4th Quarter, 2004

All of your companies reported strong earnings for the fourth quarter and the year 2004 except State Street and Merck which we believe you nonetheless should keep. We supplement our comments on your companies’ earnings and stock prices with observations about investors’ current enthusiasm for hedge funds because that is affecting the stock, bond, commodity and currency market.

State Street

State Street’s stock price declined after it reported fourth quarter results laden with extraordinary charges and burdened with costs from a discontinued employee incentive program which it replaced with one aligning manager’s compensation with their divisional operating profits. State Street’s stock price is down 8% since the beginning of the year, after declining 9% in 2004. These movements compare with a 1% decline in the S&P this year and a 9% increase for all of 2004.

Investors’ frustration with State Street stems from the company’s inability to match its revenue growth with comparable profit growth. Although fourth quarter revenues rose 8% above those of a year ago, State Street’s fourth quarter operating earnings of 57¢ per share fell below last year’s 60¢. Operating profit grew 8% during 2004 to $2.47 per share from $2.29 reported for 2003, on a 14% increase in revenues.

Many of those who sold State Street’s stock fear that implementation of the company’s recently signed outsourcing agreement with AXA Investment Managers, Europe’s second largest asset manager, may cause State Street to vacillate on its commitment to contain costs, keeping increases in expenses below realized revenue growth.

Last year State Street earned 42% of its profits from its non-U.S. operations, where operating margins consistently exceed U.S. operating margins even after including the low but increasingly profitable Global Securities Services business acquired in 2003 from Deutsche Bank. We think the experience gained through the nearly flawless conversion of GSS’s business ensures that State Street properly priced the AXA contract and will execute it profitably. State Street’s management knows it must quell investor anxiety about the cost of its large outsourcing commitments to lift the stock price. We expect they will do so. That should happen at the May investor meeting. The stock should be held until then, at least.


On March 14th Hank Greenberg, the personification of AIG for 36 years, resigned as the company’s President and CEO. New York State Attorney General Eliot Spitzer’s threat to prosecute Hank and AIG for allegedly conniving through the use of reinsurance to inflate AIG’s financial results in 2000, compelled the Board to ask for Hank’s resignation. The decision dispels suspicion about Hank’s successor which has weighed upon the stock price. The two officers elected by the Board, Martin Sullivan, CEO and Don Kanak, COO are highly qualified and were Hank’s choices. They are up to the job.

Over the past four weeks AIG’s stock price has declined steadily after rising 8% to $73 when the company reported solid per share earnings of $1.17 for the fourth quarter of last year and $4.35 for all of 2004. Hank’s comments on AIG’s earnings and prospects helped lift the stock. They were interpreted to mean that the company’s just completed $126 million settlement with federal enforcement agencies marked the end of regulatory investigations into AIG’s past dealings. The settlement dismissed charges that AIG improperly provided reinsurance to enable two companies to misleadingly strengthen their financial statements. AIG, in accord with the accountability practices imposed under Hank’s leadership, charged half the settlement cost to the incentive compensation pool of the employees supervising the transactions. That cut AIG’s payment to $53 million or 2¢ per share.

These misuses of reinsurance, though not trivial, pointed the way to more serious charges that AIG itself had used reinsurance contracts in 2000 to impart artificial strength to its own financial statements. Reports in the financial press about prosecutors and regulators examining AIG’s misleading use of reinsurance weighed ever more heavily on AIG’s stock price driving it down 11% from its recent peak when reports from “sources close to the investigation” revealed that Hank was a target and had a hand in securing the allegedly bogus reinsurance. AIG’s Board reportedly acted after the prosecutors provided independent directors with e-mail evidence contradicting Hank’s statements about his involvement in the reinsurance transaction.

All of the foregoing is a lamentable end to a brilliant career by an extraordinary corporate leader. It also is ominous because it shows that complicated financial transactions involving exchanges of risks over time may readily be interpreted as financial manipulations. Our worldwide financial system is replete with trillions of dollars of unexamined financial swaps. Only a few of which are properly priced by markets such as the Chicago Mercantile Exchange.

Hank’s removal as CEO and the financial and managerial consequences do not diminish AIG’s worldwide insurance franchises. It remains the world’s largest insurer, the most profitable property and casualty insurer in Asia and the largest life insurer in that region. Its 2004 worldwide revenues of $98.6 billion generated after tax earnings of $11.4 billion and insurance cash flows of $58.8 billion. The current stock price undervalues AIG’s business.


