A Choppy Sea Tosses All Boats

  By Eric J. Savitz

 

  Stocks slumped Friday on a fresh round of bookkeeping and balance-sheet

worries, as skittish investors moved to the sidelines ahead of the three-day

holiday weekend.

  The markets grappled with mixed signals all week. There were growing signs the

economy is pulling out of recession: retail sales are showing surprising

strength, inventories are shrinking, and jobless claims are falling. There were

also solid earnings from companies like Federal Express, Network Appliance and

Dell. But many companies still see shaky quarters ahead, and the accounting

scare that started with Enron continued to claim new victims.

  Earlier in the week, stocks rallied. Monday, the Dow gained 140 points,

building on a 119-point advance the previous Friday, as accounting issues

temporarily faded. Stock slipped modestly Tuesday, but came back Wednesday, with

the Dow rising 117, aided by a strong retail-sales report. The mood darkened

Thursday, in part due to new evidence of weakening finances at Qwest, the

Denver-based phone company which owns U.S. West -- although the Dow still

managed the session with a small gain, closing above 10,000 for the first time

since January 10. But the index didn't stay there long; stocks fell back Friday

as new accounting issues emerged over companies like Nvidia, Worldcom, Polycom,

Symbol Technologies, AES and, most significantly, IBM.

  The Dow Jones Industrial Average fell 99 points Friday, due in part to IBM's

five-point drop, to 102.89, which accounted for about a third of the day's slide

in the Dow. IBM's decline followed a New York Times article that asserted Big

Blue's earnings in the latest quarter were artificially boosted by proceeds from

the sale of a subsidiary. For the week, the Dow gained 159 points, or 1.6%, to

9903.04. With tech stocks under pressure, the Nasdaq Composite lagged, losing 14

points, or 0.8%, to 1805.19, after a decline of 38 points, or 2%, Friday. The

S&P 500, meanwhile, closed Friday at 1104.18, up 8 points, or 0.7%, for the

week.

 

  -- While there were some strong earnings reports, investors were more

interested in the cloudy outlook delivered by many companies, particularly in

the tech sector. Michael Dell, for instance, said he now anticipates a "gradual

and gentle" recovery in PC sales, noting also that home-PC sales likely will

drop in the first quarter from the fourth quarter. Hewlett-Packard predicted

that revenues for its fiscal second quarter, ending in April, would be down

slightly on a sequential basis, saying it is "uncertain as to whether the

consumer-technology spending uptick will continue." And Ingram Micro, the big

electronics distributor, said first quarter earnings will be off 7%-10%,

compared with last year's fourth quarter.

  Applied Materials issued a market-pleasing report for its fiscal first quarter

ended January. The company earned two cents a share, and reported $1.1 billion

in new orders, beating estimates. In addition, Applied forecast modest

improvement in orders for the current quarter. While expecting a 20% drop this

year in demand for chip-processing gear, the company made optimistic comments

about the outlook, prompting analysts to lift estimates.

  For the week, Applied shares gained 4.12, or 9.6%, to 47.20; the SOX (the

semiconductor stock index) gained 23.08, or 4.3% to 554.61. In a research note,

Jim Covello of Goldman Sachs -- who correctly predicted an upside surprise in

last week's Trader column -- noted that Applied trades at a lower multiple of

projected 2003 earnings than other equipment stocks.

  Still, the risk is high. Applied has made no firm predictions for 2002, let

alone 2003, and estimates for next year are all over the map: Covello sees $1.51

a share for the October 2003 fiscal year. Morgan Stanley's Steven Pelayo sees

only $1, and Lehman's Ed White, who expects 12 cents this year, and $1.35 in

fiscal 2003, warns of a "choppy" recovery until sales of PCs, cell phones and

other products improve.

  Applied's January-quarter revenues were $1 billion, down 21% from the fourth

quarter, and off 63% from last year. Let's say full year revenues hit $5 billion

(a generous assumption). With a $40 billion market value, the stock trades for a

bubble-like eight times sales. If the recovery stalls, so will Applied

Materials.

