From Briefing.com: If Meatloaf thinks two out of three ain't bad, we wonder what he would think of four out five. Dating back to last Wednesday, the Nasdaq has been down in four out of the past five sessions. Specifically, though, it has fallen four days in a row, shedding 71 points or 4.3%. Viewed in isolation, that decline would unnerve plenty of investors, but when taking into account that the Nasdaq was up 25.6% year-to-date before the recent downturn, it is a little easier to stomach.
The tech sector's recent performance, frankly, is indicative of a sector in the midst of consolidation. To that end, declines have been orderly in nature, volume hasn't been as strong, and market participants have been slow to rally around seemingly good news.
On Tuesday, that trend remained intact as the tech sector muddled through the day on relatively light volume. Meanwhile, the Conference Board's generally reassuring Consumer Confidence report, Corning's (GLW 7.13 -0.17) announcement that it would be re-affirming its Q2 (Jun) outlook, and a Merrill Lynch upgrade of Apple Computer (AAPL 18.78 -0.28) were outweighed by an inclination to stick to the sidelines ahead of the FOMC's interest rate decision, lowered Q2 sales guidance from Advanced Micro Devices (AMD 6.31 -0.28), and a downgrade of Cisco (CSCO 16.75 -0.49) by Soundview that was attributed, in part, to a lack of tangible evidence that the 2H03 growth outlook has improved.
As for the FOMC decision, it is expected around 14:15 ET on Wednesday and Briefing.com is expecting a rate cut of 25 basis points with a risk assessment that is focussed on disinflationary forces. What the market's immediate response to the Fed's move will be is anyone's guess, but for investors, the important thing to keep in mind is that lower rates, in and of themselves, are always good for stock prices.
The latter point notwithstanding, the tech sector's near-term appeal is lessened by the specter of earnings warnings and the need to hear earnings guidance that will validate the run up in stock prices that has been predicated on a belief that there will be a meaningful increase in capital equipment and information technology spending in the latter half of the year. Until then, maintaining a cautious stance at these levels is the prudent thing to do.-- Patrick J. O'Hare, Briefing.com
5:15PM FSI Intl loses less than previously reported (FSII) 3.60 -0.06: -- Update -- Upon further investigation and discussions with Reuters Research, it appears that FSII's Q3 loss is $0.45, excluding the severance related charge of $2.3 mln. According to R.R., the loss related to affiliates is recurring as analysts included it in prior quarters; however, it was not expected to be as large as expected. Either way, it appears the company still missed.
FSI Intl (FSII) 3.61 -0.05: Reported Q3 (May) loss of $0.53 per share, $0.23 worse than the Reuters Research consensus of ($0.30). There are no charges mentioned in the text of the release, but there is a $2.6 mln loss in "earnings of affiliates" in the income statement that may represent an extraordinary item, in touch with Reuters to confirm. Company expects Q4 revenues of $24-26 mln, no analyst estimates on revenues available.
12:48PM Synopsys announces STMicro collaboration (SNPS) 61.87 +0.16: Announces that it is collaborating with STMicroelectronics (STM) on an embedded Bluetooth solution
11:03AM RF Micro Device finding buy interest following Legg Mason comments (RFMD) 5.97 +0.04: Legg Mason's channel checks into the Chinese handset market leads firm to believe that wireless demand will recover to a much healthier level sooner than anticipated. According to firm, handset and service pricing is being discounted so heavily that demand is accelerating and excess inventories are being depleted. The companies that Legg Mason believes will see the most share price appreciation from a faster-than-anticipated recovery of the Chinese market are RF Micro Devices (RFMD), Skyworks (SWKS), Texas Instruments (TXN).
Transmeta (TMTA) 1.48 +0.12: Announced that Plexus (PLXS) has chosen Transmeta's TM5800 processor as a key component in embedded product design applications for Plexus original equipment manufacturer (OEM) customers.
10:50AM Intel slips back toward support (INTC) 20.06 -0.30: -- Technical -- Has weakened in recent action with a new session low established. The low from yesterday comes into play at 20.05 with the 50 day ema/sma coming into play thereafter at 19.95/19.83.
