4th Quarter, 2002

Investor concerns about the looming consequences of a war in Iraq on our economic and political prospects diminished the importance of most companies’ fourth quarter and year-end earnings reports. Surprise announcements, such as those from AIG and Concord triggered massive institutional selling, whereas unexpectedly strong results from CH Robinson and Varian only brought these stocks up to the top of their trading ranges.

Declining stock market volume and persistently high volatility are measures of the lessened willingness of Wall Street firms to risk money trading stocks, a bear market characteristic. All markets tend to overshoot by rising too high and falling too far, which reinforces our determination to wait patiently to buy shares in the few companies meeting our criteria. We wish to buy only when they sell at prices equal to our calculation of their worth.

We expect that our willingness to wait will be undisturbed by optimistic market moving forecasts from the managements of any of the companies we wish to own. Most good business leaders are increasingly hesitant about making public predictions about their businesses because these are laden with liability and recall too readily the pronouncements of recently discredited celebrity executives. Talk from neither business executives nor stock market seers ever changes the market’s direction. An upturn comes after investors see well-financed, cost-conscious operators buying moneymaking businesses from the cash strapped companies that heedlessly bought during the boom. These buyers will be distinguished by having the managerial experience that was ignored during the Internet craze.

State Street

State Street’s earnings of 56¢ per share during the fourth quarter and $2.10 for the year, before a 90¢ extraordinary gain, attest to its skill in building its fee business during difficult times and its ability to control costs. At year-end, assets under custody of $6.171 trillion were less than 0.5% below the previous year, while equity prices worldwide registered a 21% decline, as measured by the Morgan Stanley’s Capital International index. New business made the difference, especially business gained from fixed income managers, such as Pimco and Nuveen. The flattening yield curve squeezed State Street’s net interest margin, dropping it to 1.2% during the fourth quarter. Narrow interest rate spreads also hurt securities lending revenues, while heightened war worries curtailed cross-border investment flows and foreign exchange revenues.

On January 14, State Street sold 7,153,000 shares of its common stock and placed $345 million of convertible debt securities to complete the funding of its acquisition of Deutsche Bank’s Global Services Business with assets under custody of $2 trillion. This financing dilutes State Street’s equity by less than 5%. The acquisition offers an opportunity to secure revenues equal to 25% of State Street’s existing fee revenue, and, if State Street continues to control costs in a business it knows well, it could add 10% to State Street’s base earnings after a year. As of this writing, the conversion of Deutsche Bank’s clients, which began last fall, is going well with no untoward surprises. Following the offering, State Street’s stock price declined 7%, leaving it 7% above the low set on October 10.


AIG’s fourth quarter earnings report was anticlimactic because its release came ten days after the company announced its first-ever extraordinary charge to increase loss reserves on policies written during the five-year period ending in 2001. The announced $1.8 billon after-tax charge is a paltry amount when compared to AIG’s total general insurance loss reserves of $30.4 billion, but it is a large sum. An actuarial revision of this size is akin to an accounting restatement, which investors have come to loathe. After the revelation of the extraordinary charge, AIG’s stock dropped 15%. At the end of February, the stock languished 6% below its price on October 10. The extraordinary charge equals 68¢ per share. During the five years requiring retroactive additions to loss reserves, AIG’s total earnings were $10.44 per share.

After its reserves strengthening charge, AIG earned only 20¢ per share during the fourth quarter. Earnings for 2002 of $2.70 per share were 3.6% less than the $2.80 earned a year ago when it incurred losses from the World Trade Center attack. During the fourth quarter net general insurance premiums written rose to $7.2 billion, 39% higher than the previous year. Most of this increase in premiums comes from higher prices for comparable coverages, which promises a strong rebound in underwriting profit this year. Operating profit at AIG’s unequaled foreign life insurance business rose 28% in the fourth quarter and 21% during the year. AIG’s financial services businesses, which rely upon the company’s AAA rating, reported a 10% earnings increase for 2002. S&P has reaffirmed AIG’s credit rating. AIG’s stated objective is earnings of more than $3.75 per share this year.

Concord EFS

On February 13, Concord EFS announced disturbing management changes. Ed Labry, the long-time Concord President and its best salesman, remains in this position instead of being elevated to CEO in May, as previously announced. Instead, Bond Isaacson, hired just five months ago, becomes co-CEO along with the current CEO, Dan Palmer, who, had planned to move up to Chairman. Instead, Richard Kiphart, an outside director who runs William Blair’s investment banking group, becomes Chairman of the Board. Bond Isaacson was hired in the fall from Bank of America, a customer of Concord, in order re-sign contracts with eight large banks participating in the STAR ATM/debit network. Prior to Bank of America, Isaacson worked for VISA, the STAR network’s primary competitor. We have met Bond, and conclude that his rapid advancement signifies trouble. The new management structure may undermine Ed Labry’s ability to command the organization to serve customers’ needs, or worse yet, impel Ed to leave the company.

