2nd Quarter, 2007

The second quarter earnings of all but a few of your companies were strong. None had poor results. In some instances where earnings drew attention to companies’ financial strengths, the results helped their stock prices withstand the onslaught of selling that ended our stockmarket’s rise in mid-July. The market decline is linked to the proliferating number of highly leveraged hedge funds and bank-sponsored funds collapsing as a result of ill-considered investments in illiquid mortgage-backed securities. Worries multiplied as these failures spread beyond New York and London to unlikely locales such as Germany, France, Japan and Australia. We enclose a commentary on the current commercial paper crisis which is a reverberation of the mortgage-backed securities fiasco.

State Street Corporation

State Street’s stock price is down 11% since the stock market peaked in mid-July. The S&P, over the same period has declined 5.2%. False rumors about State Street’s exposure to sub-prime mortgages, sizable losses in two high-yield short duration bond funds managed by SSGA, and vulnerability to the ongoing stress in the commercial paper market drove the stock down.

On July 17 when its stock was at $73, State Street reported its second quarter earnings of $1.07 per share, 15% above the $0.93 per share earned a year ago. Management once again delivered operating leverage as revenue rose 16.4%, while expense growth was 15.5%. Immediately following the quarter-end, State Street closed the acquisition of Investors Financial, which raised total assets under custody to $15 trillion. Within weeks of the closing, State Street completed through a purchase agreement, a $1 billion dollar stock buyback as stipulated in the merger agreement. Regrettably, the price was $71 per share, $8 above today’s price. Once the commercial paper market returns to a semblance of normalcy, we expect State Street’s stock will rebound because its balance sheet, revenues and earnings remain strong.

Express Scripts, Inc.

A record 61.1% generic utilization rate and lower retail and mail drug costs contributed to a 47% year-over-year increase in Express Scripts’ second quarter earnings per share of 56¢. The company’s continued focus on encouraging the use of generic drugs also led to a 25% increase in gross profit per claim and a 31% increase in operating cash flow per claim. The company’s formulary program for cholesterol-lowering drugs has saved its clients $200 million so far this year. On May 30, Pfizer announced an agreement with Express Scripts to add Lipitor back to the formulary as a preferred brand. Express Scripts has integrated the specialty and pharmacy benefit management (PBM) drug sales, IT and marketing teams to better serve its existing PBM customers who are the major users of its specialty services. CEO George Paz reported that the integrated approach has already helped them win new business. Express Scripts recorded a $4.0 million bad debt charge during the quarter for its infusion business. The legacy billing system makes it difficult to properly bill and collect payments in this highly fragmented business. While the company is determined to fix the billing system because the infusion business may prove to be a useful tool to help clients control the costs of dispensing protein-based drugs that will enter the market in the next three to five years. Express Scripts stock price is the same as it was in mid-July, but is up 51% since the beginning of the year.

The CME Group

On July 12, The Chicago Merc completed its merger with The Chicago Board of Trade and provided an accelerated integration schedule. The key aspects of the plan are the transition of CBOT’s futures and options to the Globex electronic trading platform in January 2008 and the combination of trading floors to be completed by May 2008. Revenues during the quarter increased 17% to $329 while earnings excluding merger-related expenses rose 18% to $3.69 per share. The operating margin rose slightly to 60.5%. Average daily volume of futures and options traded at the CME rose 10.4% to 6.3 million while the average rate per contract declined 1¢ to 62¢. The continued shift to electronic trade execution is evident in a 15% rise in Globex revenues to $192 million while open outcry trades declined 6% to less than 20% of total transaction revenues. CME Clearing handled CBOT volumes of 4 million contracts per day, earning revenue of $24 million during the quarter, up 20% from a year ago. NYMEX volume of 710,000 contracts per day traded on Globex generated $14 million in revenues.

