . JP Morgan cuts their license revenue estimate for Peoplesoft, saying that checks suggest a mixed 2nd quarter. The firm believes that its verticals remain inconsistent, with strength in government and healthcare, and weakness in financial services, manufacturing, and commercial; conversations suggests slightly improving pipeline within the public sector and state universities. They are hearing that there is little cross-sell between Enterprise and Enterprise One despite some newer initiatives within PSFT, and large deals remain elusive. Firm cuts their 2nd quarter license revenue estimate to $148 million from $160 million in 2nd quarter, versus company's guidance of $150-170 million. Firm also cuts their 2004 revenue estimate to $675 million, versus guidance of $675-$695 million and consensus of $689 million.
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Strong Sectors: tobacco, homebuilding, oil & gas, communication equiptment, iron & steel, computer storage
Weak Sectors: gold & silver, discount retail, food processing & distribution
Top Stories . . . FedEx, the world's largest overnight package-delivery company, said fiscal fourth-quarter earnings rose 47 percent as a strengthening global economy boosted demand for its services.
The U.S. Securities and Exchange Commission is reviewing whether brokers who help set interest rates on $204 billion of corporate and municipal bonds misled investors and issuers.
Career Education, a for-profit education company, said it received a formal order of investigation from the Securities and Exchange Commission.
Mylan Laboratories, the largest U.S. maker of generic drugs, withdrew its earnings forecast and filed a lawsuit against the U.S. Food and Drug Administration after the agency delayed introduction of Mylan's version of the Duragesic pain-relief skin patch.
AT&T, the largest U.S. long- distance telephone carrier, said it will stop competing for residential customers in seven states after losing an attempt to revive rules that gave it discount rates when renting local-phone lines.
Quotes of Note . . . ``Earnings will continue to be strong, but share prices reflect that,'' ``I don't see significant gains in the markets in the coming months.'' Alison Porter, head of U.S. equities at Britannic Asset Management which manages $1 billion. Porter has been buying Motorola Inc., the world's No. 2 maker of mobile phones.
Gurus . . . Ken Perkins, research analyst for Thomson First Call says the outlook for second-quarter earnings is fabulous. He says S&P 500 companies in the second quarter will likely boost their third straight quarter of at least 25% profit growth. Year-over-year earnings improved 28% in the fourth quarter and 27% in the first quarter. Demand has been rising and firms have enjoyed the leverage that comes from cost cutting during the bad times. Analysts expect S&P firms’ profits will rise 20% in the second quarter, but Perkins says that given recent trends, he feels comfortable they will be up 26% when fully reported.
Ed Hyman of ISI concurs. His regression model is projecting second-quarter growth up 29%, and he is plus-20% for the third quarter. He says analyst projections are just too low.
As for technology, Alberto Vilar, who runs Amerindo Investment, says his success this year stems from his concentrated portfolio and his bets on eBay, Yahoo, Expedia, and Imclone. He would not be buying Google if the market cap exceeds 40 billion at the offering. He recently bought Eyetech Pharma and has been adding to Juniper and XM Satellite.
And on his radio show last evening, Jim Cramer says he is buying the neglected cable, radio and satellite stocks like Clear Channel, Emmis, Echostar, and Comcast. He would be selling Eight By Eight and Conexant on strength.
Barron's Online highlights an interview with Bernie Schaeffer, a Chairman and CEO of Schaeffer's Investment Research, for his stock pick's. Over the last 12 months, he says that his all-equity "master portfolio" is up 18.3% percent, beating the S&P's 500 index by almost 5 percentage points during that period. Right now, he's bearish, but is long on particular sectors, including auto makers, leading Internet companies, and several gold stocks. He also suggests that investors keep as much as 25% of their assets in cash. Mr Schaeffer currently likes Ford, General Motors, eBay, Kmart, SBC Comm., Hershey Foods, Yahoo and HOLDRs, including UTH, HHH and OIH. Mr Schaeffer currently doesn't like Microsoft. He says that of the 26 analysts that cover the stock, 25 have [Buy recommendations]. Microsoft can only minimally benefit from analyst upgrades, whereas Ford can benefit tremendously through upgrades. And short interest on Microsoft is negligible. "This stock is a prototype of a blue chip stock that I don't see having much fire power to the upside."
