COMMENTARY: INVESTORS JUST WANT TO BUY STOCKS
The hot dogs must have been very good this past Independence Day, either that, or the talk around the barbecue was especially cheery, for investors returned from the July 4th weekend anxious to buy stocks. Despite growing unemployment rolls and an economy that refuses to supply any truly positive evidence of an imminent recovery, the major indices jumped to higher levels Monday and Tuesday. They hit a pothole mid-week, but bounced up again on Friday.
FOR THE WEEK, THE DOW JONES ticked up 50 points, or 0.6%, to close at 9120.
THE S&P 500 rose 12, or 1.2%, to finish at 998.
AND THE NASDAQ soared 71 points, or 4.3%, to lead all indices, and end the week at 1734 -- above the 1700 mark for the first time since May 2002.
Where is this rally getting its gas? Well, investors have been wandering the market desert for three-plus years. They've been pointed toward a lot of "recoveries" over that time, and they're tired of seeing mirages. Now they want the real thing. Apparently resigned to the fact that a true bull market won't come to them from "on high", investors seem determined to conjure one up all by themselves. To that end they are focusing almost exclusively on the positive. Seeing how 2Q earnings season officially began this past week with reports from Dow components ALCOA (AA, $25, unch.) and GENERAL ELECTRIC (GE, $28, unch.), investors will soon have piles of earnings reports to sift through for good news.
We've noted in the past that given the exceptional hopes economists, analysts, and investors have placed a second-half recovery, 2Q earnings shortfalls might not weigh too heavily on stocks. That is, investors could be willing to look past poor results in 2Q. This assessment of ours, however, did not preclude investors reacting strongly to positive 2Q earnings news. Filled with an urge to buy and maintain this rally, investors could easily concoct ample reason to buy stocks on POSITIVE 2Q results. In other words, they would be very selective with their news.
So far, early in this earnings season, that's happening. There have been at least as many disappointing and mediocre earnings results as there have been decent ones. The major difference has been in their effect. Positive results have so far helped push markets higher, while the damage done by disappointing numbers has been restricted to specific stocks. On Monday, for instance, hopes of a MICROSOFT (MSFT, $27, up 1) dividend and predictions for stronger chip sales pushed the markets higher (including the Nasdaq up 3.5%) -- even though on the same day two Tech companies and a major pharmaceutical firm issued warnings. Later in the week, uninspiring reports from both Alcoa and GE did nothing to dampen investor spirits. In GE's case, investors chose to overlook declining profits compared to a year ago, and instead concentrate on analyst upgrades on HOME DEPOT (HD, $33, unch.) and INTEL (INTC, $23, up 2).
Of course, there were exceptions to this trend. YAHOO (YHOO, $32, down 2.50) reported strong earnings and revenue growth, but the stock sank following its earnings announcement. This could have been due to a PE that remains afloat above the clouds -- in the triple digits.
This exception aside, you have to accept the fact that this rally wants to live on, and investors just want to buy stocks. We're happy to go along and enjoy the ride -- with our well established caveat that this rally does not have sound economic fundamentals to support it. We're happy to enjoy it because obviously our Portfolio holdings will benefit. But we are also more comfortable going along with this rally than many other investors have a right to be. After all, the stocks we recommend in our Portfolios are not overbought stocks and we are not counting on a speculative economic recovery and astronomical profit growth to make them sane, sound investments. The stocks we hold are growing, profit-making, companies right now. They can grow your wealth today -- and they're going to hold their value even when the "positive" news dries up and the overpriced stocks, especially in Tech, come drifting back down to earth.
Considering the alacrity investors have shown for keeping this rally going, we could see it going on for quite some time yet. Enjoy it, but if you don't have the right stocks, then don't get too comfortable!
ECONOMY WATCH
1. CONSUMER BORROWING HIGHER THAN EXPECTED
The Federal Reserve reported that Consumer Credit totals came down in May, although the numbers were higher than expected. Consumers borrowed $7.3 billion during the month, down from April's $7.9 billion -- which was revised from a previous estimate of $10.7 billion. But the number was well above economists' estimates of $5.0 billion. Revolving Credit, which includes credit card usage, at $3.1 billion, notched its highest monthly gain since February. But Nonrevolving Credit, which includes car loans and education costs, rose by less than April's $6.6 billion increase.
