3rd Quarter, 2005

With few exceptions, your Companies reported strong earnings for the third quarter of this year although the languid price action of many of your stocks may give the impression that their earnings were dull.

State Street Corporation

State Street’s strong third quarter results lifted its stock price above the top of its four year trading range. It is now up 16% since the beginning of August. Third quarter operating earnings, before recognition of a 29¢ per share net loss on sale of an ill-conceived acquisition in 2000 of an investment management business, were 72¢ per share, 30% higher than last year’s quarterly results. Importantly, State Street’s management delivered on its goal of achieving operating leverage as it held expense growth to 13% above the amount spent during the year ago quarter while fee revenue grew 18%.

A vital component of the growth realized during the quarter are the fees from services such as transition management, securities lending and foreign exchange executions for State Street’s institutional custody clients. Together these fees were 57% higher than the amount earned during the year ago quarter. Devising and delivering services that generate added fee income from existing clients is an essential ingredient for sustained growth in an information service business such as State Street’s which must contend with unrelenting pressure from customers to reduce the price of its basic service. An ability to develop and sell innovative solutions for existing customers enhances the value of the client base, spurs growth and thereby improves the quality of our investment. During the third quarter State Street repurchased 3.1 million shares at an average cost of $48.50.

Chicago Mercantile Exchange

Chicago Merc shares have risen by one-third since the beginning of August as trading volume surged 30% in the third quarter and 40% in October. Net revenue rose 22% and earnings per share of $2.22 gained 29% during the third quarter. Average daily volume of 4.2 million contracts was comprised of 2.5 million interest rate contracts, up 34%, 1.3 million equity index contracts, up 15%, 336,000 foreign exchange contracts, up 74% and 50,000 commodities contracts up 25%. The average rate per contract of 66¢ was down from 72¢ a year ago. CME has added significant new functionality for trading complex options on its Globex electronic trading platform, leading to a doubling of option contracts traded electronically. The CME’s wholly-owned clearing house clears and settles all futures and options transactions at the Merc and at the Chicago Board of Trade. The clearing house maintains segregated customer collateral and performance bonds which are marked to market twice daily. The clearing house functioned without disruption even as its once largest customer, Refco, filed for bankruptcy following revelations about its CEO’s hidden borrowings from the company.

Express Scripts, Inc.

Express Scripts’ keen focus on improving the profitability of each claim as claims growth slows delivered a record 25% increase in gross profits in the third quarter. Increased generic drug utilization and lower drug purchasing costs drove the company’s gross profit per prescription up 50¢ to $2.13. The company processed 137.4 million prescriptions during the quarter. Express Scripts’ clients continue to benefit from lower prescription costs as well. Express Scripts now fills all of its mail prescriptions in its four high-volume pharmacies, improving its productivity by lowering the cost to fill each prescription and simplifying inventory management. Express Scripts’ stock price has leapt 41.5% since August 3 and has doubled in the last 12 months.

First Data Corporation

First Data reported third quarter revenues of $2.7 billion, up 6% and operating earnings per share of 60¢, a 7% gain over the prior year on 9% fewer shares outstanding. Operating profit of $624 million before $29 million of restructuring and impairment charges declined 4%. Western Union money transfer revenues rose 14% during the quarter as consumer to consumer transaction volume rose 22%. Merchant services revenue rose 8% and operating profit increased 7%. Total merchant transactions processed reached 5.9 billion during the quarter, up 13%. Card issuing revenue of $594 million and operating profit of $116 million were down 4% and 25% respectively.

On November 9, FDC announced that it had engaged Morgan Stanley to explore various options for its chronically under-performing US credit card issuing business. This potentially good news was offset by the revelation that First Data is forecasting as little as 5% profit growth next year for its Merchant business although its revenue growth should exceed 12%. Management stated that it needs to “reinvest in product and sales initiatives”. This is bad news since FDC spent the last eighteen months integrating Concord’s products, sales force and facilities into its own operations. In a conference call with us on November 14, CEO Charlie Fote, indicated that FDC may ultimately spend less than indicated in the November 9 statement. He promised a more definitive forecast in mid-December. Western Union will grow both revenues and profit at a double-digit rate in 2006. First Data stock is unchanged since the beginning of August.