New Tech . . . The WSJ highlights the ShotSpotter, which can detect gunshots within about 2 miles and notify police within seconds, giving them the precise location where the gun went off. ShotSpotter listens for gunshots with acoustic sensors that can be affixed to trees, telephone poles and other structures. Once a gunshot is detected, ShotSpotter calculates the position where the gun was fired and sends the data over phone lines to a central server accessible by law-enforcement agencies. Because it uses computer software to analyze sounds, ShotSpotter is precise enough to ignore fireworks, backfiring cars and other noises that could be mistaken for gunfire. To address those concerns, ShotSpotter is developing a wireless system that can be moved on the fly. By the third quarter, the co expects to be producing a device that communicates wirelessly through a set of radio frequencies that send data to the central server. "You can have a complete wireless-sensor network up in an hour," says James Beldock, CEO and president of ShotSpotter. ShotSpotter's capacity to pinpoint the source of a gunshot within a few feet doesn't come cheap. Law-enforcement agencies have to pony up $180K, which buys a license to use ShotSpotter software and eight sensors. Each additional fixed sensor costs $2,640 and each additional wireless sensor will cost about $5K. Looking ahead, ShotSpotter is teaming up with Xybernaut , a maker of wearable computers, to develop a gunshot-detection device that can be worn on the body. The wearable ShotSpotter could be sewn into jackets or mounted on bullet-proof vests or patrol cars. These sensors could send gunshot data to a PDA, cellphone or other type of digital display, letting the person know in seconds where shots are coming from and the type of gun being fired. ShotSpotter says it's currently in talks with the military on applications for the device.
Mortgages . . . Mortgage applications edged higher 0.1% in the week of June 18 as 30-year mortgage rates fell 13 bp to 6.21% and 1-year adjustable rates remain attractive at 4.10%. Refinancing showed its 6th decline of the last 7 weeks (-1.7%) as purchases rose 1.1%. The purchase index has remained strong despite the rise in long term rates as May reached a record high which should be reflected in tomorrow's release of new home sales.
New Trading Rules . . . The WSJ reports the SEC is expected to approve a pilot program today that will lift short-selling restrictions on about 1,000 actively traded stocks for a one-year period, allowing investors to more easily bet against some large stocks. But the agency is abandoning, at least for now, an earlier plan that would have allowed short-sales only at prices at least one cent above the best national bid. It now plans to expand the pilot to 1,000 companies from the 300 it proposed in October and shorten the time period to one year instead of two. The SEC will also lift restrictions for a year on some after-hours short-sales, allowing unrestricted short-selling from about 6:30 p.m.
IPO . . . Salesforce.com’s IPO priced at $11, above the expected range of $9-$10, which was raised earlier in the day from $7.50-$8.50. The company is the largest provider, based on market share, of application services that allow organizations to easily share customer information on demand. It provides customer relationship management, or CRM, service to businesses of all sizes. Providing applications that are delivered through a standard Web browser, the co substantially reduces many of the traditional expenses of enterprise software implementations. From its introduction in Feb 2000, its customer base has grown to 9,800. According to a study, the market for on-demand application services is projected to grow from $425 million in 2002 to $2.6 billion in 2007. The company posted sales of $96 million last year, up 88% year over year. The company posted its first profit last year. The co planned to go public last month, but delayed the deal to allow a cooling-off period following comments in the press by its CEO. It's not Google, but this deal has generated a lot of interest as it has been an aggressive and successful player in the CRM space. It probably would have been even more warmly received had it listed on the Nasdaq rather than the NYSE. This is a 10 mln share deal, led by Morgan Stanley and begins trading this morning.
Economic Comments . . . The government periodically divides GDP into industries. The data continues to show several well-established trends. The output of the biggest industry, financial services, continued its steady growth as a share of GDP, reaching 20% in 2003. Manufacturing and agricultural output continued to decline as a share of overall GDP.
Industry data continues to show several well-established trends.
• The output of the biggest industry, financial services, topped $2.2 trillion (all data is nominal). The industry continued its steady growth as a share of GDP, reaching 20% in 2003.
• Financial services includes two major subdivisions. Finance and insurance make up 7.9% of GDP, while real estate and rental activity make up 12.4% of GDP.
• Manufacturing output continued to decline as a share of overall GDP, falling to 13% in 2003. In 1947, manufacturing output was $65.8 billion out of a $244 billion total GDP, roughly 27%.
