BARRON'S: The Trader

 

  Market Sees Recovery, But Are Cyclicals Pricey? (Part 1 of 2)

  By Andrew Bary

 

  Federal Reserve Chairman Alan Greenspan warned last week that the recovery may

be muted, but the stock market is saying the economy is poised for a powerful

expansion.

  Reflecting that optimism, the Dow Jones industrial Average surged 400 points,

or 4%, last week to 10368, hitting its highest level since late August. Other

major indexes registered similar gains as the Nasdaq rose 78 points, or 4.5%, to

1802, and the S&P 500 was up 3.9% to 1131.

  Most of the advance came Friday, when a widely followed economic measure, the

monthly survey from the Institute for Supply Management (formerly the National

Association of Purchasing Management), showed a surprisingly strong gain in

manufacturing in February.

  The Fed is targeting 2.5%-3% real economic growth this year, but investors

seem to think that the growth could run at a 4% clip in the final three quarters

of the year, following 2.5%-3% growth in the current quarter. The Dow

Industrials rose 262 points Friday while the Nasdaq gained 71 points, or 4.1%,

and the S&P rose 25 points, a 2.3% rise.

  Industrial stocks, which have been in a bull market for much of the past

several months, continued their advance last week. The better performance of the

Dow Industrials relative to the broader S&P 500 this year largely reflects

sizable gains in formerly scorned "Old Economy" stocks like United Technologies,

Honeywell, Boeing, General Motors and DuPont.

  The Dow now is up 3.5% this year, beating the S&P, which has fallen 1.4% and

the Nasdaq, which is down 7.6%. In fact, the supposedly dowdy Dow is beating the

Nasdaq and S&P over the past one, three, five and 10 years.

  "The market is saying the Rust Belt is the place to be," says Steve Galbraith,

chief domestic equity strategist at Morgan Stanley. Looking at economically

sensitive issues in the Dow, United Technologies is up 15% to 74.20 in 2002;

Honeywell has risen 17% to 39.79; GM is up 13% to 55; DuPont has advanced 12% to

48 and International Paper has gained 9% to 44.16.

  The list of stocks hitting new 52-week highs on the New York Stock Exchange is

peppered with industrial stocks, including many second-tier companies that now

are favored by investors because they offer a leveraged recovery play. Many

industrial issues are up 50% from their post-September 11 lows and have doubled

off rock-bottom levels reached in early 2000, when well-known stocks commanded

less than 10 times earnings.

  Galbraith argues that most industrial issues "aren't cheap anymore" and some

prominent value investors like Bill Nygren, head of the Oakmark and Oakmark

Select funds, are emphasizing depressed growth stocks over economically

sensitive issues.

  But the momentum now favors industrial stocks because the economic expansion

is gaining steam and investors know that it historically has paid to buy the

group early in the cycle. Aggressive investors who play momentum strategies like

cyclical issues because they figure that a strengthening economy will produce an

extended period of upward profit estimate revisions.

  One investor also cites the so-called Tyco factor. Many institutions that

dumped Tyco International in recent months as it fell from the high 50s to under

30 may have reinvested those funds in other economically sensitive stocks.

Because most industrial companies don't have big market values, the recycled

money from Tyco, whose market value topped $100 billion in late 2001, can have a

big impact elsewhere in the group.

  Let's look at some of the valuations in the sector. Honeywell, United

Technologies and Textron trade for 15-16 times estimated 2002 profits. Emerson

Electric, at 59, trades for 20 times projected 2002 earnings; Danaher, at 68,

commands 25 times estimated 2002 profits and Illinois Tool Works, at 74.25,

trades for 24 times projected 2002 earnings. Not cheap.

 

  -- It's ironic that the ultimate industrial stock, General Electric, has been

a laggard and that its valuation premium versus its multi-industry peers has

contracted sharply. GE rose 1.36 last week to 39.45, but is well below its

52-week high of 53 and peak of 59 in 2000. It trades for 24 times estimated 2002

profits of $1.65 a share.

  GE is being held back largely because of concerns that its giant power-systems

division, which accounted for more than 100% of the earnings growth in its

industrial businesses last year, will experience a sharp downturn in 2003, 2004

and 2005 amid a fall in deliveries of big turbines to the increasingly troubled

U.S. electric industry. The power systems division generated more than $3

billion in net income for GE last year, over 20% of its total profits, and

second only in importance to GE Capital.

