2nd Quarter, 2002

In the aftermath of the shock dealt by WorldCom’s admission of massive fraud, investors all but ignored the good second quarter earnings reports from most of your companies. The stocks of companies failing to meet stated earnings goals or where there were questions about earnings quality were sold fearsomely with the notable exception of Intel, which had fallen by a third when it revised its forecast downward in June. Institutional portfolio managers who heretofore have focused obsessively on consensus quarterly earnings numbers now rush to sell shares of any company when anyone criticizes its accounting practices. Rumors about accounting chicanery have supplanted quarterly earnings whisper numbers as the fodder for institutional momentum investors, traders and short-sellers.

The frenzied public excoriation of CEO’s, which propelled quick enactment of the Sarbanes-Oxley Act after WorldCom’s implosion, deflected attention from second quarter earnings reports toward the August 14 deadline for CEO and CFO certification of the this year’s and last year’s financial statements for the 947 largest U.S. public companies. However, imposition of this criminal liability and added reporting requirements for CEO’s and CFO’s does nothing to deter dishonest corporate officers from committing fraud. Andrew Fastow, Enron’s disgraced but unindicted former CFO, would have readily signed such a certification because he thought he was so smart he would never get caught! The certification requirement probably will result in some restatements by companies, particularly those who employed Arthur Andersen. It also may incite renewed harangues from politicians and pundits about CEO deceitfulness. We believe the American people possess enough good sense to tire of this hypocritical exercise but it may last through election day.

Accurate application of GAAP accounting principles designed to match the timing of income recognition with allocable expenses on companies’ financial statements is of crucial importance to those of us who believe that earnings, or more tellingly free cash flow, determines the long-term stock market value of businesses. Nonetheless, whatever numbers are posted, managements who incline toward manipulating their results to boost their stock prices cannot build lasting shareholder value. Their lies to strangers prevent them from being honest with themselves and their employees. Businesses exist to solve problems for their customers at an economic price. Untruthful organizations are bad problem solvers.

Investors’ real protection comes from owning companies that are proven meritocracies where all employees confidently expect a fair evaluation of their contribution toward building the companies’ reputations for reliably delivering ever improving products or services at a fair price. Customers, competitors and suppliers know who these companies are, and many that we know, such as ADP, AIG, CH Robinson, Express Scripts, FDC, Merck, Harte-Hanks and State Street now sell at prices providing investors a margin of safety. They also possess the strength of realistic experienced managements who know how to adjust to changing economic circumstances without impairing shareholder value.


On June 18, AIG held its first all day investors meeting, which emphasized the strengths of the company’s unmatched global franchise and the powerful competitive advantage derived from AIG’s AAA credit rating. The managers from every one of AIG’s insurance and financial service businesses explained how their businesses were divided into units of manageable size. In each unit profitability and risks are measured by experienced professionals with differing responsibilities to ensure against loss from mispricing or faulty assumptions.

During the second quarter, AIG’s net premiums earned rose 24% above last year’s comparable results, while worldwide life insurance premiums advanced 10%. Importantly, net premiums written rose 34%, reflecting higher rates obtained from new coverages. Highly profitable foreign life premiums rose 19%. In July, AIG opened offices in Beijing and Suzhou, bringing AIG’s life insurance operations in China to eight major cities. These excellent results were marred by a 12% drop in Sun America’s net income from equity linked annuity products and a 22% decline in AIG’s net investment income from its property and casualty portfolio, caused by WorldCom bond losses and an absence of any income from investments in private equity funds.

None of these fundamental factors affected AIG’s stock price, which fell 20% in the last sixteen weeks as investors became mesmerized by unnerving news of higher loss reserve revisions by major reinsurers and rumors of possible European insurer insolvencies arising from equity portfolio losses.

State Street

State Street’s second quarter earnings rose 2% to 54¢ per share after deducting a charge of 3¢ per share to cover the cost of staff reductions announced in April. Revenues rose 3%, while the rise in operating expenses was kept to 2%. Success in gaining new business from new and existing clients fully offset the effect of declining equity prices worldwide on State Street’s customer assets under custody, which amounted to $6.202 trillion on June 30, compared to $6.203 trillion on December 31, 2001. The transfer to State Street of custody for Nuveen Investment’s $45 billion of fund assets will help compensate for the $50 billion decline since the start of the year in mutual fund assets under custody to $2.744 trillion on June 30. State Street’s management has stated often that without new business a 10% decline in equity prices worldwide reduces its revenues 2%. This metric coupled with the WorldCom induced selling of major bank stocks caused investors to ignore State Street’s strong results. The stock has dropped 30% since March 31.


DST Systems reported operating earnings per share 10% higher than a year ago. Revenues, however, declined 9%. DST’s core mutual fund account processing business, which historically generates over 80% of DST profits and all its sustained earnings growth, grew its base 7% to 80.3 million accounts. The company will convert 8.7 million additional shareholder accounts from four different mutual fund companies to its system over the next nine months. In addition, DST is the leading contender for shareholder accounting services from a dozen additional mutual fund companies, with approximately 15 million accounts.

