U.S. stocks fell for the first day in four on concern the prospect of higher interest rates has eroded the profit-growth outlook that fueled a three-week rally. Technology companies such as Intel paced the decline after helping to lead benchmark indexes' advance from their 2004 lows. Coca-Cola retreated after the world's biggest maker of soft drinks said its president will leave. The S&P 500 shed 10 points (-1.0%) to 1,131, its steepest decline since May 17. The Nasdaq Composite lost 33 points (-1.6%) to 1,990, its biggest drop since April 30. Strength from telecom giants Verizon and SBC Communications softened the decline in the DJIA, which fell 64 points (-0.6%) to 10,368. Three stocks declined for every one that advanced on the New York Stock Exchange, the broadest selloff since May 10. Some 1.28 billion shares changed hands on the Big Board, the 10th straight day that volume was below the three-month daily average.
Top Stories . . . Crude oil futures fell to a six-week low in London amid expectations U.S. fuel supplies increased last week, easing concern shortages of gasoline will develop.
Bank One, Invesco Funds Group and Conseco may reach agreements with U.S. regulators as early as this month to settle allegations that they permitted improper mutual fund trading, people familiar with the situation said.
Petro-Canada, Canada's third-largest oil company, agreed to acquire Denver-based oil and gas producer Prima Energy for $534 million in cash, the companies said.
Inventories at U.S. wholesalers unexpectedly fell 0.1 percent in April, the first decline in eight months, as companies couldn't keep up with demand for products including pharmaceuticals and imported automobiles.
The dollar rose the most against the euro in a month on speculation government reports tomorrow will show faster inflation in the U.S., underscoring the potential for the Federal Reserve to raise interest rates more than some traders had expected.
Quotes of Note . . . ``Companies will find it hard to sustain the level of earnings growth we've had in the past year. The earnings side will slow down.'' Peter Lucas at Ashburton Ltd. in Jersey, U.K., which manages $1 billion.
Gurus . . . John Berry is a Bloomberg columnist, but he used to be a financial writer for the Washington Post, with a pipeline into the Fed. He says the Central Bank will do the expected 25 basis points on June 30th, but the Fed is on the alert for inflationary pressures, and will act accordingly. On the other hand, there is still plenty of slack in the labor market, and the pace of job growth is not so rapid, as to suggest a rush to full employment. When the Fed has raised rates aggressively, it has been trying to slow growth. At this point, officials are more interested in removing some of the monetary stimulus. Thus while, the process of raising rates begins this month, anything more aggressive will await the data.
Leo Guzman runs a brokerage that specializes in index-related trades, so he likes to handicap potential changes in the S&P 500. Due to upcoming deal conclusions, several stocks will be removed, including Bank One, WellPoint, and Charter One. He sees replacements in Gilead Science, CIT Group, and Vornado Realty. Coach Inc. can also be a candidate.
Gas Prices . . . U.S. drivers should see slightly lower prices at the pumps later this summer when more oil exports from OPEC arrive in U.S. ports and help lower gasoline prices, the federal government said Tuesday. The national price for regular unleaded gasoline will average $1.89 a gallon from July through September, the federal Energy Information Administration (EIA) forecast, down from the $1.94 previously estimated.
Mortgages . . . Applications for mortgages at U.S. banks declined 8.9 percent on a seasonally adjusted basis last week. Applications for purchases fell 6 percent while applications for refinanced loans dropped 13.9 percent. The week was shortened by the Memorial Day holiday. The average rate for a 30-year fixed loan rose by one basis point to 6.25 percent from 6.24 percent. The share of refinanced loans dropped to 32.6 percent of all applications from 34.3 percent the previous week.
Housing Bubble . . . Mortgage rates have not risen to a level that threatens the health of the U.S. housing market, said Treasury Secretary John Snow. During an appearance on the CSPAN public affairs cable channel, Snow was asked whether the U.S. housing market might decline sharply, in a similar fashion to the stock market in the late 1990s, because of higher interest rates. "The housing market is a lot different from the equity market...I don't fear anything like that," Snow replied.
Market Comments . . . The strength of the global expansion is still being underestimated. Until recently, U.S. demand growth, particularly consumer demand, has been the key engine for the global economy. Two important shifts are underway:
• Domestic demand outside the U.S. is finally growing strongly, reaching its fastest pace since 1990. We think the foreign economies have pent-up consumer demand from years of economic sluggishness, pointing to durable growth in demand going forward as employment rises.
