3rd Quarter, 1999

Your companies reported third quarter earnings that have met or exceeded their stated goals with the notable exception of Intel. Because a long-term investor such as you might wish some assessment of these results instead of breathless financial media comments, we send you the following thoughts.


We believe the worry about the narrowing of Intel’s margins as prices fall on PC’s diverts attention away from the company’s crucial need to take the Intel architecture up into the server and workstation market with a new, more powerful, yet compatible microprocessor. This has not been achieved yet but Intel is propelled toward its goal by concentrating 50% of its R&D dollars on server solutions. The company plans to introduce a new microprocessor for this market by mid-year. Its shift to more exacting .18 micron manufacturing lowers the production cost of its processors by 50% at the high end and 30% at the low end. In the meantime, most analysts remain preoccupied with concerns about nagging competition in the marginally profitable low end of the market. Their misdirected focus now directs the price movement in the stock.

Computer Associates

Computer Associates reported a surge in fiscal second quarter revenue and earnings growth propelled by benefits extracted from its acquisition of Platinum Technologies, a crippled competitor. In moving quickly to cut costs while boosting revenues by flawlessly moving products to its own sales force, CA once again has shown its unequalled skill in pulling value out of a mismanaged software company. A renewal of growth in CA’s mainframe based network management software shows its ability to exploit Platinum’s product line as well as the rising Internet driven demand for mainframe power cited by CA, and IBM management in discussing their quarterly results.

First Data

First Data reported third quarter earnings of 48¢ per share, 14% higher than a year ago on revenue growth of 12% from continuing operations. First Data’s merchant alliances continue to deliver excellent growth and improved margins since the company took steps to reduce costs and improve execution a year ago. First Data converted a record 42 million credit card accounts during the quarter, bringing its total to 260 million. Western Union continues to grow 20% annually as money transfer volume outside the U.S. rose 57%. During the quarter Western Union added 12,000 German Post Office locations to its agent network, which now exceeds 78,000.

On October 18, First Data bought Transaction Systems Architects’ on-line debit card processing and ATM switching business and licensed TSA’s BASE 24 software to run the business. The acquisition allows FDC to offer its customers a fully integrated debit processing solution. First Data will invest significant resources to expand this business, which brings TSA more revenues as transactions rise. Both companies benefit.

TSA announced on October 20 that it had been selected by Deutsche Bank to implement a Pan-European multi-currency automated clearing system for branches, merchants and corporate customers’ treasury operations. This contract, valued at more than $20 million over five years, is TSA’s largest initial contract ever. The company reported a 25% gain in its fiscal fourth quarter earnings, which lifted its stock price into the mid-30’s.


Sykes reported unsurprisingly strong revenue growth of 36 percent, which the company turned into an unexpectedly large third quarter earnings of 33¢ per share, 57% higher than last year’s results and 22% higher than the previous quarter. Sykes business is underpinned by technical support services provided to PC and consumer software company’s customers. These call center and e-mail based services, which comprise three quarters of company revenues, rose 54 percent year over year. Sykes’ top five customers remain Adobe, Microsoft, Compaq, Gateway and Hewlett Packard. Last month Acer, Taiwan’s largest PC manufacturer, turned over operation of its Costa Rica call center to Sykes and contracted with the company to provide help desk services to its customers throughout the Americas.


DST reported third quarter earnings per share of 52¢, up more than 50% from a year ago, 2¢ above the company’s goal. DST’s mutual fund shareholder accounts reached 54.8 million, 10% above the total at the start of the year. This account growth comes from its existing mutual fund customers’ account growth, new Roth IRA account openings and additional 401k participants investing in multiple funds. The company reported that it has signed contracts with new funds bringing in 4.5 million accounts, which will be converted onto its shareowner processing system during next year’s second and third quarter. DST’s customer statement business benefited from growth of U.S. mutual fund shareholder accounts, wireless telephone subscribers and package delivery customers.

State Street

State Street reported third quarter earnings of 77¢ per share, 13% higher than a year ago. This good result was undergirded by a robust 19% growth in fee income from institutional investor service fees. Overall revenue growth, however, rose only 10% due to narrowing interest rate spreads between the overnight fund’s rate and the yield earned from short-term securities and loans to fiduciary customers. This kept the growth in net interest income to only 6%. When short-term rates rise, State Street’s net interest margins customarily contract until its short-dated portfolio rolls over.

