2nd Quarter, 2009

The rising stock prices we have enjoyed over the past six months after enduring punishing losses and bouts of anxious torment last fall and winter, remind us to be wary of economic forecasts particularly those that commentators say are validated by the markets. Clarity often comes from a healthy cynicism about government economic statistics which are issued primarily to serve the needs of the government. The stock market does not forecast or say anything. It records prices set by buyers and sellers which, contrary to assertions of many efficient market theorists, may not reflect all relevant information. At times, disinformation is a price determinant but more frequently prices are set by investors’ and traders’ emotions – greed and fear. As Benjamin Graham eloquently put it, “In the short-run the stock market acts like a voting machine…”

The perspective provided by the foregoing thoughts allows us to see two distinct phases in the buying that has lifted stock prices since early in March. The three month rise, until the second week of June, was a relief rally emanating from realization that our banking system would not collapse and be taken over by the government. After a modest retreat during July, the market resumed its rise, this time propelled by fund managers’ fears that they would underperform their benchmarks. The S&P has appreciated 16% since the start of the year. Surprisingly our stocks are up 20%! Our interpretation of what has occurred in the stock market does not lead us to think the prospects for our economy are any better than what the able managers of the excellent companies you own tell us. They say they have survived the worst part of the current downturn, but most cannot say where a sustainable upturn will come from within their businesses. What we hear makes us think that this is a time when smart investors will pay a premium to own well positioned, persistently profitable companies like the ones you own.

C.H. Robinson Worldwide Inc.

Robinson’s second quarter results were remarkably good. The company’s total revenues of $1.9 billion declined 17% from the prior year while net revenues, excluding the cost of third-party transportation rose 3% to $351.7 million. Earnings of 54¢ per share rose 4% from the prior year. A reduction in demand for trucking services resulted in a 5% volume decline. The magnitude of the decline in demand lessened as the quarter progressed with volumes flat on a year over year basis during July. Truckload rates paid to suppliers declined 10% during the second quarter with one-half of the drop a result of lower fuel prices. Robinson’s fruit and vegetable sourcing revenues and profits rose 12%. Its air, ocean, intermodal and miscellaneous transportation services declined 12% overall from the prior year. The company’s operating profit per employee rose 11% as the employee base shrunk 6% from a year ago. Robinson continues to sell aggressively in the marketplace and is gaining marketshare. The company’s sophisticated information technology and wide range of transportation services helps customers improve their supply chains, reducing transportation costs. This is of great importance especially during periods of weak economic activity. In June the company purchased Walker Logistics, a provider of global freight forwarding based in the U.K. and in July acquired certain assets of International Trade and Commerce, a customs brokerage company based in Laredo, Texas. Robinson’s stock price is up 7% year-to-date.

The CME Group

CME’s second quarter revenues of $648 million and earnings of $3.33 per share rose 15% and declined 9% respectively. Proforma revenues which include the results of NYMEX during the same period a year ago declined 14%. Operating expenses declined to $243 million during the quarter, producing an operating margin of 63%. Second quarter average daily volume was down 19% compared to a year ago and flat with the first quarter. June average daily volume of 11.3 million contracts was the strongest month this year. The average rate per contract was 82¢ during the second quarter, up 5% from the previous year. The volume of interest rate, foreign exchange and commodities contracts (including NYMEX) declined 15%, 12% and 9% respectively. Equity index contract trading volume was flat.

CME’s stock price is up 34% since the start of the year even after declining 16% since mid-June. We think the drop during the past few months is caused by regulatory hearings called by Gary Gensler, the newly appointed Chairman of the Commodity Futures Trading Commission, to discuss and subsequently impose position limits on energy futures trading. This results in certain traders, including sponsors of Exchange Traded Funds, to trade less on CME’s regulated exchange and to move positions to unregulated overseas or over the counter markets. We think this type of short sighted regulatory response with little underlying empirical evidence to support the regulatory constraints imposed further damages our financial system.