Recent financial market volatility has been beneficial to CME’s business. In August, average daily volume including CBOT trades was 14.9 million contracts, up 78% over combined year ago volumes. On September 5, CME completed the repurchase of 1.7 million shares tendered at $560 per share, representing 3.1% of shares outstanding for $949 million. CME had offered to purchase as many as 6.25 million shares at $560. CME shares have declined 6% from $584 in mid-July to $547 today.

Automatic Data Processing

ADP’s fiscal fourth quarter revenues of $2.0 billion increased 13% to $2.0 billion and earnings per share rose 24% to 35¢. For the year revenues rose 14% to $7.8 billion and earnings per share increased 26% to $1.85. Acquisitions made during the year contributed 1% to the rate of revenue growth and $1.9 billion of share repurchases reduced shares outstanding by 4%. The company’s core payroll and tax processing services grew 9% while add-on services rose 21% for the year. Worldwide new business sales growth was 11% while average customer balances rose 8% to $18.5 billion on June 30, 2007. The number of employees on each client’s payroll rose 2.3% during the fiscal year, consistent with the previous year’s gain of 2.4%. ADP remains one of the few companies in the world with a AAA credit rating. It continues to add large multi-national customers to its GlobalView product offering which integrates ADP’s payroll and HR functionality with SAP’s enterprise resource planning software. Initial customers include IKEA, Microsoft and American Express. One-third of the 9% decline in ADP’s stock price since mid-July occurred on September 7 when the preliminary August payroll data reported a loss of jobs in the U.S. instead of an increase. The drop wiped out the gain in ADP stock for the year.

C.H. Robinson Worldwide Inc.

Second quarter revenues and earnings at CH Robinson rose 15% and 24% respectively to $310.9 million and 47¢ per share during the quarter. The total value of transportation services provided by the company increased 10.5% to $1.9 billion. The 15.6% profit gain in the core trucking business came from both volume growth and margin improvement as capacity was more widely available in the marketplace. Profit in Robinson’s smaller freight forwarding business rose 28% boosted by new customers in both ocean and air, volume from existing customers and margin expansion. Profit from sourcing of fruits and vegetables gained 6% as higher market prices for certain produce commodities crimped margins. Total operating expenses rose just 8.6%. Robinson’s balance sheet remains remarkably strong. The company has $420 million in cash and short-term securities and no debt. Robinson shares have declined 5% since mid-July bringing the full year gain to 22%.

Donaldson Company, Inc.

Donaldson’s strong fourth quarter results demonstrate managements’ ability to profit from the global expansion of the company’s engine filter and industrial air filter business. Fourth quarter sales and earnings per share growth of 12% and 23% brought the respective full year gains to 13% and 18%. The higher growth rate of earnings per share relative to sales came from a lower tax rate. This marks the company’s 18th consecutive year of double-digit earnings per share growth. Reflecting these strong results, the stock price rose 14% since mid-July.

During the quarter, Donaldson improved the efficiency of new manufacturing and distribution facilities opened during the year, while meeting strong customer demand. Overall engine filter sales rose 9% for the year, despite a 10% decline in on-highway truck sales caused by the institution of more stringent EPA regulation on diesel engine emissions. The gain in off-road engine filter sales was 14% as Europe and Asia each rose more than 20%. Aftermarket replacement filter sales, which represent more than half of total engine filter sales, rose 13% reflecting strong equipment utilization in the global construction and mining industries. The company’s industrial filters, which include factory dust collectors, air intake filters for gas turbines, and disk drive filters, rose 17% in the quarter and 19% for the year.

EnCana Corp.

EnCana produced second quarter earnings 39% higher than its results in the year ago quarter. Earnings per share were aided by stock repurchases which reduced the shares outstanding 9.7% over the past year. As a result, EnCana reported earnings per share of $1.50, 53% higher than the $.98 it earned during last year’s second quarter. EnCana bought 12 million shares at $59.23 per share during the past quarter. Strong operating results reflected a 4% increase in natural gas volumes sold. Prices realized averaged 9% more than the prices obtained last year. EnCana’s hedges added $.32 to the profit realized per thousand cubic feet on gas sales. The company continues to hold hedging contracts covering 45% of its scheduled 2007 production and 20% of its planned 2008 production.