The Chicago Mercantile Exchange recorded total volume in 2004 of 787 million contracts, up 26% from the prior year, while revenues rose 37% and earnings per share surged 77% to $6.38. Total expense growth was only 11%, while capital expenditures increased 7%. During the year, CME successfully migrated a majority of its Eurodollar interest rate futures volume from its trading pits to its electronic platform Globex. Electronically traded contract volume rose 71% for the year, representing 57% of total volume, up from 42% of total volume in 2003. During the year, trading volume in CME’s Eurodollar futures and options contracts rose 38% and represented 55% of total volume. Equity index contracts traded, led by E-mini S&P 500 contracts, rose 10% and comprised 34% of volume. Foreign exchange volume growth was 50%, accounting for 7% of the exchanges trades. CME received $55 million in revenues, representing 10% of 2004 revenue growth from the Chicago Board of Trade under the first year of the common clearing link. CME’s clearinghouse now clears 85% of all futures transactions in the US. CME stock is down 10% in the first two months of this year after climbing 216% last year.

Express Scripts

Express Scripts reported fourth quarter and 2004 earnings per share of $1.07 and $3.89, up 24% and 21% respectively over the same periods in 2003. Mail pharmacy prescription volume rose 17% during the quarter and 21% during the year. CuraScript captured an increased share of Express Scripts’ clients’ specialty drug spend, more than doubling its patient base since the acquisition in January 2004. Express Scripts reported that its return on invested capital, the best measure of its performance, rose from 16.9% in 2003 to 17.8% last year. During the quarter, the company took a $12 million charge to write-off the loan to the Pharmacy Care Alliance because Medicare discount card enrollment did not meet expectations. This 10¢ per share charge was offset by lower management compensation expense. George Paz becomes CEO of Express Scripts on April 1. Barrett Toan will remain as Chairman of the company. Express Scripts’ stock price climbed 15.1% in 2004 and 13.5% since January 1. It reached an all-time high of $87.40 on March 7, two days after the company issued its earnings report.

First Data

First Data’s revenues and earnings per share rose 20% and 11% during the fourth quarter and 19% and 14% for the full year. First Data’s free cash flow of $2.1 billion or $2.55 per share during 2004 exceeds its reported earnings per share by 20%. This is a 28% increase over the prior year. The company repurchased 88.2 million shares during the year for $3.7 billion. This is more than one half of the 170 million shares issued on February 26, 2004, to purchase Concord EFS. The addition of Concord’s 135 million STAR-branded debit cards and one million merchant locations boosted the company’s card-based processing business. The number of merchant transactions processed rose 62% to 19.8 billion while transactions for its 406 million card accounts climbed 162% to 6.8 billion. FDC’s Western Union money transfer network continued to expand, adding 37,000 new agent locations, a 20% increase to 219,000. Consumer to consumer money transfers reached 97 million, up 19%, led by international transfer growth of 24%. First Data’s stock price is unchanged from where it stood on January 1, 2003.


Strong new business sales growth, rising employment and rising short-term interest rates resulted in double-digit earnings per share growth at ADP during its fiscal second quarter. This marks a return to double-digit growth in EPS after a two-year hiatus. Total revenues of nearly $2 billion during the quarter were 9% above the year-ago level. ADP’s pays per control, the number of people employed by each of the company’s payroll customers, rose 2% during the quarter, up from a 1.8% gain in the previous quarter. Total client balances held by ADP during the quarter rose 10% to $10.7 billion. The company’s brokerage services profitability continued to recover as back-office trades per day and investor communications mailings each rose 18%. On November 1, ADP completed the acquisition of the securities clearing and outsourcing services business of Bank of America. ADP shares have declined 3% in the first two months of this year after rising 12% last year.

CH Robinson

CH Robinson had a great fourth quarter and full year. Fourth quarter net revenues and earnings per share gained 30% and 38% respectively, while the full-year gain for each was 21% and 27%. The strengthening economy, strong customer demand for freight and tight capacity has led customers to rely more on Robinson’s flexible transportation network. The company’s core trucking business, which generates three-quarters of company profit, boosted profits 38% during the fourth quarter and 25% for the full year. During the year average profit per employee increased 8%, even as the company added 700 employees, an increase of 17%.