This report offers both good and bad news for the economy. On the bright side, it tells us that consumers are still spending, despite slow income growth and continuing job losses. But it also tells us that they're racking up a lot of debt in order to do so, which could cause problems in the future.
2. A DROP IN WHOLESALE INVENTORIES
The Commerce Department reported that Wholesale Inventories fell 0.3% in May, largely due to a 0.5% decline in sales. That marks the second consecutive month of lower Inventories, which fell 0.3% in April on a 2.5% drop in sales. The sales-to-inventories ratio was unchanged at 1.24, close to a record low of 1.21 set late last year. There's not much to glean from this economic report -- just the fact that low Inventories and a tight ratio mean an upswing in demand will have to be met by an increase in production. And that means that factories would have to increase their output, giving a positive jolt to the Manufacturing sector. Now, all we need is that all-important increase in demand!
3. JOBLESS CLAIMS HIT FIVE-WEEK HIGH
The Labor Department reported that Jobless Claims rose 5,000 to 439,000 last week, their highest level in five weeks. That pushed the four-week average -- seen as a more stable measure of the job market -- up 1,000 to nearly 427,000 claims. The average has now remained above the key 400,000 level for 19 straight weeks, and the improving trend we started to see last month has evaporated in the summer heat. The weak job market has been the biggest weight holding down this economic recovery, and the latest data didn't lend any helping hands.
4. WHOLESALE PRICES RISE
The Labor Department reported a 0.5% increase in the Producer Price Index last month. But while the overall rate rose by more than the 0.3% increase that economists expected, the Core PPI recorded an unexpected decline of 0.1%. The reason for the differing readings was a big 3.4% jump in energy costs, which aren't included in the Core rate. Gasoline prices were particularly strong, jumping 7.6%. Other than energy and food prices, most goods were cheaper last month than in May. For instance, car prices and communications equipment costs both slipped 0.7%. So, despite the increase in prices, this report doesn't do much to assuage fears of deflation.
MARKET MOVERS
I. ABBOTT LABORATORIES (ABT, $44, unch.)
Quarter 2Q02 2Q03
Revenue $4.3B $4.7B
Net Income $590M $245M
EPS $0.38 $0.16
Abbott's earnings fell a staggering 58% last quarter, as the drugmaker took a huge charge of $620 million, knocking off 34 cents a share from earnings. The stock didn't fall much on the news because Abbott had previously warned that it would take the charge, which is related to a legal settlement over misguided sales and marketing practices. Excluding the charges the firm earned 52 cents, in-line with Wall Street expectations. And Abbott held steady with its full-year earnings outlook of $2.20-2.25 a share -- excluding charges.
II. SUNTRUST BANKS (STI, $61, up 1)
Quarter 2Q02 2Q03
Net Income $335M $330M
EPS $1.20 $1.17
SunTrust's earnings fell 4% year over year, and earnings missed analysts' estimates by a penny. Net interest income slipped 2% to $810 million, but non-interest income rose 4% to $565 million, buoyed by continued strength in mortgages. Other positive developments were a 5% rise in loans and a 6% rise in deposits, as well as a 6% drop in nonperforming assets that allowed SunTrust to set aside 25% less money -- $85 million -- to cover bad loans. So it wasn't a bad quarter, but it wasn't a good one either. Hopefully, results from other banks like CITIGROUP (C, $46, up 2) and BANK OF AMERICA (BAC, $83, up 3) -- which will be released next week -- will be better.
III. PEPSICO (PEP, $47, up 3)
Quarter 2Q02 2Q03
Revenue $6.1B $6.5B
Net Income $875M $1.0B
EPS $0.48 $0.58
PepsiCo got a boost, not from its fizzy soft drinks, but from its Frito-Lay snack division. A 6% rise in division sales led to a 7% increase in overall company revenue. In addition, the firm benefited from lower costs related to its $13 billion acquisition of Quaker Oats, which the company bought in August 2001. Earnings matched expectations last quarter, and PepsiCo expects to post a profit of $2.18 a share, which would include 3 cents in merger-related cost savings.
