A slight hint of rationality returned to Wall Street today after yesterday's hysterical shake-out, based on a few grunts from Greenspan. Stocks rose as higher-than- forecast earnings from companies including Motorola and Ford Motor helped the market rebound from losses tied to concern that interest rates may increase. Share prices advanced after Federal Reserve Chairman Alan Greenspan, in a second day of congressional testimony, said the economy's expansion had yet to bring ``broad-based'' inflation. Greenspan roiled investors yesterday when he suggested the Fed may raise rates sooner than some expected. The S&P 500 added 5 points (-0.5%) to 1124 after losing as much as 0.2 percent before Greenspan's testimony. The benchmark has risen four of the last five days. The Nasdaq gained 17 points (+0.9%) to 1995. United Technologies fell, weighing on the Dow Jones Industrial Average, after the company left its profit forecast unchanged for this year. The Dow rose 2 points to 10,317. Almost seven stocks declined for every six that advanced on the New York Stock Exchange. Some 1.73 billion shares changed hands on the Big Board, the busiest day since March 11. Tomorrow, we get another rush of earnings reports, highlighted by Merck, Microsoft, American Express, Amgen, and Caterpillar.
Strong Sectors: internet, networking, semiconductor, telecom, biotech, healthcare, hotel, airline, industrial Weak Sectors: gold, metal mining, coal, iron & steel, aluminum, paper products
Top Stories . . . The dollar rose to a five-month high versus the euro and climbed against the yen on expectations Federal Reserve Chairman Alan Greenspan will set the stage for raising borrowing costs.
EBay, the world's largest Internet auction company, said first-quarter earnings surged 92 percent as more people listed items for sale and used its PayPal e- mail payment service. The company's shares rose as much as 5.7 percent after it boosted 2004 revenue and profit forecasts.
Ford Motor, the second-largest U.S. automaker, said first-quarter net income more than doubled on higher profit from automotive operations and record earnings from car loans. The carmaker boosted its 2004 forecast.
Coca-Cola, the world's largest soft-drink maker, said first-quarter earnings climbed 35 percent, the biggest gain in a year, because of higher sales of Powerade sports drinks and Dasani bottled water.
Computer Associates said Sanjay Kumar stepped down as chairman and chief executive officer amid a two-year investigation into the company's accounting that led to the firing of 14 other officials.
Federal Reserve Chairman Alan Greenspan will tell Congress today where the central bank stands on growth, inflation and interest rates. His assertion yesterday that deflation is no longer an issue for the U.S. economy sent financial markets tumbling.
The Federal Reserve will have to raise interest rates ``significantly at some point'' to prevent growth from triggering inflation, said Robert Parry, president of the Federal Reserve Bank of San Francisco.
Quotes of Note . . . ``Greenspan's comments confirmed the U.S. economy is doing well. Earnings like Motorola's are evidence of that as they show profits rise not only because of cost cuts, but because they benefit from stronger demand.'' Juergen Lukasser, who oversees $6.5 billion at Constantia Privatbank.
``Stocks overreacted to concern interest rates may rise faster than some investors expect, Greenspan will be very methodical and move in small increments, just as he did on the way down.'' Carl Peterson, president of Parkway Advisors, which has $470 million in assets.
``Investors are worried about higher rates, but boy, we're getting some great earnings numbers too,'' said Patrick Becker, who helps manage $2.2 billion for Becker Capital Management.
Gurus . . . Barron's Online highlights Caspar Rock, a co-manager of the Munder Healthcare Fund, for his stock picks. Mr. Rock's fund has gained 72.3% over the last 12 months, handily outperforming the S&P 500 Healthcare Index. The fund currently holds Caremark Rx, Given Imagining, Rita Medical and has lately been buying Icon, Coventry Health Care and Amgen while reducing the fund's OSI Pharmaceuticals and Cytycs stakes. In the health maintenance organization sector, for instance, co's should continue to beat numbers on good pricing discipline and falling medical loss ratios. Elewhere, generic drug co's had a fantastic year in 2003 and there has been a lot of profit taking in names like Mylan Laboratories and Watson Pharmaceuticals. "Now, we see some interesting opportunities compared to six months ago when the stocks were probably fully priced," says Mr. Rock. He has added positions in Teva Pharmaceutical and in MGI Pharma at the end of last year because he felt the market was underestimating sales of Aloxi. Mr. Rock does not really like hospitality stocks, through he owns Community Health Systems. He prefers to play hospital sector with specialty plays, such as the long-term acute-care hospitals, like Select Medical or the outpatient surgical centers, like United Surgical Partners, which has a better reimbursement environment, a better cost position and better growth.