EnCana’s 50-50 integrated oilsands and heavy oil refining joint venture with Conoco contributed $441 million or 17% of the company’s quarterly operating cash flow of $2.5 billion. Last year, EnCana’s wholly owned oilsands production contributed only 1% toward the company’s quarterly $1.8 billion of cash flow from operations. This huge financial benefit was realized during a quarter when the larger of the joint venture’s two refineries, the Borger Texas Refinery, was shut down for a month to add 25,000 barrels a day of heavy oil refining capacity. The first Canadian bitumen was processed there on July 10. EnCana’s stock price has declined 4% since mid-July.


Amdocs reported fiscal third quarter revenues of $712 million, an increase of 14% over the same period last year. Earnings per share rose 1¢ to 40¢. The company successfully completed its first project in China, installing an on-line billing product for both postpaid and prepaid subscribers for BMCC, China Mobile’s Beijing subsidiary. With over 300 million subscribers, China Mobile is the largest wireless company in the world. Amdocs is the first Western company to implement a billing project in China. The system runs on Amdocs 7, the company’s most advanced software platform. Amdocs provided the software and services in cooperation with Hewlett Packard. The successful implementation of this complex project positions the company well for future business in China. In spite of good execution and strong demand for Amdocs’ growing offering of products and services, its stock price has fallen 11% since the market high in mid-July.

NeuStar, Inc.

NeuStar’s second quarter revenues of $99.7 million rose 21% while earnings per share of 24¢ declined 8% or 2¢ as a result of dilution from the company’s November 2006 acquisition of Followap. Followap is meeting its operational deliverables for its mobile instant messaging capability, but revenue will not be meaningful until 2008.

Transactions under the company’s U.S. telephone number portability contracts were 74.4 million, an increase of 27%. Growth in transactions was driven by telecommunications provider customers’ technology upgrades, re-configurations of traffic flow, carrier consolidation and customer usage of a new data field. Strong revenue growth is also coming from common short code usage which is up 40% from a year ago and UltraDNS, a business which directs internet traffic and routing for e-commerce websites which account for one-quarter of the world’s internet traffic. NeuStar’s stock has risen 5% since mid-July.

Johnson & Johnson

Johnson & Johnson’s second quarter worldwide sales of $15.1 billion were 3.6% higher than the year ago quarter after adjusting for the sales added from the acquisition of Pfizer Consumer Health Products to include only the incremental year to year sales gains realized from these products. Currency gains on the translation of J&J international sales, which constitute 47% of its total revenue raise the overall quarterly sales gain to 6%. Earnings per share of $1.05 were 7.1% higher than the $.98 earned during last year’s second quarter. An accelerating drop in Cordis’ sales of drug eluting stents reduced the overall sales of the company’s innovative and profitable Medical Devices and Diagnostic division to 2.8% before currency gains. The prospect for reviving stent sales is dismal. Cordis faces two new financially strong competitors and, more importantly, doubts about the effectiveness of these stents among interventional cardiologists and regulators here and abroad. Cordis sales have declined to 15% of the Medical and Diagnostic division’s sales. The division’s other products grew 11%. An analogous problem besets J&J pharmaceutical division. Government health programs in the U.S. and Europe are intent upon reducing the cost growth of Procrit, an effective treatment for anemia, which commonly affects patients suffering from cancer and kidney disease. These payors are investigating the consequences of limiting the drug’s use.