• U.S. demand growth is shifting toward corporate spending. Corporations are unusually liquid. They are ending a period of risk aversion, low inventories, slow growth in hiring, and cautious business investment. In contrast with foreign economies, the U.S. probably doesn’t have as much pent-up consumer demand.
• Thus, there is a global shift toward faster total demand growth characterized by consumer demand abroad and corporate demand in the U.S. Recent GDP reports for most major industrial economies showed strength in domestic demand and improving prospects for job growth. Both factors point to a durable global expansion and a healthy increase in its breadth. Improved domestic demand growth abroad should reduce the dependence of the global recovery on the U.S. while adding an additional growth source for the U.S. As
global employment increases, it should add further to most countries’ domestic demand, creating a virtuous circle of gains in employment and demand.
• Demand growth in the world’s second through fifth biggest economies – Japan, Germany, the UK and France – reached a 3.6% two-quarter annualized growth rate. This is the fastest growth in their combined domestic demand since 1990.
• Adding in the U.S.’s $11 trillion of GDP, the five largest economies have GDP over $21 trillion in 2003, nearly two-thirds of the global total. Fast-growing China’s 2003 GDP was $1.4 trillion, an additional 4% of the total.
Domestic demand in the U.S. remained relatively strong during the recession. Going forward, we expect growth in domestic demand (sales to domestic purchasers, both household and business) to shift some toward corporate spending on inventory and business equipment.
Look for continued improvement in U.S. labor-market conditions. If so, incomes will grow, supporting consumer spending going forward. From the trough in August 2003, non-farm payroll employment has increased by more than 1.4 million jobs. Look for another 1.4 million jobs over the final seven months of 2004.
Japan
In a turnaround, Japan has recorded the strongest rebound in the industrial world over the past two quarters. After stagnating for more than a decade, the Japanese economy is coming out of deflation, helped by the reflationary value of the yen.
While export growth has played an important role in the turnaround, stronger domestic demand – and especially rising business investment spending – has been at the core.
• Real GDP grew at a 6.2% annual rate over the past two quarters, with the external sector contributing less than a quarter of that. Nearly 2/3 of the contribution from domestic demand was from private-sector investment spending.
• The Japanese consumer has also come to the party. Real household spending rose a seasonally adjusted 7.2% year-over-year and 9.3% in April from March, the largest monthly increase on record.
Japan’s GDP growth is now well above IMF/OECD estimates of its longer-term potential growth rate, helping labor-market conditions improve. The unemployment rate is down 0.5 percentage points in the six months to April to 4.7%, its lowest level in three years.
U.K.
Domestic demand growth has been the major driver pushing British GDP growth above mainstream estimates of the economy’s longer-term potential. However, with the unemployment rate at its lowest in nearly three decades, the Bank of England has already begun to take back some of its monetary accommodation with three 25-bp rate hikes since November 2003. Look for at least two additional 25-bp increases in the base lending rate before the end of 2004. In the first quarter of 2004, British household consumption rose 3.6% quarter-over-quarter annualized and business investment spending rose 4.4% qoq annualized. The external sector (imports over exports) exerted a significant drag, holding GDP growth to 2.4%.
Germany
The German economy continues to be the economic laggard in the industrial world. Even with a larger-than-expected 1.6% qoq annualized increase in the first quarter of 2004, GDP growth remains below already depressed IMF/OECD estimates of longer-term potential.
Moreover, in contrast with the other economies examined above, German domestic demand remains lackluster, with the recent economic rebound still relying mostly on exports. While business investment spending on equipment has staged a comeback over the past couple of quarters, consumer spending and construction activity continue to drag down overall GDP growth.
• Expect that the rebound in Germany’s investment spending will broaden over the rest of 2004, propelling the overall economy to above-trend growth during the second half of this year. Even with this pickup, however, Germany will likely be the poorest performing of the major industrial economies in 2004.
Financials . . . Ruchi Madan at Smith Barney said she was getting "increasingly bullish" on State Street, and recommends buying the stock "right now." Madan feels that the recent weakness in the stock has created an attractive entry point and that higher rates will benefit earnings. In addition, she raised her 2005 earnings forecast to $3.25 a share from $3.15 a share, and believes revenue could grow 17 to 18 percent over the next few years from prior projections of 9 percent growth.
Sanders Morris Harris initiates coverage of E*TRADE with a Buy rating and $15 target. The firm believes that the co is now well situated to excel in the rapidly expanding on-line brokerage and banking businesses, and accelerate its push for more mkt share, which should lead to faster earnings growth. Firm also finds the current price of ET at least 30% undervalued based on the closest comparable publicly-traded co's.