Barron's Online reports that the strong economy and astonishing stock market rally have pushed many stocks to premium valuations, even after some of them have slipped from their 52-w highs. And although retail sales and employment data have been strong recently, suggesting continued economic growth, some money managers are concerned that a close U.S. presidential election and an eventual rise in interest rates could lead to a stock market correction. Overall, "we feel the current market is expensive," says Jim Russell, portfolio manager with Fifth Third Asset Management. "There is no question co's are reporting very strong earnings," he continues. "But we are worried about the FED's actions and magnitude of raising rates, and we are also concerned about the possibility of a domestic terrorism attack between now and the presidential elections." Mr. Russell says he has been paring his position in some stocks that already reflect the recovery in the manufacturing economy, such as Fastenal and Parker-Hannifin. Stephen Goldfield, portfolio manager with Imperium Capital has been shorting utilities that have higher yields, low growth prospects and no obvious catalyst to drive their share prices higher as rates rise. Among his utility short sales: Progress Energy, WGL Holdings and Energy East Corp. Also, as rates rise, regional banks that rely too heavily on mortgage originations and refinancings may find there's no longer a pot of gold at the end of the rainbow. Big Southern and Midwestern regional mortgage lenders, such as Union Planters, Regions Financial and National City, which have prospered in the mortgage boom, could be particularly vulnerable.
Market Comment . . . The past week has seen economic reports continue to come in on the more friendly side of expectations. Indeed, following a long string of encouraging economic releases over in the past month, the Leading Economic Indicators Index (LEI) rose 0.3% in March, suggesting that growth should remain healthy in the second half of 2004. Still the year-over-year percentage change of the LEI slowed for a second consecutive month, arguing perhaps that the momentum of the economy, the factor that matters most for stocks, has already reached a cycle peak. The market’s lackluster reaction to all this good economic news is a sign of an impending change in market leadership — a transition that should witness the resumption of noncyclical sector leadership.
With most leading economic indicators perched near decade highs and employment growth finally showing tangible improvement, analysts wonder why more investors are not asking the question, “Why has the stock market failed to gain ground over the past three months?” Well, the answer is simple. Things are just too good! The market is a barometer of future as opposed to past business conditions, and the market’s failure to move higher seems to suggest that the consensus agrees that things can’t get much better than this. The best entry point for equities over the years has been when expectations for the economy are depressed (think March 2003), rather than when economic growth has reached a boiling point.
It is difficult for us to envision a future scenario where the equity market can deliver significant upside from here. Indeed, the friendliest part of the cycle for equity returns is now behind us. It is possible that the economy could continue to accelerate, but, in that case, interest rates would likely rise, compressing equity market multiples and limiting upside gains. Rather, if momentum in economic growth were to wane, cyclical sectors would fall out of favor, an outcome that is also consistent with limited gains. Thus, it
is increasingly clear to us that the environment for equities will not be as favorable over the next year as it has been during the last.
In essence, the range of possible scenarios point toward more measured returns for the equity market and noncyclical segment leadership. Indeed, noncyclicals usually outpace cyclical sectors when the Fed is tightening and when leading economic indicators are coming off the boil. Accordingly, analysts suggest overweighting noncyclicals is the better strategy for the rest of 2004. The best time to overweight cyclical sectors is when the leading indicators are accelerating and the Fed is easing rates policy. That, however, was 2003’s story.
Equity Outlook . . . While the fundamental backdrop is unlikely to support a repeat of 2003’s equity market gains, the outlook for equities remains constructive. Surely, with the Fed on hold and no sign of a recession in sight, equities should manage to hold their own. Nevertheless, a growing list of variables leads us to believe that the best of times are behind us. Ironically, the list underpinning our less-enthusiastic stance toward the stock market is the same one that supported our more bullish opinion a year ago. The only difference between now and then is the less-favorable readings of these indicators. The conclusion is that there is little near-term upside for the broad indices.
2003 2004
Macro Backdrop ISM Low ISM High
Echo Bubble Cycle Supportive Challenging
Valuation Attractive Stretched
Fed Policy Easing Neutral (Tightening?)
Technical Backdrop Oversold Overbought
2004: very different landscape than 2003!
The depressed, albeit improving, state of the economy in early 2003 was only one factor contributing to the favorable backdrop for stocks. Indeed, a look at a modified version of the Greenspan model shows that valuations were quite compelling at the time. Also, the equity market was favorably influenced by the tailwinds of the post-bubble cycle — all this while the Fed was easing policy and the technical backdrop was extremely oversold. From a contrarian standpoint then, the outlook could hardly have gotten any better for equities in early 2003. This year features a very different environment since leading indicators like the ISM are sitting near decade highs, valuations are no longer as compelling, the technical backdrop is less favorable, and the Fed is done cutting rates.
One of the elements contributing to the favorable backdrop for equities in early 2003 was valuation. Indeed, a modified version of the Greenspan model, which uses corporate bond yields instead of Treasury yields and sales instead of earnings, placed the S&P 500’s
valuation near the low end of its historical range. Conditions are very different this year, as the model now places valuation near the high end of its pre-bubble historical range. The rise in bond yields of late has contributed to this deterioration and shows just how sensitive the equity market has become to changes in interest rates.
