3rd Quarter, 2002

Publicly traded companies’ third quarter earnings, including the good results achieved by most of yours, were reported shortly after stock prices began rising, following a fall back to the mid-summer lows in early October. Investors, at best, ignored the results amid their preoccupation with questions about the sustainability of the rally. Stocks of companies reporting poor earnings or earnings encumbered with accounting explanations were sold ferociously. Equity mutual funds, whose fiscal years end in October, quickly sold any suspect stocks, especially if their prices fell.

Any analyst enthusiasm inspired by third quarter earnings were tempered by a desire to show probity. Unsullied analysts and especially those at the ten most eminent investment banks are understandably apprehensive about the implications of their firm’s acceptance of an ill-defined overall settlement with the SEC and state attorneys-general for the liability investment banks face for pressing analysts to tout banking clients’ stocks. The solution proposed would separate retail investment research from investment banking. The proposal envisions a fund, administered by a government research oversight board, paid for from a five-year, one billion dollar contribution from the ten largest investment banking firms to finance independent research. The research produced, however, will prove flawed, if as stated, it is directed toward encouraging retail investors to make buy and sell decisions.

The major investment banks currently spend as much as $800 million each on their investment research. They subsidize their research departments because customers are unwilling to pay the full cost. Research reports are analogous to journalists’ stories in newspapers or magazines. The advertiser pays for those. On Wall Street, the advertiser is the investment bank. Today, even The New York Times no longer pretends its news stories are free from bias. In the 70’s, The Washington Post installed an ombudsman, Ben Bagdikian, to judge the fairness of its news coverage and he was empowered to report his findings unedited in the paper. Despite his journalistic credentials, he had no effect on the Post’s editorial leanings. Goldman Sachs, in response to the investment banking research scandal, has appointed an ombudsman, Gerald Corrigan, the former Chairman of the New York Federal Reserve Bank. Like editors, research directors are ostensibly responsible for imposing standards governing the factual content and opinions expressed in reports. As events have proven, failure to carry out this duty redounds to the detriment of investment firms and all their customers.

Harvey Pitt’s resignation as Chairman of the SEC will slow the ill-conceived rush to appropriate funds from investment banks to finance government approved investment research. Delay in resolving the legal liabilities and conflicts of interest arising from investment banking firms peddling of investment advice to retail customers through their brokerage divisions leaves research analysts in limbo. The current plight of research analysts affects us. Despite the deserved discredit heaped on some, many analysts’ opinions still influence trading decisions of institutional investors, including some who own our stocks. In reacting to publicized criticism of analysts’ excessive past enthusiasm for the companies they covered, many firms now limit the number of stocks analysts can recommend as buys. This regimen introduces added caution into analysts’ interpretation of the careful forecasts provided by company executives under regulation F.D. This behavioral change disrupts the well nuanced communications institutional traders and portfolio managers have with trusted analysts, making stocks even more volatile. An October cut in the rating of First Data by an analyst at a major firm, for example, produced a two-day 20% drop in the company’s stock. As of this writing, it has more than recouped from the drop. The current confusion surrounding analyst calls should help us acquire at good prices shares of the companies we want to own during the months ahead, but it nevertheless is bad for the stock market and those analysts who adhere to professional standards of conduct.

State Street

State Street’s third quarter earnings of 56¢ per share, 6% higher than a year ago despite a 1% revenue decline, confirms management’s ability to deliver on its commitment to control costs, which were 4% below the year ago level. Lower net interest margins caused by State Street’s decision to shorten the duration of its fixed income portfolio produced the revenue decline. The company continues to gain assets from new clients added during the quarter, including custody services for the Texas Teacher’s Retirement System’s $80 billion of assets and the Ohio Public Employees Retirement System’s $55 billion.