Automatic Data Processing

ADP’s fiscal first quarter revenues rose 10% to $2.0 billion while its earnings per share increased 31% on a comparable basis. These strong results prompted the company to increase its EPS forecast to a gain of 22 to 25% including stock option expense in both periods. ADP clients’ payrolls gained 2% during the quarter, consistent with the gain during the previous 12 month period. The average tax filing float rose 12% to $11.4 billion during the quarter while the yield realized improved 0.5% to 3.8%, resulting in interest income from client funds of $108 million, up 28%. The company’s Brokerage and Dealer Services units reported operating income gains of 28% and 14% respectively. ADP shares have risen 7% since the beginning of August.

C.H. Robinson Worldwide Inc.

Led by strong price and volume gains in its core trucking business, CH Robinson net revenues and earnings per share rose 33% and 41% respectively. Overall industry capacity remains tight, providing Robinson’s motivated sales force with the opportunity to garner more business from existing customers and to develop new customer relationships in both truckload and less-than-truckload markets. Revenues from sourcing fruits and vegetables rose 56%. All of the growth came from the profitable acquisition of FoodSource, which services Trader Joe’s. During the past 12 months, through hiring and acquisitions, Robinson’s employee base has risen 20% to 5,605, while operating profit per employee has risen 17%. Robinson shares are up 27% since the beginning of August.

Donaldson Company, Inc.

Donaldson’s fiscal fourth quarter and full year sales rose 10% and 13% respectively while earnings per share increased 34% and 16% respectively, excluding a patent litigation reserve and a charge to repatriate $80 million under the American Jobs Creation Act of 2004. Total backlog remains strong, reaching $412 million, up 11%. Engine filter sales gained 10% in the quarter and 14% for the full year. Replacement filter sales, representing one-half of Engine segment revenue, rose 13% for the full year. Industrial filter sales rose 10% during the quarter and 11% for the year. Within the Industrial segment, gas turbine filters fell 4% while disk drive filters rose 16%. Donaldson supplies two small disk drive filters incorporated in Apple’s iPod. During the year, Donaldson repurchased 3.8 million shares, 4.4% of its shares outstanding, for $116 million, an average cost of under $31 per share. Donaldson stock has declined 4% since the beginning of August.

Caterpillar Inc.

Continued strong global demand and higher prices for Caterpillar machinery and engines resulted in revenues of $9 billion during the third quarter, 17% higher than a year ago while earnings per share grew 34% to 94¢. Revenues from machinery and engines rose 20% and 11% respectively while operating profit rose 50% and 71% respectively! CAT is meeting strong customer demand while remaining focused on its cost structure in order to sustain profitability when the next cyclical downturn occurs. As part of this preparation the Company is investing now to install a dealer inventory management system to improve its knowledge of final demand. During the third quarter, worldwide dealer machine inventories, measured in months of deliveries, were the same as a year earlier. CAT has forecast 10% revenue growth next year and EPS growth of 15 to 25%, or $4.50 to $4.90 a share. CAT stock is up less than 2% since the start of August.

Varian Medical Systems, Inc.

Varian Medical Systems’ stock price jumped almost 10% on October 17 after the company announced strong demand for the advanced radiation therapy products that allow radiation oncologists to modify treatments to account for patient or tumor movement. With 275 orders for on-board imagers since their launch in March 2004 and 110 systems operating or being installed Varian provided concrete evidence of the fast uptake of this new technology. The company reported earnings per share of 45¢ for the fiscal fourth quarter and $1.50 for the year, increases of 21.6% and 23% over the same periods last year. Varian generated double-digit order growth in Europe, the Far East and North America during the quarter while revenues grew 12% to $386 million. Fiscal year 2005 revenues were $1.4 billion, a 12% increase over last year. Varian’s stock price has risen 21.4% since August 3, reaching a new high of $50.27 on November 15.