DST’s quarterly results were hurt by a severe decline in its print mail profits and poor results from its cable subscriber billing business. These two businesses generated 46% of operating revenues, but only 8% of profits. DST’s stock is down nearly one-third from the beginning of the year because of concerns about profit erosion at these two peripheral businesses. The stock now trades at its lowest earnings valuation since its public offering in 1995.

First Data

First Data reported strong quarterly growth in revenue and earnings per share of 9% and 21%. Western Union worldwide money transfers rose 18% during the quarter driven by 32% growth in overseas transactions. Western Union agent locations reached 130,000, up 20%, while the backlog of agents signed and scheduled to receive installation before year-end 2003 stands at 29,000. Western Union now has 7,800 agents servicing customers in China and India, giving it a strong start toward its goal of having 20,000 agents operating in those countries by the end of next year.

FDC processed 2.5 billion merchant Visa and Mastercard transactions, an increase of 14% over last year. The total dollar volume processed during the quarter of $137 billion is 12% above a year ago. Credit card accounts on file rose 6% to 315 million. First Data will convert 70 million additional cards onto its Omaha processing system, including GE’s retail cards, by year-end 2003. The stock is down one-quarter since March 31.

Concod EFS

Concord’s stock declined 20% after reported revenues and earning per share advanced 28%. Operating profit rose 27%. The reported earnings per share of 18¢ included nearly a penny per share gain from the sale of leased merchant terminals. The second quarter also marks the first quarter that Concord fully expensed the cost of acquiring new merchant accounts. Up until now, Concord capitalized this cost, which added about one penny to quarterly earnings. Quibbles about these accounting changes rattled investors and sent the stock down.

PIN-based debit transactions acquired from supermarkets, gas stations, convenience store and retailers rose 37%, and transactions routed across the STAR network grew 31%. Acquisitions made during the first half combined with an increase in network interchange rates (treated as both revenue and expense) added four percentage points to revenue growth. Core Data, the largest of the three acquired businesses, boosts by one-third the number of ATM’s driven by Concord to 93,800, one-quarter of all ATM’s deployed in the US.


Harte-Hanks reported a 4% advance in earnings per share on revenues equal to last year. This marks an improvement from the last four quarters when overall revenues declined. Direct marketing revenue, however, continued to fall, dropping 4% as an upturn in retail and high-tech/telecom segments was outweighed by continued double-digit declines in financial services and health care segments. Revenues from Shoppers rose 6%, driven by automotive and real estate in-book advertising. Building upon its success with BMW and Volvo, Harte-Hanks signed a marketing agreement with Mazda to improve customer loyalty and provide tools to generate more productive sales leads. Harte-Hanks repurchased 1.9 million shares of common stock during the quarter, about 2% of fully diluted shares outstanding. The stock declined 21% from March 31 through July 23, the day the company announced its second quarter results. It has since rebounded 15%.

CH Robinson

CH Robinson reported 11% growth in earnings per share on a 3% improvement in net revenues. Robinson’s continued focus on controlling expenses along with an improvement in trucking volumes was offset somewhat by higher costs to book available trucks. The company’s fresh produce sourcing business rose 5% while its T-Chek truck driver information and fuel management business rose 25%. Robinson’s stock has gained 5% this year.

Automatic Data Processing

Automatic Data Processing’s stock was bought in mid-July after CEO Art Weinbach announced that the company would not grow at a double-digit EPS rate for its 42nd consecutive year. He stated that ADP would attain only mid-single digit growth, half the historic rate if: 1) the economy did not improve over the next four quarters, 2) interest rates remained at the current low level for the next four quarters, 3) no gains were realized in the investment portfolio, 4) the planned repurchase of 4% of the outstanding stock was delayed until late in the year and 5) no acquisitions of privately owned processing companies, which have been a stable source of incremental growth for ADP over the past decades.

In explaining his forecast, Art Weinbach pointed out that ADP’s revenue and profit is linked to the pace of economic activity. During business upturns employment lags behind growth. ADP’s earnings from the float it earns on customer payrolls rise when short-term interest rates go up. Mr. Weinbach pointed out that he cannot predict the future course of interest rates. He also stated that he did not want to impose his forecast as a determining factor in managers’ consideration of the timing of the realization of portfolio investment gains, stock repurchases or acquisitions. That’s precisely what long-term investors should hope the leaders of their companies would say in these times that have been made more arduous by the over-reaching forecasts of now fallen celebrity CEO’s.

Express Scripts

Express Scripts reported earnings per share and revenues of $0.61 and $3.4 billion, increases of 33% and 51% respectively. Increased mail prescriptions and higher levels of generic utilization increased profitability per claim to $1.01 for the second quarter, a 7% increase sequentially and a 13% increase over the second quarter of 2001. Express Scripts’ stock price reached a high of $65 in early May, before falling 24% below its March 31 price.

Varian Medical Systems

Varian Medical Systems reported fiscal third quarter earnings of $0.32 and revenues of $216 million, increases of 31% and 17% respectively. Strong acceptance of SmartBeam® IMRT systems by hospitals and clinics in North America drives this growth. Gross margins have also improved as cancer centers purchase higher margin software and ancillary products to upgrade recently purchased radiation equipment. The company also announced orders worth $6 million for baggage screening tubes from two U.S. companies. Sales of the tubes began late in the quarter and will continue into fiscal 2003. Varian’s stock price reached an all time high of $47 before dropping back to its March 31 price.