Another interesting tailwind to the equity market in early 2003 was the influence of the post-bubble cycle. Indeed, the equity market has followed the pattern of other significant asset bubbles very closely in recent years. Post-bubble theory suggests that an asset class typically rallies an average of 16 months after a post-bubble low and then enters a range-bound environment. Ironically, the January 2004 peak in the Nasdaq came 16 months after the October 2002 post-bubble low — right on cue with post-bubble theory.
Interest Rates . . . The bond market sell-off of the past month has revived investors’ interest in the influence of interest rates on the equity market. Surprisingly, many market pundits argue that interest rates are not that important to the equity outlook. While some analysts are more constructive than many on interest rates, essentially viewing other areas as being of greater concern to equities at this time, the S&P 500 is more rate-sensitive today than it has been in several decades. A sustainable rise in the long end of the bond market would at the very least dampen equity returns going forward, in our opinion, or possibly mark the beginning of a bear market in stocks.
Interest rates have been a major boon for stocks over the past 20-odd years. Indeed, a quick breakdown of the two major contributors of equity returns will show that earnings have been accountable for about 60% of the growth in the equity market since 1980, while the decline in interest rates, or the expansion in the market’s multiple, has contributed the other 40%. Another way of analyzing the impact of rates on the equity market is simply to look at the performance of the S&P 500 in months where interest rates rose and those where they declined. Since 1970, the S&P 500’s annualized returns in rising rate periods have been 1.4% while those in declining rate periods have been 6.9%. History is clear: equities prefer declining interest rates.
The most common argument used by those who disregard the impact of interest rates on stocks is that the environment is “different this time” — a view that is likely supported by the fact that the stock market held its own last summer when rates rose. The reason the market did not react negatively at that time was because it was undervalued, and could therefore absorb the effect of higher rates. Investors should be warned not to underestimate the influence that a change in interest rate trends will have on the equity market.
The equity market is more rate-sensitive today than it has been in several decades because of high multiples, but also because of its constituents. Indeed, the S&P 500 currently has more interest-rate-sensitive stocks than it has had in at least 30 years. This makes the index somewhat more vulnerable to a rise in rates. The relationship between corporate bonds yields and the forward P/E of the S&P 500 shows just how influential the decline in rates has been over the past 20 years. Indeed, the S&P 500 sported a forward multiple of about 6.0x in 1980, when rates were very high, whereas it now stands in the high teens with interest rates near decade lows. The trade-off between changes in rates and those in the forward multiple shows that a 50-basis-point change in rates changes the fair value forward multiple by about one full point.
The one element that may very well compound the influence of interest rates on the equity market is the high proportion of rate sensitive stocks in the index. While the impact of interest rates has usually been only a P/E phenomenon, in today’s world it possesses a second avenue of influence since the financials sector now represents over 20% of the index. This implies that a rise in bonds yields would put extreme pressure on almost one-quarter of the index. It’s difficult to see how the S&P 500 could rise significantly if one quarter of its constituents decline!
All Roads Lead to . . . Noncyclical Leadership?
The rules of basic portfolio strategy suggest that the best time to overweight cyclical sectors is when the Fed is cutting rates and leading economic indicators are low and just beginning to rise. Since the Fed is no longer in easing mode, and leading indicators of the economy are sitting at 20-year highs, the risk/reward profile for owning cyclical sectors is no longer compelling. Rather, at this juncture, it seems that there are two potential scenarios that could unfold, both of which would favor noncyclical leadership. The first
scenario is that the economy remains red hot, causing the Fed to raise rates. The second scenario is that the economy loses steam on its own and the Fed remains benign. In either case, noncyclical sectors will likely outperform cyclicals.
In the first scenario, if the economy were to continue accelerating at full speed and leading indicators of the economy remained at elevated levels, the Fed would likely raise rates in the near term to prevent the economy from overheating. Higher interest rates would cause market multiples to compress, and equity returns would thereby be limited. As the chart above indicates, during the last 30 years, noncyclicals have typically outperformed cyclicals in the weeks leading up to and then following the first Fed rate hike. Thus, if the Fed were to raise rates, we would expect noncyclicals to assume market leadership, following this usual pattern.
The second scenario is that the economy loses steam on its own as the effects of fiscal stimulus wear off and the pace at which the economy has been accelerating starts to wane. As such, leading economic indicators of the economy would recede from current highs, indicating that the momentum of the economic recovery has begun to slow. In this case, the Fed could remain benign but noncyclicals would still likely assume leadership of the market, since they tend to outperform cyclicals when the second derivative of the economy (the pace at which it accelerates) begins to slow.
