1st Quarter, 2003

After the U.S. led coalition’s military successes allayed investors’ fear of dire repercussions flowing from prosecution of a war against Saddam’s regime, the U.S. stock market leapt nearly 13% from the low registered in mid-March to a peak in mid-May. At that point, the S&P was up 4% from the start of the year. So far this year stock prices have moved inversely to spot oil price gyrations. The oil price soared almost 20% from the beginning of January through mid-March. It thereupon dropped precipitously and then rebounded slightly to a mid-May price 4% below the price at the start of the year.

The current low interest rates, which are the lowest in 42 years, and the prospect of continued low rates implied in the Fed’s announced concern about forestalling deflation augurs well for the stock market. In his testimony this week, Alan Greenspan stated that “the probability of an unwelcome substantial fall in inflation [a phrase connoting deflation] over the next few quarters, though minute, exceeds that of a pickup in inflation.” This statement along with the thrust of his testimony confirms the Fed’s commitment to keeping rates low.

The assurance of low short-term rates during the months ahead will help facilitate the financing of deals transferring assets bought during the boom by poorly managed, over-leveraged companies to competent operators. These deals cleanse our economic system. They also enable analysts to see clearly the value of predictable free cash flow generated from business operations, because acquirers spell out the future sources and uses of cash to secure their financing. The arrival of these deals at the end of past bear markets has rekindled investor confidence. Interested observers then can see managements using realistic projections to make money for themselves and their investors. The use of investment research tools by smart, well-financed buyers for the purpose of making sound moneymaking long-term investments inspires other analysts and investors to search for similar opportunities in the stock market.

State Street

State Street’s first quarter operating earnings of 44¢ per share were 15% below its year ago results, although fee revenue from institutional investor services rose 17% to $694 million, including a $96 million contribution from Deutsche Bank Global Securities Services (GSS). State Street’s revenues from its base business rose 2 ½% during the quarter, reflecting the competitive strength of its core franchise. The earnings decline is attributable primarily to a compression of short-term interest rate spreads, which drove down net interest revenues 27%. Narrowing spreads also caused a 15% decline in securities lending revenues. In the quarter, State Street incurred a 7¢ per share after tax acquisition expense and paid a retroactive Massachusetts tax assessment equal to 8¢ per share. Dilution from sales of shares to finance the acquisition of GSS cost 2¢ per share. Assets under custody at the end of the quarter rose to $7.9 trillion, including $1.9 trillion from GSS.

Since the signing of the GSS purchase, State Street has secured $60 million in annual fees for fund pricing and administration that were not included within the boundaries of the deal. This adds to the $159 million in annual revenues obtained from Deutsche Bank Asset Management. In addition, State Street has received firm commitments or signed 60% of GSS’s top 100 clients who account for 71% of its revenues. State Street remains confident that it will convert 90% of the top 100 to its system.

The opportunity posed by the GSS acquisition and cost pressures throughout the securities industry have impelled State Street to cut costs in its existing business by offering early retirement inducements to employees over age 50 who are reluctant to rely on State Street’s technology to serve client needs. The cost cutting will reduce ongoing quarterly operating expenses in State Street’s base business to $650 million, an 8% reduction from the first quarter run rate. State Street’s stock price declined 7.6% from the beginning of the year through May 15. This decline includes a strong 19% rebound from its March low.


AIG reported first quarter earnings of 90¢ per share, 11% above the 81¢ earned a year ago. These operating results were achieved despite a $1.17 billion addition to AIG’s insurance reserves. This addition comes on top of the $2.8 billion fourth quarter addition to reserves, which raises total property and casualty reserves to an astounding $31.5 billion. These reserves compare to the $27.4 billion of net premiums earned from these insurance lines last year. The reserve additions do not reflect an escalation of AIG’s exposure to asbestos liabilities nor is an increase required because AIG’s reinsurers are failing to pay claims when they come due. None of AIG’s risks were reinsured by Gerling Re, the near insolvent German reinsurer that cannot pay $47 million in claims owed to GEICO, Berkshire Hathaway’s auto insurance subsidiary. AIG’s added reserves enable it to insure more risks while ceding less to reinsurers, which buttresses current and future earnings growth.

Operating earnings at AIG’s unequaled foreign life insurance business rose 21% during the quarter. Premium income in China rose 25% during the quarter, although this growth occurred before the government imposed restrictions to contain SARS. These restrictions curtail the activities of AIG’s 15,000 Chinese agents. Until the disease is contained, AIG’s Chinese life insurance business will remain hobbled. Financial services operating profits rose 11%, although profits from ILFC, AIG’s aircraft leasing subsidiary were no higher than a year ago. It is insulated from the implosion of the U.S. airline industry. The only U.S. carriers it leases to are Jet Blue and Southwest Airlines. After recovering 28% from its March low, AIG’s stock price on May 15 was 4.7% below its price at the start of 2003.