Walgreen Company

Walgreen reported fiscal fourth quarter 2005 earnings per share of 35¢ bringing earnings for the year to $1.53. The respective year-over-year increases were 12.1% and 17.7%. These results do not include a charge related to the effects of Hurricane Katrina or a gain from a litigation settlement. Revenues for the quarter and the year grew 11.3% and 12.5% to $10.5 billion and $42.2 billion. The company filled 490 million prescriptions in 2005, a 10.9% increase over 2004 and more than any other pharmacy retailer. Increased use of generic medications raised Walgreen’s 2005 gross margin to 27.9%, its highest in 10 years. The company opened 435 stores in 2005 and now operates 4,953 drug stores in 45 states and Puerto Rico. Walgreen’s stock price has declined 3.1% since August 3 and is 6% below its all-time high.

Patterson Companies

Investors’ calm reaction to Patterson Companies weak earnings for its fiscal fourth quarter ending July 30 provides yet another example of how this well-managed company prepares itself to methodically work its way through a temporary slowdown in its rate of sustainable growth. Patterson’s stock price has fallen less than 3% since the beginning of August although its fiscal first quarter revenue and profit rose only 3% and 5% respectively. The quarter’s results end sixteen quarters of uninterrupted double digit growth. Inclusion of an extra week in last year’s fiscal fourth quarter made yearly comparison of the quarterly results appear worse than they were. If the additional week were eliminated for comparative purposes, Patterson estimates that its Dental Distribution business, which generates over 75% of total company revenues and 80% of profits, grew 7% instead of a reported 1%.

Decelerating growth of dental equipment sales to less than 5% from quarterly rates regularly exceeding 30% cut the sales contribution from this profitable segment by ten percentage points to 25% of total dental distribution revenues. Part of the decline is attributable to absence of price promotions by one of Patterson’s key suppliers. During the quarter, Patterson strengthened its dental business through the cash acquisition of Accu-Bite, one of the ten largest distributors in the US adding $50 million in annual sales to Patterson’s core dental distribution business. We expect a reacceleration of dental equipment sales will enable Patterson to deliver 15% earnings growth to $1.50 per share for the current fiscal year ending in April 2006. We intend to buy stock if the price falls below our $39 valuation.

Stryker Corporation

Stryker reported third quarter revenues of $1.2 billion and earnings per share of 40¢. Year-over-year increases of 13.9% and 21.2% respectively. Orthopedic implant revenues increased 11% in constant currency during the quarter with strong growth in knees, spine and trauma, offset by weaker growth in hip implants. Hip implant sales grew 2% in constant currency because fewer surgeries were performed during the summer. The MedSurg businesses grew 20% in constant currency. Steve MacMillan, Stryker’s CEO expressly stated that the strong new product flow in these businesses delivered the revenue growth. R&D expenses increased 29% during the quarter as the company invests to deliver new products in all of its businesses in 2007 – 2009. Stryker has been planning for the tougher pricing environment for reconstructive implants for at least 18 months and expects the breadth of its business to sustain 20% earnings per share growth in 2005 and 2006. Fund managers have focused solely on the impact of lower prices for reconstructive implants and have sold shares in the three large orthopedic device companies. Stryker’s share price has dropped 16.5% since August 3, providing us with a good buying opportunity.

Beckman Coulter, Inc.

Beckman Coulter reported third quarter revenues of $593.4 million and earnings per share of 74¢, not including non-recurring charges. Both of these results were significantly above forecast because the company sold more instruments with sales-type leases than planned. Beckman Coulter’s new chemistry and high-throughput immunoassay platforms continue to gain market share with one-third of new chemistry systems displacing competitive systems and with more than half of new high throughput immunoassay instruments displacing a competitor as the primary analyzer in large hospital labs.

We sold our Beckman Coulter shares because of the unpredictability of the company’s near-term financial performance. We expect this noise to continue for several quarters. Beckman Coulter sells most of its instruments during the fourth quarter, so next quarter’s revenues and earnings will hit or miss its forecast based on the number of sales-type leases executed during the quarter. Management has told us that it will take six to eight quarters for the company to complete the transition to operating leases. We intend to remain on the sidelines until the revenue and earnings growth become more predictable or the stock price drops to fully reflect the uncertainty. Investors reacted favorably to the unexpected upside in earnings per share by sending the stock price up 12.9% since the earnings call on November 2.