 

  -- Accounting and balance-sheet issues continued to plague stocks. Tyco again

came under fire, sliding 1.92, or 6.4%, to 27.90. The company offered a weak

earnings outlook, citing the effects of higher interest costs and intense public

scrutiny. It also backed away from its proposed breakup plan. EMC shares slumped

1.18, or 8.2%, to 13.19, on news that the SEC was looking at the data-storage

company's revenue-recognition practices. Accounting concerns also pressured

Edison Schools, the operator of public schools, which retreated 1.47, or 10.6%,

to 12.46.

 

  -- Nvidia, a graphics chip company which last year rose more than 300% -- by

far the best performance among S&P 500 stocks -- slumped 4.81, or 7.8% Friday,

to 57.35. Late Thursday, the company reported a blow-out fourth quarter, and

raised its outlook for its January 2003 fiscal year, powered by strong sales of

Microsoft's Xbox game console, for which it provides the graphics chips.

  Nvidia now expects to earn $1.70-$1.75 a share this year, much higher than its

previous forecast of $1.30. But the company also disclosed an SEC accounting

inquiry which it said stemmed from a previously announced insider-trading probe

involving its engineers. Nvidia says it's reviewing reserves and expenses taken

in the fourth quarter of 2000 and the first three quarters of 2001. For the

week, the stock fell fractionally. When trading starts Tuesday, the stock will

face a new challenge: late Friday, S&P put Nvidia on its watch list with

"negative implications."

  -- The strong XBox sales -- and similarly robust demand for Sony's Playstation

2 and the Nintendo Game Cube -- drove big 2001 gains in video-game-related

stocks. Shares of Electronics Boutique more than doubled in 2002. Last week,

Barnes & Noble spun off GameStop, another video-gaming chain. Priced at 18, the

stock finished the week at 19.90, giving it a market capitalization of about $1

billion. Friday saw the much-delayed debut of PayPal, the online payments

network popular with customers of eBay and other online auction sites. PayPal

priced 5.4 million shares at $13, or the middle of the expected range. But

after-market trading was reminiscent of Internet deals of old; the stock closed

Friday at 20.09, up 54.5%.

 

  -- The telecom sector had another miserable week. The focus this week was on

Qwest, which tumbled 2.04, or 21.3%, to 7.56, as fears spread that the company

could be headed for insolvency. Both S&P and Fitch downgraded their ratings on

Qwest's debt this week. But the real trouble came with its apparent inability to

roll over $3.2 billion in commercial paper. Instead, Qwest drew down $4 billion

on a standby credit facility, a development that roiled the credit markets. As

of January 31, Qwest had nearly $25 billion in debt outstanding, making it one

of the nation's largest corporate-debt issuers.

  Other telcos had problems, too. Worldcom sank again, falling 1.45, or 17.7%,

to 6.73. The company said it had suspended three employees, and halted

commission payments to a dozen others in relation to allegations that they

artificially inflated commissions in three branch offices.

  Both Sprint stocks fell, with Sprint FON down 1.15 or 8% to 13.30, and Sprint

PCS off 2.94, or 24%, to 9.27. There are fears Sprint could be the next carrier

to get hit with troubles in the commercial-paper market. One way Sprint could

raise extra cash would be to accelerate the sales of its large position in

Earthlink, the big Internet service provider. Earlier this month, the company

filed to sell three million shares, reducing its stake to 25.6 million shares, a

position worth close to $250 million. Earthlink gained a few pennies last week,

closing at 9.12.

  Meanwhile, telecom suppliers were in a funk. Nortel announced CFO Terry

Hungle's resignation in an apparent case of insider trading. And the company

warned that current-quarter sales were softer than expected. For the week,

Nortel shares slipped 73 cents, or 11.6%, to 5.56. Ciena, Lucent, Juniper, and

Riverstone also finished the week with significant losses.

