4th Quarter, 2008

Investor fears about profit deterioration deepening as a consequence of a worsening worldwide recession, as government efforts to revive the credit markets sputter, pushed down the prices of all your stocks. The stock market as measured by the S&P has declined 16% since the start of the year. Managements’ cautionary statements about declines in sales and profits rendered even good fourth quarter results inconsequential. All your companies stocks are selling at prices that make them good values. In our judgment a crucial test of these, and other companies of comparable quality that we know well, is management’s ability to cut costs to preserve cash, maintain profitability and position the business to profit from new opportunities emerging when the economy starts expanding. Getting rid of the vestiges of promising initiatives that failed to perform is one of the keys to revitalizing a business and the sign of undaunted, realistic management. We are in the midst of asking companies about the actions taken to reduce costs and are deferring purchases until we complete our assessment. The insights from the able managers we know well helps us understand and evaluate what others tell us. We believe these investigations will save and make money for you. This process reinforces our determination to invest on the basis of facts about the businesses we would own and not on macroeconomic forecasts. Your portfolios hold significant cash reserves which has helped buffer the decline in market value resulting from the punishing fall in stock prices.

State Street Corporation

A fourth quarter increase of $5.5 billion in State Street’s unrealized loss on $100 billion of asset-backed securities held in the company’s portfolio and in four funds it administers and guarantees for mutual fund customers diverted investor attention from the company’s good fourth quarter operating results. Fears then and wariness now, of the effect these escalating losses might have on State Street’s required regulatory capital have rattled investors. Management’s decisions to book a $302 million fourth quarter restructuring charge, to pay for staff cuts, and its payment of $450 million to restore most of the market value lost in fixed-income funds managed by SSGA wiped out all but 15¢ per share of State Street’s fourth quarter earnings. Negligible earnings, rising portfolio losses and fears about capital adequacy drove State Street’s stock price down 60% on January 20 when earnings were reported and commented upon by management. On February 5, the day of its scheduled annual analyst meeting, State Street’s management announced it had rescinded $278 million of employee incentive compensation, cut its quarterly dividend to 1¢ per share, saving $99 million annually and committed to shrink the size of its investment portfolio by almost $4 billion a quarter during 2009. It will accomplish that by investing the proceeds from scheduled maturities of asset-backed securities in State Street’s account with the Federal Reserve Bank of Boston. The company already has deposited $8 billion received from securities maturing at year-end. State Street’s stock price improved in response to these actions, demonstrating management’s commitment to strengthen the company’s capital position. The way these decisions were taken, however, indicates that management may be daunted by all that has happened. The stock price, after rebounding from its low, is down 39% from the beginning of the year.

The CME Group

CME’s pro forma revenues of $692 million and $3.1 billion in the fourth quarter and for the full year 2008 rose 1% and 11% respectively. Pro forma earnings of $3.58 and $16.17 per share during the quarter and the year were flat and rose 16% respectively. These are respectable results considering that during the fourth quarter average daily volume declined 14% to 10.4 million contracts. Transaction volume reached a low point in December 2008 when 8.2 million contracts traded per day. In January and February 2009, 9.5 million and 10.8 million contracts per day traded, down 41% and 28% respectively year-over-year, but up 16% and 32% respectively from the December nadir. March volumes to date are 11.8 million contracts per day.

Consolidation of trading platforms and integration of common functions after the 2007 combination with the Chicago Board of Trade and 2008 acquisition of the New York Mercantile Exchange led to a 2% decline in pro forma operating expenses to $1.1 billion, resulting in an operating margin of 65% versus 60% the prior year. CME’s compensation as a percent of revenue has declined to 12% in 2008, down from 14% in 2007 and 17% in 2006. (It is 27% at the New York Stock Exchange and 49% at Goldman Sachs.) In the fourth quarter of 2008, 82% of CME revenues came from clearing and transaction fees with 28% from equity index products, 21% energy, 19% interest rate, and 14% from commodities and foreign exchange products. CME shares are 3% below the price at the start of the year.

Automatic Data Processing

Revenues of $2.2 billion during ADP’s fiscal second quarter rose 5.5% before a 3% reduction from foreign exchange. Earnings of 59¢ per share from continuing operations rose 11%. During the quarter the company acquired 5.1 million shares at $37.25 per share, after purchasing 6.1 million shares during its fiscal first quarter for $42.50 per share. Revenues generated from core U.S. payroll and payroll tax filing increased 3% while add-on services rose 10%. Employees per existing client payroll have begun to decline, falling 0.6% during the quarter. ADP’s Professional Employer Organization (PEO) increased average worksite employees by 13% to 193,000, generating quarterly revenues of $283 million, up 14%. Reflecting weaker new sales activity ADP is reducing operating expenses while continuing to invest in products and client-facing resources. ADP’s annual dividend of $1.32 generates a current yield of 4%. ADP shares have declined 11% since the beginning of the year.