  The collapsing share prices of such independent power producers as Calpine and

AES, not to mention the bankruptcy of Enron, illustrates the woes of part of

GE's customer base. GE's power systems division rode the independent power

industry's boom in 2000 and 2001 and is set to suffer from the coming bust

although GE says it can mitigate  the falloff in turbine profits with increased

service revenues. GE sees the power unit's after-tax profits peaking at around

$4 billion this year and then falling by around $500 million in 2003.

  But J.P. Morgan analyst Don MacDougall recently estimated that the 2003 drop

could be $600-$800 million. "The bigger implication for GE is that we could see

at least two lean years beyond 2003" for the power division, he wrote.

MacDougall and other GE watchers believe that the company can generate 10%

annual profit growth in both 2003 and 2004 even with the power downturn. "GE is

clearly not a leveraged recovery play, but should be viewed as a sustainable

growth story," he told clients.

  The problem now is that investors don't want sustainable industrial growth

stories like GE, especially given concerns about whether poorly understood GE

Capital can continue to generate its customary 15%-17% profit gains from a very

high profit base. Another issue is that GE's power problem isn't going away

anytime soon. Wall Street fears that the news flow on GEs turbine orders and

deliveries will only get worse this year.

 

  -- Elsewhere in the market, retailers, homebuilders and auto-parts companies

have been especially strong. The country's No. 1 retailer, Wal-Mart Stores, rose

nearly three points last week to 62.81, a new closing high, and now boasts a

market value of $280 billion. The homebuilding sector has been buoyed by the

combination of robust profits and relatively low valuations.

  The auto-parts group is one of the market's strongest sectors because vehicle

sales remain surprisingly robust and automakers are replenishing depleted

inventories. Steve Girsky, Morgan Stanley's  auto analyst, says he favors GM and

Ford Motor over the parts stocks because GM and Ford have trailed the parts

group. Depressed Ford, at 15.64, isn't much above its 52-week low. Ford could

get a lift if investors look for laggards.

 

  -- Many consumer stocks also are hitting new 52-week highs, including PepsiCo,

Procter & Gamble, Clorox, Avon Products and Wrigley. It may seem funny that

traditional defensive issues are doing well at the same time as economically

sensitive stocks, but this is an unusual market.

  "You have to throw away the traditional playbook," says Galbraith. "Remember

that the ultimate rule of not fighting the Fed didn't work last year." Galbriath

urges investors to focus on company fundamentals and stock valuations rather

than any historical trading patterns.

  Another surprise is that technology stocks, normally beneficiaries of a

recovering economy, have been weak this year. One of the issues dogging the tech

sector is the fear that first-quarter corporate technology spending will be

weak. Reduced spending by the battered telecom industry also doesn't help.

  The troubles in the tech sector were highlighted after the close of trading

Friday, when Oracle warned profits in its just-ended fiscal third-quarter would

be nine cents a share, a penny below forecasts.

  Oracle dropped 1.27 to 14.72 in after-hours trading after losing 63 cents

during the regular session. Oracle's drop during the regular session on huge

volume of 78 million shares looks a little suspicious in the face of the

Nasdaq's 4% gain. The decline suggests that word of the Oracle warning could

have leaked out ahead of the official news.

  AT&T Wireless was off 1.50 to 8.60, a new low, on Friday, after the No. 3 U.S.

wireless company said it lowered its 2002 guidance for revenue and cash flow.

The AT&T Wireless news underscores the difficulties in the wireless sector and

could speed consolidation efforts in the industry.

  There's talk that AT&T Wireless, Cingular (a 60-40 joint venture of SBC

Communications and BellSouth) and Voicestream, a part of Deutsche Telecom, are

more willing than ever to consider mergers. It wouldn't be surprising to see two

of those companies announce a deal this year

 

  -- Hewlett-Packard chief executive Carly Fiorina made a final appeal to Wall

Street last week to support Hewlett-Packard's proposed acquisition of Compaq

Computer, but her efforts may not be enough to turn the tide ahead of the March

19 shareholder vote.

  Fiorina faces an uphill fight because various H-P trusts controlled by the

heirs of William Hewlett and David Packard that own 18% of H-P stock plan to

vote against the deal. A New York investment firm, Brandes Investment Partners,

that controls over 1% of H-P's 2 billion shares, last week announced its

opposition to the deal. Another big institutional shareholder is rumored to be

leaning against the deal.

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BARRON'S: The Trader -2 of 2-

 

 

  The math is tough for Fiorina. Assuming 10% of H-P shareholders don't vote,

H-P needs about 70% of the votes cast, outside of the trusts, to carry the day.