Automatic Data Processing

ADP’s fiscal fourth quarter revenues of $2.1 billion declined 5% from a year ago while earnings from continuing operations of 45¢ per share rose 7%. Unfavorable foreign exchange rates reduced revenues by 4%. ADP’s key business metrics continued to decline during the fourth quarter. The number of employees on clients’ payrolls in the U.S. declined 5.7% bringing the full year decline to 2.5%. Client retention was down 1.2 percentage points during the quarter and new business sales declined 29% for the quarter and 15% for the year. ADP’s core payroll and tax filing business declined 4% while add-on services sold to core payroll customers rose 4% during the quarter.

Management’s continued focus on controlling costs along with lower incentive based selling expenses resulted in a 21.5% pre-tax margin for the year, up from 20.6% last year. During the fiscal year ADP generated 1% revenue growth, 10% earnings per share growth and more than one billion dollars in free cash flow. It returned all free cash generated to shareholders through dividends of $629 million providing a current yield of 3.4% and share repurchases of $580 million, which reduced diluted shares outstanding by 4%. ADP’s stock price is down 2% from January 1.

Global Payments

Global Payments fiscal fourth quarter and full year revenues of $402 million and $1.6 billion rose 17% and 26% respectively. Operating earnings of 46¢ per share for the quarter and $2.23 per share for the year declined 12% and rose 13% respectively. The fourth quarter earnings decline is attributable to an adverse foreign currency swing. It’s U.S. business, which generated one-half of company revenue reported 7% revenue growth during the fiscal fourth quarter when overall credit and debit card volumes were declining. The company, through its effective U.S. sales force comprised principally of independent selling organizations, continues to expand market share especially at small and mid-size merchants. During the year, Global Payments expanded its international merchant processing business with its joint-venture partner HSBC in both the UK and the Philippines. The company continues to invest in its G2 common front-end authorization system and plans to convert its U.S. business this fall, followed by Canada, the UK and Russia next year. It’s U.S., Canadian and Asian businesses are already on a common back-end processing system and the U.K. will convert next year. These system investments lower operating costs and provide a sales and marketing advantage by allowing customer specific pricing adjustments. Global Payments shares, which closed at $44, are well above our recent purchase price.

EnCana Corp.

EnCana’s second quarter operating earnings of $1.22 per share were 38% below earnings for last year’s comparable quarter. Despite the decline, these results are good because average prices for natural gas and oil during this year’s second quarter were respectively 70% and 50% lower than a year ago. Fortunately, EnCana’s practice of prudently managing the risk of fluctuating oil and gas prices through hedging transactions allowed it to avoid the brunt of the precipitous gas decline. The effect of hedging two-thirds of its planned gas production at $9.13 per mcf resulted in a realized price, net of transportation costs, of $5.68 per mcf, 14% less than the comparable price realization last year. Absent the hedge, EnCana would have gotten only $1.81 per mcf. The hedging contracts at $9.13 per mcf expire at the end of October, providing price protection through the third quarter. Thereafter EnCana has acquired contracts providing price protection at $6.05 per mcf through October 2010 for 45% of its planned production. The current spot price for natural gas on the NY Mercantile Exchange is $3.25. Natural gas prices are out of kilter. Normally they relate to the energy equivalent of gas to oil. Six mcf of gas equals one barrel of oil. Because oil is more easily transportable, this ratio frequently rises slightly above ten to one. With oil trading at $72, the ratio is over twenty-two to one! Natural gas prices have collapsed because application of improved horizontal drilling and rock fracturing technology to develop deep U.S. and Canadian gas bearing shale formations by companies like EnCana has brought vast quantities of newly discovered gas onto the market. Much of the development drilling cannot be halted because leases from mineral rights owners require delivery of commercial quantities of gas to a pipeline to hold a lease from at least one well per section. Rising imports of LNG also weigh upon the gas price. EnCana has shut-in 10% of its daily production.

The after-tax gain realized by EnCana on its hedging transactions during the past quarter was $900 million or $1.20 per share, which helped lift the company’s cash flow per share to $2.87 during the quarter, only 25% below the $3.85 generated during the second quarter of 2008. EnCana complements its skill in hedging product pricing risk by encouraging cost conscious behavior among all its employees. These skills combine to help the company adjust to changing conditions in the oil and gas industry which enhances EnCana’s strength as a long-term investment. Emphasis on cost control enabled EnCana to bring its second quarter operating expense down 33% below last year’s level, although material and service provider costs dropped only 20-25%. The difference is attributable to good management.