United Bankshares will sell its mortgage banking subsidiary, George Mason Mortgage, to Virginia-based Cardinal Finance in an effort to make future earnings "less volatile," and to payback long-term debt. The company said it would receive George Mason's tangible net worth plus $17 million in cash for the sale. United Bankshares plans to use the proceeds to repay long-term advances of about $135 million provided by Federal Home Loan Bank, which will lower annual interest expenses by $8.7 million, but lead to a charge of about $16.8 million. "With an increasing interest rate environment approaching, we believe the time was right to sell our mortgage banking subsidiary," said Chairman Richard Adams.
Oil & Gas . . . Prima Energy agreed to be acquired by a Petro-Canada (PCZ: news, chart, profile) subsidiary for $534 million, or $39.50 a share in cash. That represents a 0.2 percent discount to Tuesday's closing price of $39.56.
The Energy Department reported that crude stocks for the week ended June 4 were up 400,000 barrels at 302.1 million barrels. Motor gasoline supplies rose 2.1 million barrels in the latest week to 206.4 million. Distillate inventories were down 600,000 barrels at 108.3 million barrels. Following the news, July crude is down 78 cents at $36.50 per barrel. July unleaded gasoline is down 3.43 cents at $1.132 a gallon and July heating oil is down 1.41 cents at 94.7 cents a gallon.
Homebuilders . . . The WSJ's "Ahead of the Tape" column highlights homebuilders, which may fall short of expectations. Monday night, Dominion Homes warned that its Q2 results would not meet expectations, citing a 15% drop-off in gross sales for April and May and a jump in cancellations that led to a 35% decline in net sales. As far as the home builders go, Dominion is small player in the field and Dominion does about 70% of its business with first-time buyers, people who are heavily dependent on financing and, as Dominion pointed out, are more likely to delay buying in a rising-rate environment. That isn't the position that most of the big builders, which sell houses with higher price-points than Dominion, are likely to find themselves in. Their core customers have higher earnings, longer credit histories and, most important, equity that they have built up in the homes they already own. But just because the rise in rates may not affect outfits such as Toll Brothers as directly as it affected Dominion, big builders have reason to fret. To trade up into a bigger, more expensive home, a customer has to do something about the old home first. "First-time buyers are the suckers who are supposed to buy my house at its inflated price so I can move to a McMansion," says Northern Trust chief U.S. economist Paul Kasriel. "I might have a problem."
Retail . . . JoS. A. Bank Clothiers declared a 25 percent stock dividend. Shareholders of record as of July 30 will receive one additional share for every four shares owned on August 18. The men's apparel retailer said its number of outstanding shares of common stock will increase to 13.3 million from 10.6 million following the distribution. The company noted the dividend will be its second stock dividend in the past six months. "This action by the Board of Directors recognizes that the company's earnings per share were up 135 percent in the most recent quarter, earnings have increased no less than 30 percent during each of the past four years, and we are on track for another record year in 2004 with an expected net income gain exceeding 40 percent," said Robert Wildrick, the company's CEO, in a press release.
Food & Beverage . . . Smithfield Foods earned $122.7 million, or $1.09 a share, in the fourth quarter, up sharply from $5.1 million, or 5 cents a share, a year ago, boosted by a strong rise in live hog market prices. The figure includes gain of 44 cents per share from the sale of Schneider Corp on April 15. Earnings from continuing operations increased to 63 cents a share from 4 cents a share. The average estimate was for earnings of 51 cents a share. Sales climbed to $2.5 billion in the latest three months from $1.8 billion a year ago. The company said 2005 "could well be another record year" as hog prices remain high, pork demand is strong and beef margins continue to be favorable.
Transports . . . Harley-Davidson Moves to Bolster China Presence. Zongshen Motorcycle Group will facilitate Harley-Davidson's entry into the Chinese motorcycle market and enhance Zongshen's capabilities in its home market. Harley-Davidson Chairman and Chief Executive Officer Jeffrey Bleustein said "Harley-Davidson's primary objective is to export our American-made motorcycles to China and to develop political and motorcycle industry alliances in anticipation of the market becoming more accessible."
The NY Times reports that increasing the pressure to obtain labor concessions, Delta Air Lines has told its employees that stiff competition and its own high costs mean its bid to avoid bankruptcy protection may not be under its control. That message, delivered in a strongly worded memorandum dated Monday from the airline's CEO, Gerald A. Grinstein, was Delta's latest effort to stress the urgency of winning cuts from its pilots, who Delta maintains are paid far more than their counterparts elsewhere. A Delta spokeswoman, Catherine Stengel, said Mr. Grinstein "just thought it was time to rally the troops and make sure they understand his vision and direction."