10:30AM Sector Watch: Semiconductor : Group under pressure most of the morning with AMD -6.6% pacing the way following a warning. Other components posting sizeable declines include: BRCM -4.5%, LSI -3%, TXN -2.2%, NSM -1.8%, AMAT -1.5%. Bucking the negative bias today is LSCC +0.5%. The sector index (SOX 356.8 -1.7%) has fallen to support in the 354/353 area (50 day/chart) and has held thus far. Need sustained gains through intraday resistances at 359/360 and 362 to improve the short term pattern.
9:41AM PMC-Sierra cut to Underperform at Piper Jaffray; target $5 (PMCS) 11.73 -0.38: Piper Jaffray downgrades to Underperform from Mkt Perform due to weak service provider spending in Asia and the seasonal summer slowdown; firm also cites excessive valuation, saying the stock is vulnerable to correcting the excesses of the Feb-June runup. Target is $5.
9:28AM S&P 500 and Dow levels : -- Technical -- Initial support for the S&P 500 is in the 980/979.20 area with a posture above leaving the door open for further short term recovery attempts. Resistances are in the 985/986 area and at 990. Secondary support, on a failure, is at yesterday's low (977.40) followed by 975. For the Dow will be watching the 9060/9055 area during any early pressure for an indication of the strength of the slide. Intraday resistances, if this level hold firm, are at 9085 and 9105. Yesterday's low at 9038.36 provides next support.
9:18AM Advanced Micro cuts Q2 sales forecast (AMD) 6.59: Co cuts their Q2 sales outlook to $615 mln, down from previous guidance of at least $715 mln. "The anticipated global sales improvement in the month of June did not materialize as we had anticipated... In particular, the decline in personal computer and handset sell-through in China and other Asian markets, largely related to the SARS epidemic, significantly affected AMD's sales in the second quarter."
8:43AM FTC requests additional info from GNSS and PXLW (PXLW) 6.18: GNSS and PXLW announced it has received a request from the Federal Trade Commission for additional information and documentary material in connection with the proposed merger between the two companies.
8:37AM Corning reaffirms Q2 outlook (GLW) 7.30: Ahead of conference presentation today, co says it will tell investors that it continues to make significant progress on its three main priorities of protecting its financial health, returning to profitability in 2003 and investing in its future. Corning expects to be profitable for the full-year and will return to profitability in the third quarter, if not sooner, excluding special items. Co also reiterating Q2 guidance.
8:33AM Intersil announces sampling of true global WLAN solution (ISIL) 24.62: The Co. announced its sampling a "true" dual band Wireless Local Area Networking or WLAN solution with its key customers and Original Design Manufacturers or ODMs. It is called the PRISM WorldRadio and is capable of allowing its users to establish a network connection throughout the world with any standards compliant 802.11 infrastructure encountered, which includes 802.11a, b, d, g, h, i, or j. It is capable of ranges that cover the vast WLAN spectrum of 2.40-2.50 and 4.9-5.85 GHz. In addition, the PRISM WorldRadio delivers the industry's best power performance by consuming up to 75% less power than competitive designs.
8:24AM Dell to offer Novell's Linux software services to its enterprise customers (NOVL) 3.22:
7:28AM Juniper Networks downgraded at Wachovia (JNPR) 12.54: Wachovia downgrades to Underperform from Mkt Perform, saying checks lead them to believe that spending in both China and Europe slowed in Q2; also, firm says the stock's valuation at 80x their 2004 est is probably reflecting stronger business momentum than is likely to materialize; sees valuation range at $8-$10.
