3rd Quarter, 2007

The vast majority of your companies generated good revenue and earnings growth during this year’s third quarter. In reading about your companies results please bear in mind that the third quarter earnings for the companies comprising the S&P 500 declined 3%. They were weighed down by the dismal results of most of the financial companies – but not any you own – included in the index. As of this writing the S&P is up less than 4% since the beginning of the year. The results of several of your companies were exceptionally strong. However, execution lapses at a few uncharacteristically slowed their profit growth. Their comparatively poor results rattled investors who already were apprehensive about a stock market buffeted by revelations of astoundingly large losses at eminent financial institutions. Commentators’ alarms about ever more horrendous losses as yet unrevealed increased investors’ jitters. Most institutional investors, who behave like traders, have little inclination to hang onto any stock whose price falls below its recent trading range. Fear of loss now has supplanted investors’ voracious appetite for risk and will persist while the Fed and central banks elsewhere provide injections of liquidity to prevent seizures in the money markets. The slow process of cobbling together a costly solution to fix the huge misallocation of capital wrought by financiers who became caught in the arcane complexity of their own debt creations, should offer the well-run companies we own ample opportunities to strengthen their fine businesses at the expense of financially less sound competitors. That would be good for us.

State Street Corporation

Since its mid-August low of 59, State Street’s stock price has risen 32% to 78 and is up 17% since the beginning of the year. The cause of the August sell-off was oft-repeated ill-informed rumors about State Street’s exposure to sizeable losses on asset backed securities which supposedly were as prone to default and as unmarketable as the illiquid structured mortgage-backed debt instruments disrupting debt markets worldwide and forcing institutions to recognize horrendous losses.

In reporting State Street’s strong earnings in mid-October management provided detailed confirmation of the high quality of the securities held in its investment portfolio as well as those held in the asset-backed programs it administers for seven mutual fund customers. That quelled most remaining fears. Management cited a quarterly year-to-year 87% increase in foreign exchange and brokerage revenues and a 90% rise in securities lending revenues as evidence of gains derived from turbulent markets. The third quarter includes for the first time the results of Investors Financial Services acquired on July 1. Although the acquisition diluted quarterly earnings by $.05 per share, success in integrating the business, 90% of which is being retained, will result in dilution of only a penny in the fourth quarter and none next year. Management originally forecast dilution of $.14 for this year. After a $.24 per share merger integration charge, State Street’s quarterly earnings per share were $.91 compared to $.83 per share earned a year ago. Total third quarter revenue of $2.2 billion was 48% higher than last year. For the twelfth consecutive quarter, management delivered positive operating leverage. Remarkably during the quarter, State Street secured new servicing contracts for assets of $825 billion, of which $335 billion is for private equity custody and accounting. During the quarter State Street earned 51% of its profits from operations outside the U.S.

The CME Group

Elevated financial market volatility lifted the average daily volume of futures and options traded at CME to 12.7 million contracts during the quarter, a 48.5% increase over the same period last year. Each of CME’s product lines experienced strong volume growth from a year ago. Interest rate futures and options were up 43%, equity index products 78%, foreign exchange 50% and commodities 15%. The number of contracts traded electronically reached a record 77% of total volume. During periods of market anxiety CME’s deep liquid pools swell as market participants seek the anonymity, capital efficiency and reduced counter-party risk the CME provides. Total revenues increased 106% above the year ago quarter to $565 million and earnings per share rose 31% to $3.87. These GAAP results include the Chicago Board of Trade results from July 12 and $48.5 million in merger related charges. Pro-forma revenue growth of 41% and EPS of $4.31, up 46%, reflect the combined operating results of CME and The Chicago Board of Trade. CME’s balance sheet remains exceptionally strong. As of September 30, 2007, the company reported nearly $900 million in cash and marketable securities, short-term debt of $165 million and $12.1 billion in shareholders equity.