IV. JUNIPER NETWORKS (JNPR, $14.48, up 1.15)
Quarter 2Q02 2Q03
Revenue $115M $165M
Net Income $6.2M $13.6M
EPS $0.02 $0.03
CISCO SYSTEMS (CSCO, $18.57, up 1.05) rival Juniper reported a profit that more than doubled, as sales surged 41% in a tough Telecom spending environment. Earnings of 3 cents a share were a penny better than expected. The company's CEO was "encouraged by both the broadband momentum around the world as well as the sound financial footing of Juniper Networks in the marketplace." So, are Juniper's results a sign that Telecom firms are finally starting to spend again, after years of overcapacity in the sector? We'll have a better idea when larger rival Cisco reports next month.
V. EMC KEEPS THE TECH MERGER TRAIN ROLLING
The mergers in the Tech sector keep on coming. In a sector which in recent weeks has seen a PALM (PALM, $17.34, up 0.79)/HANDSPRING (HAND, $1.06, down 0.01) merger -- as well as the contested PEOPLESOFT (PSFT, $17.84, up 0.03) acquisition of J.D. EDWARDS (JDEC, $14.54, up 0.04) -- the first major deal of the third quarter was announced today. Data storage firm EMC (EMC, $10.88, down 0.04) will acquire LEGATO SYSTEMS (LGTO, $9.58, up 0.87) for $1.3 billion in stock. The deal for Legato, a maker of storage software, gives EMC a larger software platform for its storage machines, which the firm has struggled to sell following the Tech bust. EMC expects the deal to be completed at the end of 2003, and to be accretive to earnings next year. We expect to see even more deals in the Tech sector in the coming weeks.
On another note, EMC offered a 2Q profit outlook that is in-line to slightly better than current estimates. The company expects earnings of 3-4 cents a share in the second quarter, vs. the 3-cent consensus estimate. And EMC projects sales to hit the high end of its previous $1.43-1.48 billion guidance range.
VI. SLOW SALES BEWITCH SCHOLASTIC'S PROFITS
Oh, no, Harry! SCHOLASTIC (SCHL, $27, down 3), publisher of the hugely popular Harry Potter line of books, warned that quarterly profits would fall short of Wall Street expectations, due to slow sales of trade books and weak book fair business. The company expects to report fiscal 4Q (ended May 31st) earnings of 71 cents a share -- well below analysts' estimates of $1.15. For the full year, Scholastic plans to turn a $1.45 profit, down from already-lowered forecasts of $2.00. The new results reflect a 17-cent charge that the company announced in May related to layoffs.
This sounds surprising, considering the amazing success of the fifth Harry Potter book, which set sales records across the board on its release last month. But sales of the book will be reflected in next quarter's results. So, the company is hoping for some Potter magic to prop up results next year.
VII. GONE ARE THE SALAD DAYS FOR WENDY'S
WENDY'S INTERNATIONAL (WEN, $28, down 1) offered up another earnings warning, blaming higher state corporate income taxes for its downward revision. The fast-food chain expects to earn $2.00 a share for all of 2003, down from previous forecasts of a $2.05 profit. Taxes will also lower the company's 2Q earnings, by 3 cents to 53 cents -- a penny below 2Q02 results. Additionally, Wendy's reported that same-store sales fell nearly 2% in June. Analysts blamed the recovery of rival MCDONALD'S (MCD, $23, unch.) for Wendy's sales pressure, as the Golden Arches rode the success of a few new products. McDonald's new Premium Salads are a true hit with consumers, lessening demand for Wendy's Garden Sensations salads. Now, McDonald's has a healthy alternative, which will keep the chain from losing as much business to its competitors, both in the fast-food industry and in the sandwich market.