• Agricultural output continued its long-term downtrend as a share of GDP. At $112 billion, it produces roughly 1% of GDP. In 1947, agricultural output was $20.7 billion out of a total GDP of $244 billion (in nominal 1947 dollars.) The uptick in the early 1970s was related to a definitional change in the data at that time.
• Mining (consisting mostly of oil and gas extraction) continues to be a relatively minor share of overall GDP, at 1% ($125 billion) of GDP in 2003. It was the fastest-growing industry in 2003, up 18.3%, due to the strength in oil and metals prices. The bulge in this industry’s share of GDP in the late 1970s as the dollar weakened, inflation rose, and equities in this sector surged.
Market Comment . . . Economic data releases continue to bring surprises to the upside. Indeed, last week’s release of industrial production for the month of May and the Philadelphia Fed Index for the month of June demonstrated that the economy is still delivering robust results. Nevertheless, all this positive news on the economic front has done little to revive market volume. In fact, in recent weeks we have begun to see typical summer season trading patterns emerge as volume on the averages has started coming in on the soft side. This probably marks the beginning of what is often a very dull season for the markets . . . summer.
Market Comment . . . June marked the beginning of what is typically the slowest season for market volumes. The common complaint is about the lack of liquidity in the market. Undoubtedly, vacation season lies just around the corner and investors are unlikely to make big commitments ahead of it. June historically represents 8.1% of total annual NYSE trading volume. July tends to be even slower, with about 7.9% of total volume, and August typically marks the depth of this cycle with an average of 7.6% of the total annual volume.
Summer rarely offers much excitement as far as volumes are concerned, and, unfortunately, this dull trend seems to seep into market performance as well. The summer months have typically been associated with some of the worst market episodes of the past 50 years! All in all, the combination of seasonal headwinds and a lackluster technical backdrop, as evidenced by the neutral reading on our MIBS composite (Momentum- Intensity-Bullish Sentiment) of oversold/overbought conditions, seem to suggest that significant market upside in the near term is unlikely.
The economy continues to show signs that it is firing on all cylinders, demonstrating some of the most robust growth we have seen in decades. The unavoidable consequence of such a strong economy is that inflationary concerns have begun to mount. As such, it is looking more and more likely that the Fed will raise rates at its next FOMC meeting at the end of the month. Indeed, in an interview this past week, Fed governor J. Alfred Broaddus, Jr. stated that “we’re clear that we need for rates to move up . . . We have a
credibility for low inflation, and we aren’t about to give it up.” Language from other Fed governors has been equally strong in recent weeks.
The Fed’s approach to monetary policy has been somewhat predictable over the years, since it is largely based on the concept of excess capacity. Essentially, the Fed waits for the economy to absorb excess capacity before moving the fed funds rate higher. We have a total economy capacity utilization rate that incorporates both the manufacturing and services sectors (the latter consisting of the portion of unused labor in the economy). Excess capacity is quickly being absorbed, and the utilization rate is nearing levels that are typically associated with the beginning of a tightening cycle.
The economy is currently running at 87.2% of total capacity, a level that is close to past levels associated with the beginning of monetary tightening cycles. Indeed, the utilization rate has risen significantly in the past two months, bringing us closer to the first Fed rate hike. At this pace, by the time the June economic data are figured in, the Fed should have the conditions it has historically viewed as necessary in order to begin raising rates.
The beginning of tighter monetary policy does not have to be a dire outcome for the equity market since at least a portion of the adjustment has already been discounted. Indeed, the backup in bond yields suggests that a large part of the tightening cycle is already being priced into the market, at least when it comes to the forward market multiples. The fact that the yield curve is currently sitting at a 50-year high suggests that the long end of the curve may not have to rise as much as the fed funds rate over the tightening cycle.
A different way to analyze what is currently being discounted in the market is to look at the term structure of the futures market. The fed fund futures are already pricing in more than a 125-basis-point fed funds rate increase by the end of this year, in a relatively linear, gradual path. Furthermore, investors are currently expecting the fed funds to continue on this gradual path into early 2005.
The conclusion to be drawn from the fed funds futures market and the bond market is that the first few rate hikes could be somewhat easier to digest than in prior cycles and that market multiples don’t have to be drastically affected since much of the outcome is already priced in. The uncertainty remains in how the tightening cycle will affect earnings, since rising rates tend to dampen the growth outlook. In short, while rising interest rates are never a positive for the market, the effect may not be as dire as some are
predicting in the current cycle.