The 26% rise in EnCana’s stock price to just over $58 since the start of the year bears little relation to the company’s reported earnings, nor is it correlated with oil and natural gas price movements. Instead, the stock price probably reflects investor judgment that ownership of shares in the largest owner of oil and gas producing acreage in North America is a prudent way to safeguard capital in these uncertain times. Our view apparently is confirmed by a rise in the stock price last Friday when EnCana announced its intention to go ahead with its plan to divide itself into two publicly traded companies. The division would be non-taxable for shareholders who would receive shares in a company owning EnCana’s oil sand and refining joint venture assets plus its Canadian shallow gas and oil producing properties, and its undeveloped oil sand acreage. EnCana would retain all its U.S. and Canadian unconventional tight sand and shale gas producing properties and prospects. The division is scheduled to occur by the end of November.

Exxon Mobil

Worldwide price realizations for Exxon’s oil and gas production during the second quarter were 48% and 54% lower than prices obtained a year ago. These lower prices had the predictable effect of driving the company’s earnings for the quarter down by a greater percentage than product prices dropped. Accordingly, earnings for the quarter of 84¢ per share were 63% below the $2.27 earned in the comparable year ago quarter. The company reported without comment a 1% increase to 50% in its income tax rate for the quarter. Oil and gas production volumes fell 2.5% below prior year volumes due primarily to declining European demand for natural gas from industrial users. The decline more than offset new natural gas volumes from start-ups of projects in Qatar and the Piceance basin in western Colorado. When fully operational, the Piceance will add 15% to Exxon’s natural gas production in the U.S., which constitutes 15% of the company’s total. Gas volumes starting to come on stream from the newly completed Qatargas 2 liquefied natural gas (LNG) production train will add when this stage becomes fully operational, ten times the planned capacity from Piceance. The multi-stage Qatargas project is scheduled to add more than 20% to Exxon’s worldwide natural gas sales. The initial regasification terminal for receiving Qatargas is located in Wales. It became operational during the quarter. When the project becomes fully operational, two-thirds of Qatargas’ LNG shipments are destined for Asian terminals where prospective demand is stronger than Europe or the U.S. The year-to-year profit decline in Exxon’s refining and petrochemical business matched the severity of the drop in its oil and gas operations. Although exploration and capital expenditures of $6.5 billion during the quarter almost equaled the cash flow Exxon generated from operations, the company continued its stock repurchase program, drawing upon its immense cash balances to buy 75 million shares for $5.2 billion. At quarter-end, Exxon held $15.6 billion in cash and equivalents. Since the beginning of the year, Exxon’s stock price has fallen 12%.

Express Scripts, Inc.

Express Scripts reported another quarter of double-digit gross profit and earnings growth. Gross profit rose 18% over the same period last year to $594 million and earnings per share rose 16% to 88¢. The quarter’s earnings included 5¢ per share dilution from the issuance of 26.45 million shares and $2.5 billion of public debt to finance the purchase of NextRx. Express Scripts prudently took advantage of investor demand for debt from credit-worthy companies to obtain a good yield of 5.1%. Operating earnings per claim rose 20% to $3.20 as members used more lower-cost branded drugs in addition to generics. Plan sponsors obtain lower drug costs and rebates when their members use preferred branded drugs. Express Scripts’ 2009 selling season has been successful so far with 132 new account wins. Five of these accounts have over one million claims per year. The company attributes its success to its ability to demonstrate increased member participation in its clinical programs which improve health outcomes and lower costs. Express Scripts’ stock price has risen 44% since January 1.

Varian Medical Systems, Inc.