T.G.I.O. (Thank God It's Over!!) No more ad nauseam speculation about the Federal Reserve rate decision. Now that it is over, let’s get back to the basics – confessionals, economic numbers, and second-quarter results. U.S. stocks dropped after the Federal Reserve cut its benchmark interest rate by less than some economists had expected. The DJIA fell 98 points (1.1%) to 9,011, after trading higher earlier in the session. The S&P 500 lost 8 points (-0.8%) to 975. The Nasdaq dropped 3 points (-0.2%) to 1,602. The move left the Fed funds rate at 1 percent, the lowest rate in 45 years. One member dissented and said a half-point cut would have been better. The lack of bullishness in the Fed's remarks left Wall Street in a selling mood, although some broader strength remained as advancers narrowly outnumbered decliners on both the Nasdaq and the New York Stock Exchange. In the bond market, benchmark 10-year Treasury note moved lower after the Fed's move. The 10-year was recently down 22/32 at 102 14/32, lifting its yield to 3.33 percent from 3.25 percent in the previous session.
Strong Sectors: wireless, semiconductor, home entertainment, communications equipment, oil & gas service, gold, commercial prods, electronic manufacturing
Top Stories . . . U.S. durable goods orders unexpectedly dropped in May while new and existing home sales rose, presenting more mixed signals for Federal Reserve policy makers just hours before they are to announce a decision on an interest-rate cut.
Freddie Mac, the second-largest source of mortgage financing in the U.S., said it understated profits by as much as $4.5 billion the past three years, in part because executives sought to make earnings less volatile.
Goldman Sachs, the world's third-biggest securities firm by capital, said second-quarter profit rose 23 percent as revenue from trading bonds, currencies and commodities surged. The company more than doubled its dividend.
General Electric, which lost more than $500 million from its insurance businesses last year, is close to selling its Tokyo-based life insurance unit for about 300 billion yen ($2.6 billion), people familiar with the talks said.
Top 10 Lists . . . Lehman Brother’s 10 Uncommon Values List Amgen, Burlington Resources, Cisco, Exelon, Harrah’s Entertainment, Hewlett Packard, JetBlue, Nextel, Teva Pharma, US Bancorp. Price targets of interest from this list include: NXTL $23, JBLU $39, TEVA $54, CSCO $18, AMGN $76, HPQ $22.
Gurus . . . Chet Currier, columnist for Bloomberg, says the 3-month rally invokes what might be called the "80-20 Rule." This dictum states that 80% of the payoff from owning stocks or stock mutual funds comes in 20% of the time. The second-quarter of 2003 marks one of those "Golden Periods," where 28 of the 30 categories of stock funds tracked by Morningstar showed 3-month gains of at least 10%. In the last 30-years, there were 14 other quarters in which the S&P 500 gained 10% or more, and 33 quarters where the NASDAQ rose at least 10%. This bolsters the view of the Buy-and-Hold School of Investing, because once you miss one of these "Golden Periods," your overall return falls sharply.
Market Comments . . . While the sharp reversal of the last week is likely to give investors cause for concern, the recent softness in equities as a healthy market pullback, and investors should not be surprised if the path to our year end S&P 500 target of 1050 involves a visit to the 900 range first.
While rising equity prices typically signal that an economic recovery is on the horizon, the outperformance of the Health Care sector of late would suggest that the economy may not be on the one-way upward trajectory that many are expecting.
Most surveys of sentiment and measures of momentum suggest the market is still overbought. Over the past two weeks there has been a sharp drop in the put-to-call ratio; a missing piece of the technical puzzle that is now confirming the level of stock market overoptimism.
The Nasdaq has tracked the performance of assets classes in the wake of historical bubbles. Apart from a two-month war distortion this winter, the recovery in tech stocks has been more or less textbook. From a seasonal standpoint, the summer months tend to be rewarding in the third year of a Presidency.
High-beta segments have delivered almost twice the performance of the average S&P 500 stock year-to-date. However, the market is nearing an important inflection point, one that will likely see the end of beta dominance and the re-emergence of solid fundamentals as a dominant investment theme with focus on earnings, valuation, and dividends.
Hot IPO . . . American Financial Realty announced the pricing of IPO, 55.9 million common shares of beneficial interest at $12.50 per share. Underwriters are Banc of America & Friedman, Billing, Ramsey. The transaction is scheduled to close 6/30. Company expects to raise $642 million.