Legg Mason downgrades JB Hunt to Hold from Buy based on valuation, as they believe the Street is discounting much of this performance in the current valuation and that there is limited upside potential over the next 12 months for investors.
Apparel . . . Tommy Hilfiger warned that fiscal 2005 revenue would decline from fiscal 2004 levels in the "high single digit percentage range," which is a bigger decline than prior forecasts, due to weakness in its wholesale business. For its fiscal first-quarter of 2005, the apparel company now forecasts a loss of 10 to 13 cents a share, vs. the average analyst estimate of a profit of 3 cents a share. For its fourth-quarter of fiscal 2004, net income was $26.9 million, or 29 cents a share, vs. a loss of $1.26 in the same period a year ago. Excluding charges, earnings were 40 cents a share, above analyst estimates of 37 cents a share. Revenue rose 2.4 percent to $510.1 million.
Medical Devices . . . ThinkEquity resumes coverage of QLT, Inc. with an Overweight and $29 target. Growth in the AMD market will be driven by aging demographics, increasing awareness among patients and physicians leading to higher rates of diagnosis, and new treatment options. This should provide a positive backdrop for market leader QLT and its lead product, Visudyne. The target is based on a 26x P/E multiple to estimated 2005 EPS of $1.10.
Biotech . . . Medarex said results of a Phase II trial of MDX-060 for the treatment of Hodgkin's disease were "promising." The company said of the 17 patients treated with MDX-060, one patient experienced a complete response of over three months and two patients experienced partial responses of over three months. Medarex added that no infusion reactions or drug-related adverse events were reported. Eighty-five percent of the patients had failed prior therapies. "We are excited with the safety profile and with the results in patients responding to the MDX-060 treatment," said chief executive Donald Drakeman. "We expect to continue the rapid development of MDX-060 as a potentially important new treatment option for refractory Hodgkin's disease."
Bernstein downgrades Genentech to Market Perform from Outperform and cuts their target to $63 from $67.50 based on the following factors: 1) slowing growth of Rituxan and Herceptin, 2) slower than anticipated adoption of Avastin in first line colorectal cancer and in off-label indications, and 3) limited positive catalysts for the balance of the year after ASCO.
Hotel & Leisure . . . MGM Mirage extended to Friday night a deadline for Mandalay Resort Group's response to a $7.6 billion buyout offer.
Banc of America downgrades Alliance Gaming to Neutral from Buy and cuts their target to $18.50 from $30 after the yesterday's warning. Even though the stock has fallen dramatically over the past 2 months, they anticipate the stock will trade sideways over the next 6-12 months given competitive and internal issues; while gaming expansion in Pennsylvania remains a possibility, firm believes that other issues outweigh the potential upside.
Electronics . . . William Blair comments that it has come to attention that DirecTV sold its entire 3.5 mln stake in TiVo shares last night for about $7.20 per share. Importantly, DIRECTV also sold 55% of its Hughes Software Systems group to Flextronics for roughly $226 mln. DTV recently sold its entire 19 mln-plus shares of XM Satellite radio for more than $475 mln. The firm believes the Hughes and XM sales show that the block sale of TiVo shares is not an isolated or targeted event. Firm's opinion is that if DTV sold its TiVo stock and then changed its relationship with TiVo as a DVR provider, this would be a material event and DTV/News Corp. would have to disclose that before selling the stock. According to the firm, it appears the company is selling noncore assets via a treasury auction at News Corp. to help improve DTV's financial position, which includes $2.6 billion of debt. Moreover, if DTV sold its stake in TiVo and immediately turned around and changed its relationship with TiVo, the buyers of those shares would, in firms view, have a cause of action against DTV. Therefore, this gives to the firm comfort that there are no immediate changes going on at DTV regarding the TiVo partnership.