Varian Medical Systems reported fiscal third quarter earnings of 68¢ per share, an increase of 11% over the same period last year. Revenues of $510 million were unchanged, with foreign currency reducing revenues by 3%. Oncology Systems’ international business reported sales and order growth of 10% and 8% respectively with 11% revenue growth in Europe and 31% revenue growth in Asia. Software sales contributed strongly to revenue growth during the quarter, and the company achieved record orders for the NovalisTx, its radiosurgery system. This system, which opens a new market for Varian, uses their most sophisticated x-ray source and beam-shaping accessory. North American revenues were flat, but orders were down 9% because of tight hospital capital budgets, uncertainty about health care reform and reimbursement rates for free-standing cancer clinics. Weak performance of Varian’s X-Ray Products business offset the good performance of Oncology Systems with revenues down 13% during the quarter. A smaller decline in net orders during the quarter suggests that customer inventories of x-ray tubes are returning to normal levels, so this business should be less of a drag in the future. On August 31 Varian introduced two radiation therapy systems designed for emerging markets. These systems offer Varian’s image-guidance, treatment planning and information management software with a new low-power x-ray source. The $1 – $2 million price includes training and five years of service. The compact x-ray source fits into existing treatment rooms making it easier to replace older systems, many of which are Cobalt based. Varian’s stock price has risen 26% since the beginning of the year.

IDEXX Laboratories

IDEXX Laboratories reported revenue and earnings growth during the second quarter despite a 4% decline in pet visits to vet clinics. The company’s revenues of $265.7 million from continuing operations rose 5% in constant currency over the same period a year ago. Foreign currency reduced revenue growth by 5% during the quarter. Earnings per share rose 2% to 55¢. Revenues from instrument consumables and reference lab services rose 4% and 5% to $56.9 million and $77.9 million respectively. Sales of in-clinic diagnostic instruments rose 27% to $18.4 million. The Catalyst Dx high volume chemistry instrument led this growth with 437 placements up from 340 in the first quarter. One-fifth of these placements were to new customers who often buy a full suite of instruments. The company upgraded the reliability of the Catalyst with a new motor to insert the slides and two software upgrades. The rework of instruments prior to sale contributed to a one percentage point decline in the gross margin for the quarter to 52%. Slower growth of the high margin rapid assay tests also compressed the gross margin. Marketing programs and more volume purchases by large clinics and animal shelters resulted in Rapid Assay revenues of $41.6 million, an increase of 2%. Good operating expense control offset the decline in gross margin. IDEXX Labs’ stock is up 47% since the beginning of the year.

Patterson Companies Inc.

Patterson Companies’ earnings for its fiscal first quarter ending July 25 were 38¢ per share, one cent less than the 39¢ earned in last year’s comparable quarter. Sales, 6% higher than a year ago, are attributable to three small acquisitions. Absent these, sales equaled the year ago amount. The recession’s impact made all of Patterson’s customers wary of purchases that might not produce immediate revenues. Their caution is understandable. Dental patients remain inclined to defer discretionary procedures. Demand for physical therapy and sports medicine treatment is sluggish. Uncertainty about future profits depressed basic equipment sales in all of Patterson’s businesses. Sales of dental chairs and lights for example were 15% lower than a year ago. Dentists’ purchases of technology-based equipment offering a proven rapid investment payback, however, rose rapidly. Patterson’s quarterly sales of CEREC tooth restoration equipment soared 84% above prior year’s amount. Trade-in incentives encouraged many of the 10,000 dentists using the CEREC chairside tooth restoration system to buy CEREC’s new LED blue light digital imaging camera. It produces within two minutes a digitally precise image for making dental impressions for tooth restoration. Demonstrable, rapid return on investment also lifted digital x-ray sales, which grew 16% during the quarter, spurred by discounts dental customers earned by purchasing consumables through Patterson’s Advantage Program.

The quarterly results indicate that management’s redirection of its dental sales and service organization has positioned Patterson to benefit from selling and servicing productivity enhancing digital imaging tools to its top customers who comprise two-thirds of the 30,000 dentists who are early adopters of technology-based solutions to improve patient treatment and their practice’s profitability. On the day the quarterly results quantifying the improved dental equipment sales were announced, Patterson’s stock price went up 7%. Its rise since April is over 33%.

Stryker Corporation

Stryker’s second quarter revenues of $1.6 billion were unchanged from the second quarter of 2008 in constant currency. Foreign currency decreased revenues by 4.6% during the quarter. Earnings of 73¢ per share were also unchanged. Stryker’s stringent cost controls reduced operating expenses by 9% over the same period a year ago. Orthopaedic Implants revenues rose 5% to $1.0 billion with 9% revenue growth in the U.S. and a 0.4% increase in international shipments. The MedSurg businesses continued to suffer with revenues of $620.1 million, down 7.7%. Revenues from these businesses fell 11% in the U.S. with sales of the capital intensive Medical business declining 30%. International MedSurg revenues were unchanged from a year ago. Stryker reported that while hospital capital spending is low, it does not appear to be getting worse which may help the MedSurg businesses in the second half of the year. Stryker’s stock price has risen 17% since the beginning of the year.