Financials . . . Bankrate was initiated with a Buy at Adams Harkness and a target $15. The firm cited the following factors: 1) new management has streamlined operations, paid off debt, and re-focused the company on its core assets; 2) the recent sharp rebound in rev growth has driven margins, profits, and cash flows; 3) interest rate volatility is driving increases in traffic to the site and attracting more advertisers at premium rates; and 4) valuation.
Charles Schwab will buy State Street's Private Asset Management Business for $365 million. The private asset management business of State Street Corporation and it's $11.5 billion in assets under management for $365 million in cash. The deal is expected to close in 4th quarter 2003.
Paychex was cut to Market Perform from Outperform at Raymond James.
Paychex’s payroll service revenue for 4th quarter 2003 increased 20% to $236.7 million. Positive year-over-year growth was due to the Advantage and InterPay acquisitions, a bigger client base, increased utilization of ancillary services, and price increases. Importantly, checks per client increased by 0.3%, the first positive showing since early calendar 01. The declining check volume trend peaked in the 3rd quarter 2002 and began to improve in 4th quarter 2002. The year-over-year declines in checks per client from 1st quarter 2002 through 3rd quarter 2003 were 1.9%, 3.8%, 4.1%, 2.6%, 1.7%, 0.3%, and 0.1%, respectively. The improvement in checks per client is encouraging. The HR unit’s revenue increased 18% year over year to $40 million. This growth is primarily related to growth in clients for Retirement Services and in client employees served by the company's Paychex Administrative Services (PAS) and Professional Employer Organization (PEO) bundled services. In 4Q03, Retirement Services revenue increased 13% to $17.2 million (or 43% of HR revenue). Paychex is confident that it can continue to post solid, consistent results. The company has been extremely successful at cross-selling ancillary services. In addition, the company is achieving strong results in the major account segment. Revenue from Major Markets Services increased 40% in 4Q03 to $28.4 million (10% of total revenue).
Goldman Sachs reported 2nd quarter earnings of $1.36 per share, $0.17 better than the consensus of $1.19. Revenues rose 3.5% year/year to $3.98 billion versus the $3.81 billion consensus. The Board of Directors has also increased the firm's quarterly dividend to $0.25 per share from $0.12 per share. Next dividend will be paid on 8/28 to common shareholders of record on 7/29.
Freddie Mac expects restatement to increase retained earnings $1.5-$4.5 billion. The company also reported that it expects a material increase in the fair value of shareholders' equity for year-end 2002 over 2001.
North Fork announced a balance sheet restructuring initiative, which bodes well for the company's outlook. They also announced an increase in the dividend payout ratio to 40%-50% (from 40% currently) and a substantial increase in its share repurchase program from 4 million shares to 8 million shares. NFB is basically undoing the leverage which it put on its balance sheet in the second half of 2002. The company plans to reduce the securities portfolio by $2.5-$3.0 billion (or 32%) with proceeds being used to reduce short term borrowings by a like amount or about 70%. Additionally, the company will restructure $1 billion in certain long term borrowings (average cost nearly 5% currently). These proactive initiatives are viewed favorably. The net effect of this strategy should be to increase capital ratios (and more importantly capital flexibility), expand the net interest margin, and improve NFB's interest rate risk profile. This transaction will result in approximately $13 million in charges in 2nd quarter 2003 ($11 million for the debt restructuring, $2 million for securities sales) which will be offset by a like amount of gains from securities sales. Second-quarter 2003 reported EPS should be in a range of $0.60-$0.62 versus a consensus of $0.67 (which now becomes the operating number).