The second scenario is more likely to unfold since there are a number of indicators currently suggesting that the momentum at which the economy has been accelerating is beginning to wane. However, point out that either scenario leads to the same conclusion — noncyclicals should outperform cyclical sectors at this juncture. There are a number of other factors that also support a noncyclical overweight, including the valuation of cyclicals to noncyclicals, which shows that the risk/reward profile of owning cyclicals is not very compelling; Presidential election cycle theory, which suggests that noncyclicals generally outpace cyclicals during an election year cycle; and our quantitative analysis, which also confirms the transition
to noncyclical sectors at this juncture.
With many leading indicators of the economy sitting at, or coming off of, historical highs, we believe a transition phase in market leadership is under way. A turning point in cyclical pressures would have significant implications for sector performance. In fact, the economic cycle has proven to be one of the best gauges for measuring the risk/reward of cyclical positioning over the last few decades. With indicators of the economic cycle sitting at, or having recently declined from, historical highs, the cyclical trade has grown long in the tooth, and encourage investors to hedge their cyclical positions.
Finanicals . . . Countrywide reported earnings of $2.22 per share, $0.47 better than the consensus of $1.75. Revenues rose 52.7% year/year to $2.21 billion versus the $1.99 billion consensus. The company also raises guidance, now sees Y04 EPS of $7.00-8.25, versus the consensus of $7.19 and prior guidance of $6.00-8.00.
Knight Trading reported GAAP earnings of $0.26 per share, $0.04 better than the consensus of $0.22. Revenues rose 89.8% year/year to $239.8 million versus the $219.3 million consensus. The company raises full year EPS guidance to $0.75-$0.95 versus prior guidance of $0.65-$0.85 and versus consensus of $0.84.
Golden West reported very strong first quarter earnings of $1.93 per share, representing a ROE of 20%. Analysts are raising estimates and rating. This reflects view that returns will remain very
high and earnings growth will remain very strong, despite an expected increase in short-term interest rates later this year. The company's loan portfolio grew at a 24% annualized rate in 1st quarter. Analysts forecast portfolio growth at a 25% to 30% annualized rate for the remainder of this year and at a 20% rate in 2005, reflecting Golden West's ability to continue to generate new ARMs in a higher rate environment. The net interest margin remained relatively stable during the quarter (2.99% vs. 3.01% in 4th quarter), although it seems likely to decline when short-term interest rates increase. Expect strong loan growth to offset margin compression. Expect double digit EPS growth even as funding costs and mortgage rates rise. With NPAs at 48 bps and net charge-offs at 0.4 bps, credit risk remains very low. Golden West's capital levels remain much higher than many other lenders, even though its risk profile is better.
Friedman Billings Ramsey upgrades Northern Trust to Market Perform from Underperform in the wake of the 13% decline in NTRS shares since the co reported 4th quarter 2003 earnings and in light of the solid results the co exhibited for the Q1. Excluding the noise in the quarter, company's core fundamental trends suggest that rev drivers continue to improve while efforts to rein in costs last year have taken hold.
JP Morgan Chase reported earnings of $0.92 per share, $0.05 better than the consensus of $0.87. Revenues rose 6.8% year/year to $8.98 billion versus the $8.38 billion consensus. The company states, "In the first quarter, we delivered strong financial results and made significant progress on our merger integration with Bank One. Our quarterly earnings grew 38% year-over-year, due to stronger results in our capital markets-related businesses and continued improvement in our commercial credit portfolio. This combined strength more than offset the anticipated earnings decrease in Chase Financial Services as mortgage originations declined".
US Bancorp upped to Buy from Neutral at Advest. Price target $29. The firm believes the strong 1st quarter results provide further evidence that mgmt's hard work for turning around the company are paying off and USB is in the beginning stages of stronger revenue growth, improving credit quality trends and maintaining tight control of expenses. Further, with the stock down 12% year-to-date, firm believes it is oversold.
Charles Schwab reported first quarter operating earnings of $0.12 per share – 1 cent above estimate and inline with consensus. Also, the firm announced a 43% increase to its quarterly dividend (from $0.014 to $0.02 per share). Higher-than-expected asset management revenues drove the upside to our number. Partially offsetting this upside was comp expense, which crept up to 44.4% of net revenues. Overall, pretax margins remained flat with the prior quarter at just under 21%. Schwab's dividend increase announcement drives the firm's payout ratio above its 5 year historical average of roughly 12%. That said, taking 2004 and 2005 EPS estimates into account, we see it unlikely that this dividend increase will have any substantial impact on the firm's potential acquisition decisions over the next 12 to 18 months. At this time, analysts are raising our: 1) 2nd quarter 2004E from $0.12 to $0.13 per share; and 2) 2004E from $0.47 to $0.51 per share. 2005E remains at $0.55 per share.
Greater Bay Bankcorp reported earnings of $0.43 per share, $0.03 better than the consensus of $0.40.