During the quarter, State Street’s revenues grew faster than expenses, a promising development. Management expressed confidence in the prospect of doubling its UK fund business with the addition of customers recommended by Lloyd’s TSB, which announced its exit from the institutional custody business in July. Although variable costs are incurred in adding customer assets in the predominately fixed cost business, this allows State Street to realize higher operating margins.

State Street during the quarter bought back 1.4 million shares at an average price of less than $65 per share. It also bought on September 30 Wachovia’s pension trust and custody business, which had 200 customers with portfolio assets of $61 billion. At the end of the quarter, State Street’s management stated that sale of its New England lending business, which closed on October 4, would depress its fourth quarter operating earnings by as much as 5¢ per share, bringing earnings down to less than 75¢ per share compared to the 68¢ earned last year. The gain on the sale amounts to one dollar per share.

American International Group

American International Group reported a good increase in third quarter results with earnings rising 14.5% above a year ago, despite a 30% increase in catastrophic losses largely attributable to the Taiwan earthquake and a typhoon in Japan. In adhering to its strict underwriting standards, the company during the quarter turned away $95 million of U.S. casualty business because it failed to meet its profitability criteria. AIG’s important overseas life insurance business achieved a 22% increase in third quarter operating profit with improved results throughout Asia, while its newly acquired Sun America U.S. annuity business produced a 34% operating income gain. AIG is positioned to benefit from relaxation of financial industry regulation in the U.S. and Japan.


Harte-Hanks reported solid third quarter revenue and earnings growth from both direct marketing and shoppers. Company revenues rose 13 percent and earnings per share of 26¢ were 18 percent better than a year earlier. Direct Marketing revenue growth of 15 percent was propelled by database and response management, which signed a multi-year, worldwide agreement with Texas Instruments. Harte-Hanks California Shoppers, which expanded circulation by 117,000 in Palm Springs and 160,000 households in Northern California, reported 10 percent revenue growth. During the quarter the company repurchased 1.1 million shares bringing the year-to-date total to 3.0 million, reducing shares outstanding by five percent.

The stock’s poor 1999 performance reflects investor impatience with the company’s insistence upon placing shareholder value before strategic considerations in assessing acquisition opportunities. In today’s deal-charged atmosphere, this means that Harte-Hanks is confined to relatively small incrementally profitable acquisitions instead of the expensive business transforming deals many analysts hoped for. This stock now sells at its lowest relative valuations since the public offering four years ago.


Merck reported third quarter earnings of 64¢ per share, an increase of 14% over last year. Strong volume increases drove sales growth this quarter. Vioxx, a cyclo-oxygenase 2 (cox-2) inhibitor launched in May, achieved worldwide sales of $111 million this quarter. Total sales since launch are $208 million, an indication of the rapid acceptance of this anti-arthritis and pain drug with specialists and hospital formularies. Sales of Fosamax, Merck’s non-hormone treatment for osteoporosis, had its strongest quarter since its launch with third quarter sales of $280 million, a 44% increase over last year. Fosamax is on its way to being a blockbuster drug with sales of $755 million in the first nine months of 1999. It is the only agent shown to reduce hip fractures and increase bone mass density.

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Capital Counsel’s investment strategy combines disciplined fundamental analysis with patient execution. We hope this letter helps you understand that stock selection is at the core of our investment strategy. We seek to invest in profitable well-managed companies that generate recurring free cash flow. These companies should possess strong balance sheets and earn attractive rates of return on shareholders’ capital. We know the companies and their proven execution focused managers well. They deal with problems openly and effectively, and have incentives aligned with shareholders. We evaluate the company, as an informed private buyer might, to determine the value of the business based upon its ability to generate free cash flow. We manage concentrated portfolios which have provided our clients with good long-term results. The financial strength of the companies held in client portfolios has lessened the drop experienced when markets decline.

Client portfolio holdings may change, and stocks of companies noted may or may not be held by one or more client portfolios from time to time. Investors should not consider references to individual securities as an endorsement or recommendation to purchase or sell such securities. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall client portfolio rebalancing. Investing in the stock market involves gains and losses and may not be suitable for all investors. Investment return and principal value of an investment will fluctuate.