EnCana Corp.

EnCana reported fourth quarter earnings of 60¢ per share, 40% lower than the $1.17 earned in the year ago quarter. Cash flow from operations declined 32% to $1.73 per share from $2.56 realized in the fourth quarter of 2007. The declines in earnings and cash flow are primarily attributable to a 30% drop in the price realized for the heavy oil produced by EnCana’s integrated oilsands joint venture with Conoco, along with refining margins for the joint venture 30% lower than last year. Gains realized on natural gas hedges enabled EnCana to realize a price of $7.18 per thousand cubic feet (mcf) comparable to the price realized a year ago without any hedge benefit. Absent hedges, EnCana would have gotten a price of $5.54 per mcf. Gas production increased 4% quarter-to-quarter. During the year, EnCana added 2.5 trillion cubic feet to its proven natural gas reserves, raising the total to 13.7 trillion cubic feet. EnCana has hedged two-thirds of its 2009 natural gas production at an average price of $9.13 per mcf, substantially above a current price of $3.87 per mcf. These valuable hedges are not just a lucky happenstance, but instead are an example of EnCana’s determination to prudently lock in returns, and thereby, protect the capital commitments it must make to sustain production on its properties. The company has prepared a flexible, but disciplined capital spending program for 2009 which permits it to curtail or increase drilling expenditures in its most promising fields if depressed natural gas prices keep profit margins
tight or production costs fall, widening margins. EnCana’s stock price has declined 16% since the start of the year, while natural gas prices have fallen 31%.

C.H. Robinson Worldwide Inc.

CH Robinson’s growth slowed in the fourth quarter as a result of the sustained slow freight environment. Fourth quarter net revenues and earnings of $344 million and 52¢ per share rose 6.6% and 6.1% respectively. Full year 2008 net revenues and earnings of $1.4 billion and $2.08 per share rose 10.5% and 11.8% respectively. Despite a 4% decline in truckload volumes in the fourth quarter, Robinson’s truck business generated 3% profit growth as a result of a lower cost of hire for trucks. Robinson continues to expand its services to meet customers diverse supply chain needs. Its freight forwarding and transportation management business rose 26% in the fourth quarter and for the full year. Truckload volumes deteriorated during the fourth quarter and through the start of 2009 with volumes down 8% in January. Robinson has stopped replacing voluntary and performance-based attrition which will reduce personnel costs. Robinson’s variable-cost business model results in lower expenses when revenues fall, protecting profitability. Cash generated from operations rose 45% during 2008 with a significant improvement in working capital accounting for one-half of the year over year increase. The company has nearly $500 million in cash on its balance sheet and no debt. Robinson’s stock is down 23% since the start of the year.

Express Scripts, Inc.

Express Scripts reported fourth quarter and full year 2008 earnings of 83¢ and $3.13 per share, increases of 28% and 36% over the same periods last year. Operating earnings per claim increased 16% during the quarter and the year to $2.90 and $2.72 respectively. Generic drug utilization rates reached new highs of 67.3% for the quarter and 66.1% for the year. The 2008 generic drug utilization rate rose 4.3 percentage points over the rate for 2007. As the economy weakened, both plan sponsors and members turned to Express Scripts’ programs to save money. Members lowered their total co-pays for the second year in a row by taking advantage of the opportunities to save money by using more generic and low-cost branded drugs. The company’s stock price is down 14% since the beginning of the year. It declined 10% since Express Scripts reported its fourth quarter results on February 26 because of the uncertainty of the impact of the administration’s health care reform proposal on the future profitability of the company.

IDEXX Laboratories

IDEXX Laboratories is the leading provider of diagnostic and information technology products and services to veterinarians that care for pets. The company reported fourth quarter and 2008 revenues of $243.3 million and $1.0 billion, increases of 6.5% and 9% in local currencies. Foreign exchange offset revenue growth by 5% during the quarter. Earnings per share were 44¢ and $1.90 for the quarter and the year, increases of 10% and 20% respectively. Revenues from diagnostic instrument consumables declined 5% to 6% during the quarter because pet-owners deferred annual check-ups and elective procedures such as teeth-cleanings for their pets. Sales of consumable products for IDEXX Lab’s installed base of diagnostic instruments account for 60% of total revenue.