On October 23, CME made two announcements which expand their global distribution and processing capabilities. CME will acquire 10% of the Brazilian Mercantile and Futures Exchange in exchange for a 2% equity interest in CME. BM&F is the fourth largest futures exchange in the world and the largest in Latin America with average daily volume of 1.8 million contracts. In addition, CME announced an agreement with the Korea Exchange to list the heavily traded KOSPI 200 futures contract on CME Globex beginning in 2008 for trading each day after the Korea Exchange closes. CME’s shares have risen 28% since the beginning of the year.

Automatic Data Processing

ADP’s fiscal first quarter revenues of $2.0 billion were 13.5% higher than last year while per share earnings from continuing operations rose 25% to 45¢. Core payroll and tax filing revenue was up 8% and add-on services rose 18%. The number of employees on clients’ payrolls increased 1.6% during the quarter, down from the 2.1% increase the previous quarter. Client retention improved 50 basis points and worldwide new business sales rose 11%. A 7.5% average increase in client funds balances to $13.5 billion along with a 30 basis point improvement in yield to 4.6% resulted in a 15% increase in interest earned to $155 million. ADP remains one of only a handful of companies in the world with a AAA credit rating. Its balance sheet as of September 30, 2007 recorded total assets of $25.7 billion, which primarily comprised $17.6 billion in funds held for clients and $1.9 billion of cash and marketable securities. Long-term debt was just $43.5 million and stockholders’ equity is $5.0 billion. The company holds no sub-prime asset backed securities, no CDO’s and no CLO’s. ADP’s shares are up 3% year to date.

EnCana Corp.

EnCana reported strong third quarter operating earnings of $1.27 per share. An 8.3% reduction in shares outstanding resulting from share repurchases, including 3.5 million shares bought during the quarter at $61.60 per share, helped lift the earnings per share gain 27% above the $1.00 earned in the year ago quarter before inclusion of a $255 million, or $.31 per share, gain on sale of the company’s ownership interest in Brazilian offshore leases. Importantly, operating cash flow of $2.2 billion, or $2.93 per share, was 27% above the $2.30 earned in the year ago quarter. All the increase in cash flow is attributable to $441 million earned from the company’s integrated oil sands and refining joint venture with Conoco. It has contributed cash flow of $1 billion to EnCana since it began operating on January 1. At the end of June processing of 25,000 barrels a day began at the joint venture’s Borger Refinery in the Texas Panhandle. Profitability well above forecast has helped meld the joint venture into an excellent working partnership. During the quarter, EnCana increased its natural gas production to 3.6 billion cubic feet per day, which will raise 2007 production 4% above last year’s. Hedging contracts enabled the company to realize $6.75 per million cubic feet (mcf) which is $1.65 above the $5.10 per mcf realized from gas sales. The market price was 11% below that of a year ago. EnCana has 45% of its fourth quarter production hedged at $8.77 per mcf and 20% of its 2008 production hedged at $8.49. Last week EnCana completed its $2.55 billion purchase of 50% of the Amoruso Field in the Deep Bossier formation in East Texas that it did not already own. EnCana initially acquired a 50% interest in 2004 and has since raised natural gas production from zero to 215 million cubic feet per day. It estimates that the Deep Bossier contains 1.5 trillion cubic feet of recoverable reserves. EnCana’s stock price has risen 18% since mid-August and is 42% above its price at the beginning of January.

C.H. Robinson Worldwide Inc.

Compared to last year’s results CH Robinson’s third quarter revenues and earnings rose 12.5% and 20% respectively to $313.2 million and 48¢ per share. The total value of transportation services provided during the quarter was $1.9 billion, up 9% from a year ago. Robinson’s core trucking business, which comprises three-quarters of company revenues, rose 12% to $238.8 million. All other revenue, which includes sourcing fresh fruit and vegetables, intermodal, air and ocean services rose 14% to $74.4 million. During the quarter, Robinson experienced a continued softening in demand as the overall freight industry experienced flat to down shipment volume. Robinson’s 12% gain in truck revenues was comprised primarily of increased volumes as the company continues to gain market share. Lower prices per truckload were offset by higher realized margins. The company held personnel expense growth to 8% and kept SG&A growth below 10%, resulting in pre-tax income growth of 18.6%.