Johnson & Johnson

Johnson & Johnson’s Medical Device and Diagnostics and Consumer divisions recorded another quarter of double-digit revenue growth that contributed to overall third quarter revenue growth of 6.6%. Earnings per share rose 11.5% to 87¢. Generic competition and lower sales of Procrit pushed Pharmaceutical sales down 1.1% in spite of strong double-digit revenue growth in most of the company’s key drugs.

On November 2, the Federal Trade Commission approved Johnson & Johnson’s acquisition of Guidant, providing that the firm divested certain assets. Johnson & Johnson threatened to walk away from the original deal because the impact of previously announced recalls of Guidant’s implantable cardiac defibrillators and the related regulatory investigations materially reduced its value. On November 15, Johnson & Johnson and Guidant announced revised terms that lowered the acquisition price to $21.5 billion, 15% lower than the original $25.4 billion price agreed to in December 2004. Johnson & Johnson’s stock price leapt 4% on this news but nonetheless has fallen 2.6% since August 3.

Merck & Company, Inc.

On November 3, the jury in the second Vioxx product liability trial ruled in Merck’s favor on all counts. Merck presented a more understandable explanation of their evolving understanding of the cardiovascular risks associated with Vioxx as its scientists analyzed the results from numerous clinical trials. The company’s expert witnesses also made a strong case that short-term Vioxx use did not increase the risk of heart attacks or strokes. The first federal product liability case begins on November 28th in Houston, Texas. Merck’s success in explaining the development of the science surrounding Vioxx’s cardiovascular risk bodes well for the federal cases where the standards for the admission of scientific evidence are stricter.

The company’s third quarter revenues declined 3% over the third period of 2004 while earnings per share rose 7%. Sales of Vytorin and Zetia, the Merck/Schering Plough cholesterol-lowering drugs, rose 83% during the quarter and will have sales above $2 billion in 2005. Profits from Merck’s animal health, vaccine, and Schering Plough joint ventures grew 56% to $480 million during the quarter and accounted for 24% of Merck’s pre-tax income. Sales from these ventures are not included in Merck’s revenues. Merck’s stock price has risen 2.6% since August 3.


Strong consumer demand for Pepsico’s non-carbonated beverages fueled their 24% volume growth during the third quarter of 2004 as Gatorade and Aquafina beverage volumes leapt 30% and 40% respectively. This exceptional performance along with continued strength in the company’s international business pushed the quarter’s revenues up 13% to $8.2 billion. Earnings per share rose 18% to 78¢, not including a tax charge associated with repatriating $7.5 billion of international earnings. Pepsico’s stock price has risen 7.1% since August 3 and reached an all-time high of $59.39 on October 31.

Harte-Hanks, Inc.

Revenues and earnings per share at Harte-Hanks rose 7% and 17% respectively during the third quarter. Direct marketing revenue growth slowed to 4%, but operating margins expanded, resulting in operating cash flow growth of 12%. The high tech/telecom segment declined about 8% while the retail and healthcare/pharmaceutical verticals delivered growth in excess of 10%. Automotive gained 8%, and the financial segment was up 5%. Shopper revenues and operating cash flow rose 13% and 10% respectively. The acquisition of the Tampa Flyer during the second quarter boosted Shopper revenue growth by about 8%, but cash flow growth
by only 3-4%. Fourth quarter EPS will be negatively impacted by damage inflicted on Harte-Hanks South Florida Shopper operations by Hurricane Wilma. Harte-Hanks share are 3% lower than at the beginning of August.

Kronos, Inc.

Kronos reported good results for its fiscal fourth quarter ending September 30. Revenues and earnings rose 17% and 7% respectively above the results for the comparable year ago quarter. Fourth quarter earnings of 60¢ per share brought 2005 fiscal year earnings up to $1.65 per share, 14.5% higher than the prior year’s $1.44.

Combined year-to-year growth of nearly 22% in maintenance and service revenues once again corroborated customers’ commitment to Kronos’ workforce management solutions. A doubling of the year-to-year growth rate for new product sales, after two quarters of 5% growth while the company revamped its mid-market sales force, provided solid evidence of successful management of this complicated change. The absence management and self-scheduling capability of the company’s workforce solutions furthered Kronos’ penetration of the hospital market while its system’s unmatched ability to manage the complexity of union requirements secured company-wide adoption of Workforce Central by Knight Ridder.