The decline in consumables’ sales was offset by sales of new products. In addition to the launch of new diagnostic tests for both cats and dogs, IDEXX Labs placed 500 Catalyst Dx machines, bringing the installed base to 750. The Catalyst Dx, IDEXX Labs’ new chemistry analyzer, automates sample preparation, reducing the time to run routine tests on blood and urine samples to the time it takes to prepare a sample to send to an outside lab. The company expects to place 2,000 instruments in vet clinics in 2009. The chemistry analyzer is the most widely used diagnostic instrument in the clinic, and IDEXX Labs has an installed base of 30,000 chemistry analyzers worldwide. The company also reported fourth quarter revenue growth of 15% for its practice management and digital radiography systems. IDEXX Labs continues to invest in better connectivity of its instruments and its practice management system to improve the efficiency of vet practices and to capture revenue for all of the services they perform. Vets that use paper forms to record tests and procedures miss as much as 15% of the billable revenues. IDEXX Labs’ stock is down 13% since the beginning of the year.

Varian Medical Systems, Inc.

Varian Medical Systems reported strong fiscal first quarter results with revenues, orders and earnings all growing more than 10% over the first quarter of 2008. Revenues rose 13% to $509 million and earnings grew 14% to 56¢ per share. Oncology Systems, X-Ray Products and Security and Inspection products posted order growth of 11%, 21% and 15% respectively. RapidArc continues to drive the growth of Oncology Systems. During the quarter hospitals and clinics accessed credit to place at least 125 orders for radiation systems capable of performing RapidArc treatments, bringing total orders for the last twelve months to 425. More than 70 systems are being used to treat patients. Revenues for the X-ray Products business rose 23% to $86 million with strong growth in both x-ray tubes and flat panels for filmless x-ray imaging. Net orders for Security and Inspection products increased 15% because of a bulk order for units that will be installed in the Middle East. Varian’s stock price has fallen 16% since the beginning of the year. Investors sold the stock in the days after the announcement of the administration’s health care reform proposal sending the stock price down 7.5%.

Stryker Corporation

Stryker reported fourth quarter and 2008 revenues of $1.7 billion and $6.7 billion, increases of 7.7% and 12% in constant currency. Foreign currency reduced the quarter’s sales in U.S. dollars by 4.1% and annual sales by 1.5%. The company reigned in costs quickly by stopping sales force expansion and curtailing some projects as sales deteriorated at the end of October. This action contributed to earnings of 74¢ per share for the quarter and $2.78 per share for the year, increases of 12.1% and 18% respectively.

Fourth quarter Orthopaedic Implant sales of $1.0 billion rose 8.9% with knees, spine, trauma and CMF (head and jaw) implants delivering double-digit revenue growth. MedSurg revenues rose 6% during the quarter to $701 million. Declining hospital capital expenditures in the U.S. slowed the revenue growth of the U.S. endoscopy and medical businesses. Endoscopy sales also fell in expectation of the launch of a higher resolution camera and a wireless 26 inch high definition TV monitor. Double-digit growth in the international endoscopy and medical businesses offset some of the weakness in the U.S. businesses. The instrument business delivered strong sales growth in the U.S. and weaker growth internationally.

Stryker spent $50 – $55 million on its global compliance initiative in 2008 and expects to spend $60 – $90 million in 2009, the second year of its three year effort. This initiative remains a work-in-progress as demonstrated by the recall of a cranial implant because the vendor received an FDA warning letter. Stryker’s compliance program includes validating vendors to ensure that they are compliant with FDA regulations. While Stryker had twice as many uneventful FDA inspections in 2008, they want the three FDA warning letters lifted in 2009. Stryker’s stock price has fallen 18% since the beginning of the year. It has dropped 11% since February 27 because investors sold health care stocks in light of the uncertainty of the administration’s health care reform proposal on Stryker’s future profitability.