  UBS Warburg global technology strategist Pip Coburn's advice on

communications-equipment stocks: "Avoid them like the plague." He says companies

like Lucent, Nortel, Alcatel, Siemens, Ericsson, Nokia, Marconi, NEC, Fujitsu

and Motorola built up infrastructure to support an industry growing at 20%-plus.

But the sector could see three years of declining revenues before it turns. When

it does, Coburn predicts that growth will be no better than the high single

digits. "You've got all of these global companies attacking far too few

opportunities."

  Ariane Mahler, telecom-equipment analyst at Kleinwort Dresdner Wasserstein,

has attacked Cisco shares in recent sessions, asserting that the company has

overstated profits by improperly using pro forma accounting for certain

writeoffs of inventory and investments. She rates it a "sell," and thinks it

will drop to $13, from Friday's close of 17.09, up slightly for the week.

----------------

 

BARRON'S: The Trader

 

  Mahler raised her rating on Nortel to "accumulate," anticipating the stock

could go to 8 by yearend. She thinks cost-cutting measures will improve margins

at the company throughout the year -- and says management has been fiscally

conservative, with $3.5 billion in credit lines it's "terrified" of using.

Mahler notes that Nortel trades at 1.5 times sales, versus 5 times sales for

Cisco, or 6 times for Juniper.

 

  -- Qwest's inability to roll over its commercial paper led to a new set of

fears: that banks may have a major off-balance sheet liability in large standby

letters of credit, like the one tapped by Qwest last week. JPMorgan, Bank of

America and Citicorp dominate that market; all three stocks lost ground last

week on concerns about their vulnerability to the troubles of companies like

Tyco and Qwest. Citi came under added pressure Friday on news that Warren

Buffett's Berkshire Hathaway apparently exited the stock in the fourth quarter;

Berkshire had held 2.7 million shares a quarter earlier. For the week Citicorp

slipped 1.36, to 44.13.

 

  -- Contract manufacturing stocks got a boost last week -- when Thomas Weisel

Partners analyst Jim Savage theorized that they could grow earnings smartly,

even without a big pickup in hardware demand.

  Indeed, Savage says his firm takes a dim view of the immediate prospects for

tech spending. But the key issue for the contract manufacturers is that

production levels last year ran well below end-market sales. In short: A huge

surplus of raw materials, work in progress and finished goods has been tamed.

  "Production levels are beginning to rise, and EMS companies are getting better

visibility on production, which means they can plan more effectively," he says.

"Inventories at the top-tier companies in the business are down 35% since the

end of the 2001 first quarter." Ingram Micro, he says, has seen inventory drop

from 35 days to 27 days, near historic lows.

  Savage adds that there's been a pickup in new-product development in servers,

routers and storage. And he says the contract manufacturers have cut capacity on

average by 25%, closing inefficient plants and moving some production offshore,

all of which should help margins.

  Jabil Circuit is Savage's top pick in the group, although he also like Sanmina

SCI and Celestica. Jabil, he says, has been gaining market share with large

customers like Cisco, while also adding some higher-margin business with new

customers like Agilent, Nokia, Qlogic and Tellium. Savage expect steep

profit-growth in coming quarters: 8 cents in the company's February quarter, 13

cents in the May quarter and 20 cents in the August quarter. For the August

year, he expects 52 cents a share, with $1.05 in fiscal 2003. Jabil, he figures,

could hit 30 in the next 6-12 months; last week the stock closed at 21.22, up 98

cents.

 

  -- This has been a nasty month for on-line banks. Earlier this month, the FDIC

seized the banking assets of NextCard, a once red-hot, Internet-based

credit-card issuer. Last week, G&L Internet Bank, a Pensacola, Florida-based

lender that catered to gay and lesbian customers, announced plans to liquidate.

Those closures add to a list of once-promising online banks that have been

closed or acquired, such as Wingspan Bank, Compubank and Security First Network

Bank.

  The sector's struggles make the success of NetBank all the more surprising.