Profit from Robinson’s produce sourcing business declined 9% during the fourth quarter, after rising 4% during the first three-quarters of the year. The company attributed the year over year decline to the lack of high margin strawberry shipments this year relative to the year ago period when Sourcing profits jumped 17%. On February 14, Robinson announced the acquisition of FoodSource, a leading produce sourcing business headquartered in Monterey, California. The acquisition, which will add one penny per quarter to EPS, boosts the size of Robinson’s Sourcing business by 38%. FoodSource has strong relationships with west coast growers and organic producers. They are the largest supplier of pre-mixed salads in the country. Robinson’s shares rose 47% in 2004. They are down 3% during the first two months of this year.


Donaldson posted a 17% increase in revenue to $388.4 million in their fiscal second quarter. Net income was $26.7 million, or $.31 cents a share compared to $.28 per share earned in the year ago quarter. Backlog grew 11% to $417 million, an all-time high. The engine business, which accounts for 56% of over all sales and 72% of profits, grew 19%, led by higher U.S. and European truck build rates and steady growth in the aftermarket replacement/retrofit business. The PowerCore line of filtration products continues to gain acceptance, doubling aftermarket sales from the same period last year. PowerCore is designed to grow the company’s share of the aftermarket/retrofit business, a market whose importance increases with implementation of stricter U.S. diesel particulate standards in 2007. The industrial products segment, 44% of overall sales, grew 14% driven by continued demand from industrial customers. While gross margins, at 31.2%, suffered from high raw materials costs, recent price increases imposed by the company should lead to expanded margins in the second half of the year. Shares in Donaldson have risen 14% since July.


Fourth quarter revenues for Caterpillar rose 58% to $8.6 billion bringing full year revenues to $30 billion up 33% over 2003. The company generated a revenue increase of $6 billion in machinery and engine sales. EPS reached $5.75 for the year, up from $3.13 in 2003. The continued global demand for mining and construction machinery, petroleum exploration and power generation equipment, in addition to strong North American on-highway truck build rates support Caterpillar’s continued growth. CAT has broadened its product offering for 2005 with a new Global Pipeline effort which will service the oil and gas pipeline construction industry. CAT has announced price increases for the spring of 2005 of between 1 and 5 percent and is focused on managing its material costs, especially steel, and transportation costs. Since the end of November CAT shares are up over 9%.

Varian Medical Systems

Varian Medical Systems reported first quarter earnings per share of 29¢, up 38% from the first quarter of 2004 while revenues grew 12% to $299 million over the same period. Oncology Systems reported sales of $271 million, an increase of 9% from the first quarter of last year. International orders rose 24% during the quarter while North American orders fell 7%. Order growth for the last twelve months, the key measure of the state of this business, was 17%, above the long-term market trendline growth of 10 – 15%. On January 26, the company announced the formation of Varian Surgical Services, a new organization that will directly address the $250 million radiosurgery market with solutions built from the Trilogy system and the on-board imager.

Varian Medical System’s stock price rose 25.5% during 2004; however, investor fears about stagnant growth in the North American oncology market have driven the share price down 15.4% since the beginning of the year. Oncology Systems is a technology driven business. Sales in a region soar as clinics invest in equipment with the latest technology. When 90 to 95% of the orders include the new technology, such as intensity modulated radiation therapy accessories and software in the U.S. market, orders grow with market demand. Once the leading clinics demonstrate the efficacy and clinical practicality of a new technology, image-guided radiation therapy in this case, the purchasing cycle begins again. International markets tend to lag the North American markets by three or four years, so the relative strength of the international orders at this phase of the IMRT market is expected. These well-known purchasing patterns demonstrate why investors should focus on global market growth trends.


Walgreen’s reported record first quarter earnings per share growth of 26.8% to 31¢ per share. Revenues for the quarter grew 13.4% to $9.9 billion with pharmacy sales growing 14.4% and front-end sales growing 6.1%. Prescription sales in comparable stores grew 11.3% in the quarter. Better purchasing terms, digital photofinishing and better generic drug sales pushed gross profit margin up 1% to 27.4%. Walgreen’s captures more profit from digital photofinishing because it eliminates the outside film processor. Walgreen’s stock price rose 5.5% during 2004, and has risen 16.3% since the beginning of the year. Walgreen’s stock is trading within 4% of its five-year high of $45.75.

Patterson Companies

Patterson Companies’ revenue and earnings during its fiscal third quarter ending January 29, rose 22% and 25% respectively over the results for last year’s third quarter. The company’s important dental supply business, which generates about 80% of the company’s overall revenues, achieved sales growth of 18%, 50% higher than the previous quarter’s sales growth rate. This accelerated sales growth was propelled by a 30% rise in dental equipment sales and the first sequential upturn in consumable sales in over a year as sales finally moved above a 7% growth rate to 10%.