First Data

Eight days after announcing its agreement to acquire Concord EFS for $7 billion in stock, First Data reported strong first quarter results. Revenues of $2 billion rose 15% while earnings per share grew 22% to 39¢. Growth was primarily driven by the continued expansion of Western Union’s agent network, fueling money transfer volumes. Merchant processing services also contributed to the quarterly improvement.

Western Union’s consumer-to-consumer money transfers, representing the bulk of division profits, rose 23% worldwide, including a one-third increase in US to Mexico transfers. Overall international transfer volume rose 27%. Consumer-to-business transactions, mostly for payment of utility bills, rose 11%, while ValueLink stored value card transactions, notably for Starbucks, rose 43%. The number of Western Union’s money transfer agent locations rose 28% worldwide to 159,000. During the quarter Western Union added 8,000 new agents including 3,000 new Australia Post agents.

Merchant services grew at a double-digit rate driven by 21% and 23% gains in transactions processed and dollar volume processed respectively. Implementation of the VISA and MasterCard settlement with retailers in the “Wal-Mart suit” is expected to provide a lift in transaction volume through First Data’s NYCE pin-based debit network, which is scheduled to be combined with Concord’s much larger STAR network. The Concord acquisition is expected to close by this year’s fourth quarter, after regulatory and shareholder approval. FDC’s stock price has risen 16% since the beginning of the year.


ADP reported fiscal third quarter revenue of $1.9 billion, up 2%, and earnings per share of 54¢, down 4%. ADP’s core payroll processing business posted a revenue gain of 6% and profits 15% above a year ago. This improvement came because existing customers continue to utilize additional ADP products despite weakness in new client sales and a small reduction in client payrolls. Overall results were pulled lower because trades processed per day declined 26% at the company’s brokerage services division. This decline in high margin retail trade activity reduced segment profit by half. ADP’s recently announced outsourcing agreement with E-TRADE will help. ADP’s stock price is down 12% since the beginning of the year.

DST Systems

DST Systems reported a first quarter decline in earnings per share of 7% on flat revenues, marking the first quarterly fall in earnings per share since the company came public in 1995. The most disappointing aspect of the results is the deceleration in profit growth obtained from the company’s core mutual fund shareowner account processing operation. Mutual fund shareholder accounts processed, excluding the 5.5 million accounts converted onto its system from AIM Management, declined by 0.5%. The company’s printing and mailing operation continues to be a drag on profits, as revenue and profit fell 6.8% and 41.5%, respectively. Management lowered its forecast of earnings per share to only 3% to 6% for the full year. DST shares have declined 6% since the beginning of the year.

Express Scripts

Increases in generic drug use, mail pharmacy and specialty distribution claims produced first quarter earnings per share of 74¢ for Express Scripts, a 35% gain over the first quarter of 2002. Generic drug use reached a new high of 47%, mail pharmacy claims grew to 19% of adjusted claims and specialty distribution claims grew 33% to 900,000. Revenues for the quarter were $3.2 billion, a 26% increase over the first quarter of last year. The company’s newest mail pharmacy in Tempe, Arizona can fill 60,000 prescriptions per day and has operated without error since January. This pharmacy will fill mail prescriptions for the Department of Defense, the largest mail pharmacy contract in the nation. Express Scripts’ stock price increased 31% since the beginning of the year. It is close to its 52-week high of 65.


Walgreen’s second quarter 2003 earnings grew 14% to 36¢ per share versus the same period last year. The company also reported record quarterly sales of $8.4 billion, a 13% increase over last year. The total number of prescriptions filled has grown more than 6% over the second quarter of fiscal year 2002. Walgreen’s celebrated the opening of its 4,000th store by offering its 141,000 full-time and part-time employees a one time stock option grant of 100 shares. Walgreen’s stock price has increased 9% since the beginning of the year.


Merck reported first quarter earnings per share of 76¢ and revenues of $13.4 billion, 7% and 10% increases over the first quarter of 2002. The company’s pharmaceutical sales grew 18%. On April 22nd, Merck announced that it would spin off Medco Health Solutions to shareholders later this year. Medco’s sales were $8.3 billion, an increase of 4% over the first quarter of 2002. An improvement in gross margin accounted for a 71% increase in net income for the quarter to $102 million. Merck’s stock price has increased 5% since the beginning of the year, despite a steady din of adverse publicity about drug manufacturers’ marketing practices.