When Congress passed the Tax Relief Act last month, we wrote that REITs generally would be excluded from the tax reduction on dividend income but that some portion of the REIT payout would benefit. The key implication is that the relative income advantage enjoyed by REITs will be reduced, but not eliminated. Analysis of the 2002 dividend for the 107 REITs we track implies that 72.8% is considered ordinary income, and the balance (27.2%) is comprised of capital gains or return of capital. As such, on average the blended REIT dividend tax rate would be 27.5% under the new tax law, versus 30.6% previously, and in comparison to 15% for conventional corporate dividends. After Tax Yields. The current average dividend yields for the RMS index, the S&P 500, and the S&P Utility Index are 6.53%, 1.63%, and 4.05%, respectively. Based on the new tax law, and assuming the 2002 dividend composition remains applicable, the blended calculated after tax RMS yield is 4.73%, versus 1.39% for the S&P 500 (a 3.35% spread) and 3.44% for the S&P Utility Index (a 1.29% spread). A significant amount of REIT shares are held in tax-advantaged accounts including pension funds, other institutional retirement vehicles, and 401-K's, which will not be impacted by the new tax legislation. Further, REITs have a statutory imperative to maintain high dividend payouts. Believe that the dividend tax cut will not have a meaningful negative impact on REITs. In fact, based on a company by company analysis of 2002 payouts, we continue to believe the sector is more attractive on an income basis versus the broader market.
Transports . . . JP Morgan downgraded Fed Ex to Neutral from Overweight based on a slowdown in volume and relative valuation.. While margin trends were solid, volume growth slowed sharply at Ground and international, suggesting increased competition from UPS; with a further slowdown in ground volumes expected in fiscal 1st half 2004 the firm believes FDX's discount to UPS (25%) is appropriate.
Defense . . . Millennium Cell has been chosen to receive a grant from the U.S. Department of Energy (DOE) for hydrogen research and development. Funding in this first year is anticipated at up to $600,000, with total potential funding of $3.5 million over three years.
Identix receives $1.4 million in orders for new biometric ID product.
Consumer Products . . . CIBC believes that consumer staples stocks are poised to underperform the market after a 3-year bull run due to continued concerns regarding valuation, sector rotation, and increasingly difficult Year over Year comps. The firm thinks large-cap consumer staples stocks could be relatively overvalued by 15-20%, with the stocks most at risk including Clorox and Gilette, and they continue to favor those co's pursuing business models based on scale such as Proctor & Gamble, or niche-focused company's such as Scott’s and Jarden.
Retail . . . Autobytel.com was downgraded at B. Riley to Neutral from Buy after the company announced it has completed a 5 million share private placement. While firm believes ABTL is eying further acquisitions that may help it grow its business, they are more wary of co's that believe their stock is at an attractive enough price to issue equity. Target is $5.26.
Family Dollar reported earnings of $0.40 per share, in line with the consensus of $0.40. Revenues rose 15.1% year/year to $1.18 billion vs. the $1.17 billion consensus.
Stamps.com sues PayPal/eBay for breach of contract. The breach is tied to the implied covenants of good faith and fair dealing, and interference with contract, among other claims, with respect to the license agreement signed between Stamps.com and PayPal in June 2002. Stamps.com believes PayPal did not work to launch the Stamps.com functionality in any reasonable time frame, made misrepresentations to Stamps.com and acted in bad faith.
Rite Aid was upgraded at Morgan Stanley to Equal-Weight from Underweight. The firm is saying the company has been steadily reducing its risk profile through improvements in operating performance and cash flows, debt reduction and a major refinancing program which has pushed most of its 2005 debt maturities to 2008 and beyond.
Medical Devices . . . GKM resumes coverage of STAAR Surgical with an Outperform and $15 target. The firm believes the co is beginning to reap the benefits of two and a half years of restructuring, and even assuming extremely low market penetration rates the company's upcoming implantable contact lens. The FDA approval decision expected in 1st quarter 2004 could create a significant market opportunity for STAAR.
Healthcare . . . Fulcrum reiterated a Buy on Columbia Labs. The firm raised their 2004 estimate to $0.90 from $0.70, and increases their target to $17 from $11.50. The firm cites the removal of the FDA overhang on Striant, increased possibilities from the buccal delivery method, and their belief that pre-term labor studies could significantly increase company's feminine hygiene business.
Drugs . . . King Pharms received Notice of Paragraph IV Certification on Levoxyl from generic drugmaker KV Pharma. Although Levoxyl can be considered a major drug for KG, the news from KAVA should not be considered a major event as KG says its '581 patent covering Levoxyl extends through Feb 15, 2022.
Biotech . . . ICOS Corp new studies support Tadalafil safety and efficacy.