The current monetary policy cycle has a number of elements that are similar to the policy cycle of the early 1990s. Indeed, in both the easing cycles of the early 1990s and that of the past three years, the fed funds rate dropped by about 500 basis points. Furthermore, the time period over which the rate cuts took place is also turning out to be quite similar. Both scenarios experienced less than a year-and-a-half between the last rate cut and the first rate hike (assuming the Fed in fact raises rates later this month). Thus, in terms of magnitude and duration, there are a lot of similarities between the two cycles.
Indeed, similarities certainly exist between the two episodes with respect to the amount of time in which the easing policy occurred as well as the magnitude of the rate cuts. Rates declined 525-550 basis points in each easing cycle, after which troughs in the monetary cycle (i.e., the period between the last rate cut and the first rate hike) lasted about a year to a year and a half. Furthermore, six months after the first rate hike in 1994, rates had risen 125 basis points — the exact same increase the fed funds futures are currently projecting for the end of this year (or six months from now).
Most investors seem inclined to focus on the similarities between the current cycle and that of the 1990s and are therefore ignoring the differences that exist this time around. In our view, what will be most helpful for portfolio positioning this year is to concentrate on the differences rather than the similarities to the early 1990s. At the heart of these differences is the pattern we have seen in leading indicators of the economy, which, of course, was influenced by the stimulating tax package in the recent cycle, causing leading
indicators to accelerate more intensely than in the earlier episode. Indeed, this difference is extremely important in regard to how the market will likely react to the Fed cycle this time around, in our opinion.
The biggest difference between the current backdrop and that of the 1990s is the pattern of leading economic indicators and the timing surrounding their respective peaks. For instance, at this juncture, it appears that leading indicators may have already seen a peak in momentum, whereas in 1994 they did not peak until nine months past the first rate hike. This difference has implications for sector positioning — in 1994, it meant that cyclicals maintained leadership despite the Fed raising rates (because leading indicators were still accelerating). Indeed, it is the direction of leading indicators that drives the relationship between cyclical and noncyclical sectors.
Another useful longer-term leading indicator is the momentum in global short-term interest rates, which tends to lead many indicators by about six months. The recent increase in the momentum of global rates suggests that leading indicators, like the ISM, may have already seen their peaks for the cycle and could soon begin to lose momentum. Even if global short-term rates remained flat, the index line would trend toward zero, suggesting that other leading indicators could soon follow suit, somewhat earlier than they did in the 1990s scenario.
While there are typical aspects to the equity market’s response to a tightening in monetary policy, understanding the dynamic of these leading indicators gives the best reading of what is likely to happen, in our opinion. While we cannot predict exactly how the market will react when the Fed raises rates, we can attempt to understand past patterns in market activity following a first rate hike to get a better sense of what is likely in store for the months ahead. However, the conclusion at the market level has not been as completely consistent over the years as it has been at the sector level. Indeed, sector leadership during a tightening cycle has been overwhelmingly dominated by noncyclical leadership — a theme we think will be key for portfolio positioning for the remainder of the year.
In a typical cycle, the equity market begins to lose some momentum heading into a tightening cycle. We have found that, on average, the S&P 500 typically loses steam about three months prior to the first Fed rate hike. In fact, the overall index rarely makes significant headway in these last few months leading up to a change in monetary policy. On average, the equity market has only managed to gain about 2%-3% in the 50-day period preceding an initial rate hike.
In addition, the S&P 500 on average has been down 3.5% from its intra-period (i.e., between the last rate cut and first rate hike) peak at the time of the first Fed rate hike. With that in mind, the S&P 500 reached 1158 in February, marking the high point for the current cycle. This suggests that the market should close at around 1125 on the day the Fed first raises rates if this were to play out as a perfectly typical cycle. As such, the current market level seems to be right where it should be, indicating that it is on cue for a Fed rate
hike.
The most predictable element of tighter monetary policy is the reemergence of noncyclical leadership. Indeed, a higher fed funds rate usually has an impact on the growth outlook, which inherently favors noncyclical, more stable segments of the market. A turning point in the relative performance of the most cyclically-sensitive industries usually occurs an average of 17 weeks before the first rate hike of a Fed tightening cycle — a trend we have seen begin to unfold in the market recently, suggesting that we are already in line with a typical path.