VIII. EMPLOYEES WALK AWAY FROM STATE STREET
Financial firm STATE STREET (STT, $42, up 1) will take $295 million in restructuring charges, related to recently announced layoffs. The company will take the charges in the second quarter, resulting in an earnings hit of 58 cents a share. Three months ago State Street announced a round of 1,800 job cuts as part of a voluntary buyout plan. But apparently the terms were too good to pass up, and 3,100 employees accepted the buyout. So, the firm will hire 800-1,000 employees this year. But the net change in jobs at State Street is negative, which is all that really matters for the job market.
IX. MORE BUSINESS, MORE FOOD FOR DELTA
DELTA AIR LINES (DAL, $14.68, up 0.48) reported encouraging ticket bookings over the 4th of July holiday period, suggesting that many consumers may have returned to the skies for their travel needs. However, the data suggest otherwise: Traffic in the overall industry fell 4.1% in June and 6.1% for the whole second quarter. We'll see how real the pickup in air travel really is when the current month ends.
In other news, Delta was the latest airline to introduce food sales on its flights. Following in the footsteps of U.S. Airways and America West Airlines, Delta will offer what it calls "restaurant quality" food at a cost to its passengers, hoping to generate revenue through alternative measures. We'll have to try the food before we decide that it's "restaurant quality." Good luck with that!
X. DAIMLER CHRYSLER MAY TAKE A PAGE FROM THE MICROSOFT BOOK
Call it the MICROSOFT (MSFT, $27, unch.) effect. A day after the Software giant unveiled a groundbreaking plan to eliminate stock options and offer expensed stock grants in their stead, automaker DAIMLERCHRYSLER (DCX, $36, unch.) hinted that it would do the same. The company will explore alternative forms of compensation for its employees, such as bonuses tied to stock performance. In the meantime the firm will expense its stock options beginning in its 2Q earnings report, due on July 24th. U.S. rivals FORD MOTOR (F, $11.29, up 0.42) and GENERAL MOTORS (GM, $36, unch.) already do so. Stock options accounting have been a hot topic for a while, but Microsoft's move drew another spotlight onto the practice. Expect to see more companies come out with similar plans.
XI. NIKE GOES OLD SCHOOL WITH CONVERSE ACQUISITION
Sneaker maker NIKE (NKE, $54, unch.) bought longtime rival Converse for $305 million. Converse and its popular Chuck Taylor All-Star sneakers will provide Nike with a better presence in the growing retro shoe market. Late last year FOOT LOCKER (FL, $13.58, up 0.59) dedicated more shelf space to "old school" shoes like those made by Puma and Adidas, which have grown in popularity and cost significantly less than Nike's marquee basketball "kicks." Nike didn't mention whether the deal will be accretive to earnings. For those of you who are afraid that your next pair of Chuck Taylors will sport the Nike swoosh instead of the famous star logo, rest assured that Nike will keep the Converse brand intact.
XII. THE REAL THING? FEDS INVESTIGATE COCA-COLA FRAUD
We told you last month that COCA-COLA (KO, $44, down 2) was accused of misleading consumers by rigging a product test of its Frozen Coke beverage. Prosecutors from the Justice Department got into the mix today, initiating an investigation into the fraud charges. The SEC is already undergoing an investigation of the matter. Coke declined to comment on the investigations, except to say that the company will fully cooperate. The firm denied another major accusation, that over 80,000 of its Frozen Coke machines were defective and added their own ingredient to the drink: Metal residue. But Burger King, which sells the product in its fast-food restaurants will phase out the drink and stop using the machines. This news just adds to our opinion that Coke's shares will be frozen in place for a while (as we've been saying for years now. The stock was at $44 in March of 2000.)
XIII. CIGNA LOWERS EARNINGS ESTIMATES
After the bell today health insurer CIGNA (CI, $44, down 3) cut its earnings estimates for the current quarter and the whole year. Citing slower-than-expected progress in its Healthcare business, the company slashed its 2Q profit target to $150 million, or about $1.07 a share -- well below the $1.48 profit that analysts previously expected. For the full year, CIGNA should earn $725 million, or $5.12 a share. Analysts expected the firm to post a $6.00 profit this year. This goes to show you that not all Health insurers are alike. Invest in other Healthcare stocks we recommend (to see our picks, you must be a subscriber to THE BULL MARKET REPORT DAILY).