SGS Group

SGS Group delivered 6% constant currency revenue growth to $2.1 billion and 2% earnings growth to $0.32 per share for the first half of 2009. In March, SGS distributed a $345 million dividend to shareholders. Nine of the company’s ten business units grew during the first half of 2009 with greater than 10% revenue growth achieved in the Consumer Testing, Agricultural, Industrial, and Government and Institutions businesses. The notable exception was the 9% decline in the Minerals Services business, which in recent years has been the fastest growing and most profitable businesses for SGS. Customer spending for SGS geochemistry and metallurgical services declined due to a curtailment of mineral exploration and production. Many of SGS’ businesses are beneficiaries of the trend toward greater regulation. In Consumer Testing, revenue rose 14% as demand rose as a result of new regulations introduced by the U.S. Consumer Product Safety Commission. The Consumer Products Safety Improvement Act, a 63 page Act enacted by Congress a year ago, cites the need for mandatory third party testing for certain children’s products, including requirements and procedures which must be adhered to for reporting compliance with the statutes of the Act.

Our discussions with SGS management, along with the good financial results delivered by the company in a difficult economy, lead us to expect that SGS will continue to efficiently allocate capital and resources in a manner that protects both the company’s profitability and its ability to generate prodigious free cash flow. Management will remain disciplined acquirers of businesses, and in the absence of attractive deals, will continue to pay out excess cash as special dividends to shareholders in addition to the ordinary dividends paid. SGS shares have risen 27% since January 1.


Mettler-Toledo’s second quarter sales of $407.4 million declined 14% in local currencies from the second quarter of 2008. Foreign currency reduced revenues by another 7%. Earnings per share fell 16% to $1.17. The company continues to execute well in a difficult economic environment. Gross margin increased 40 basis points during the quarter to 50.6% because price increases of 1.5% taken 18 months ago held while material costs declined 4%. A 22% reduction in selling, general and administrative expenses during the quarter demonstrates that the cost cutting initiative begun during the fourth quarter of 2008 continues to provide benefits. Mettler-Toledo continues to introduce new products to strengthen its position in its markets. The company recently launched a thermal analyzer that measures melting points of solid samples. Pharmaceutical and chemical companies use melting point to confirm the identity of a compound. In this widely-used but tedious test, a technician heats a small sample in a tube and watches it until it melts and then records the temperature. This analyzer performs this measurement for up to six samples with one press of a touch screen. A high-resolution digital camera records the melting process for later review. Mettler-Toledo’s stock price has risen 34% since the beginning of the year.

Donaldson Company, Inc.

Donaldson’s fiscal fourth quarter revenues of $421 million declined 31% from the prior year while earnings of 35¢ per share fell 42% excluding 5¢ per share of restructuring expenses incurred during the quarter. The sales decline was most severe in Europe which fell 35%. In the Americas sales declined 25% and in Asia the decline was 19%. Engine filters sold to original equipment manufacturers including Caterpillar and Paccar dropped 41% as these equipment makers shut down facilities during the summer and worked off inventory whenever possible. Replacement engine filter sales fell only half as much, declining 21% during the quarter. Sales of industrial filters, gas turbine filters and specialty filters, which includes disk drive filters and specialty membranes used in biotech research, declined 36%, 30% and 13% respectively. CEO Bill Cook cited continued signs of stabilization from certain end markets, however, some major customers, including GE (gas turbines) and Deere (agricultural equipment) expect shipments to continue to weaken for at least the next six months.

During the past fiscal year, Donaldson reduced accounts receivable by $134 million and inventories by $84 million. CapEx was cut to $46 million from $71 million a year ago. The company’s free cash flow was a record $238 million or $3.00 per share, up from $107 million or $1.32 per share the previous year. During the past year, the company executed a significant, painful restructuring to protect profitability, reducing its workforce by 2,800 or 21%. This will result in a $100 million reduction in expenses during the next twelve months. Donaldson’s stock price is up 7% since the beginning of the year.