State Street’s reported results were received by investors in the context of the poor results announced by Bank of New York and Northern Trust and, therefore, they provided relief. Any enthusiasm was lessened by anticipation of the terms State Street might obtain through exclusive negotiations for the acquisition of Deutsche Bank’s Global Securities Services, which were announced on November 5. The terms specify a minimum price of $1.2 billion at closing for State Street’s acquisition of annual revenues of $700 million for providing global custody, fund administration, benefit payment services and performance measurement services to Deutsche Bank’s institutional customers in Europe, the U.K., Asia and the U.S. The agreement includes a performance payment of up to an additional $300 million based upon the profitability of the business retained by State Street. It also includes a ten-year contract from Deutsche Bank guaranteeing continuation of revenues from Deutsche Bank’s investment management businesses, which generate 25% of the acquired revenues.

This acquisition will add over $2 trillion to State Street’s assets under custody, more than doubling the assets serviced in Europe and should raise State Street’s return on equity. Under the agreement, State Street can fund $650 million of the purchase price by issuing stock to Deutsche Bank. That may result in a 5% increase in shares outstanding. The acquisition may reduce next year’s earnings by as much as 3¢ to $2.35 per share. Although State Street’s stock price has risen 30% above its October low, it still is 18% below its price at the beginning of the year.


AIG reported third quarter earnings of 85¢ per share, 13% above last year’s results before inclusion of losses incurred in 2001 from the terrorist attack on the World Trade Center. During the quarter, AIG’s net premiums earned rose 28% above last year’s comparable results, while worldwide life insurance premiums increased 16.5%. Highly profitable foreign life premiums rose 21%. AIG now has 14,000 life insurance agents trained and licensed to sell insurance in China.

We believe investors remain spooked about AIG’s exposure to capital markets through its financial services division, which produces 18% of operating profits. These worries are exacerbated by the disappearance of earnings from AIG’s private equity portfolio and equally poor results from SunAmerica’s private equity investments. This has led to close scrutiny of the poor performance of Sun America’s variable annuity business and the newly acquired American General fixed annuity business, which is meeting its goals. Together these two businesses constitute 6¢ of AIG’s earnings. Two weeks ago Moody’s reaffirmed AIG’s AAA rating. AIG’s stock price has declined 20% this year in line with the S&P.

First Data

First Data reported an 18% jump in earnings per share on 13% revenue growth. Western Union posted a 17% increase in money transfer transactions overall, driven by strong international transaction growth of 33%. Western Union added 5,000 agents to its network this quarter bringing its total worldwide agents to 135,000 locations. FDC processed 2.6 billion credit and debit card transactions, an increase of 18% during the quarter. Merchant dollar volume processed rose 17% to $144 billion. Merchant transaction growth was boosted 4% by the company’s acquisition of PayPoint, a large PIN-based debit transaction processor. Card accounts on file rose 7% to 325 million. FDC stock rose 25% during October, but remains down 11% this year.

Concord EFS

Concord EFS reported 30% revenue growth and 6% earnings per share growth, in line with management’s reduced earnings forecast on September 5. During the quarter PIN debit transactions surged 35% as total credit, debit and ATM transactions rose 22%. The company remains on track to process 10.5 billion total transactions this year. Concord continues to streamline its operations following several acquisitions and is recording the full expenses associated with these activities in its operating results.

Concord’s stock remains depressed as investors worry about the margin compression resulting from acquisition integration costs and the impact of lower per transaction prices charged to large merchants. Additional uncertainty relates to six large banks, which are current STAR ATM/debit network customers under contract through 2004. Concord’s STAR network is the industry leader, but VISA is vying to secure part of this business. Concord’s stock moved from NASDAQ and began trading on the New York Stock Exchange under the symbol “CE” on November 7, 2002. The company’s stock has fallen 55% since the start of the year.

Automatic Data Processing

ADP reported a 10% increase in earnings per share on a 2% improvement in revenues during its fiscal first quarter. The company’s core payroll processing business reported 12% profit growth driven by reduced costs and growth in add-on services such as Total Source, ADP’s human resource management outsourcing business. Brokerage services profit dropped 17% as industry consolidation and declining retail trading activity hurt its business. During the quarter ADP invested $640 million repurchasing 18 million of its shares, about 3% of fully diluted shares outstanding. ADP stock has risen 22% in October and is up 38% from its mid-July low.