Human Genome announced its been cleared by the FDA for a new drug application to initiate human trials of ABthrax, which is an experimental drug for the prevention and treatment of Anthrax infections.
Medarex announced the publication of positive results from the initial cohort of 14 patients in an open-label MDX-010 Phase II melanoma study in the Online Early Edition of the "Proceedings of the National Academy of Sciences." In the study, an objective response rate of 21%, which included two complete tumor responses, was observed in the initial cohort of 14 patients with metastatic melanoma. The data also indicates that MDX-010 may be able to induce a reversible state of autoimmunity. "We are excited by these significant anti-tumor responses in metastatic disease and by the apparent correlation of tumor responses with the advent of Autoimmune Breakthrough Events."
First Albany initiated OSI Pharma with a Neutral rating and $27 fair value estimate. While the company's primary product in development, Tarceva, looks increasingly promising. The firm thinks that the genuine risks ahead (no Phase III data yet, crowded EGFR inhibitor field) are not fully discounted in the shares.
Affymetrix was cut to Peer Perform at Thomas Weisel on valuation. Price target $24.
Hotel & Leisure . . . Carnival reported 2nd quarter earnings of $0.21 per share, excluding a $16 million litigation charge, $0.01 worse than the consensus of $0.22. Revenues rose 34.8% year/year to $1.33 billion versus the $1.60 billion consensus. The company sees 3rd quarter EPS of $0.83-0.87 versus consensus of $0.93.
Media . . . Lazard Freres downgraded EW Scripss to Hold from Buy and cuts their target to $97 from $104. The firm reduced their 2003 EPS est. to account for lower revenue and higher expenses at the broadcast division, and lowers their 2004 est. due to a more conservative outlook for margins across the board.
Dow Jones guides for 2nd quarter as the firm sees 2nd quarter EPS of $0.23-0.25 in line with consensus of $0.23.
Smith Barney upgraded AOL Time Warner to In-Line from Underperform. The firm is saying they expect the bias to financial results to be more positive in the quarters ahead. while the company still faces challenges in the uncertain turnaround at AOL and ongoing federal investigations. The firm believes the stock's performance may get more in sync with its media/internet peers. The firm raised target to $17 from $11.
Pulitzer reaffirmed 2003 guidance in line with consensus of $1.99, during its presentation today at Mid-Year Media Review Conference in New York City.
The Wall Street Journal's "Heard on the Street" column discusses the Scholastic stock's ups an downs despite its Harry Potter franchise. The article discusses investors interest in the co's worth given both the strength of the Potter franchise and corporate doldrums of the past. It currently trades at 15.6x analyst analysts' consensus estimates for the fiscal year ended May 31. The question the article addresses is "which version" of the company will emerge as it enters the "inter-Harry lull". The business has seen weak orders, cuts in school spending and too many offerings. However, the company believes it is bigger and profitable with a current slowdown due to the economy and not a weak product.
Bank of America initiated coverage of Fox, Viacom and Disney Fox gets a Buy rating and $36 target, VIA gets a Neutral rating and $49 target, and DIS with a Neutral rating and a $21 target. The firm believes stocks in the entertainment sector already largely discount a continuing modest recovery in the advertising market in late 2003 and a strong 2004. In addition, firm notes a number of long-term secular concerns: after 2004 advertising should return to trendline growth of only slightly faster than nominal GDP, technology advancements are unlikely to yield significant new software replacement cycles, the benefits of globalization aren't materializing as once hoped, and further deregulatory gains will likely be modest
Telecom . . . AirGate PCS was upped to Market Perform from Underperform at Raymond James. The financial separation of iPCS has contributed to a marked improvement in co's financial and operational situation.