Indeed, we have already seen a shift from cyclical sector leadership to noncyclical leadership, suggesting that the reaction from equities has been typical thus far. We expect the noncyclical trend to continue and to intensify for the foreseeable future. The portfolio implication is clear: a decline in leading indicators and a dampened growth outlook from a higher fed funds rate suggest that investors should be defensively positioned at this stage. We caution investors that a pro-cyclical posture at this juncture has become a riskier venture.
Financials . . . Goldman Sachs upped to Outperform from Market Perform at Wachovia. The upgrade is reflective of a broader call on the brokers as well as Goldman specifically. Broadly, the firm thinks M&A is beginning to pick up again, fixed income is stronger than initially thought, and GS shares are simply becoming more attractive. Wachovia is raising their 2004 and 2005 estimates to $8.90 and $8.56 to reflect better fixed income trading, security service revenue, and modestly lower costs. Firm's full-year 2004 and 2005 ROE is now 20% and 16%, respectively. Valuation range $103 to $108
Education . . . Career Education cut to Peer Perform from Outperform at Bear Stearns.
Merrill Lynch downgraded Career Education to Neutral from Buy following news the company has received a copy of a formal order of investigation from the SEC. As they understand it, the significance of the SEC investigation becoming formal is that they have access to current and former employees and can fine the company if wrongdoing is found. Firm believes that this news, and to a lesser extent, an amended shareholder lawsuit filed against Career Education last Thursday, puts the company under a cloud that could hang over it for some time.
Transports . . . FedEx reported earnings of $1.33 per share, excluding a $0.04 gain and a $0.01 charge, in line with the consensus of $1.33. Revenues rose 20.8% year/year to $7.04 billion versus the $6.8 billion consensus. Company issues upside guidance for 1st quarter (Aug), sees EPS of $0.90-1.00 versus consensus of $0.80; for 2005 sees $4.20-4.40, consensus $4.29.
Tobacco . . . Deutsche Bank upgrades RJ Reynolds to Buy from Hold and raises their target to $75 from $64 after the FTC approved the company's bid to buy British American Tobacco's U.S. assets. The firm cites the speed of approval, steady domestic fundamentals with upside potential to their 2004 estimate, and heightened prospect of a dividend boost this year.
Restaurants . . . Piper Jaffray notes that, despite the upside reported last night from Darden, May same store sales at the two core formats were disappointing. Red Lobster fell 4.5% compared to the firm's 4.0% expectation while Olive Garden struggled with a 1%-2% gain compared to the firm's 6% estimate. The results were aided by stronger-than-expected margins (a phenomena the firm does not expect to continue), a lower-than-expected tax rate, and fewer shares outstanding. Also, management subtly reduced its long-term EPS growth expectations from its most recent "at least 15%" to one of "double-digits."
Darden’s Red Lobster same store sales declined 4-5% in May, slightly above our estimate, with traffic declines of 1-2%. Olive Garden's May comps rose only 1-2%, slightly below our estimate, with traffic declines of 1-2%. Negative May traffic for Olive Garden may raise concern that Olive Garden slows before Red Lobster turns. For the quarter, Red Lobster comps declined 6.4% while Olive Garden was up 5%. Darden repurchased 4.4 million shares of stock in the 4th quarter, which added approximately $0.01 to earnings versus estimates. Margins were lower than expected due primarily to unusually high SG&A costs, partially offset by lower food and beverage and other operating costs. Darden issued 2005 EPS guidance of up 8-12% growth ($1.62-$1.68), based on 50-60 new restaurants and 1-3% same store sales growth. The sales guidance is below DRI's prior historical target of 3-5% comp growth, but seems more realistic and should result in less aggressive advertising and promotion. DRI toned down its long term EPS target to growth in a "double digit range" from 15% or better.
Retail . . . Harris Nesbitt downgrades Dick's Sporting Goods to Neutral from Outperform, but raises their target to $35 from $32. The firm believes that the stock's valuation is full and fair, and they have some reservations about the benefits of the recently announced Galyns acquisition. Firm questions whether the returns from the acquired GLYN stores will match the industry-leading returns shareholders have come to expect from DKS, and they believe that the integration process could pose some disruption risk that could impact DKS's steady growth record.