CH Robinson

CH Robinson reported 15% earnings per share growth on an 11% rise in total revenues. Robinson’s core truck brokerage business picked up during the quarter gaining 5% from a year ago, the highest growth reported since last year’s third quarter. Robinson’s transportation of perishables business rose 8%, and T-Chek, its fuel and fleet management business, rose 27%. Margins expanded again this quarter as management held operating cost growth to 3%. These strong results attest to managements’ focus on execution and demonstrate the attractiveness of Robinson’s flexible operating model. CH Robinson stock was up 9% in October and is up 3% since the start of the year.


DST Systems reported a 13% gain in earnings per share as overall revenues declined 6%. DST’s core mutual fund shareholder account processing business grew its account base to 85 million, up 8% since the start of the year. New clients include Columbia, Nuveen and Pioneer. DST is scheduled to convert 6 million additional new accounts onto its US system in the first quarter of 2003 and will add nearly 2 million accounts on its UK platform by the end of 2003. In addition, there are 12 fund groups with 21 million accounts actively seeking a new processor. DST’s print mail and cable/satellite subscriber billing businesses remain a drag on growth as a result of lost business and client consolidation.

One-third of DST’s shares outstanding are held by Stilwell Financial. As part of Stilwell’s reorganization plan, the incoming management team from Janus has stated that they intend to monetize its DST holding. The uncertainty related to the disposition of these shares may continue to depress the price of DST stock. If DST sold its 12.8 million shares of State Street and its 8.6 million shares of Computer Sciences and repurchased half the shares held by Stilwell/Janus, the company would increase its earnings per share. DST stock is down 38% this year through the end of October.


Harte-Hanks reported flat earnings per share results on a 1% improvement in revenues. Harte-Hanks Shoppers continue to post strong results with revenues and operating income up 6% and 11% respectively. Harte-Hanks announced its plan to significantly expand its distribution in Northern California next year which will boost revenue growth but depress margins during the start-up. Revenue from Direct Marketing posted its smallest year-over-year revenue decline since the first quarter of 2001. Operating income from this business declined 24%, however, as pricing pressures and an inability to further reduce expenses hurt margins. Business from retail and hi- tech and telecommunications customers, who account for more than one-half of direct marketing revenues, were flat during the quarter. The smaller automotive segment reported double-digit revenue growth while healthcare, pharmaceutical and international customers spent less. These disappointing results lead us to conclude that 2003 will remain a difficult year for Harte-Hanks business. Free cash flow remains strong, but profitable growth is harder. Harte-Hanks stock is up 2% this year.

Varian Medical Systems

Varian Medical Systems’ fourth quarter earnings per share rose 29% on revenues of $261 million, a 16% increase over last year. Earnings for the year were 31% above last year’s, while revenues increased 13% to $873 million. The high margin North American market for advanced radiation oncology systems grew 27% in the fourth quarter compared to the same period last year. A recent survey of radiation oncology centers indicated that 90% of the 170 respondents have either installed advanced systems or plan to do so within the next three years. New products introduced during October’s annual meeting of radiation oncologists will accelerate Varian’s sales and earnings growth in fiscal year 2003. Varian’s stock price increased 12% in October and is up 33% this year.

Express Scripts

Express Scripts reported a 39% increase in earnings on revenues of $3.4 billion, an increase of 44% over the third quarter of 2001. Organic growth accounted for about half of the quarter’s increases in mail pharmacy and retail network claims, which grew 30% and 26% respectively over the same period a year ago. The company’s growth continues to be driven by the savings the company provides to plan sponsors and their members by encouraging the use of the mail pharmacy and generic drugs. The expanded use of three new generic drugs has saved plan sponsors $124.2 million and consumers $37.4 million through lower co-payments over the last 14 months. The company raised its earnings forecast for 2003 to $3.10 in mid-October. Express Scripts’ stock price increased 8% in October and has risen 12% since the start of the year.