Patterson Dental

Patterson Dental reported fourth quarter earnings per share of 40¢ and fiscal year 2003 earnings of $1.70. Revenues grew 12% in the fourth quarter to $447.3 million and 17% for fiscal 2003 to $1.66 billion. Sales of dental equipment and software grew 14% in the fourth quarter as manufacturers of the office based crown restoration and digital radiography systems introduced ancillary products that make their productivity enhancing equipment easier to use. The company has also rolled out its enhanced technical service system during the quarter. All service vans are equipped with GPS devices so dispatchers can reduce customer call response times by sending the closest technician. Technicians also have handheld computers to track inventory in real time and to improve customer billing. The stock price has recovered 23% from its March low once the company addressed investor concerns about the sustainability of its above market growth rates.

Varian Medical Systems

Varian Medical System’s second quarter fiscal 2003 results were stronger than they expected. The company reported earnings per share of 48¢, revenues of $266 million and orders of $277 million, increases of 41%, 21% and 27% over the same period last year. Oncology systems experienced rapid growth in orders of high-margin upgrades, accessories and software needed to implement its advanced radiation systems. The number of clinics offering Varian’s SmartBeam™ IMRT systems rose by 60 to 292, 12% of the clinics that use Varian’s equipment. The company raised its fiscal year 2003 earnings guidance for the second time this year from $1.68 to $1.74 per share, a projected increase of 31% over fiscal year 2002. The company’s stock price has increased 6% since the beginning of the year. It is 5% below its 52-week high of 55.


The launch of the Centrino™ Mobile Technology was the highlight of Intel’s first quarter. This launch marks the beginning of the convergence of computing and communications that Intel has been investing in and promoting for several years. Centrino™ enables wireless connectivity, extended battery life and thinner and lighter notebook designs. Initial demand for notebook PCs with Centrino™ technology exceeded the company’s expectations with shipments of several hundred thousand units. Intel expects to ship more than one million units during the second quarter. Paul Otellini, Intel’s Chief Operating Officer, expects that by the end of the year all purchases of new notebook PCs will include wireless capabilities, an acceleration of the forecast adoption rate and a driver of new sales. Intel reported earnings per share of 14¢ on revenues of $6.75 billion. Earnings were unchanged from the first quarter of 2002, while revenues declined 2%. Intel’s stock price has increased 25% since the beginning of the year.


PepsiCo reported earnings per share of 45¢, a 17% increase over the first quarter of 2002. Revenues grew 5% to $5.5 billion. Frito-Lay’s total volume grew 4%, at the high end of the expected range. Growth was hampered by lower convenience store sales because of the cold stormy winter. The initial response to new “natural” and/or “organic” salty snacks contributed to the 25% revenue increase in the “better-for-you” snack category during the quarter. Pepsico’s stock price has increased 3% since the beginning of the year, having recovered 17% from its March low.


Harte-Hanks reported first quarter results below management’s forecast. Revenues rose less than 1% and earnings per share dropped 14% to 18¢. The entire profit decline occurred at the company’s direct marketing unit. For the first time since the public offering in 1993, direct marketing contributed less than half of the company’s operating income. This also marks the first quarter since 1993 that earnings per share fell below the corresponding quarter of the previous year. Direct marketing operating income dropped 28.3% on a 1.5% decline in revenues as costs soared. Financial services, pharmaceutical and healthcare customers spent at least 10% less for Harte-Hanks services this quarter than they spent a year ago. Retailers and technology companies barely increased spending. Management uncharacteristically failed to keep a lid on costs during this period of increased business uncertainty, continued pricing pressure and delayed customer decision making.

Harte-Hanks shoppers generated satisfactory results with revenues rising 4.5% and operating income up 1.2%, during a period when sales were disrupted by departures of military dependents from San Diego as sailors and Marines moved out to the Middle East. Shares of Harte-Hanks have risen 3% this year.

CH Robinson

CH Robinson’s year is off to a strong start as the rebound in the company’s trucking services operation continues. Gross revenues during the first quarter rose 10%, while revenues net of third-party transportation costs rose 17%. Robinson’s earnings per share soared 29%, as expenses remained contained. The company plans to hire more people to support its customers who are outsourcing more of their transportation needs to Robinson. Management commented that the trucking marketplace remains volatile with changing capacity and fuel and insurance costs adding to near-term uncertainty. This honest assessment of Robinson’s difficult operating environment is characteristic of the candor expressed by this company’s excellent executives. It exemplifies the forthrightness we expect from the executives of the companies we choose for investment. The stock price has appreciated 20% since the beginning of the year.

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.