On February 18, Concord announced 2002 revenue growth of 28% to $2.2 billion and earnings per share growth of 16% to 68¢. Fourth quarter earnings per share rose only 6%. Competition in Concord’s markets is fierce, requiring attentive selling to secure and renew customer contracts. Overall credit, debit, ATM and electronic benefit transfer transactions processed by the company rose 18% last year to 10.8 billion, about one-fifth of all such transactions in the US.

Concord cut its earnings forecast for 2003 to between 75¢ and 79¢ per share, lowering growth to between 10% and 16%. Concord’s operations, excluding interchange settlement, which can fluctuate based upon the last day of the fiscal year, generated $300 million in free cash flow. Cash and marketable securities on the company’s balance sheet exceed $3 per share. Concord’s stock has declined 20% since October 10th.

First Data

First Data reported strong fourth quarter and full year results driven by continued growth in Western Union money transfers and electronic card-based transactions processed. Revenue during the quarter rose 18% to more than $2 billion, and for the full year reached $7.6 billion, up 15%. Earnings per share rose 17% in the quarter and 18% for the year to $1.66. The company’s operations generated free cash flow of $1.4 billion. Management forecast full year 2003 results of between $1.87 and $1.93, representing an increase of 13% to 16%.

Western Union money transfers rose 22% worldwide as agent locations increased 31,000 to 151,000, up 26%. More than one-third of the new agents are in India and China. The current backlog of signed locations scheduled for installation in 2003 is 23,000. Credit and debit card transactions processed at merchants grew 16% to 10.2 billion as the total dollar volume processed increased 15% to $562 billion. During the year First Data boosted its ownership stake in several merchant alliances, notably with Wells Fargo. Credit and debit card accounts processed reached 325 million, a gain of 4%. The company plans to convert its 82 million card backlog, which includes GE’s retail cards, during the next two years. Bank One has announced its intention to license a competitors card processing software and insource the processing of its 50 million cards in mid-2004. First Data’s stock is up 16% from the low on October 10th.


ADP’s fiscal second quarter earnings per share of 43¢ was 2% higher than a year ago with no revenue growth. These results reflect no increase in client payrolls, low interest rates and an increase in the rate of decline in the company’s broker trade processing operation. Client retention in ADP’s core payroll processing operation improved from already high levels. Add-on services, including 401k and benefit plan administration, rose 13%. Revenues from these add-on services now comprise 30% of the Employer Services segment revenues, up from 10% ten years ago. ADP’s payroll and tax filing float reached $8.0 billion, up from $7.8 billion a year ago. Art Weinbach, ADP’s Chief Executive, forecasts low single digit revenue and earnings per share growth for the full year, bringing earnings per share for fiscal 2003, ending in June, to $1.80. Free cash flow will again reach $1.3 billion. ADP stock has declined 11% since the October 10th low.


Harte-Hanks’ management bluntly reports that its business remains difficult. The company reported fourth quarter revenue and earnings per share gains of 3% and 4% respectively. Comparable figures for the full year showed a revenue decline of 1% and earnings per share gain of 2% to 96¢. Harte-Hanks fourth quarter direct marketing revenues were up marginally versus a year ago while operating income declined 4%. This result was substantially better than last quarter’s unexpected decline of 24%. Management changes at many US businesses, along with war worries, have caused many customers to defer signing new contracts. Customers are even putting out existing business for annual re-bids to ensure competitive pricing. The shopper publications, distributed principally in California, continue to perform consistently as revenue rose 6% and operating income gained 11% in both the fourth quarter and the full year. Harte-Hanks generated free cash flow of $106 million for the year, up 8%. Harte-Hanks’ shares are down 3% since October 10th.


DST Systems reported fourth quarter revenue growth of 3% and operating earnings per share of 44¢, up 7%. For 2002, operating earnings per share rose 11% to $1.77 despite revenues remaining stagnant at $2.4 billion. DST’s overall results continue to be hampered by sharply lower earnings from its print mail and subscriber billing business. US mutual fund shareowner accounts processed reached 80.0 million, an increase 5.6 million or 7.5% from a year earlier. During the fourth quarter, the company added 1.7 million new accounts from Columbia, Nuveen and Pioneer. During the year, DST added 4.7 million new retirement plan accounts and 1.4 million new 529 savings plan accounts, offset by the closing of 2.4 million taxable accounts. DST will convert 6 million additional new accounts in this year’s first quarter. Free cash flow for the year exceeded $150 million. The company forecast earnings per share of $1.89 to $1.94 for 2003, a year over year increase of between 7% and 10%. DST’s stock is up 5% from the October 10th low.