Walgreen continues to post strong sales and earnings growth with increases of 17.5% and 21.4% respectively for the quarter. Comparable total store sales increased 11.5% during the quarter while comparable store pharmacy sales rose 16.5%. Walgreen’s execution continues to excel with average daily store pharmacy sales 30-45% above those of their major competitors. Walgreen’s stock price has declined 13% since March 31.


Merck reported sales of $12.8 billion and earnings per share of $0.77 during the second quarter. Sales increased 8% while earnings per share were down 1% compared with the same period last year. Human health sales decreased 3% during the quarter including a 4% unfavorable effect from the patent expirations. Managed care organizations appear to be reacting favorably to the changes in the Vioxx label. Groups covering 20 million lives have included Vioxx as the only COX-2 inhibitor on their formularies. Merck also reported that they have not lost a single managed care formulary decision to Pfizer-Pharmacia’s Celebrex/Bextra. Sales of Vioxx outside the U.S. increased 24% during the quarter.

Merck’s share price has dropped 21% since the beginning of the quarter as a result of a controversy about the accounting at its pharmacy benefit management subsidiary, Medco. The furor delayed a public offering of Medco shares. The accounting did not distort Merck’s profits, but recorded higher revenues for prescription drug claims from network pharmacies and higher costs than the method used by competitors. Many strident commentators impugned Merck management’s motives for choosing this different accounting treatment and quickly pointed out that Arthur Andersen had been Merck’s auditor. The stock’s sudden drop is a measure of investors’ feverish worries about anything to do with accounting.


Mettler-Toledo’s disappointing second quarter results reflect weak market conditions in the pharmaceutical industry worldwide and the European retail sector. Second quarter earnings per share were $0.54, unchanged from last year on a comparable basis. Total revenues grew 6% to $296 million. Strong revenue growth for Rainin offset a 4% decline in organic growth in local currencies. European sales decreased 12% from the second quarter of 2001. Germany was particularly hard hit and Mettler forsees these harsh conditions becoming prevalent throughout Europe.

Changes in the senior management team will test Robert Spoerry’s ability to develop managerial talent. Dennis Braun has officially begun his tenure as CFO. Bill Donnelly, the former CFO, will become the interim head of the laboratory business in addition to his new responsibilities for the packaging division. Lukas Braunschweiler, the head of the lab division, left the company in July to become the CEO of Dionex, a manufacturer of liquid chromatography equipment. Spoerry reduced his earnings forecast to $2.10 – 2.15 per share, 4% less than earnings last year. The stock price declined 40% from its March 31 price before we sold the stock.


PepsiCo reported second quarter earnings per share of $0.52 and net revenues of $6.2 billion, increases of 14% and 2% respectively. Worldwide volume increased 3% with snacks up 4% and beverages up 3%. The weakening dollar, soft Tropicana sales and high promotional spending for Frito Lay North America each shaved 1% off the projected revenue growth of 5%. All of Pepsi’s beverage brands gained market share during the quarter with Gatorade showing strong volume growth of 13%. Synergies from the Quaker merger and division productivity efforts increased the operating margin 2% to 21%. Despite these operational gains the stock price dropped 14% on July 19 when revenues failed to reach the company’s prior forecast.


The business environment remains tough for Intel. Sales of $6.3 billion were unchanged from last year. Earnings per share declined 17% from the same period last year to $0.10, excluding a $0.03 per share charge for closing its web-hosting business and the write-off of acquired technology. Intel reported solid market share gains in microprocessors, chipsets and flash memory with average selling prices holding firm for PC microprocessors. Server and laptop microprocessor segments delivered strong growth. Intel continues to increase its technological lead with more than 50% of its microprocessors built with 0.13 micron geometries. The company’s stock price has declined 40% since March 31.


At the end of June, Solectron reported its fifth successive quarterly operating loss. Quarterly revenues for the third successive quarter reached $3 billion, indicating that Solectron’s business decline is nearing an end. The company expects its fiscal fourth quarter revenues will show no improvement, but no significant decline. Solectron has secured new production contracts from existing customers, such as Cisco and new customers such as Delphi and Maytag, which will bring revenues up to $4 billion a quarter when customers finally commit to full scale production.

Solectron is operating at 55% of manufacturing capacity, which is 40% below its peak during the third calendar quarter of 2001 when revenues surpassed $5.6 billion. The company has incurred restructuring costs of $1.1 billion to cut capacity and to shift one-third of its remaining capacity from high cost locations in the U.S. and Europe to low cost Malaysian, Chinese, Mexican and Eastern European plants. During this agonizing period, Solectron has improved its balance sheet by reducing inventories, receivables and debt. In June, it repurchased, at a discount, nearly two thirds of next year’s putable debt. The absence of any signs of any upturn in production rates for communication and information technology equipment has crushed Solectron’s stock, which now sells at tangible book value.

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