Unlike most transportation companies, CH Robinson’s business is not capital intensive. It does not own trucks, trains, planes or ships. The company’s capital requirements consist of expenditures for information technology, branch offices and working capital to fuel growth. Robinson is a preferred business partner for truckers, in part because they are fast payers. On average they pay transportation suppliers five days prior to being paid by their customer. Robinson has no long-term debt and has cash and short-term securities of $411 million after purchasing $107 million of its common stock and paying $94 million in dividends this year. Robinson’s stock is up 24% since the beginning of the year.

Express Scripts, Inc.

Express Scripts’ continued success in encouraging members of its pharmacy benefit plans to increase generic drug utilization lifted the company’s third quarter earnings to $.60 per share, 43% higher than the record third quarter earnings of a year ago. During the quarter the generic utilization rate reached an industry high of 62.2% compared to 58.3% last year. The gross profit per claim reached $3.59, 20% higher than a year ago while operating cash flow per claim rose 32%. During the quarter Express Scripts bought back 6.1 million shares for $51.41 per share, raising the total number of shares bought this year to 23.1 million, 8% of the shares outstanding. The shares were repurchased at an average cost of $49.36. The total amount spent was $1.14 billion, 55% of which was provided from operating cash flow. Express Scripts stock price has advanced 90% since the beginning of the year, including a 5% spurt on November 27 after the company announced an earnings growth objective of 22% to $2.80 per share for 2008.

Stryker Corporation

Stryker continues to post strong results with third quarter revenues of $1.4 billion, up 15.7% operationally over the third quarter of last year. Foreign exchange contributed 2.3% to revenues during the quarter. Earnings per share from continuing operations rose 22.2% to 55¢. Domestic sales of orthopaedic implants rose 16% while MedSurg revenues rose 20%, the division’s 33rd consecutive quarter of double digit revenue growth. International sales grew 11% including no growth in Japan, Stryker’s second largest market. Government-mandated reimbursement cuts on January 1 and April 1 pushed prices for orthopaedic implants down 7% over the same period last year. On July 3, the FDA approved the Cormet hip resurfacing product, a bone-sparing procedure that allows certain younger patients to return to their active lives faster. Stryker is currently educating and training surgeons about which patients will benefit most from this procedure and how to perform it. On September 27, the company announced the resolution of a Department of Justice investigation of consulting contracts with surgeons. Stryker was the only orthopedic implant company not to pay a fine. Stryker’s stock is up 32% since January 1.

Varian Medical Systems, Inc.

Varian Medical Systems’ stock price jumped 12% during the two days after the company released its fourth quarter and fiscal year 2007 results. The stock price is up 6% since the beginning of the year. Fourth fiscal quarter revenue grew 15% and orders rose 17% with earnings per share rising 13% to 61¢ over the same period last year, not including one-time items and discontinued operations. Revenues for the year grew 11% to $1.8 billion with earnings per share growing 10% to $1.83. New orders for radiation systems capable of performing Image Guided Radiation Therapy (IGRT) returned to earlier levels of growth. Varian’s IGRT technology has successfully moved into mainstream cancer clinics. All new systems ordered in North America and 70% of the high-end orders internationally included the on-board imager, the key enabling technology for IGRT.

Varian also announced the development of Volumetric Arc Therapy, the next generation of IGRT. This technology delivers a treatment in a single rotation of the radiation source. By changing the shape of the X-ray beam, its dose and the speed of rotation throughout the treatment, RapidArc reduces treatment times for even the most complex head and neck cancers to about two minutes. This technique delivers a dose that conforms more closely to the shape of the tumor and reduces the dose required to treat the tumor by 60%. Clinics can modify their existing orders to include the capability to perform RapidArc. The company expects it to be on the market in April 2008.