Consumer Electronics . . . Palm reported revenue upside on reduced losses for 4th quarter 2003 but provided tepid guidance for 1st quarter 2004 that was within expectations. While visibility remains limited and competition is intensifying, more pertinent question is on valuation -- using Apple Computer as a comparable (ex excess cash) on a P/S basis, we believe that Palm maybe fairly valued at current levels. As for 4th quarter 2003, Palm reported a proforma EPS loss of $0.30 (vs. loss of $0.62 a year ago) on revenue of $225.8 million, which beat our estimate of a loss of $1.00 on $184.7 million in revenue. The upside was due to successful launch of new products (Zire 71 and Tungsten C) and strong European sales. As for the balance sheet, cash declined from $264 million to $242 million. Palm is expects to burn $20-$25 million in 1st quarter 2004. From a larger perspective, Palm continues to face a number of challenges, including anemic demand, PalmSource spin-off and HAND integration. More specifically on the merger, while there are strategic positives (i.e., acquiring a product line, eliminating a competitor, and obtaining a design team known for creative products), competitive challenges from Microsoft-based products are intensifying. Analysts are maintaining a 2004 EPS loss at $2.00 but lowering revenue expectations from $898.9 million to $859.1 million owing to expectations for a more pronounced seasonal decline in revenue during 2nd half 2004. Analysts are maintaining 1st quarter 2004 revenue estimate of $181.7 million but reducing EPS loss from $0.91 to $0.82 on lower tax and other expense assumptions.
IT Services . . . UBS expects EDS shares to be weaker following news of $1.1 billion debt offering (which is higher than firm anticipated) and one notch downgrades by Moody's and Fitch. Reasons cited by the agencies for their actions included lowered 2003 free cash flow guidance and the magnitude of the company's projected cash charge for severance.
The Wall Street Journal reports IBM plans to show off its new software aimed at the small and medium sized business markets in an effort to penetrate Microsoft's turf. The new software will be unveiled in New York and will be priced 25% lower than Microsoft's for key products such as databases and Internet business software.
Storage . . . Thomas Weisel ups McData to Outperform and cuts Brocade to Underperform.
Network Equipment . . . RBC Capital started coverage of Interdigital with a $34 price target and a Buy rating. The firm said that IDCC's potential for further 2G and 2.5G license agreements, as well as its potential to sign 3G license agreements, lead it to believe that co is a compelling holding for longer-term, growth oriented investors.
For Nortel’s 2nd quarter 2003, expect revenues to be flat sequentially (in-line with consensus expectations). 2nd quarter 2003 results of potentially flat sequential revenues are below normal seasonal trends. We believe that bookings may also show some weakness with a book to bill below 1 (Book to bill was .9 last quarter). Therefore, believe the most likely scenario is that management does not given guidance but hints at revenues trends of flat to slightly down. On the EPS side, our and consensus estimates are for break-even. There could be a penny upside to our EPS estimate of break-even. Second quarter revenues usually benefit from some strong seasonal trends (usually up a few percentage points). Therefore, the trends for Nortel are weaker than expected (not what you would expect in a “recovery”). Part of this could be attributed to a stronger than normal 1st quarter, which makes the sequential comp more difficult. Mainly, in 4th quarter, expectations were set very low and the company was able to push out business into 1st quarter 2003. By segment, wireless and enterprise appear weak while wireline and optical may be experiencing continued stabilization. The wireless segment (40% of revenues) for Nortel likely experienced weak trends in the CDMA business. Spending with carriers such as Sprint is likely declining. Also, in the past couple quarters, Nortel has benefited from a couple of large software upgrades as well as a couple of larger projects that are now winding down (in China and with European carrier mmO2). Our checks also indicate that pricing remains quite aggressive. In fact, at Nortel’s recent analyst meeting, management mentioned that the company has walked away from certain bids due to aggressive pricing (more in the GSM market due to overcapacity). Margins in this business for Nortel are likely the second highest in the company, after the enterprise business. Margins for this business may come down slightly.
Nortel benefited last quarter from a couple large software upgrades. Also, the segment has benefited from higher mix of business towards switching and less on radio infrastructure.