Healthcare . . . UBS downgrades Laboratory Corp to Neutral from Buy based on valuation, as the stock is near their $48 target; also, while free cash flow yield (7%) and the potential for share buybacks are positives, they think year/year price comparisons will continue to be challenging for the reminder of the year.
Barron's Online highlights PacifiCare Health, suggesting its recent sell-off provides an attractive entry point. "It is worth far more than it is trading at," says Joe Pappo, portfolio manager with Lotsoff Capital Mgmt. "We think the stock has upside." Though many insurers abandoned or reduced their Medicare businesses a few years ago, PacifiCare held fast, garnering the biggest market share. That and several new products should give it a leg up if enrollment in Medicare health plans spikes next year, as many expect. Meanwhile, a healthy increase in government reimbursements should bolster PacifiCare's profits, offsetting a possible price war among commercial insurers. "Medicare is not the only driver. But the key to PacifiCare's stock will be success in Medicare," says William McKeever, an analyst with UBS. PacifiCare projects enrollment in its Medicare + Choice program will jump by about 7% to 736K by year-end. Paul Ginsburg, president of the Center for Studying Health System Change, says seniors are becoming more comfortable with this new breed of Medicare health plan, and he expects enrollment in these plans to pick up next year. By the end of 2005, enrollment in PacifiCare's Medicare health plans should reach the company's goal of 787K, according to Scott Fidel, an analyst with J.P. Morgan. By 2006, membership could exceed a million, estimates Christine Arnold, an analyst with Morgan Stanley. According to the article, PacifiCare's stock looks cheap-particularly compared with its peers. At 11.49x projected earnings over the next 4 quarters, the shares fetch an 18% discount to a group of managed care stocks and a 33% discount to the S&P's 500. The stock trades above its historical median of 9.1x projected earnings. Based on projected earnings for 2005, PacifiCare still has the second lowest P/E multiple among the ten largest publicly traded health insurers in the U.S. and its PEG ratio remains attractive.
Medical Devices . . . OraSure Tech gets FDA approval for HIV-1/2 test to detect HIV-2 in oral fluid. With this approval, the OraQuick HIV-1/2 Test is the only rapid, point-of-care test approved by the FDA for use in detecting antibodies to both HIV-1 and HIV-2 in oral fluid, finger stick and venous whole blood, and plasma samples.
Drugs . . . Morgan Stanley upgrades Baxter to Overweight from Equal-Weight, as they believe that the company is in the early stages of a turnaround. The recently announced restructuring efforts and additional actions by new management should improve the company's earnings quality and growth prospects over time. Target is $41. Firm also downgrades BDX to Equal-Weight from Overweight based on valuation, as the stock is approaching their $56 price target.
JP Morgan adds Forest Labs to their Focus List, saying yesterday's weakness is overblown. The firm feels the Celexa controversy in the media is irrelevant, since: 1) Celexa is not approved for adolescents and has never been marketed for such, 2) there was no intent to suppress the data from the failed Lundbeck study, 3) the FDA has had the safety data from both studies and has not raised any concerns, 4) Celexa is going generic, and 5) they find little legal basis for a suit similar to Paxil. Firm also notes that the SSRI mkt growth rate has been declining for over a year, although they think there will be a rebound, especially with Lilly's imminent launch of Cymbalta. At $57, firm notes that the stock is trading at 20x CY05 EPS, which is close to its 2-year trough valuation and below the 28x 2-year avg. Target is $68.
CIBC notes that a posting on the FDA's web site suggests the agency has reversed the approvable status of Mylan's ANDA for generic Duragesic, which is a $1.3 billion transdermal fentanyl product and the most significant near-term event in MYL's pipeline from final to tentative. Firm says they have limited information on details and were unable to reach MYL mgmt, although they believe that the FDA's move, despite mgmt's past proclamations, negates the possibility a launch post patent expiry on 7/23/04 until the expiration of a six-month pediatric exclusivity period. Firm says that Street estimates (2005 consensus is $1.35) almost universally assume a July launch, and they anticipate downward estimate pressure. However, firm thinks that MYL could still hit their $1.31 number, which factors in a Jan 2005 launch, assuming no JNJ-authorized generic and limited additional generics.
Schering-Plough will continue to co-promote INTEGRILIN with Millennium in the United States and retains rights to the product in other territories outside of Europe. Schering-Plough will continue to pay royalties to Millennium on INTEGRILIN sales in other territories outside of the United States. In the United States, Schering-Plough and Millennium co-promote INTEGRILIN and share profits. Financial details of the agreement pertaining to the return of the European rights are not being disclosed.