REITs . . . REITs began reporting 1st quarter results last week, and earnings season should last through mid-May. On average, expect year-over-year FFO per share to decline 6.7% in 1st quarter 2004, compared to a 0.9% decline in 4th quarter 2003. Analysts project full year 2004 FFO per share to be flat for our coverage universe. Property markets remained relatively soft in the quarter, leading to anemic financial results; investment strategy continues to be a "lesser of the evils" exercise. In contrast, specialty finance fundamentals remain strong, which should result in positive earnings (4.3%). In the core property types, retail and industrial will lead, multifamily and office will lag. The economy appears to be improving. With the positive job growth data (as of April 2nd) and higher CPI than anticipated, fundamentals could begin to improve for sectors such as multifamily. Although it is too soon to invest in multifamily or office, the signaled inflection point will be sustained job growth; continue looking for an entry point. The recent pullback in REIT prices on the heels of a back-up in the interest rate markets perhaps signals the move of momentum investors out of REIT stocks. Do not believe it points to a bear market for
REITs however, though movement in the 10 year Treasury could influence the direction of REIT stock prices. Still anticipate low double digit total returns from REITs in 2004. For 2004, analysts are highlighting those sectors, and stocks, with better earnings growth potential, which should therefore generate higher total returns to shareholders. Recommend the industrial, retail, and finance sectors.
Oil & Gas . . . Arch Coal reported earnings of $0.14 per share, excluding gains related to sale of a significant portion of company's remaining interest in Natural Resource Partners as well as charges related to severance costs at soon-to-be-idled Skyline Mine and termination of hedge accounting for interest rate swaps, $0.04 better than the consensus of $0.10. Revenues rose 23.2% year/year to $403.5 million versus the $395.1 million consensus. Co also guides, sees 2nd quarter EPS of $0.20-0.30 versus the consensus of $0.22.
Transports . . . Ford, the second-largest U.S. carmaker, reported earnings of $0.96 per share, $0.52 better than the consensus of $0.44. Revenues rose 13.7% year/year to $38.84 billion versus the $36.56 billion consensus. The company sees 2nd quarter EPS of $0.30-0.35 versus consensus of $0.34, for 2004 now sees $1.50-1.60 versus consensus of $1.30.
Education . . . CSFB downgrades Devry to Underperform from Neutral after the company reported weaker than expected results. The firm also believes the environment for technology students could continue to provide a challenging headwind for the co over the near-term. Maintains $25 target.
Imaging . . . Eastman Kodak’s first- quarter profit exceeded analysts' estimates, and the world's biggest photography company raised its forecast for 2004 earnings to as much as $2.45 a share from $2.05 to $2.35. Eastman Kodak reported earnings of $0.18 per share, excluding multiple ex items, $0.01 better than the consensus of $0.17. Revenues rose 10.6% year/year to $2.92 billion versus the $2.89 billion consensus. The company sees 2nd quarter EPS of $0.55-0.65 versus consensus of $0.60.
Consumer Durables . . . Whirlpool, the largest maker of home appliances, said first-quarter earnings rose to $1.43 a share, surpassing the $1.38 expected.
Food & Beverage . . . Coca-Cola, the largest company to report earnings today based on market value, said first-quarter profit climbed to 46 cents a share because of higher sales of Powerade sports drinks. That beat the 43-cent forecast. Sales of $5.08 billion exceeded analysts' forecast of $4.89 billion.
Restaurants . . . Goldman Sachs downgrades Outback Steakhouse to Underperform from In-Line following weaker than expected results. In addition, firm says the stock's valuation does not reflect the company's below-trend 2004 EPS growth, margins are under pressure due to continued food commodity pressure, with no relief on still-high indirect labor costs, and they expect normalization of comp trends after a spectacular 1st quarter.
PF Chang's reports earnings of $0.27 per share, before special charges related to accounting modification for its partnership structure as well as the settlement of various California litigations, in line with the consensus views of $0.27. Revenues rose 29.0% year/year to $169.8 million versus the $169.1 million consensus. The company also guides, sees 2004 EPS of $1.27 (before special charges) versus the consensus of $1.27.
The Cheesecake Factory reported 1st quarter EPS of $0.32, in line with estimates and the consensus. Same store sales rose 6.1% in the quarter, above+5% expectation. Had commodity costs not unexpectedly increased late in the quarter, the company would have beat estimates by $0.01. Commodities cost the company $1 million - $1.1million (60bps as a percent of sales or $0.01 in EPS) more than expected, driven by higher fresh poultry and non-cream-cheese dairy costs. If commodity prices remain where they are, earnings will likely be negatively impacted by approximately $0.01 per share per quarter. Sales trends continue to be strong early in the 2nd quarter, although the company did not specify the degree. Cheesecake plans to take another price increase in the June/July time frame in order to help offset some of the higher cost pressures. Analysts are lowering 2004 EPS estimate by $0.03 to $1.36 from $1.39 due to higher commodity costs, slightly offset by increased sales. Analysts are lowering each of the remaining quarters by $0.01. We expect 2nd quarter to be more negatively affected by higher commodity costs, but some of this will be offset by lower than expected pre-opening costs in that quarter.