TiVo has added new enhancements and capabilities to its service, including online scheduling and home media features. These features allow subscribers to enjoy their favorite TV programs and easily connect to all oftheir favorite content -- including music and photos -- simply by connecting their TiVo(R) Series2(TM) DVR to their home network. TiVo also announced today a new multi-service pricing plan that will allow subscribers to fully benefit from these new service features at a lower cost than ever. Under this new multi-service plan, service for the first TiVo service subscription in the home isthe standard $12.95 per month, while each additional TiVo service subscriptionis just $6.95 per month. This cuts almost in half the subscription fee for additional TiVo boxes. And, for a limited time, TiVo and participating retailers are offering a 10 percent discount on TiVo DVRs by lowering the purchase price to as little as $129, with mail-in rebate
NY Times reports that TiVo plans to announce a new set of Internet-based services today that will further blur the line between programming delivered over traditional cable and satellite channels and content from the Internet. It is just one of a growing group of large and small companies that are looking at high-speed Internet to deliver video content to the living room. The new TiVo technology, which will become a standard feature in its video recorders, will allow users to download movies and music from the Internet to the hard drive on their video recorder. Although the current TiVo service allows users to watch broadcast, cable or satellite programs at any time, the new technology will make it possible for them to mix content from the Internet with those programs.
IT Services . . . The WSJ highlights IBM, which is making strong gains in the $46 bln global market for heavy-duty "servers" that power most big businesses. IBM's server surge hasn't gained much notice, in part because it has been overshadowed by a slowdown in the co's giant services business, which accounts for about half of its total rev. But it has put the squeeze on competitors. After regaining the top spot in servers in 2002, IBM captured 32% of the world-wide market last year, widening its lead over Hewlett-Packard, at 27%, and a sinking Sun Micro., with 12%, according to IDC. Dell, the only other major co that is growing in server-market share, stood at 9%. IBM's gains also defy widespread predictions that the computer landscape is moving toward domination by low-priced, low-profit "Wintel" machines based on Intel microchips running Microsoft's Windows software. It also stands to be a long-term rev builder for IBM, since servers drive add-on sales of software, peripheral equipment and some service business. Although IBM has had success selling Wintel boxes of its own, its most powerful, higher-priced models use IBM-made chips and a variety of other OS software. IBM says the key to its gains was its decision to continue designing and manufacturing a proprietary line of microprocessors instead of standardizing on Intel chips as many competitors have done. IBM also has been selling more servers that run on the free Linux. IBM's strategy is to capture the high-profit part of the server market by using its chips to design machines with unique advantages, and avoid competing with Dell for the low-margin commodity business. Innovation can "break monopolies," says IBM server CEO Bill Zeitler.
While reiterating the goal of growing EPS at 20% “this year and the next couple years,” H-P’s Fiorina highlighted at the company’s analyst meeting its three-fold execution plan to get there around improving profitability (more direct, improved supply chain), growing share of wallet (bundling opportunities) and leveraging its portfolio (Adaptive Enterprise, Smart Office). Concerns relate to how H-P can achieve EPS growth which is more than 2x its revenue growth when margins may under pressure in multiple segments. Though we credit H-P for giving a compelling marketing message, also focus on how H-P will address Dell’s growing presence in printers with its direct model and more efficient economics -- although H-P downplays that challenge. While H-P spoke about its edge over Dell (characterized as IP-less distributor) and IBM (burdened with Microelectronics), view is that two business models can work in the IT world in line with a "Darwinian Computing" thesis: one focused on high-volume/commodity segments to Dell’s benefit, and the other on innovation-driven, value-added areas (de-emphasizing commodities) to IBM’s benefit. With no financial update from H-P, analysts are maintaining our estimates for 2004 of $1.45 in EPS (vs. $1.16), for 2005 of $1.65 and for 2006 of $1.80, which we note are below H-P's 20%+ EPS growth target owing to margin pressures. For 3rd quarter 2004 (July), we are also maintaining EPS of $0.31 (vs. $0.23) on revenues of $19.2 billion. H-P's 2nd half 2004 outlook is for revenues of $39.7-$40.7bn and EPS of $0.74. As to valuation, using a 14x-16x multiple (the mid-point of H-P’s historic forward P/E range of 10x-20x and at a discount to IBM’s 16x valuation on 2005) on 2005 EPS estimate of $1.69, arrive at fair value of $24-$27, suggesting the stock has some room to move to the upside.
Storage . . . All about Disk Drives
MATURING DESKTOP MARKET: The desktop-class hard drive market (defined primarily by the 3.5-inch form factor as well as the ATA interface) is a maturing segment – despite the growth in use of the desktop class drives (owing to their high-capacity, low-cost pitch) in consumer (DVRs) and enterprise storage applications, the primary consumer for this segment, the desktop PC, is also seeing maturing market trends. Further, the 3.5-inch form factor will eventually migrate to a smaller (2.5-inch) form-factor.
• 3.5-inch desktop-class drive units are expected to grow at a 2003-2008 CAGR of 3% (IDC forecasts). Currently, this segment accounts for 72% of total HDD units and 55% of total HDD revenues.