The FDA plans to extend patent protection for the pain-relief patch Duragesic by six months, Janssen Pharma said, delaying the launch of a generic version. Separately, Mylan announced that it is filing suit against the FDA in the U.S. District Court for the District of Columbia, seeking to restore final approval for its fentanyl transdermal system. "In siding with Janssen and withdrawing Mylan's final approval, the FDA has acted contrary to multiple sections of the Federal Food, Drug, and Cosmetic Act and the Administrative Procedures Act, its published regulations and the legal precedent on point. We view this decision as yet another assault on the generic pharmaceutical industry. Among other problems created by the FDA's decision, this opinion encourages branded pharmaceutical companies to ignore the 45-day timeline to sue and effectively eliminates a generic company's ability to challenge patents that are nearing expiration." Local procedural rules require a hearing in the suit to be held prior to July 23, 2004, and as a result, MYL suspended annual earnings guidance.
Biotech . . . Friedman Billings Ramsey maintains their Outperform on Imclone and raises their target to $93 from $82. The firm is saying recent head and neck cancer data suggests Erbitux potential with radiation therapy in multiple cancer types; firm raises their Erbitux sales estimate for 2nd quarter to $55 million from $31 million (consensus $45-$50 million), and raises 2004 estimate to $232 million from $154 million (consensus $225-$230 million).
Media . . . Jeffries upgrades Ask Jeeves to Buy from Hold and reits $39 target. A 22% pullback in the last 30 days, combined with an expected strong 2nd quarter report, make the stock attractive. The firm also believes that an extension of the Google agreement before the Google IPO is likely.
Electronics . . . Barron's Online highlights PalmOne, which saw its shares pop 36% Tuesday, after the company soundly beat analysts' expectations and boosted revenue for its FY. But, according to the article, PalmOne shares may have had their run. The Treo line could still prove to be a small portion of an industry where larger rivals like Dell loom and PalmOne's core organizer market erodes. The risk continues that once the early adopters have been captured, the Treo will be unable to cross [to mainstream consumers]," wrote Charles Wolf, an analyst at Needham in a note to investors. Despite the popularity of 'smart' phones like the Treo, "there could be a backlash" in the next several years, says Todd Kort, an analyst at Gartner. While the Treo is certainly cool, its price isn't likely to woo the masses. After rebate, a Treo 600 costs about $450 at AT&T Wireless. And most of Treo's impressive demand is coming from PalmOne's organizer customer base, a market in which PalmOne is losing ground. Gartner ests that PalmOne lost 7 percentage points of worldwide organizer market share last year to 35%. Further, organizer demand is stagnant. Gartner expects organizer unit sales to be essentially flat at 11.3 millon organizers by next year from 2003. And the Treo may have a lot more competition very soon. "You're going to see more and more models from more vendors," says Kort. Mr Kort expects Hewlett-Packard and Dell to enter the combination device fray some time next year. According to the article, PalmOne also trades at a lofty 4x its expected long-term annual earnings growth rate and at roughly 40x the consensus for its 2005.
Telecom . . . Smith Barney says that Vodafone's announcement of two mgmt changes in Southern Europe/Italy and Asia Pacific/Japan adds uncertainty to the stock. The firm thinks the former mgmt change is more negative, as the CEO was more involved in day-to-day operations and the business has performed well; maintains Hold rating.
The WSJ reports that Qwest Communication is expected to announce today it will launch a new Internet calling service for business customers in mid-July. The service, which will be available in major cities across the nation this year, will allow users to route calls through the Internet from laptops while on the road and forward voicemails to e-mail. It will also offer standard features such as call waiting and caller identification, 911 service and speed dial. The Internet calling service will run mostly over Qwest's long-haul and local network and comes with unlimited local and long-distance service.
AT&T will stop competing for local and long-distance residential customers in Ohio, Missouri, Washington, Tennessee, Louisiana, Arkansas and New Hampshire (approx population of $38 mln). This action is a result of a 6/9 decision by the Administration and the FCC not to appeal a recent Federal court decision that overturned FCC wholesale rules put in place to introduce competition in local markets. The reversal of local competition policy by the Administration will permit the Bell companies to raise wholesale rates as early as November. The increase in wholesale rates means that T will likely be unable to economically serve customers with the competitive bundles currently available.