Sales of Patterson’s veterinary distributor, Webster Veterinary Supply were 64% higher than sales during the year ago quarter, aided by excellent execution at the two distributors acquired during the quarter as well as 12% growth in Webster’s base business. Milburn, one of the companies acquired, is a leading distributor of equine veterinary supplies and opens a new market for Webster. Milburn grew rapidly and is surprisingly profitable. During the quarter, Webster also signed a distribution agreement with Pfizer for Rimadyl, an anti-inflammatory drug used to treat osteoarthritis in dogs. Patterson stock has risen 15% since the beginning of the year on top of a 37% increase last year. The company’s stock price is beginning to reflect Patterson’s superb ability to consistently execute its straightforward business strategy.

Beckman Coulter

Beckman Coulter reported fourth quarter and 2004 earnings per share of 91¢ and $3.21 respectively. Revenues for the quarter and the year grew 8.5% and 9.8% to $693 million and $2.2 billion respectively. Strong equipment sales depressed operating margins by 2.5% in the fourth quarter. These sales have lower margins than reagent sales, and Beckman Coulter invested in its service organization to support its equipment placements. Large clinical labs depend on Beckman Coulter to keep these machines running at full capacity to provide accurate, reliable and quick test results. Scott Garrett, the COO of the company succeeded Jack Wareham as CEO on February 21. Jack Wareham retired after more than 15 years at the helm of the company, having led the company since its spin-off from SmithKlineBeckman in 1988. Beckman Coulter’s stock price rose 31.8% during 2004 and has climbed an additional 5.5% since the beginning of the year.

Johnson & Johnson

Johnson & Johnson’s fourth quarter and 2004 earnings per share grew 17.5% and 17% to 67¢ and $3.10 respectively. All three divisions delivered double-digit revenue growth leading to fourth quarter revenue growth of 13.3% to $12.8 billion. Revenues for the year grew 13.1% to $47.3 billion. Four of Johnson & Johnson’s drugs reported worldwide revenue growth above 20% for the year contributing to 13.4% revenue growth for the Pharmaceutical division as compared with 2003. The company filed new drug applications for a urology drug and a cancer drug in December 2004. International sales of the CYPHER stent grew 59% during the fourth quarter, capturing 57% of the international drug eluting stent market. The successful launch of CYPHER in Japan contributed 12% of this share. On December 20, Johnson & Johnson announced that it planned to acquire Guidant, a leading company in the treatment of cardiac and vascular disease for $23.9 billion. This acquisition will strengthen the company’s stent business and will broaden Johnson & Johnson’s medical device offering with its profitable implantable defibrillator business. Growth in the company’s skin care brands and SPLENDA continue to drive strong revenue growth in the Consumer division. Revenues grew 14.3% in the quarter and 12.1% for the year. Johnson & Johnson’s stock price increased 22.8% during 2004 and an additional 7.9% since the beginning of the year. The stock price reached a ten-year high of $68.68 on March 7.


Merck reported fourth quarter and full year earnings per share of 50¢ and $2.61. Worldwide sales of Merck’s four major drugs Cozaar, Fosamax, Singulair and Zocor grew 13% during the year. The Merck/Schering Plough joint venture was profitable this year, contributing $132 million to the year’s net income. 2004 sales of Zetia were $1.1 billion.

Merck’s stock price declined 30.4% during the year. Since the beginning of 2005, investors have responded to the news flow, sending the stock price down 10% on January 28 when the U.S. Court of Appeals for the Federal Circuit in Washington, D.C. found Merck’s patent claims for the once-weekly administration of Fosamax to be invalid. The drug will now lose its market exclusivity in 2008 instead of 2018. The company disagrees with this decision and will request reconsideration. Merck’s stock price jumped 13% on February 18 when the FDA Advisory Committee evaluating the safety of COX-2 Inhibitors voted 17 – 15 that Vioxx was safe enough to be sold on the market. Merck has taken reserves of $675 million for future defense costs for the Vioxx litigation. The company has not yet established reserves for any potential liability related to the Vioxx lawsuits because “there are many claimants and the claimants seek indeterminate damages.” With all these gyrations, the stock price has declined about 1% since the beginning of the year.