CH Robinson

CH Robinson reported an accelerating rebound in its core truck brokerage operation which helped lift fourth quarter operating earnings per share 29%. For the full year Robinson reported operating earnings of $1.15 per share, a 17% year over year gain. During 2002, Robinson delivered 2.7 million shipments for more than 15,000 customers globally. Total transportation revenues retained by Robinson rose 12% during the fourth quarter and 5% for the full year. Robinson’s perishables transportation business, where its largest customer is Wal-mart, was flat in the quarter, but improved 3% for the full year. T-Chek, Robinson’s fleet information and payment management business, rose 28% in the fourth quarter and 23% for the full year. Free cash flow reached $100 million in 2002. John Wiehoff, Robinson’s Chief Executive indicated that double-digit revenue growth in 2003 remains achievable. He noted that January business volumes reflected the same strength achieved in the fourth quarter. Robinson’s stock has risen 14% since the October 10th low.


Pepsico’s comparable earnings per share grew 15% to 50¢ for the fourth quarter and 14% for 2002 to $1.96. Net revenues for the divisions rose 4% to $7.4 billion for the quarter and $25.0 billion for the year. The company’s effort to improve Tropicana’s performance showed results during the quarter. Volume grew 2% during the quarter, and Tropicana gained both market and dollar share in the chilled juice category in January. Pepsico’s stock price declined 6.6% since the market low on October 10th.


Intel reported earnings per share of 16¢ and 51¢ for the fourth quarter and 2002 respectively. Earnings were up 7% from the fourth quarter of 2001 and down 2% for the full year. Full year sales of $26.8 billion were unchanged from last year. Original equipment manufacturers are beginning to see the fruits of Intel’s large research and development effort. The company introduces Intel® Centrino, its new mobile computer technology this month. The Centrino platform includes a new low power processor, chipset, integrated wireless networking and other features that nearly double the battery life of thinner, lighter notebook computers. Intel’s stock price has risen 16% since the October 10th market low.


Merck’s key drug franchises, all #1 or #2 based on worldwide sales in their classes, carried the company through a difficult year. Sales of these drugs grew 18% in the fourth quarter to $4 billion, representing 66% of pharmaceutical sales. The company reported flat quarterly and full-year earnings of 83¢ and $3.14 on revenues of $13.9 billion for the quarter and $51.8 million for 2002. Merck continues to work successfully with the FDA. Its new drug application for EMEND®, the company’s Substance P inhibitor for cancer induced nausea and vomiting, received a priority review on December 6. The FDA awards priority reviews to novel drugs that offer a significant improvement over current treatment of the disease. Merck’s stock price has climbed 17% since the market low on October 10th.

Express Scripts

Express Scripts’ earnings per share for the fourth quarter and 2002 rose 38% and 35% to 72¢ and $2.55 respectively. Revenues grew at similar rates to $3.6 billion and $13.2 billion for the quarter and 2002. Increased use of generic drugs and the mail pharmacy helped Express Scripts lower its clients’ drug costs while improving its own profitability. Operating profit per claim rose 17% to $1.03 in 2002 as generic drug prescriptions reached a record high of 46% of total prescriptions filled and mail pharmacy claims rose from 17.1% to 18.3% of adjusted claims. Express Scripts expects these trends to continue in 2003 along with the growth of Specialty Distribution Services as payors turn to Express Scripts to control costs and ensure the safe use of biotech drugs. The company’s stock price declined 3.6% since the market low on October 10th.

Patterson Dental

Patterson Dental reported third fiscal quarter earnings per share and revenue growth of 19% and 18% respectively over the same period in 2002. Sales of equipment were up 37% as dentists took advantage of tax credits for small businesses. Patterson strengthened its newest single source initiative with a new turnkey package of software, digital radiography equipment, hardware and technical support to both automate and network the dental office. This program produced strong growth in both digital radiography equipment and the clinical software that optimizes the productivity of this new equipment. Patterson’s stock price has increased 3.6% since November 21st when investors reacted negatively to a 1¢ earnings per share shortfall.


Walgreen’s first quarter 2003 earnings grew 21% to 21¢ per share versus the same period last year. The company also reported record quarterly sales of $7.5 billion, a 14.1% increase over last year. Same store pharmacy sales increased 14.7% while the number of prescriptions filled increased 6.7%. Walgreen’s also gained market share in 56 of its 60 core non-pharmacy categories during the last 52 weeks versus all other food, drug and mass market retailers. Sales growth in the categories adjacent to the pharmacy, such as cough and cold products, diagnostic devices, dental needs and cosmetics grew faster than store growth. Sales in these product categories are the most reliable and most profitable non-pharmacy categories for the company. Walgreen’s stock price has declined 13.5% since the market low on October 10th, in spite of its strong first quarter performance.

Varian Medical Systems

Varian Medical System’s performance in the first quarter of fiscal year 2003 exceeded management’s high expectations with earnings per share up 59%, sales up 18%, and orders up 26% compared with the first quarter of fiscal 2002. The backlog increased $121 million to a record $743 million from the first quarter of last year. Orders for oncology systems grew 20% during the last twelve months with 18% growth in North America and 24% growth in international markets. Sales of higher margin ancillary products – attachments to the radiation source, software and service – accounted for 61% of sales this quarter and are growing at twice the rate of the core radiation source business. Varian raised is full-year earnings per share guidance from $1.60 to $1.68. The stock price increased 17% from the market’s October 10th low.

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.