Drugs . . . Elan announced an agreement to license its proprietary NanoCrystal technology to Roche. In the agreement, ELN will provide Roche with formulation services and technology in exchange for research revenues, development milestones and royalties on sales of the product incorporating or made using NanoCrystal technology.
The WSJ reports that five years ago, Eli Lilly had high hopes for an experimental chemotherapy drug called Alimta. But after three patients taking Alimta died suddenly in 1999, Lilly halted trials of the drug. It looked like a fatal blow for Alimta, despite strong evidence that it could reverse tumor growth. Paolo Paoletti, the Lilly doctor running the trials, begged for two weeks to save the drug. He teamed up with a Rwandan mathematician, Clet Nyikiza, whom Lilly keeps on staff largely to study drug failures. By analyzing blood samples and medical records, Messrs. Paoletti and Nyikiza identified a surprising problem with an unexpectedly simple solution. Today, Alimta is an approved treatment for mesothelioma, a rare type of cancer caused by exposure to asbestos. It's under FDA's consideration as a treatment for lung cancer, a much more common ailment. Alimta's resurrection helps illustrate why Lilly is coming out with a flood of new medicines even as many of its competitors struggle to replace blockbuster drugs coming off patent. Lilly has long had a culture that looks at failure as an inevitable part of discovery and encourages scientists to take risks. If a new drug doesn't work out for its intended use, Lilly scientists are taught to look for new uses for a drug. Other drug company's are also seeing the importance of tolerating, and learning from, failure, a valuable strategy since about 90% of experimental drugs in the industry fail. For example, Pfizer originally developed the blockbuster impotence drug Viagra to treat angina, or severe heart pain.
The greatest positive differentiation of Pfizer relative to its peers is the size, depth and breadth of its business which, while making it hard to move the needle up, also makes it hard to move the needle down. These factors create for Pfizer a vastly different (lower) risk profile relative to its peers, assuming the company successfully fends off the Lipitor patent challenge (trial starts in November). Additionally, analyst have always been a fan of its two mergers—Warner Lambert and Pharmacia—the results of which allow the company to generate unprecedented cash flow, buy growth (and write billion dollar checks) and return monies to shareholders via share re-purchases and dividend increases. These factors also contribute to a lower risk profile.
The company’s normalized earnings growth rate is about 10%. We believe that the base business (excludes the pipeline and products which lose exclusivity) can grow revenues in the mid-to-upper single digits–the expected loss of around $5.0 billion in sales due to patent expiration/successful challenges is offset by roughly $5.0-$7.0 billion in new product revenue. Although after tax margins are relatively high they could go higher as gross profit margins could tick up modestly, while R&D and SG&A should grow less than sales. EPS should be leveraged by share repurchases. In sum, 7-9% top-line should be leveraged into about 10% bottom-line and all with below-average risk. Higher risk periods to keep in mind reflect Lipitor litigation and include this summer when there is a risk of summary judgment (although likely a low probability event) and as the company gets closer to the Nov. 30th trial date. Additionally, 2006-2007 gets more challenging due to the expected loss of exclusivity on Zoloft in 2006 and Norvasc and Zyrtec in 2007.
However, by 2006-2007 the company should be experiencing the launch of several waves of new products ranging from small incremental line-extensions to billion dollar blockbusters, including some new products which could be transformational even for a company this big, for example torcetrapib for HDL raising/LDL lowering, varenicline for smoking cessation and, to a lesser extent, Macugen and Exubera.
Media . . . Sirius Satellite reports a loss of $0.12 per share, not clear if this is comparable to consensus of ($0.10). Revenues rose 481.3% year/year to $9.3 million versus the $9.0 million consensus. The company added 91K subscribers approx in line with Analyst estimates. For 1st quarter of 2004, average monthly revenue per subscriber, or ARPU, was $9.92, excluding the effects of mail-in rebate programs, ARPU was $11.06.
Yahoo Japan, the country's biggest Internet auction operator, said fiscal fourth-quarter net income doubled to 7.7 billion yen ($71 million) because customers bought and sold more on its Web sites, boosting fees. Yahoo owns 33 percent of Yahoo Japan.
Hotel & Leisure . . . MGM Mirage reported earnings of $0.70 per share, ex items, $0.23 better than the consensus of $0.47. Revenues rose 12% year/year to $1.07 billion versus the $1.00 billion consensus. The company sees 2nd quarter EPS of $0.51 inline with the consensus of $0.51.