Although Procrit’s sales decline may slowly evolve toward stability, its downturn hurt J&J pharmaceutical division. Only three years ago it was J&J’s largest selling drug. J&J’s lucrative anti-psychotic franchise faces the prospect of a vast contraction next year when Risperdal goes off patent. Pharmaceutical sales which account for 41% of J&J’s total sales and 40% of its international sales, have slowed to 3.8% growth before currency gains even before the loss of Risperdal, which produces just under 20% of the company’s pharmaceutical sales. Under the circumstances, J&J’s decision announced on August 1 to incur restructuring costs of as much as $750 million this year to reduce annual operating expenses by $1.3 to $1.6 billion in 2008 and thereafter attests to management’s determination to deal with problems expeditiously and directly. Unsurprisingly, the cost savings will come from paring plants and personnel within the worldwide pharmaceutical business and streamlining the sales force. The company’s $10 billion stock repurchase program and the strong results of its consumer products group has helped keep J&J’s stock price up. Its decline since mid-July is only 1%.

Stryker Corporation

Stryker posted excellent second quarter results with revenues up 16% in local currencies to $1.5 billion and earnings per share from continuing operations up 17.3% to 61¢. On June 4 Stryker announced the sale of its non-strategic, less profitable physiotherapy business to a private equity firm for $150 million in cash. Revenue growth in the U.S. was 17% with revenue from Orthopaedic Implants up 17% and MedSurg revenues up 18%. Worldwide hip implant revenues rose 8% during the quarter, the best performance in two years. The trauma and spine businesses continue to show quarterly revenue growth above 20% as investments in the sales forces and product line breadth continues to payoff. Sales of Stryker’s new high definition video camera and accessories contributed to Endoscopy’s 20% revenue growth. Broad acceptance of the System 6 and Precision Blade power tools pushed Instrument revenues up 18% during the quarter. Styker’s stock price is up 4% since the middle of July.

Varian Medical Systems, Inc.

Varian Medical Systems’ fiscal third quarter revenues rose 7% to $424 million. Earnings per share fell 2¢ to 39¢ from the same period last year. While net orders for Oncology Systems exceeded overall market expansion implying that Varian gained market share during the quarter, setbacks in the brachytherapy business and reduced sales of intensity-modulated radiation therapy (IMRT) systems outside North America, held revenue growth in Oncology Systems to 2% during the quarter. The decline in international sales for IMRT systems follows several years of rapid adoption of this technology. In July, Varian introduced two upgrades to its treatment planning software that significantly reduce the time to develop a treatment plan for IMRT and image-guided radiation therapy. One upgrade automatically outlines organs and other anatomic structures within diagnostic images and the second automatically selects the positions of the X-ray beam to optimize the treatment. Varian’s stock price has fallen 11% since mid-July.

Walgreen Company

Walgreen reported fiscal third quarter revenues of $13.7 billion, an increase of 12.5%. Strong sales of generic drugs reduced revenue growth by 3.4% during the quarter, but boosted earnings per share 19.6% to 56¢ during the quarter. Walgreen took market share in the pharmacy with same-store prescriptions growing 5.4% versus 4% for all retail and mail channels according to IMS Health. Same-store front-end sales rose 5.6% with 56 of the company’s 60 core categories taking share from other drug, grocery and mass merchandisers. Walgreen made two acquisitions to broaden its patient-focused health care services. The company acquired the privately-held convenient clinic operator Take Care Health Systems in May. Take Care Health operates 60 walk-in clinics in Atlanta, Chicago, Kansas City, Las Vegas, Milwaukee and St. Louis. Walgreen plans to roll out 400 convenient care clinics throughout the country by December 2008. On July 2, the company announced the acquisition Option Care, a specialty pharmacy and home infusion business, for $850 million which includes the assumption of $86 million of debt. Option Care currently operates more than 100 specialty pharmacies in 34 states. More than 40,000 patients with acute or chronic conditions are treated at home, in the physician’s office or at one of Option Care’s walk-in clinics. Walgreen’s stock price has increased 1% since mid- July.

Patterson Companies, Inc.