• The top three vendors (Seagate, Maxtor, Western Digital) account for nearly 82% of the market.
• The other two vendors, Samsung and Hitachi do not appear to have plans to exit the segment and in fact, are positioned well to grow share.
• With varying degrees of internal component efforts (and a fairly consolidated component supplier base), no company appears to have a sustained cost advantage.
• While the slowing technology curve has limited vendors’ ability to reduce product cost significantly (i.e., number of components), pricing has turned more aggressive.
• The next areal density transition to 120GB/platter (and then to 160GB/platter) starts in late ’04 – However, longer product cycles do imply less supply constraints and thus a more competitive environment.
• The most intriguing element of longer product cycles is the (negative) impact on profitability -- if new products don’t allow significant reductions in cost (amidst competitive pricing), then sustained industry profit growth is unlikely even with the vendors attempting to manage demand/supply in balance.
MORE COMPETITION IN MOBILE: With “mobility” (wireless computing, consumer devices) as a demand driver as well as the ability of hard drives to provide a low-cost, reliable, and small form-factor solution, mobile hard drives are seeing and are expected to strong growth trends – albeit in the face of increased competition.
• Mobile drive units (2.5-inch, 1.8-inch, 1-inch, and soon 0.85-inch) are expected to grow at a 2003-2008 CAGR of 28% (IDC forecasts). Currently, this segment accounts for about 19% of total HDD units and 23% of total HDD revenues.
• The market share leaders here are the Japanese vendors, Hitachi, Toshiba, and Fujitsu. Korean vendor Samsung has recently entered the 2.5-inch mobile market.
• Seagate is the only US vendor in the 2.5-inch mobile market although Western Digital and Maxtor are expected to join this segment in late 2004 / early 2005.
• By early 2005, all the seven major vendors in the hard drive industry will participate in this segment which will lead to intense competition and eventual exits/consolidation.
• Moreover, there are two new entrants in this market with 1.8-inch and 1-inch products – Longmont, Colorado based Cornice and Chinese vendor(s) GS Magicstor/GS Magic drive.
• The variable to watch is availability of components (glass substrate, which is controlled by one Japanese vendor Hoya) although tight component supply may push PC OEMs and drive vendors to push on using aluminum disks in the 2.5-inch laptop market.
ENTERPRISE: REVENUE CHALLENGES: Defined by the interface technology (SCSI/SAS/Fibre Channel) as well as by performance/reliability features, the enterprise market is characterized by relatively small volumes, a concentrated customer base (in a few large OEMs like EMC, Dell, HP, IBM), as well as secular pressures from “good enough” technology (i.e., desktop class ATA drives increasingly used in enterprise storage applications).
• Enterprise drive units (SCSI / Serial Attached SCSI (SAS) / Fibre Channel (FC)) are expected to grow at a 2003-2008 CAGR of 4% (IDC forecasts). Currently, this segment accounts for about 8% of total HDD units and 22% of total HDD revenues.
• High-capacity, low-cost desktop class drives (with an ATA or soon, Fibre Channel interface) are now being used in enterprise applications. While there could always be some differentiating features, this evolution will place secular pressures on unit growth and pricing conditions in the enterprise market.
• After years of Seagate’s dominance, the enterprise market has seen improved execution from Hitachi, Fujitsu, and Maxtor leading to an intense competitive environment.
• Given low-unit volumes – with a market size of only about 21 million units – as well as secular longer-term pressures from encroachment of ATA class drives, the enterprise market cannot sustain four vendors, long-term.
• Supply constraints and share gains are usually the results of execution missteps on product transitions (areal density, interface, spindle speed, and now, form-factor). The next transition to higher areal density, SAS interface, and 2.5-inch small form factor is expected to be (in volume) in late 2004 / early 2005.
YES, THERE ARE NEW ENTRANTS: The general theme in the hard drive market over the past few years has been one of structural consolidation with the industry down from nearly 20 vendors in the late ‘80s to about seven (major) vendors now. Over the past year though, there have been new entrants in to the market – in the form of entry in to a new segment by existing vendors or new startups in the HDD market, particularly in the small form factor market owing to the opportunity in consumer applications.
• In 2003, Seagate joined the 2.5-inch mobile drive market…followed by Samsung in early 2004…and to be followed by Western Digital and Maxtor in late 2004 / early 2005 – i.e., all the seven major HDD vendors will participate in the 2.5-inch laptop hard drive market by 2005.
• Seagate is expected to join Toshiba and Hitachi (as well as Cornice and GS Magicdrive) in the 1-inch HDD market in second-half of 2004.