That's a big number considering the opposition to the deal among many

professional investors who don't want to see H-P's best division -- printers --

diluted by the Compaq purchase. Some think that opponents of the deal are more

motivated to vote than those in favor of the transaction.

  The arbitrage market appears to be putting the odds of a favorable shareholder

vote at 50% or less. Compaq, at 10.44, now trades about $2.40 below the value of

the H-P offer. H-P, at 20.21, is offering 0.63 of its shares for each Compaq

share. The spread has ranged from about $1 to $5 since the proposed merger was

announced last September.

  Determining the implied merger odds from the arb spread involves some

guesswork because it requires an assumption about where H-P and Compaq will

trade if the deal is rejected. The betting now is that the arb spread might

widen to $4 or $5 a share if the merger is voted down.

  In such an event, H-P could rise one to two points while Compaq could drop a

point. If an arb stands to make $2.50 a share if the deal happens and lose $2.50

if the merger is voted down by H-P holders, the implied merger odds are 50-50.

  Toni Sacconaghi, analyst at Sanford Bernstein, puts the odds of approval at

just 35%. Wall Street will be focused this week on an expected recommendation

from Institutional Shareholder Services, which advises many big investors. If

ISS urges a no vote, the H-P/Compaq merger likely is dead and if ISS recommends

approval, the odds could tip slightly in favor of the deal.

  The betting on the Street is that ISS will side with Fiorina and H-P.

Sacconaghi, however, doesn't think a favorable ISS recommendation will mean all

that much. He and others point out that ISS's specialty is corporate governance

issues, like the option programs, and not industry knowledge or merger

expertise. The irony is that ISS's recommendation will have some influence even

if the quality of its analysis is suspect.

  One investor who opposes the deal says that H-P's printer business is worth

$20 a share, or around 20 times projected 2002 profits. Assuming that $20 value,

investors are effectively getting  for nothing the rest of the company, which

had more than  $25 billion in sales in H-P's latest fiscal year, ending in

September. H-P is expected to earn $1.10 a share in its current fiscal year.

  H-P hasn't been making money outside printers, but assuming the non-printer

business, including servers and other hardware, is worth a conservative 50% of

sales, H-P stock could appreciate into the mid-to-high 20s.

  Sacconaghi points out that until the H-P/Compaq merger was announced, H-P

stock didn't drop below 24 despite ongoing negative profit news from the

company, because investors figured the printer business was worth $20-$25 a

share. Add Compaq to the mix and H-P's share-count will rise to 3 billion from 2

billion and the value of the printer business will get diluted from an estimated

$20 per H-P share to about $13 a share.

  Fiorina's fans says that a rejection of the Compaq deal could cause turmoil at

H-P because Fiorina likely would quit, forcing H-P to find new leadership.

Fiorina's opponents argue that her departure would be a plus because H-P doesn't

need a Fiorina-style marketer but a leader with strong operational skills who'll

make hard decisions about improving efficiencies and exiting bad businesses.

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                       VITAL SIGNS

 

                      FRIDAY'S   WEEK'S    WEEK'S

                       CLOSE     CHANGE    % CHG.

 

DJ Industrials       10368.86    +400.71    +4.02

DJ Transportation     2897.13    +171.48    +6.29

DJ Utilities           284.05      +7.73    +2.80

DJ 65 Stocks          2991.81    +123.30    +4.30

DJ US Total Mkt        261.95      +9.82    +3.89

NYSE Comp.             588.63     +20.35    +3.58

Amex Comp.             872.78     +16.47    +1.92

S&P 500               1131.78     +41.94    +3.85

S&P MidCap             515.44     +19.02    +3.83

S&P SmallCap           233.76      +7.77    +3.44

Nasdaq                1802.74     +78.20    +4.53

Value Line (arith.)   1235.69     +45.84    +3.85

Russell 2000           478.34     +13.27    +2.85

Wilshire 5000        10560.01    +380.72    +3.74

 

                                 Last Week     Week Ago

 

NYSE Advances                     2,499         1,712

Declines                            859         1,638

Unchanged                           116           129

New Highs                           416           234

New Lows                             99           137

Av Daily Vol (mil)               1,646.6        1,612.9

Dollar

(Finex spot index)                119.40          118.48

T-Bond

(CBT nearby futures)              103-00          104-21

Crude Oil

(NYM light sweet crude)            22.40           21.07

Inflation KR-CRB

(Futures Price Index)             195.05          191.71

Gold

(CMX nearby futures)              298.00          293.20

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