Harrah's reported earnings of $0.76 per share, ex items, $0.10 better than the consensus of $0.66. Revenues rose 4.7% year/year to $1.11 billion versus the $1.07 billion consensus.
Penn National Gaming reported earnings of $0.52 (excluding Hollywood Casino - Shreveport) per share, $0.11 better than the consensus of $0.41. Net revenues (excluding Hollywood Casino - Shreveport) rose 38.3% year/year to $293.9 million versus the $285.2 million consensus. The company also raises 2004 EPS guidance (without Hollywood Casino - Shreveport) to $1.90, versus the consensus of $1.76 and prior guidance of $1.75.
Telecom . . . SBC Communications, the second-biggest U.S. local-telephone carrier, had first-quarter earnings of $0.37 per share, ex items, $0.05 better than the consensus of $0.32. Revenues fell 2.4% year/year to $10.13 billion, not comparable to consensus estimates as quarter SBC's reported revenues do not include revenues from Cingular Wireless, of which it has 60% ownership.
CIBC upgrades Sprint to Sector Perform from Sector Underperform to reflect the imminent inclusion of PCS wireless assets starting 4/23. The firm is more positive on the newly combined Sprint given that the inherent conflicts in the tracking stock format are gone, wireless fundamentals are robust and FON has valuable local exchange assets, half of which are rural and do not seem fully reflected in a sum of the parts valuation. The firm believes FON is fairly inexpensive at 5.1x estimated '05 EBITDA.
EarthLink reported 1st quarter results: revenue was in-line, while OIBDA and EPS were ahead of our estimates. With cost savings being realized earlier than expected, management significantly increased its 2004 OIBDA guidance, while maintaining its revenue guidance of 1% to 3% growth. Management now expects 2004 OIBDA to be up in the range of 27% to 42% (vs. 2003), compared to its previous guidance of 1% to 16% growth. As a result of the increased visibility on the cost side, analysts are raising 2004 OIBDA estimate 21% from $149 million to $180 million, equal to 34% growth year-over-year. Analysts are maintaining 2004 revenue estimate of
$1.43 billion, equal to 2% growth. Yesterday's 4.4% increase in ELNK's share price can be attributed to the stronger-than-expected OIBDA guidance revision; however, sustainable share price appreciation will only come once there is improved visibility on top-line growth.
EMS . . . Sanmina-SCI, world's third-largest maker of electronics for other companies, said profit for the second quarter ended March 27, excluding some costs, was 5 cents a share. On that basis, the company was expected to earn 4 cents.
Sanmina-SCI upgraded at Soundview on stronger than expected results.
Storage . . . Imation reported earnings of $0.60 per share, $0.01 better than the consensus of $0.59. Revenues rose 24.1% year/year to $339.3 million versus the $339.0 million consensus. C.E.O.- "We believe we can deliver 15 percent revenue growth for the full year, at the high end of our previous projections. In addition, we believe operating income can grow to a range of $123 million to $127 million, up from our previous guidance of $120 million to$123 million."
Network Equipment . . . Motorola said that first-quarter profit more than tripled because it's winning market share with phones incorporating cameras, color screens and MP3 music players. Excluding some items, it earned 19 cents, almost three times the average analyst forecast of 7 cents. Second-quarter profit will be as much as 18 cents, with handset sales rising up to 80 percent from a year ago, Motorola said. Analysts forecast a profit of 9 cents in the second quarter.
Tellabs reported earnings of $0.05 per share, excluding items, $0.05 better than the consensus of $0.00. Revenues rose 18.6% year/year to $263.8 million versus the $252.5 million consensus. Stronger revenues, improved margins and lower expenses contributed to company's first profitable quarter in two years.
Analysts baffled by the unbelievably strong quarter by Motorola with upside literally everywhere including infrastructure, semiconductors, cable and government, not to mention handsets. Most firms out this morning raising their estimates for 2004 and 2005. On the margin front, Smith Barney out noting they think that the greatest inflection point in operating margins or profitability has occurred with the handset margins doubling from 5%- 6% to around 10%. While they expect margins to improve from this level, the expansion will be governed by revenue-driven leverage and longer-term initiatives such as improving engineering efficiency. Firm is increasing their target to $25 from $22 as 2004 EPS estimate moves to $0.77 from $0.43 and 2005 moves to $0.90 from $0.64... UBS out noting they think the key to Motorola's stellar performance in the handset business was due to the combination of a solid new lineup of new products, strong market growth (possibly over 30% year-over-year) and a weakened Nokia, which enabled the co to grow unit volumes 13% sequentially and increase ASPs 12% sequentially. Firm believes good fortune in handsets will likely continue in the current quarter with Nokia's intention to cut prices not hurting the mid-tier segment of the market, but more likely lower end products. Firm raises target to $25 from $21. CIBC upgrades to Sector Outperform, noting that it appears MOT is firing on all cylinders for the first time in recent history. The firm raises 2004 to $0.90 from $0.45 and FY05 to $1.25 from $0.69; tgt $25
RW Baird upgrades Foundry Networks to Outperform from Neutral based on solid fundamentals and valuation, as the stock is down 54% from its Jan 20 high; firm thinks that investors can buy the stock in front of the quarterly call on April 29 because bad news is expected, and they feel the risk is that the co has a more positive call than Q4's and the stock could recover $2-$4 from current levels. The firm says that on the call, mgmt needs to do a better job of articulating its strategy to the Street and provide a realistic industry outlook vs its previous "Armageddon" forecast. Target is $25.