SGS Group

SGS reported strong results for the second half and the full year 2008 with revenues in constant currency up 18% and earnings per share up 14% during each period. Cash flow from operations of $750 million during the year was used to fund capital expenditures of $265 million, shares repurchases of $210 million and fourteen acquisitions at a cost of $175 million which added 3% to revenue growth. Cash flow also contributed $255 million toward dividend payments. During the year, SGS received $108 million after-tax from the Government of the Philippines related to unpaid receivables from work completed in 2002 enabling SGS’ Board to declare a dividend payment 40% above its ordinary amount. On March 26 shareholders will receive their pro-rata share of this $365 million payment which represents a dividend yield of 4.5% at the current share price. SGS Minerals, Industrial and Consumer Testing Services businesses each rose 20% or more during 2008. The sharp fourth quarter decline in commodity prices will reduce exploration and project spending by SGS customers in 2009, slowing revenue and profit growth. SGS management focus on the capital expenditures, working capital and operating expenses of each of their ten business divisions. Reductions implemented in the second half of 2008 continue in 2009. Labor costs, which accounts for 54% of revenue will fluctuate with revenue changes at each division, protecting margins. SGS shares have declined 7% since the start of the year.


Mettler-Toledo’s fourth quarter sales were $509.7 million, a decrease of 4%. Foreign currency declined 5% offsetting 1% growth in local currencies during the quarter. Annual sales of $2.0 billion rose 10% over 2007 with 6% growth in local currencies and a 4% benefit from foreign exchange. Earnings per share for the quarter and the year were $1.98 and $5.76, increases of 15% and 22% respectively. Performance during the quarter was mixed with Laboratory revenues down 2%, Industrial revenues up 2% with strong sales from the product inspection business and Food Retail sales up 6% with strong sales growth across all regions.

Mettler-Toledo has approached the economic downturn with the realistic outlook and attention to detail that characterizes their day-to-day management of the business. The company began implementing a cost-cutting initiative during the fourth quarter as sales began to soften. The company will reduce its workforce by 5% to save $40 million in operating expenses annually. This initiative, which will cost $15 to $20 million, enabled the company to deliver 6% growth in operating income during the fourth quarter. The company’s stock price dropped over 9% the day after they announced the fourth quarter results, the cost-cutting program and their response to a precipitous decline in sales in the month of January. On March 12, CFO Bill Donnelly reported to investors that the company drew down its $650 million credit line because of concerns that their lenders would pull it. The company is managing the businesses quarter to quarter and plans to inform investors about a second cost-cutting initiative when they report first quarter earnings in April. Mettler-Toledo’s stock price is down 32% since the beginning of the year.


We sold your Amdocs shares on January 22, the day after the company reported its fiscal first quarter results. Revenues for the quarter rose 1.6% to $754 million over the same period a year ago, while earnings declined 1% to 43¢ per share. Sales were 6% lower than the company projected. While service providers did not cancel any projects during the quarter, they delayed signing contracts for new projects. These projects account for 30% of the company’s annual revenue. Amdocs’ management expects that it will be more difficult to get deals signed during fiscal year 2009, especially large deals that require board approval, and thus cannot forecast 2009 revenues. The company reduced operating costs by $60 million in the first quarter to maintain the operating margin they delivered in the previous quarter. Management continues to reduce operating expenses in preparation for a possible revenue decline of 9% to 12%. While Amdocs’ telecom customers have cut their investment in new projects, the cable and satellite business remains strong with increased revenue from Comcast and the signing of a major deal with Rogers Communications, a leading cable and wireless provider in Canada.

Donaldson Company, Inc.

Donaldson experienced a sharp broad-based decline in orders during its fiscal second quarter with sales down 10% to $461 million and operating profits down 37% from the prior year. The company has reduced its workforce by 1,850 and is implementing restructuring and cost reductions to cut annual operating expenses by $85 million. Donaldson’s Engine Products business suffered the sharpest decline while aerospace and defense, retrofit emissions and gas turbine filter sales remained strong. Geographically, sales in the Americas were flat, Europe was down 7% and Asia down 14%. On highway truck filter sales to OEM’s (original equipment manufacturers) dropped 43% to $16 million during the quarter, while filter sales to OEM’s of off-road vehicles fell 12%. Demand from aerospace and defense customers offset weak demand from global construction, mining and light industrial applications. Replacement filters, which account for 54% of engine filter sales declined 11% as lower equipment utilization reduces replacement sales. Industrial filter sales fell 8% during the quarter while gas turbine filter sales rose 38% to $57 million. Fiscal 2009 will mark the first year-over-year decline in Donaldson’s earnings in 19 years. Its stock price has declined 25% since the beginning of the year.

PepsiCo, Inc.