Walgreen’s reported fourth quarter and fiscal year 2002 revenues of $7.2 billion, a record, and $28.7 billion respectively, increases of 15% and 16% over the same period last year. Earnings per share climbed 14% for the quarter and 15% for the year. Prescriptions dispensed in fiscal year 2002 grew 12% to 361 million, more than double the countrywide prescription growth rate of 5%. Superb inventory management has positioned the company for accelerated earnings growth. Inventory levels grew 5% during the year while the company opened 363 stores. Investor fears of weak holiday season spending have brought Walgreen’s stock price to within 2% of its July low.


Merck continues to progress through a difficult year with no surprises. Third quarter earnings per share declined 1% to $0.83 while revenues for the quarter grew 8% to $12.9 billion. Recent good news has begun to restore investor confidence in the company. On October 28, the FDA approved the launch of Zetia®, the novel cholesterol-lowering drug from the Schering Plough joint venture. On November 4, a U.S. District Court upheld Merck’s patent for once-daily Fosamax® against a challenge by two generic drug manufacturers. Merck’s stock price has increased 15% during October, leaving it 8% below its price at the beginning of the year.


Intel’s third quarter sales of $6.5 billion were unchanged from the same period last year, while earnings per share increased 43% to $0.10 from $0.07 on a comparable basis. Strong sales of microprocessors brought Intel’s market share to its highest level in four years. The company introduced 18 processors based on 0.13 micron technology, including Pentium 4 processors with speeds of 2.5 to 2.8 GHz and a lower cost Celeron processor with a speed of 2.0 GHz. Intel’s recently announced nanotechnology breakthroughs should allow the company to produce chips with 90 nanometer (0.09 micron) geometries on 300 mm wafers in volume next year. Although the company’s stock price has increased 45% from its 12-month low in October 8, it remains 45% below its price at the start of the year.


PepsiCo’s third quarter earnings increased 14% on revenue growth of 4%. New products such as Go Snacks (bite-sized snacks in canisters), Pepsi Blue and Propel (water with vitamins and electrolytes) accounted for most of the market share gains and sales growth. These products also carry premium prices. The company reported market share gains in all segments, especially for salty snacks where share in measured channels grew 1.9% during the quarter, its 19th straight quarter of gaining share. After rising 18% from its September low, PepsiCo’s stock is down 12% for the year.


The unrelenting decline in information technology and telecommunications equipment sales hurt Solectron’s sales and earnings this year. The company reported fiscal year 2002 sales of $12.7 billion, down almost one-third from last year. Sales in the fourth quarter of $3.1 billion were unchanged from the third quarter, as was the 4¢ loss per share. New business from existing and new customers offset the weak telecommunications equipment market during the fourth quarter. The Global Services division, Solectron’s newest and most unique outsourcing service for the electronic equipment aftermarket, more than doubled this year with sales of $823 million, compared with $310 million a year ago. The decreasing lifecycle of computers, peripherals and other electronic equipment has resulted in a large volume of obsolete equipment that cannot be disposed of in local landfills. Solectron offers a range of lifecycle management services including technical support, repair of new equipment and refurbishing, remanufacturing, recycling and disposing of obsolete electronic equipment.

Solectron’s management stated that they are near completion of planned plant closings in the US and Western Europe. This rebalances the company’s production toward low cost regions with two thirds of remaining capacity in Asian, Mexican, and Eastern European plants. The company anticipates up to $150 million of further restructuring charges over the next two quarters to complete this process. Solectron has also made progress restructuring its balance sheet with a $1.3 billion reduction in inventories, a $655 million reduction in accounts receivable and a $1.9 billion reduction in debt. Solectron’s stock price has increased 67% since October 1 and has doubled from its September low. The recent rise from the low is partially due to mutual funds taking tax losses before their fiscal year end on October 31.

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.