AmTech upgrades Qualcomm to Buy from Hold: 1) the firm believes the global handset market is stronger than most investors have expected and will continue to exceed expectations - growth rates and ASPs continue to rise (QCOM's fixed % of royalties will go up with rising phone prices). 2) As evidenced by datapoints streaming from wireless carrier reports, CDMA carriers are gaining share in North America, the largest CDMA market in the world. 3) CDMA chipset competitors look weak as CDMA substitutes have not harmed the company's business to date. Nokia's weakness means more market share for QCOM. These factors should create a financial template for QCOM numbers to go upwards in trend and higher than current expectations for all of 2004.
Research In Motion signs agreement with Motorola to license RIM's technology under RIM's BlackBerry Connect licensing program. Through this deal, Motorola will have the option to enable specific mobile phones to connect to BlackBerry services including support for both BlackBerry Enterprise Server and BlackBerry Web Client.
Semiconductors . . . JMP Securities out positive on Advanced Micro Devices saying simple, sum-of-the-parts valuation could yield a $26 valuation for AMD, suggesting levels 50% above current trading price and 30% above their current target. According to the firm, AMD's flash memory business estimated to be worth $3.5 billion to AMD shareholders as is can achieve $3 billion in revenues by 2005. Also, applying a 3x revenue multiple (low end SOX average) to AMD's processor revenues of $3 billion in 2005 yields an implied market capitalization of $9 billion; assuming 475 million fully-diluted shares outstanding by the end of 2005 would imply a $26 stock by 2005. Firm notes the co could potentially unlock the hidden shareholder value in their FASL Flash memory JV through an IPO followed by a tax-free spin-off to shareholders. Any strategic sale of the Spansion Flash memory business would improve AMD's balance sheet immediately through cash additions, debt pay-down, and improving AMD's debt/equity ratio.
CIBC upgrades Applied Micro to Sector Perform from Underperform following strong 4th quarter results, as they think the bias on the stock has changed to positive from negative. The firm also cites their belief that momentum in the company's core WAN business should continue, and they expect accretive, strategic acquisitions.
Germany and Italy are under a formal European Commission probe for tenders favouring computers with Intel chips, barring fair competition by rival AMD, a Commission spokesman said. Austria, Belgium, Finland, France, the Netherlands, Sweden and EEA member Norway are also being looked at. "Italy and Germany are subject to formal infringement procedures and we are investigating the other countries," Commission spokesman Jonathan Todd said in response to an inquiry by Reuters. Governments may be paying far too much for computers because thousands of tenders across the European Union specify Intel chips by name, or more indirectly, he said.
DSP Group reported earnings of $0.24 per share, pro forma, $0.05 better than the consensus of $0.19. Revenues rose 33.4% year/year to $38.7 million versus the $37.6 million consensus.
Prudential downgrades Semiconductor sector to Neutral from Favorable as several data points lead firm to suspect that above seasonal semiconductor order rates in the MarQ are being driven by inventory replenishment in selected markets. The firm expects the second derivative on rev growth to peak during the June Quarter and believes that the group will realize most of its operating leverage by the 2nd half 2004. The firm downgrades TXN and Analog Devices to Neutral Weight from Overweight, STMicro, Marvell Tech, Agere to Underweight from Neutral Weight, upgrades ALTR to Neutral Weight from Underweight, and Maxim Integrated, Linear Tech to Overweight from Underweight. The firm cuts targets on PMC Sierra to $14 from $18, Broadcom to $48 from $50, Intel to $33 from $39 and Xlininx to $46 from $52.
Software . . . Sybase reported pro forma earnings of $0.18 per share, $0.01 worse than the consensus of $0.19. Revenues rose 0.9% year/year to $183.2 million versus the $184.0 million consensus. The company also reaffirms 2004 EPS guidance of $1.08-1.10 versus the R.R. consensus of $1.08.
First Albany upgrades Check Point to Buy from Neutral on the heels of the second quarter in a row of solid results. Even though the stock has had a strong move this year, the firm sees more upside potential, based on: 1) recent sales momentum should continue with new product releases throughout the year; 2) company's core firewall/VPN products sell into an important part of the security space; and 3) company will finally have a true answer for the hot SSL VPN space next month.
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