• Longmont, Colorado based Cornice is shipping a 1-inch 2GB hard drive with an estimated ASP of around $60 and has had success shipping in to CE products, mostly MP3 players.
• GS Magicstor and GS Magicdrive (which share common investors and management team), based out of Guizhou province in China are shipping 1-inch and 1.8-inch hard drive products. While the success for these products to date appear to be limited, the manufacturing facility, under construction in Guizhou, China, is expected be capable of nearly 3 million units by the end of 2004 and 10 million units in 2005.
• Excelstor, manufactures (in Shenzhen China) single-platter desktop HDDs for Hitachi and can also ship its branded desktop products under license from Hitachi. Volumes of branded products are small currently with about half-amillion units in 1st quarter 2004 (1% of total desktop shipments).
Network Equipment . . . Pacific Growth comments that yesterday Riverstone announced a pact to sell the design rights for a core enterprise class layer 3 switch to Hewlett-Packard for $28 million for use in HP's ProCurve networking product line. Hewlett-Packard currently OEM's a core switch from Foundry and in firm's opinion the transaction will probably reduce Foundry's sales prospects to Hewlett-Packard over the long-term but not much in the short-to-intermediate term. Foundry's OEM sales to Hewlett-Packard have generated roughly 4% of revs over the last several qtrs. Firm has not viewed Foundry's OEM relationship with HP as a growth driver for Foundry; therefore, does not feel that any long-term changes in the relationship with HP materially changes Foundry's long term fundamentals. Accordingly, would be buyers of Foundry on any resulting weakness in the stock.
The WSJ's "Tracking the Numbers" column reports that Motorola and Scientific-Atlanta have surfaced frequently in the federal fraud trial of four former executives of Adelphia Comm., most recently in an e-mail message read aloud in court this week that indicated top Scientific-Atlanta executives approved a transaction that allegedly helped Adelphia cook its books. The electronic message, read by a defense attorney, comes on top of earlier testimony about the same set of transactions by the government's star witness, former Adelphia CFO James R. Brown. He testified that in 2000 and 2001, Adelphia agreed to overpay both Scientific-Atlanta and Motorola for set-top boxes it bought with the understanding that the co's would give the money back in the form of marketing support for Adelphia. The deals were so-called wash transactions whose only impact was to make Adelphia's financial performance look better from an accounting standpoint. Mr. Brown said Motorola actually threatened to halt the wash transactions unless Adelphia ordered more new equipment, and he provided names of some executives with whom he said he discussed the arrangements, including Scientific-Atlanta's then-CFO, Wallace Haislip. Motorola and Scientific-Atlanta said in interviews that they accounted for the transactions properly. That may not be a sufficient excuse in the post Sarbanes-Oxley world. In the past two years, the SEC has taken a harder line on suppliers, customers, bankers and others who knowingly helped co's commit accounting fraud. "If I were Motorola or Scientific-Atlanta, I think I would be concerned," says Alan Bromberg, a securities-law professor at Southern Methodist University's Dedman School of Law in Dallas. Mr. Bromberg says the SEC increasingly has viewed outsiders who help a co facilitate a fraud as "aiders and abettors, or conspirators.
Semiconductor Equipment . . . United Microelectronics received a downgrade from Goldman Sachs to "in-line" from "outperform" on the belief that accelerations of capital spending and increases of inventory are limiting foundry stocks' upside potential.
Taiwan Semiconductor received a downgrade from Goldman Sachs to "in-line" from "outperform" on the belief that accelerations of capital spending and increases of inventory are limiting foundry stocks' upside potential.
Semiconductors . . . Chinese PC maker Lenovo Group is using the AMD Athlon 64 and AMD Athlon XP processors for a desktop PC series. The systems are widely available in Lenovo 1+1 stores throughout China.
The WSJ reports that EU regulators said they are gathering new information in a long-running antitrust probe of Intel that had appeared to be winding down. The case originated with an Oct 2000 complaint by AMD. Investigators are believed to be studying whether Intel offers improper discounts or other financial incentives to persuade computer makers to use Intel chips exclusively. Amelia Torres, a spokeswoman for the European Commission said the commission has entered "a new fact-finding phase" in the case. As part of that effort, the commission has sent letters to computer makers and retailers about Intel's activities. Ms. Torres said the Intel investigation remains at a "beginning" stage.