PepsiCo reported fourth quarter earnings per share growth of 12% to 58¢ and full year earnings growth of 13% to $2.32. These earnings figures do not include non-recurring restructuring costs or tax benefits. PepsiCo International continued its strong performance with 14% revenue growth and 25% operating earnings growth in 2004 compared with 2003. Snack and beverage volumes grew 8% and 12% respectively during the year. New single-serve multi-snack packaging and double-digit volume growth of Lay’s Stax potato chips pushed Frito Lay’s 2004 volume up 3%. Operating earnings grew 7% in spite of increased corn oil and energy costs during the year. Non-carbonated beverage volumes grew 8% during the quarter and 10% during the year with strong performances from Gatorade and Aquafina. Pepsico’s stock price rose 12.0% during 2004 and has increased an additional 3.9% since the beginning of the year.


Harte-Hanks fourth quarter and full year revenues and earnings per share each gained 9% and 14% respectively. The company’s reported free cash flow declined 16% in the fourth quarter after its capital expenditures doubled from the year ago period. The full year gain in free cash flow was 7%. Direct Marketing revenue growth during the fourth quarter approached 12%, the first double digit gain in three years. During the fourth quarter operating cash flow from Direct Marketing improved 22% while the operating margin reached 19.8%, similar to the level achieved two years ago, though still below the mark set three years ago. Shoppers expanded circulation by 600,000 households during the year. Shopper revenues gained 8% during the year and operating cash flow rose 10%. Harte-Hanks purchased 3.6 million shares which reduced fully diluted shares outstanding by 2.4%. Harte-Hanks stock has moved up 3% this year after a 19% rise last year.


Kronos reported first quarter fiscal 2005 earnings per share of 33¢, an increase of 44% over the same period last year. Strong sales of WorkForce Central 5.0 software and the associated terminals pushed the quarter’s revenues up 19% to $118.3 million. Kronos saw strong adoption of its new attendance module by its manufacturing, hospitality, health care and transportation customers. This software module tracks paid and unpaid leave, allowing employers to track the rate of unscheduled absenteeism. Each unscheduled absence costs an employer $610. In addition, Kronos has improved the security of its terminals and added more self-service tools to its software. The company’s stock price rose 29.1% during 2004. The strong first quarter results pushed its stock price up an additional 7.9% since the beginning of the year where it is trading within 1% of its all-time high.


Ten new wins propelled Amdocs’ first quarter fiscal 2005 revenues to $469.5 million up 9.6% over the first quarter of last year. Earnings per share rose 25% to 32¢. On January 14, Amdocs announced that Svyazinvest, Russia’s largest wireline communications provider serving more than 35 million subscribers, had selected Amdocs software to provide an integrated customer management platform. Amdocs and IBM have begun to replace Svyazinvest’s 180 billing systems with Amdocs’ full suite of software including its billing, customer care, ordering, self-service and partner relationship manager systems. The signing of major contracts for Amdocs’ software and services by first tier wireline companies pushed the company’s stock price up 16.8% in 2004. Amdocs’ stock price has climbed an additional 8.2% since the beginning of the year.


Intel reported fourth quarter earnings per share of 33¢, unchanged from the fourth quarter of 2003. Earnings per share for the year rose 36% to $1.16 on record revenues of $34.2 billion, an increase of 13.5%. Quarterly revenues rose 10% to $9.6 billion. Unit sales of mobile processors grew 50% during the quarter as notebook sales reached nearly half of all retail PC sales in the U.S during the holiday season. Intel saw strong performance in its enterprise processors during the quarter as well, shipping more than 1 million 64-bit Xeon server processors. Intel’s stock price fell 27% in 2004. Renewed investor confidence in Intel’s performance during 2005 has pushed the stock price up 7.4% since January 1.


Strong performance from the Server & Tools division drove Microsoft’s second quarter earnings per share and revenues up 14.3% and 7% respectively. The $2.2 billion employee option transfer program cost is not included in the 2003 earnings per share. Second quarter revenue for the Server & Tools division grew 18% year over year to $2.5 billion with 17% growth in new Windows Server licenses and 25% growth in SQL Server licenses. SQL Server is Microsoft’s database platform for small and mid-size businesses, its major database customer group. Unit sales of servers grew 15% in the quarter. Operating income from the seven businesses increased $470 million from the second quarter of 2004, while revenue grew $700 million in the same period. Microsoft returned $33 billion to shareholders during the quarter through its special $3.00 per share dividend. Microsoft’s stock price rose 8.5% during 2004, but has declined 4.7% 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.