Kronos’ stock price has advanced only 3% since the beginning of August and received no boost from the company’s forecast, in conjunction with its earnings report, of no less than 10% earnings growth for the coming fiscal year.

Dolby Laboratories

On August 15, Dolby Laboratories lowered its revenue forecast for its fiscal year ending September 30, to a range of $315 to $330 million from $335 to $350 million. This reduction is based on receipt of about one-half of the royalty reports Dolby will receive during the quarter from its consumer electronics customers. These reports indicate a slowdown in sales of traditional DVD players and a mix shift to low end players manufactured in China which incorporate fewer Dolby technologies. This shift exacerbates Dolby’s revenue slowdown because Chinese manufacturers typically underreport shipments subject to royalty payments. Dolby has begun auditing select licensees to ensure it receives proper royalty payments, but this is a lengthy and contentious process. Mass market adoption of the next generation high definition DVD players may proceed more slowly than Dolby anticipated because two different technologies are competing to become the industry standard, Sony’s Blu-Ray and Toshiba’s HD-DVD. Dolby Digital technology is incorporated in both, but consumers will await a winner before buying these systems. Dolby will report fiscal fourth quarter earnings after close of business on November 17. We will realize any losses in taxable portfolios before year-end.


Amdocs reported a strong finish to fiscal year 2005 with revenues up 26.7% (15% organic growth) for the quarter and up 14.9% for the year. Annual revenues crossed the $2 billion mark for the first time. This milestone is important to management because financial strength is an important metric in its bids for the largest deals. Earnings per share of 37¢ for the quarter and $1.39 for the year rose 23.5% and 25.9% respectively over the same periods a year ago. SBC recently successfully completed two field trials of Project Lightspeed, its ambitious project to provide high-speed broadband service to 18 million homes over fiber optic cable. In addition to providing voice and data, SBC demonstrated that the system would support high definition television programs delivered over the Internet. The company plans to begin offering this new service to customers in 2006. Amdocs will provide the billing, customer relationship management and ordering systems along with its consulting services for this important project. Amdocs’ stock price has declined 7.7% since August 3, because fund managers worry that Amdocs will ultimately lose business from its large customer Nextel now that the merger with Sprint is complete. SpintNextel’s ability to provide profitable bundled services to its corporate customers depends on Amdocs’ platform, making a move away from Amdocs seem unlikely.

Intel Corporation

Intel’s third quarter earnings per share rose 43.5% to 38¢, not including non-recurring items. Revenues of $9.96 billion grew 18% over the third quarter of 2004 with record unit volume shipments of microprocessors, chipsets, flash memory, wireless network connectors and applications processors used in smartphones and PDAs. The company is now producing commercial volumes of dual-core microprocessors with its 65 nanometer process technology on 300 millimeter wafers and expects to ship millions of these processors to customers during the fourth quarter. On November 10, Intel raised its dividend 25% and announced a $25 billion share buy-back program. The company’s stock price has fallen 9.1% since August 3.

Microsoft Corporation

Microsoft’s first quarter earnings per share grew faster than revenues in spite of significant investments in pre-launch marketing for SQL Server 2005, its new database program, and XBOX 360. Revenues rose 6% year-over-year to $9.7 billion while earnings per share increased 19% to 31¢, excluding legal charges associated with a settlement with RealNetworks. The company repurchased 114 million shares of stock for $3.0 billion or $27.33 per share and plans to complete its $30 billion repurchase plan by the end of 2006, two years early. The company launched SQL Server 2005 and other development tools on November 7 and will launch the XBOX360 in the U.S. on November 22, in Europe on December 2 and in Japan on December 6. On November 1, Microsoft announced Windows Live and Microsoft Office Live, the first web-based subscription offerings of its major software platforms, but fund managers are waiting to see how well Microsoft executes its new product launches and redesigns its software development process to better compete with Google. Since August 1 Microsoft’s stock price has been locked in a trading range, first dropping 6% to the bottom of the range and then rising 13% to finish near the top.

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.