PepsiCo reported fourth quarter and full year 2008 revenues of $12.8 billion and $43.3 billion, increases of 3% and 10% over the same periods last year. Earnings per share were 88¢ and $3.67 per share for the quarter and the year, up 11% and 9% respectively. The earnings results do not include mark-to-market losses on commodity hedges or restructuring charges from the Productivity for Growth program or from the Pepsi Bottling Group. In 2008 global snack and beverage volumes were both up 3% with international beverages up 10% and international snacks up 5.5%. Frito-Lay North America held volume virtually flat during the year despite implementing unprecedented price increases to offset commodity price inflation. Revenue in grocery and convenience stores rose almost three times as fast as average revenue growth in the total store. Frito-Lay delivers snacks to stores once a week and gives them thirty days to pay. The local sales force continually adjusts the products delivered to respond to changes in consumer demand. The three-week float provides retailers with cash.

Performance of the North American beverage business remained weak during the quarter. Net revenue fell 10% and operating profit fell 16% as a result of lower volumes and higher input costs. The brand revitalization program began at the end of the fourth quarter with the successful re-launch of 1,200 items. Pepsi will launch new value items such as 18-packs and a sixteen ounce can of soda priced at 99¢. The company also recently introduced zero calorie SoBe Light water and Tropicana50, orange juice which has half the calories of regular orange juice. These beverages are the first to be sweetened with the natural sweetener stevia. PepsiCo’s stock price is down 12% since the beginning of the year.

Intel Corp.

Intel drastically reduced chip production to meet the steep declines in demand for microprocessors and chipsets after sales of notebooks and PC’s declined precipitously in mid-October. Revenues for the fourth quarter of $8.2 billion fell 23% below the fourth quarter of 2007. Earnings for the quarter and the year were 4¢ and 92¢ per share. Both include a $1 billion or 23¢ per share charge for writing down Intel’s investment in Clearwire, an internet services provider that uses a WiMAX network. Fourth quarter sales of Atom processors were $300 million, a 50% increase over the third quarter. The Atom microprocessor is about half as powerful as the lowest-end Celeron chip that is used in low-cost notebook computers and is more profitable. Atom processors have about one-fourth the capabilities of the Centrino chips used in higher-end notebooks. The 32 nanometer manufacturing process will allow Intel to combine the Atom microprocessor and its chipset into a system-on-a-chip. Intel expects these new chips to remain profitable as the cost of the final products, netbooks and other consumer electronic products, decline. Intel’s stock price has held up well since the beginning of the year, declining 4.5%.

Western Union

Western Union’s fourth quarter and full year 2008 revenues of $1.3 billion and $5.3 billion declined 1% and rose 8% respectively. Fourth quarter and full year earnings of 34¢ and $1.24 per share rose 6% and 12% respectively. The company’s 2008 cash flow from operations of $1.25 billion less capital expenditures of $154 million exceeded net income by 20%. Western Union’s consumer-to-consumer money transfers rose 9% in the fourth quarter and 12% during 2008 to 49.1 million and 167.7 million respectively. Agent locations reached 375,000 at year end, up 12% or 40,000 from the prior year. In 2008 the company handled $67 billion of cross-border transfers, up 17% from the prior year, though the average amount of each transfer declined in the fourth quarter, reducing revenues and profit per transfer. The decline in the average amount transferred and the associated reduction in profit per transfer is continuing in 2009. The company’s cost per transfer declines as well as 65% of expenses are variable. Western Union is reducing its fixed operating costs by consolidating or closing certain call center and IT facilities, incurring $83 million of restructuring expenses during 2008. These actions will reduce annual operating costs by $40 million beginning in 2009. Western Union shares have declined 16% since the start of the year.

Exxon Mobil

Exxon-Mobil reported fourth quarter earnings of $1.55 per share, 27% below last year’s quarterly results. The earnings decline is almost entirely attributable to oil price realizations 40% below the year ago price on production volumes 1% lower as a consequence of production sharing agreements with host country governments. Quarterly earnings from the company’s refining operations were 6% higher than during the comparable year ago period. This improvement was achieved through efficiently operating the company’s well-planned and constructed overseas integrated refinery and petrochemical facilities which can quickly adapt to process as many as 135 different crudes. This flexibility lowers costs and boosts margins. The company’s U.S. refineries produced a loss. During the quarter, the company announced plans to invest $1 billion to produce low sulfur diesel at three refineries in the U.S. and Europe. At year-end, Exxon had $31 billion in cash on its balance sheet. Its stock price is 18% lower than it was at year-end.

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.