Patterson reported fiscal first quarter sales of $701.4 million, up 7% from the same period last year. Earnings per share rose 14% to 35¢. Sales for the dental business grew 6% during the quarter supported by solid sales of consumables. Equipment sales grew 7% with strong sales of digital X-ray systems and other basic equipment dragged down by weaker sales of CEREC chairside tooth restoration systems. The company sold fewer new milling chambers than they planned this quarter because they purchased demonstration units for the branch offices. Twenty percent of the dentists who currently have CEREC systems want to acquire the new milling chamber, so CEREC sales should grow during the rest of the year. Revenues for Webster, Patterson’s veterinary business, rose 10% to $110 million. Equipment and software sales grew 31% off a small base. The company will soon release a new version of its IntraVet practice management software that will make it easier for vets to incorporate digital images and lab results into patient records. Patterson Medical’s revenues rose 10% to $91.3 million. Five quarters of steady revenue growth has increased senior management’s confidence that this business will benefit from the value-added services a direct sales force and branch offices deliver to physical therapists, occupational therapists and athletic trainers in private rehabilitation clinics. Patterson’s stock price has risen 3% since mid-July because investors have more confidence that CEREC sales will return to historical levels this year.

Merck & Company, Inc.

Merck’s second quarter earnings per share rose 12% to 82¢ not including restructuring charges. Sales of Merck products rose 6% to $6.1 billion with vaccines contributing revenues of $1 billion. Januvia, Merck’s diabetes drug, posted quarterly revenues of $144 million and is now the third most prescribed oral diabetes drug in the U.S. The company continues to advance promising new drug products through its pipeline. Isentress, the first of a new class of HIV/AIDS drugs received a favorable review from an FDA advisory committee on September 5. This drug reduces the viral load in patients with HIV that is resistant to existing antiretroviral drugs. Merck submitted its lipid-modifying drug for FDA review on September 2. This drug combines long-acting niacin, a compound known to significantly raise HDL cholesterol, with an anti-flushing agent that allows patients to take therapeutic doses of niacin. On September 6 the New Jersey Supreme Court reversed a lower court ruling granting national class-action status to insurance companies and HMO’s seeking reimbursement for their Vioxx expenses. Merck’s stock price jumped 2% in response, and is unchanged since the market high in mid-July.

PepsiCo, Inc.

PepsiCo reported another good quarter with revenues rising 10% to $9.6 billion and earnings per share up 15% to 94¢. Strong performance from Frito Lay and Pepsi International offset slower operating profit growth in the North American beverage division which lapped unusually strong growth of 13% in the second quarter of last year. Frito Lay posted revenue growth of 6% led by double digit growth in Doritos, SunChips, new Tostitos dips such as the All Natural Picante Sauce, and multipack servings. Operating profit grew 8% on top of a double digit increase in Frito’s advertising and media budget. Pepsi International’s operating profit rose 18% during the quarter. Snack volumes rose 9% with double digit growth in Russia, India and Mexico. Beverage volumes rose 8% during the quarter on top of 10% growth in the second quarter of 2006 with Pepsi, 7-UP, Mirinda and Mountain Dew volumes each growing in the high single digits. PepsiCo’s stock price has risen 5% since mid-July.

Rockwell Automation

At the beginning of August we uncharacteristically realized a short-term gain from the sale of Rockwell Automation at $71. The stock was sold because our effort to meet with the managers running the company’s software automation control business came to naught when for the third time after more than seven months of waiting, the company cancelled our scheduled meeting in Cleveland. Meeting division managers to gauge their capability, commitment and understanding of how their work contributes to the company’s overall good is a crucial factor in our qualitative assessment of the companies we choose to invest in for clients. Moreover, because meetings of this sort are an integral part of our research process, we are obliged to do so and to eschew investments in companies that deny us such access. These instances are rare.

Intuit Inc.