The enterprise business (26% of revenues) for Nortel could be slightly down. The telephony portion of the business (60% of the segment) is outperforming the data networking portion. On the data side, Nortel is being impacted by the recent aggressive moves by Cisco. Nortel is trying to offset this weakness by being more aggressive on the telephony side. This strategy helps on two fronts. By being aggressive on the telephony side, revenues can benefit and more sales can be pushed to one of the more profitable product lines (possibly offsetting weakness in wireless – another of the more profitable business lines). The wireline business (23% of revenues) and optical (11% of revenues) will be up slightly. Based on checks with other major vendors, believe trends are stabilizing with a hint of a slight up-tick. Wireline was up 10% sequentially last quarter driven by circuit to packet (still relatively small) and general strength in the North America. Optical networking was the weakest segment, down 22% sequentially last quarter with business falling off in North America and Asia. Most vendors are experiencing some positive trends within their optical business this quarter. Lucent’s optical business could be up high single digits. Tellabs at SuperComm stated that they are experiencing a slight up-tick. Nortel should be seeing the same slight up-tick. Carriers continue to spend cautiously as their fundamental trends, while stabilizing, remain difficult. Therefore, we could see a slight up-tick in spending but carriers will likely remain at maintenance levels. Similar to the wireless carriers, many service providers are trying to pay down debt and generate cash flow. Capex is still the main lever carriers are using to
achieve those targets. On the positive side, RFPs (request for proposals) have increased recently and expect some level of stability. The issue remains pricing.
Gross margins were 42.9% last quarter versus 39.3% in 4th quarter 2002. Gross margins may show little if any improvement this quarter. Nortel is already close to its margins as seen in 2000. Pricing remains extremely aggressive and sales are not expected to experience a major bounce-back. Versus competitors such as Lucent, Nortel has done a good job getting gross margins in-line. Do not believe there is significant upside to the current gross margins in the near term. Conditions are still difficult for vendors. Significant excess capacity remains for most product areas. Also, vendors are very keen on capturing what little business is incrementally available.
The restructuring continues at Nortel. The company took incremental cash charges of around $180 million last quarter versus $300 million the two quarters prior. Another $600-$700 million in cash charges is expected in the remainder of 2003. Expect around $200-$220 million in the current quarter. Continue to be cautious on Nortel’s stock in the near term. Carriers are still experiencing revenue declines and dealing with balance sheet issues. Overall capex is likely to see a slow recovery. Also, Nortel is not in the best of positions from a portfolio standpoint to take advantage of certain spending trends in 2003. For instance, one of the areas that may see more spending is broadband. Nortel would not benefit in the near term because the company does not play in that area. As seen by Alcatel, broadband has been one of the strongest areas of spending, particularly internationally. The last issue is the stock’s valuation. Nortel appears slightly over-valued on an absolute basis and fairly valued on a relative basis.
Below is an analysis of Nortel’s valuation using several methodologies.
1. Based on a discounted cash flow analysis, Nortel is currently discounting 12% long term growth. That longer term Nortel’s revenues will track slightly over carrier revenue growth or around 6%. Other assumptions include 12% operating margins, 10% WACC and terminal growth of 4%.
2. Normalized P/E – If we attempted to normalize our 2004 estimate for Nortel we come up with earnings of approximately $.16. This analysis implies a price to normalized earnings of approximately 18x. For this analysis, assume an operating margin of 12%. Nortel typically has exhibited margins in the high single digits for the past several years (excluding 2001 and 2002 when there were larger losses), with peak margins just over 11%. Going forward margins will be in the high single digit range due to the level of overcapacity in the industry. Also, buying power at the carrier level is likely to continue to flow to an even smaller number of carriers. Larger
incumbents are likely to consolidate. The last negative factor we would like to highlight is the shift in revenues to the international markets. Revenues are continuing to move to such areas as China and the rest of Asia. Offsetting the negative factor for Nortel is the fact that they have exited many lower margin businesses such as access. Use 12% in analysis just to show that Nortel still seems slightly expensive even while using somewhat aggressive assumptions.
Enterprise value to sales – Nortel is currently trading at an enterprise value to sales multiple of approximately 1.2x. This multiple takes into account the debt position and forecasted burn rate over the next 12-18 months. In this environment, Nortel could trade anywhere from .7x sales to 1.5x revenues. Therefore, Nortel is in the middle of the range.
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