PepsiCo, Inc.

PepsiCo reported second quarter revenues of $10.6 billion, an increase of 5.5% in constant currency. Revenue growth in U.S. dollars was unchanged from the second quarter of 2008. Earnings per share rose 8% in constant currency to $1.02. PepsiCo’s international and U.S. food businesses, which account for 80% of the revenues and division operating profits, continue to perform well. FritoLay’s revenues and operating profits grew 8% while volumes rose 3%. Consumers snapped up value offerings which add 20% more chips to family-size bags of Frito’s and Dorito’s. PepsiCo International’s revenues and operating profits rose 14% and 21% respectively in constant currency over the comparable period a year ago. Despite weak economies in Western and Eastern Europe, the strength of Pepsi’s brands allowed the company to raise prices which resulted in 9% operating profit growth while holding or gaining share in most markets. PepsiCo’s domestic beverage business had another weak quarter with revenues and division operating profit down 7% and 5% respectively. A steep decline in Gatorade sales caused most of the decline. While Gatorade kept its core athlete users, other consumers who had contributed to double-digit revenue growth over the last three years traded down to tap water, carbonated sodas and less expensive flavored water drinks. PepsiCo’s marketing challenge is to switch these less athletic Gatorade drinkers to their non-carbonated drinks.

On August 4, PepsiCo announced the acquisition of Pepsi Bottling Group and PepsiAmericas for $36.50 and $28.50 per share respectively, a 30% increase to the initial offer on April 20. The company also expects to realize $300 million in cost savings rather than $200 million over the next three years which may have made the disciplined management team comfortable in raising the price so much. Most of the benefits come from faster product development and more efficient distribution in the U.S., Mexico and Russia. Time will tell whether these less quantifiable benefits justify the acquisition of these lower-margin businesses. PepsiCo’s stock price has risen 7% since January 1.

Western Union

Western Union’s second quarter revenues of $1.3 billion declined 2% in constant currency and earnings of $0.31 per share were flat with the prior year. Total consumer money transfer transactions of 49 million rose 3%, comprised of 11% growth in Europe, the Middle East, Africa, and South Asia, 19% growth in Asia Pacific, and a 5% decline in the Americas. Mexico fell the most, declining 15%, while India posted amongst the largest increases, up 27%. Principal per transaction declined 2% year-over-year, but was stable with the first quarter. Western Union ended the quarter with 385,000 agent locations, up 8% from a year ago. Notably, the company signed Fifth Third Bank to offer Western Union money transfers at 1,300 locations in twelve states.

On September 1, Western Union completed the acquisition of Custom House, a provider of international business-to-business payments, for $400 million. The company, which generates $100 million in annual revenues and is growing approximately 20% per annum, processes small and mid-size payments for 40,000 businesses in seven originating countries for payout in 120 countries. The cross border payments market for small and mid-size businesses is estimated by Western Union to be at least as large as the consumer-to-consumer money transfer market which the company dominates. Western Union shares are up 33% year-to-date.


MSCI results for its fiscal second quarter ending May 31 were good. Revenues rose 1% despite a 17% decline in equity index asset based fees and earnings rose 5%. Since the end of May, the market value of assets linked to MSCI indexes upon which Exchange Traded Fund fees are based has risen 22% from a monthly average of $162.1 billion to $197.6 billion at the end of August. Asset based fees, the most volatile component of MSCI’s revenues, constitute 14% of revenues but are closely watched by investors because these asset values are publicly reported monthly. Revenues from annual equity index subscriptions contracts, which constitute the core of MSCI business, advanced 13.1% during the quarter. The company constructs and maintains over 120,000 indices for subscribers which are used to manage portfolio assets. Asset managers constitute 61% of the subscriber base. Brokers are 12% with another 12% evenly divided between asset owners and hedge funds. The company’s Barra equity portfolio analytics which constitutes 30% of total revenues, experienced a 6.8% revenue decline during the quarter. MSCI is investing in an upgrade of the Barra analytics. Its newest product achieved an 11% growth in subscription revenues to $9.6 million in the quarter. At its current $29 price, MSCI’s stock is trading above the cost of our recent purchases.

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.