Intuit’s fiscal fourth quarter sales of $432.7 million rose 31.3% while full year sales of $2.7 billion rose 16.6%. GAAP earnings per share of $1.24 include acquisition related charges of $20.0 million, share-based compensation expenses of $76.3 million and a $31.7 million gain on the sale of a small fully outsourced payroll business to ADP. Non-GAAP earnings per share of $1.43 rose 18% from the prior year. These strong results were overshadowed by the news that Steve Bennett, the company’s able CEO will retire at the end of 2007. He will be succeeded by Brad Smith, who currently runs the Small Business Division which generates half of company revenues. Previously Brad ran Intuit’s Consumer Tax business. Brad Smith joined Intuit in 2003 from ADP where has was an executive in the Employer Services Division. Prior to that he worked at PepsiCo.

Each of Intuit’s major products and services reported double-digit revenue growth for the fiscal year. QuickBooks Small Business Accounting revenue of $598 million was up 11% while its Payroll & Payments revenue sold to QuickBooks customers reached $517 million, up 12%. Revenue from Intuit’s Turbo Tax franchise rose 13% to $1.1 billion as consumer Turbo Tax revenue rose 15% and professional tax products increased 7%. Revenue from Digital Insight, the online banking and bill payment solutions provider, acquired mid-fiscal year, was $150 million. This business is growing 15% annually. Intuit’s stock has declined 6% since the mid-July market high.

Intel Corp.

Intel reported second quarter revenues of $8.7 billion, an increase of 8% over the second quarter of 2007. Earnings per share rose 33% to 20¢ not including one-time charges. Server units and revenues grew more than 10% during the quarter with the strong acceptance of Xeon Quad Core processors. Intel has shipped more than one million of these processors since the launch last November. Strong manufacturing execution continues to deliver very high yields, improved equipment utilization and faster throughput times. The company lowered its 2007 capital spending forecast by $600 million because of efficient equipment use. The restructuring program has reduced research and development and marketing, general and administrative expenses by 15%. This reduction offset a slight decline in the gross margin to deliver a 26% increase in operating income. Reports of stronger than expected sales of notebook computers using Intel’s newest processors lifted the company’s stock price to $26 on September 6. It is down 2% since the middle of July.

Western Union

Western Union’s second quarter revenues of $1.2 billion rose 8% while earnings were 26¢ per share. The company’s operating margin during the quarter was 27%. A year ago the company was a unit of First Data. Consumer to consumer money transfers rose 14% overall to 41.7 million. International transfers which account for one-half of total company revenue rose 20% year over year. Domestic transfers declined 5% and U.S. to Mexico rose 5%. The growth in both of these categories accelerated during the quarter. Consumer to business transactions rose 67%, due to an acquisition made earlier this year. Total agent locations reached 312,000 worldwide, up 12%. During the second quarter the company repurchased 7.8 million shares for $168 million or $21.50 per share. Western Union shares have declined 3% since mid-July.


Exxon-Mobil reported that revenues, operating earnings and oil and gas production all declined 1% from the results produced in last year’s second quarter. Nevertheless operating earnings exceeded $10 billion during the quarter and net cash from operations equaled the $11.3 billion generated in the year ago quarter. Cumulative share repurchases of $32.5 billion over the past four quarters, which reduced the number of shares outstanding by 7%, lifted second quarter earnings per share 6% to $1.83 from the $1.74 earned a year ago. During the quarter, on the Northern Pacific Island of Sakhalin in Russia, Exxon completed the longest extended reach well ever drilled. The well’s measured depth at 37,016 feet is more than seven miles. We cite this feat as an example of both Exxon’s technological prowess and the difficulties the company confronts in its quest to replace its oil and gas reserves. The Russians now are pressing Exxon to reduce its economic interest in the project even though they lack the technical skills to manage a drilling project of this complexity. On June 27th, the Government of Venezuela expropriated Exxon’s interest in the Cerro Negro heavy oil field in the Orinoco Basin. Exxon’s stock price has declined 2% since mid-July.

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.