Johnson & Johnson

Johnson & Johnson’s third quarter sales of $15.0 billion grew 2.4% operationally over the same period last year with sales from Pfizer Consumer Health included in both periods. Foreign currency contributed 3.0%. Earnings per share for the quarter of $1.06 increased 8.2%. The company’s cost-cutting program announced in July has already begun to deliver savings. Consumer sales of $3.6 billion were up 3.5% over the same period last year when the Pfizer sales are included in both periods. Both Skin Care and Baby and Kids Care, which account for about 35% of the segment’s revenues, delivered revenue growth of 12% and 7% respectively. Medical Devices and Diagnostics reported third quarter sales of $5.2 billion, up 3% over the same period last year. A 40% decline in the sales of CYPHER drug eluting stents from the third quarter of last year offset growth in the other six franchises. The Total Vision Care and Diabetes franchises posted revenue growth of 15.5% and 12.5% respectively. Pharmaceutical sales grew an anemic 1.2% during the quarter as Risperdal faces increased generic competition in several European markets and sales of Procrit declined 27% because a new reimbursement policy for Medicare and Medicaid patients restricted sales. The product pipelines for the Medical Devices and Diagnostics and Pharmaceuticals segments contain innovative products that are progressing through the FDA approval process. Johnson & Johnson’s stock price is up 3.5% since the beginning of the year. It is buoyed by the $8 billion remaining in the company’s $10 billion stock buy back program.

Walgreen Company

On October 1, Walgreen surprised investors with its announcement of fourth fiscal quarter earnings per share of 40¢, unchanged from earnings a year ago. Its stock price plunged 15% that day and is down 16.5% for the year. Walgreen’s senior management uncharacteristically did not rein in $50 million of controllable expenses such as image advertising, store repairs and pharmacist hours needed to offset a decline in profit per prescription filled during the quarter. We await the company’s first earnings conference call on December 21 to see whether the company has regained its cost-control discipline while it continues to expand the products and services offered in its stores.

Walgreen posted good results for fiscal year 2007 with revenues growing 13.4% to $53.8 billion and earnings per share up 18% to $2.03. Front-end sales rose 5.8% in stores open more than one year, while the number of prescriptions filled rose 5.7%. Walgreen’s filled 583 million prescriptions in 2007 and now fills nearly 17% of all retail prescriptions in the U.S. We sold Walgreen shares that clients owned at a cost above $39 to free funds for other investments and to realize the loss.

Patterson Companies, Inc.

Patterson Companies reported disappointing revenue and earnings growth for its fiscal second quarter ending October 27. Total sales rose to $742 million, 7% higher than last year’s comparable quarter while earnings rose 11% to $.39 per share up from $.35 a year ago. Dental equipment sales declined 2% below a year ago as sales of digital x-ray systems, basic equipment, including chairs, and CEREC chair-side tooth restorative systems slowed. The latter is surprising because Patterson’s management at its September 6 analyst meeting confirmed solid demand for a new, faster, more precise crown milling machine from 20% of the existing users of the 8,000 CEREC systems that were sold and are serviced by Patterson. Production difficulties are impeding the CEREC manufacturer from increasing the rate of milling machine deliveries while Patterson’s need to equip its sales and service centers further restricts availability. Meanwhile a competitor has succeeded in reviving dentists’ interest in seeing a long-awaited yet to be introduced crown restorative system before ordering a CEREC system which cannot be delivered for months. The probability that dental equipment sales would remain in the doldrums was validated by management reducing its forecast earnings for fiscal 2008 to a range of $1.68 to $1.73 per share thereby cutting the earnings growth rate to 12% from an earlier goal of 16%. The resultant selling left Patterson’s stock down 22% on the day and down 12% for the year to date. The execution in all of Patterson’s other businesses was excellent during the quarter. Sales increased 7% for dental consumables and 14% for both veterinary and medical rehabilitation supplies and equipment. We are selling all the Patterson shares clients own at a cost above 30 to free the funds for other investments and book the loss.

Merck & Company, Inc.

Merck reported third quarter revenues of $6.1 billion and earnings per share of 85¢, increases of 12% and 67% respectively over the same period last year. Merck’s vaccine revenue for the quarter was $1.2 billion with its three new vaccines accounting for $650 million. Total sales of Gardasil, Merck’s HPV vaccine, were $555 million during the quarter including $137 million in sales from the Sanofi Pasteur/Merck joint venture that sells vaccines in 19 countries. Merck’s marketing and administration costs rose 6% during the quarter to support the launch of its diabetes drugs and anticipated product launches.