SBC announced it will spend $4 billion-$6 billion on a fiber-to-the-node (FTTN) network upgrade over five years, pending the successful completion of video field trials and further
regulatory clarity on network sharing requirements. Estimate about two-thirds of the capital plan represents incremental spending. The FTTN plan will facilitate an IP-based video offering, utilizing Microsoft's IPTV product supported by the Windows Media 9 video codec. With the Microsoft platform, SBC could theoretically deliver four separate video channels (including HDTV), VoIP and several Mbps of broadband data. SBC expects to complete field trials of the
service by 2004 or early 2005. Estimate the $4B-$6B capital plan will cover ~10 million of SBC's in-region homes, equating to ~$500 cost per home passed. The capital plan includes building fiber to remote terminals within ~5,000 feet of each target home and using ADSL2+ access technology for the last mile. The plan does not include CPE or local/in-home network upgrades which may be necessary to support video services. While analysts are cognizant of the possibility that regulatory posturing could be one motivation for today’s announcement, a viable video solution remains a key goals for all of the RBOCs. This plan would likely be dilutive to earnings during the build phase, and possibly for a more protracted period depending on customer take rates. It is increasingly evident that SBC views video as a key component of its product bundle. Expect a spirited battle between the RBOCs and cable competitors as each attempts to enter the other’s core business. The result will be lower margins for all participants.
IT Services . . . IBM and Motorola announced that they plan to work together to promote highly integrated, standards-based computing platform technologies for telecommunications based on IBM's industry leading eServer BladeCenter system.
Network Equipment . . . Lehman cuts their 3Com target to $6.50 from $8 after the company reported solid results. However, firm says the disappointing resale of J.V. products and the unexpected departure of the CFO and COO place the company's long-term story on hold. Maintains Equal-Weight rating.
The WSJ reports SBC Comm. said it will test a new fiber-optic network this summer and could potentially invest as much as $6 billion to roll out the technology to millions of consumers during the next 5 years. SBC's move to invest in fiber reflects increased competition from cable-television company's and Internet start-up businesses that are ramping up the rollout of inexpensive phone services. The new network could allow users to get high-definition TV, super-fast Internet connections and Internet phone calls. Separately, Sprint said it will upgrade its wireless-telephone network to provide data speeds comparable to home digital subscriber line or cable-modem connections.
Semiconductors . . . Janney initiates Zoran with a Buy rating and $21 target. The firm is saying the company offers investors a great opportunity to invest in a growth story specifically focused on consumer electronics that is less than $1 billion in market cap. Firm expects the co to benefit from several emerging market opportunities, including its DVD, DTV, Digital Imaging, Digital Camera, and mobile handset business units. Although they anticipate integration issues and view Zoran's higher cost structure as a disadvantage, they believe these end markets, which are all experiencing growth rates in excess of 20% for the next few years, will permit our earnings growth forecast of 42% from 2004 to 2005.
Banc of America believes that AMD's 2nd quarter is tracking in-line to better than seasonal as a result of strong demand for NOR flash products (~51% of sales) and a better mix of processors (49% of sales) into a seasonal PC mkt. As a result, firm raises their 2nd quarter estimates to $0.11 from $0.09 and raises their 2004 estimate to $0.60 from $0.57, versus consensus of $0.09 and $0.60, respectively. Firm also notes, the recent weakness in shares of AMD presents a buying opportunity, as the recent concerns of Intel regaining share in the NOR Flash market are overblown. The firm thinks that given the tightness in capacity and the continued strength in the handset market, both Intel and AMD can both benefit from the overall strong demand environment. Target $20.
Software . . . JP Morgan cuts their license revenue estimate for Peoplesoft, saying that checks suggest a mixed 2nd quarter. The firm believes that its verticals remain inconsistent, with strength in government and healthcare, and weakness in financial services, manufacturing, and commercial; conversations suggests slightly improving pipeline within the public sector and state universities. They are hearing that there is little cross-sell between Enterprise and Enterprise One despite some newer initiatives within PSFT, and large deals remain elusive. Firm cuts their 2nd quarter license revenue estimate to $148 million from $160 million in 2nd quarter, versus company's guidance of $150-170 million. Firm also cuts their 2004 revenue estimate to $675 million, versus guidance of $675-$695 million and consensus of $689 million.
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