Good investing next week!
Todd Shaver
Editor in Chief
Editor@BullMarket.com
THE BULL MARKET REPORT
United States of America
Educating investors since 1997
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1. SECTOR-RELATED NEWS
TECHNOLOGY
MICROSOFT OPTS FOR NO OPTIONS
Bellwether MICROSOFT (MSFT, $27, unch.) sent a major signal to Wall Street and other Tech firms, by ending its use of stock options as employee compensation. The Software giant will stop awarding its 50,000 employees stock options, and instead award direct stock grants, and will expense them in their accounting. The new plan will take effect in September and reduce earnings in fiscal 2004 (ending June).
The firm will also restate past financial results to display the effect of the move, and employees currently saddled with underwater options -- those that have strike prices above the stock's current price -- will be able to sell them for their estimated value.
TODD'S TAKE: This was a surprising move by Microsoft, but a smart one. With accounting regulators looking into the possibility of requiring companies to expense their stock options, the company stepped up to the plate and addressed the issue itself. The market wants more transparency and disclosure, and Microsoft's change will provide that to investors.
And coming from Microsoft, the quintessential Tech company and the backbone of the Tech boom, that's big news.
But not all Tech firms agree that expensing stock options or eliminating them altogether is the way to go. Two other bellwethers -- CISCO SYSTEMS (CSCO, $18.57, up 1.05) and INTEL (INTC, $23, up 1) -- are staunchly opposed to the move. Both firms said that Microsoft's decision did not change their mindsets on the matter. Cisco called stock option plans "the future of the Technology industry," while Intel labeled expensing options as "bad accounting."
Perhaps the real reason why Cisco and Intel are opposed to options expensing is a financial one: The move will cost the firms big money. During the late 1990s, stock options became the chic form of non-monetary employee compensation, akin to the company car or day care services. About 7-10 million Americans hold stock options.
Microsoft currently has around 1.5 billion options outstanding, so replacing them with expensed stock grants won't be cheap. The firm addressed the issue of options expensing in May, estimating that doing so would have cost the company $650 million in its fiscal third quarter (ended March 31st). That would have dropped Microsoft's net income to $2.1 billion. 2000 profits would have been 13% lower than the $9.4 billion that the firm earned, while last year's results would have taken a 31% hit, or $2.4 billion, to a total income for the year of $5.4 billion, from the accounting change.
But for Microsoft, the new plan is a way to keep talented employees from jumping to faster-growing companies. The firm said that weak equity compensation was the chief employee gripe about working with Gates & Co. Options were great when the market was skyrocketing during the Tech boom. But as Microsoft's stock came back to earth, many employees who started working in the past few years have seen little to no benefit to holding their options.
Starting in September, though, Microsoft's new practice of awarding actual stock instead of merely the right to buy shares allows workers to profit even if the market doesn't go up.
Microsoft is no longer a high-growth, up-and-coming Tech firm. Instead, it's a mature company that makes hordes of cash. With fewer opportunities for big growth in the path ahead, the firm has realized that it should use its cash to add shareholder value. The first step was offering a dividend -- albeit a miniscule one. This is the next step. And it's a smart one, in our opinion.
Will the next move be a special $1 a share dividend? Watch the stock soar, and the market with it, if and when this happens.
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PHARMACEUTICALS
SCHERING-PLOUGH(ED) DOWN
TODD'S TAKE: SCHERING-PLOUGH (SGP, $17.08, down 1.98) drastically cut its earnings estimates due to sliding drug sales. The struggling Pharmaceutical firm expects 2Q results to come in at just 12 cents a share, 6 cents lower than expected. For the full year the outlook is worse, as profits could fall 66% year over year, to just 48 cents.
What's the reason for such a drop-off in profits? Usually in the case of a Drug firm, it means that the patent expired on one of its blockbuster drugs. That's exactly what happened to Schering-Plough. The company's antihistamine treatment, Claritin, was the definition of "blockbuster," selling for $100 a bottle and generating over $3 billion in sales at its peak. That amounted to one-third of Schering's total sales in 2001.