On November 9, Merck announced an agreement to settle all outstanding heart attack and stroke claims against Vioxx for $4.85 billion. To qualify for the settlement, each plaintiff must demonstrate injury, that he had taken Vioxx for at least 30 days and that the injury occurred within 14 days of the last dose of the drug. The agreement limits Merck’s liability by requiring plaintiff attorneys to recommend the settlement to all of their clients and to register their claims to establish the universe of all existing claims in the U.S. Merck’s stock price has risen 37% since the beginning of the year and is at its five year high.


Amdocs reported fourth quarter and fiscal year 2007 revenues of $726.7 million and $2.8 billion, increases of 9.2% and 14.4% over the same periods last year. Earnings per share for the quarter rose 4.9% to 43¢ while earnings for the year increased 3.4% to $1.63. The 12-month backlog grew 1.9% to $2.2 billion over the backlog in the third quarter and accounts for about 70% of the company’s projected 2008 revenue. Amdocs reported winning two managed services contracts that include the modernization and consolidation of existing billing systems. Their on-going large billing system projects for AT&T’s internet protocol-based network and Sprint Nextel are meeting established milestones and requirements. The company’s stock price is down 15% since the start of the year because investors have few metrics with which to measure Amdocs’ growth. The decline does not reflect any concerns about the company’s financial strength. Their highly competitive Tier 1 communication service provider customers severely restrict the information that Amdocs can release to the public.

NeuStar, Inc.

NeuStar’s third quarter revenues totaled $111 million, up 34%, while earnings of 32¢ per share surged 45% from the prior year. Transactions under the company’s U.S. telephone number portability contracts rose 40% to 83.2 million, the 22nd consecutive quarter of growth. Transactions are driven by fundamental routing modifications, many resulting from enhanced and improved services within thousands of networks which must inter-operate. The company’s UltraDNS business manages Internet traffic for 3,000 customers including 13 of the top 20 ecommerce websites. Total Internet queries to its directory during the quarter reached 520 billion, up 78%. NeuStar manages 2700 Common Short Codes used by mobile phone users, up 34% from a year ago. The company’s newest service offering, Next Generation Messaging, a mobile instant messaging platform recorded just $1.8 million in revenue during the quarter. This business was acquired 11 months ago. During the quarter, NeuStar began offering wireless number portability services in Canada. NeuStar shares have risen 3% year to date.

Donaldson Company, Inc.

Donaldson reported another strong quarter with sales up 18% to $525 million and earnings up 23% to 53¢ per share over the same period last year. Overall North America sales increased 6% while Europe and Asia rose 29% and 24% respectively. Donaldson was able to generate an 11% overall increase in its engine products despite a 41% or $20 million decline in its on-highway truck segment resulting from the short-term impact of new U.S. EPA diesel engine emissions regulations. This decline was offset by strong sales of off-road products whose sales rose 31% or $25 million. Replacement filter sales, which account for one-half of total sales, gained 19%. Demand for Donaldson’s Industrial filter products remained strong, posting a sales gain of 27%, led by an 88% surge in revenues from gas turbine products. Donaldson’s total revenue and earnings were up 13% and 14% respectively excluding the beneficial impact of foreign currency translation. Donaldson shares are up 32% since January 1.

PepsiCo, Inc.

PepsiCo’s consistent performance has raised its stock price to a new high of $77, an increase of 21% since January 1. Third quarter revenues and division operating profits rose 11% and 10% respectively over the same period a year ago. Earnings per share were 99¢, an increase of 11% excluding one-time items. All three divisions navigated significant input cost inflation with new products, price increases and productivity improvements. On November 5, the company announced a major reorganization of its businesses. PepsiCo Americas Foods and PepsiCo Americas Beverages combine their respective North American and Latin American businesses. John Compton, the CEO of PepsiCo North America, will oversee the food business which includes Frito Lay North America, Quaker and the company’s large Mexican snack businesses Sabritas and Gamesa. Massimo D’Amore, a 13 year veteran of PepsiCo International, will take responsibility for Pepsi-Cola, Gatorade and Tropicana in addition to the Latin American beverage businesses. Mike White, the current CEO of PepsiCo International will lead the food and beverage businesses in the U.K., Europe, Asia, the Middle East and Africa.