Software . . . First Analysis downgrades Red Hat to Equal-Weight from Overweight, citing the following factors: 1) an overwhelming amount of alternative Linux products have rapidly entered the mkt over the past 3-6 months, and customers are taking more time to evaluate the marketplace, 2) aggressive pricing from Microsoft's operating system offerings and Sun's indication of making its Solaris operating system code open, and 3) company's support infrastructure is struggling to maintain a high level of service quality.
The WSJ's "Heard on the Street" column suggests that four major players have emerged in business software, and many smaller vendors will be gobbled up or forced to change the way they do business. According to the article, Microsoft, Oracle, SAP and IBM now are considering deals to solidify their positions in the technology infrastructure and application programs needed by businesses large and small. In the aftermath of the SAP talks, Microsoft is left with smaller targets, analysts say. Jason Maynard, an analyst with Merrill Lynch, speculates Microsoft may pursue business-software companies such as Siebel Systems and Lawson Software, or even service companies such as Automatic Data Processing or Affiliated Computer Services. Another frequently discussed possibility is an acquisition by Oracle of BEA Systems.
Barron's Online highlights THQ, which may benefit from falling game console prices. Earlier this year, Sony cut the price of its PlayStation, after Microsoft lowered the price of its Xbox. There are big returns in targeting kids with THQ's "Finding Nemo" game generating sales of about $100 mln. According to the paper, the stock may keep climbing as console price cuts further broaden its games' mainstream appeal. THQ has promising games due out soon, such as one based on Pixar's next holiday movie, The Incredibles. Paul Tryon, an analyst at First Albany, expects THQ's Incredibles game to do at least as well as "Finding Nemo." Video games are no longer the realm of teenage boys who spend hours conquering territory or downing enemy planes. In fact, about 65 mln U.S. consumers owned at least one console last year, according to the Video Software Dealers Association. The presence of so many consoles makes it easier for THQ to sell "units of three to 4 mln [per game]," says Mr Tryon. "That wasn't possible in the early part of the [video game] cycle." Market research firm DFC Intelligence expects the worldwide market for video games and interactive entertainment to grow by 44% to $33.4 bln in 2008 from $23.2 bln in 2003. Shawn Milne, an analyst at FBR, expects THQ's operating margins to rise a percentage point this FY to 7.6% and to about 9% the following year as it develops more of its own games. THQ has also been cutting development costs by buying game developers like Relic Entertainment, and making more games for PCs, where license fees are less than what it would have to pay console manufacturers. Mr Tryon says THQ also has ample cash to develop games for the new consoles when they hit the market: $187 mln, or $4.93 a share, in cash and little debt. The shares trade at a slight premium to their long-term expected earnings growth rate and sells at a modest premium to its 5-year historic median multiple of 19.7x projected earnings, but its 1.4x P/S ratio is well below rivals Activision, which goes for 2.3x sales, and Midway Games' 12x sales.
PepsiCo has selected SAP to provide the primary business platform to unify operations, standardize processes and increase efficiency across its divisions.
Pacific Growth says the recent sell-off in WebEx provides an excellent buying opportunity. The firm says that recent claims of Microsoft offering per port pricing at 1/10th the price charged by WEBX actually compares one pricing scheme to a completely different pricing scheme, resulting in totally meaningless and highly inaccurate conclusions; in addition, firm thinks that many investors have also been confused by management's statements about the sharp drop (approx 35%) over the past year in effective price per minute, but firm says a falling effective price per minute is positive for WEBX's business and has nothing to do with the actual revs WEBX receives from customers. Firm believes that virtually nothing has changed about the competitive situation in this industry.
Despite lousy April Quarter results and guidance from Take Two, Piper Jaffray advises investors to buy some aspirin and stick with the stock. Potential catalysts exist: 1) Easier NPD comps in coming months; 2) 2005 growth prospects remain attractive; 3) valuation is compelling; 4) CEO is conservative and will be positive; 5) San Andreas poised to be the the biggest video game ever; 6) strong balance sheet and cash flows; 7) share buyback likely post-SEC resolution; and 8) SEC issues will be resolved.
Piper Jaffray notes that NPD sales of Symantec products totaled $54.5 million in the first 9 weeks of the June quarter, down 15.8% from the first 9 weeks of the March quarter. The firm believes the Street is looking for a 0-5% sequential decline in consumer offline sales from March to June. Also, firm notes that on a weekly sequential basis, the week of May 17-23 showed a decrease of 15.9% from May 10-16 to $6.0 million from $7.1 million. While firm expects SYMC to meet Street estimates for the June qtr, they believe that upside related to the company's offline biz may be less than the previous 2 quarters. However, firm believes the implications of the weekly NPD data are already reflected in the stock.
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