But the drug went off of patent protection in December, and NOVARTIS (NVS, $39, unch.) and WYETH (WYE, $48, up 2) were given exclusive rights to sell generic versions. That exclusivity runs out later this month, at which time a horde of other competitors will offer generic versions of the popular drug.
This change will cause prices to drop even further. Prescription Claritin currently sells for about a buck a pill, but one competitor plans to sell its generic version for as little as 10 cents a tablet. That would mean Claritin would sell for $3 a bottle -- $97 less than its peak price. Analysts expect the generics to steal a quarter of Schering's market, which would shave $70 million from the firm's sales.
Drugs go off of patent protection all the time, so how did Schering-Plough fail to prepare for this? You can chalk it up to a number of things, including unsuccessful moves to curb revenue loss and ambiguous outlooks for future Claritin sales.
One failed attempt to make up for Claritin sales losses was the introduction of Clarinex, a drug nearly identical to its older brother. That was the problem -- why would patients and health insurers pay significantly more for a drug that was virtually a carbon copy of a cheaper treatment? Insurers answered that question definitively, effectively preventing patients from switching.
Furthermore, management dropped the ball in preparing for the loss of such a big seller. They were reluctant to provide estimates for when Claritin sales would slow down, and instead surprised the market with earnings cut after earnings cut.
And dealing with a fallen giant isn't the only problem facing Schering-Plough. Two of its other major treatments, Nasonex and Intron A, aren't selling as well as expected. In fact, Intron A took a big hit from a Harvard research study which found that the drug did little to help its target patients, people infected with hepatitis C.
While we like the Drug sector, we know that not all firms are created alike. Schering-Plough has too many problems and too few potential blockbusters in its pipeline to be a bargain at this price level. We'd rather invest in PFIZER (PFE, $34, unch.), which has a variety of billion dollar revenue-producing drugs and new treatments on the way to market. Stay away from Schering-Plough if you know what's good for your portfolio's health.
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ECONOMY
JOBLESS RATE HITS NINE-YEAR HIGH
The Labor Department released its latest jobs report last week, with an unexpected result. Economists expected a rise from 6.1% to 6.2%, but the Jobless Rate jumped to 6.4% -- its highest level in nine years. 30,000 jobs were lost in June, and May job losses were revised upward, from 17,000 to 70,000. So far this year, over 235,000 jobs have been lost.
Additionally, Weekly Jobless Claims surged 21,000 to 430,000, surprising economists who expected a decline. Although the four-week average fell 4,500 to 425,000 -- its lowest level since the first week of April -- it remained above the 400,000 mark for the 18th straight week.
TODD'S TAKE: During the first half of 2003, we have seen improvement in the economy. The housing market showed few signs of slowing, and there are signs that the Manufacturing sector is on the road to recovery.
But one constant remains: There has been NO improvement in the job market.
The June Jobs Report tells us that this hasn't changed. The Jobless Rate is at a nine-year high. We repeat: The Jobless Rate is at a nine-year high. One of the reasons may be that the optimism in the economy drew prospective workers back to the job hunt. But obviously, the economy isn't ready to accommodate these additional workers.
Here's a look at some of the other numbers. While 610,000 new people decided to enter the work force, the total number of employed people rose by a mere 250,000. That's over 350,000 people who weren't looking for a job in May that are still looking in July. And the news isn't much better for the seasoned job hunters. Over half of the unemployed have been on the hunt for 12 weeks or more, and the average time that the prospective worker spent in the unemployment line was 20 weeks -- the highest level since 1984.
And as for that pickup in the Manufacturing sector, so far it hasn't translated into more jobs. In fact, the sector shed workers -- 56,000 of them.
If you're hoping that the job market will improve soon, we have some bad news for you. Even if calls for a second-half economic recovery are answered, it's not a given that more jobs will be created. Remember, capacity utilization is at its lowest level in over 20 years. And that means that economic output can rise without the addition of many workers. We need to see "strong and consistent growth," according to economists, before the job market shows significant improvement. And as optimistic as some economists are, no one thinks we'll see that any time this year.
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