Intuit Inc.

Intuit’s seasonally small fiscal first quarter results were good. Revenue of $445 million rose 27% while the non-GAAP operating loss was 10¢ per share compared to a 12¢ loss a year ago. Total sales to Small Businesses rose 13% to $278 million with Quickbooks products up 9% to $147 million and Payroll & Payments up 18% to $131 million. Sales of Internet banking and bill payment products to financial institutions of $66 million provided the balance of the revenue growth. Internet banking end users of 8.1 million represented a year over year increase of 13% and 2.2 million online bill payment end users were 23% above the year ago figure. During the quarter, the company booked more new financial institution customers than ever before in its history. As of this writing, Intuit is launching Turbo Tax products for the 2007 tax year. Delays in implementation of AMT tax law changes for 2007 could shift revenues from Intuit’s fiscal second quarter ending January to its fiscal third quarter ending April. Intuit shares have declined 2% since the beginning of the year.

Intel Corp.

Strong demand for Intel’s high-end microprocessors for notebooks and servers contributed to the company’s excellent third quarter results. Revenues rose 15% to $10.1 billion over the same period last year, while earnings per share leapt 41% to 31¢. The company shipped two million quad-core microprocessors for servers during this quarter alone. Sales in the Mobility division rose 30% as its newest Centrino wireless platform has been widely accepted by notebook computer manufacturers. On November 13 Intel launched 13 microprocessors made with next generation 45 nanometer production technologies. These chips are the first produced with a novel metal insulator instead of silicon dioxide. This important technical breakthrough enabled Intel engineers to increase the number of transistors on the microprocessor from 580 million for a processor made with the current 65 nanometer processes to 820 million while shrinking the size of the chip. In addition, Intel reported a 38% increase in performance with the same energy consumption as the previous generation of microprocessors. Intel’s stock price has risen 29% since the beginning of the year.

Western Union

Western Union’s third quarter revenues of $1.3 billion are 10% higher than last year’s while operating earnings were 28¢ per share. Western Union ended the quarter with 320,000 money transfer agent locations, an increase of 12% from a year ago. During the quarter total consumer to consumer money transfers rose 15% to 43.1 million driven by International growth of 20%. Transactions that originate outside the U.S. and generate one-half of total company revenue posted 29% transaction growth. Domestic transactions declined 4% and U.S. to Mexico transactions rose 7%. India and China transactions grew 69% and 28% respectively in the third quarter. Consumer to business revenue grew 14% during the quarter.

In the past three months, Western Union renewed several important agent relationships including Safeway, K-Mart (which now includes Sears) and Kroger. Wal-Mart Canada was added as a new agent relationship as well as several international banks, retailers and post offices. Western Union counts as agents 8 of the top 10 U.S. supermarket chains. During the quarter, Western Union repurchased 15.3 million shares of its common stock for $300 million, an average cost of $19.59 per share, bringing the year to date total to 29.2 million shares for $601 million.

In October, Western Union announced an agreement with GSMA, the global trade association which represents 700 million mobile phone operators worldwide, to facilitate the development of money transfer services. Western Union shares remain unchanged since the beginning of the year and are up 22% from the mid-October low.


Exxon Mobil reported third quarter earnings of $9.4 billion, 10% less than the year ago quarter. Share repurchases, which reduced outstanding shares 6%, resulted in third quarter earnings per share of $1.70, 4% less than the $1.77 earned in the comparable year ago quarter. Although all the company’s operating divisions experienced a decline from the near record profit levels attained in last year’s third quarter, narrower margins in refining and marketing pushed its U.S. and overseas operating income in this segment down 26%, led by a 28% drop in U.S. refining. Higher realized crude oil prices of almost $71 a barrel kept oil and gas production income from declining more that 3% even though worldwide volumes fell 4%. Exxon’s operating cash flow rose 4% to $15.1 billion during the quarter, 3% above last year’s quarterly results. Its balance sheet with $30 billion of net working capital is impregnable. The company’s stock price is up 15% 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.