The Alpharetta, Georgia-based bank, which went public in 1997, turned profitable

in 1998 and has never looked back. In recent weeks, the company's shares have

been red hot. For the year, NetBank shares have gained 42%, to $14.71, close to

a new 52-week high. (It's still way below its bubble-era peak of nearly $80 in

early 1999, however.)

  The company is no NextCard, says NetBank CEO D.R. Grimes. "They were an

Internet credit-card company, with a bank charter to raise deposits to fund

receivables," he says. "The softening economy caused deterioration of the credit

quality of their portfolio, putting their deposits at risk. But they were no

more a traditional bank than Capital One or MBNA. NetBank is more of a

straight-forward bank."

  A straightforward bank with no branches, that is. Depositors access their

accounts via the Web or ATMs; NetBank has been finding new customers primarily

through banner ads. While the company offers credit cards, it acts only as an

originator, passing the credit risk on to First USA. Rather, most of its assets

are residential mortgages. On that score, Grimes is no Web purist. The big

problem for online banks has not been finding depositors -- the problem has been

finding borrowers.

  To remedy that, the company last year bought Market Street Mortgage, a

Clearwater, Florida, mortgage banker with offices in 11 states. Last year, it

originated $2.5 billion in mortgages. The acquisition was a huge success, and

led NetBank to sign an even more aggressive deal: to buy Resource Bancshares

Mortgage Group, a wholesaler which in 2001 originated $12 billion in loans. When

the deal closes later this quarter, NetBank will become one of the nation's 20

largest mortgage originators, according to the American Banker.

  The bank exited last year with $2.9 billion in assets. This year, it expects

to expand deposits 25%. But it's also growing cautiously: To keep credit-risk

and interest-rate risk down, the company expects to sell most of the mortgages

it originates into the secondary market. The result, says Grimes, will be

fast-growing profits. Last year, the company earned 22 cents a share, 10 cents

of that in the fourth quarter. The Street thinks 2002 profits will more than

double, to 50 cents.

  Grimes says NetBank should exit the year earning an average of 22 cents a

quarter, which hints at 2003 earnings pushing $1 a share. If that happens, the

stock should run higher. Bank on it.

 

  ---

                      VITAL SIGNS

 

                      FRIDAY'S   WEEK'S    WEEK'S

                       CLOSE     CHANGE    % CHG.

 

DJ Industrials        9903.04    +158.80    +1.63

DJ Transportation     2684.23     +24.29    +0.91

DJ Utilities           279.45      +1.12    +0.40

DJ 65 Stocks          2854.00     +34.59    +1.23

DJ US Total Mkt        255.62      +1.67    +0.66

NYSE Comp.             571.25      +5.91    +1.05

Amex Comp.             849.16     +15.35    +1.84

S&P 500               1104.18      +7.96    +0.73

S&P MidCap             500.24      +4.68    +0.94

S&P SmallCap           228.19      +2.61    +1.16

Nasdaq                1805.2      -13.68    -0.75

Value Line (arith.)   1204.54     +11.96    +1.00

Russell 2000           469.25      +2.58    +0.55

Wilshire 5000        10315.47     +66.15    +0.65

 

                                 Last Week     Week Ago

 

NYSE Advances                     1,337         1,734

NYSE Advances                     2,213         1,226

Declines                          1,145         2,143

Unchanged                           118           118

New Highs                           303           250

New Lows                            106           177

Av Daily Vol (mil)                1,485.5       1,860.8

Dollar

(Finex spot index)                  118.60        118.98

T-Bond

(CBT nearby futures)                104-07        102-22

Crude Oil

(NYM light sweet crude)              21.50         20.26

Inflation KR-CRB

(Futures Price Index)               191.58        191.76

Gold

(CMX nearby futures)                298.40        303.50

  ---

---------------

 

BARRON'S: Tech Trader: Will Tech Companies Get Called On Options?

  By Bill Alpert

 

  Reform is on a roll, after Enron. Accounting reformers have renewed calls for

companies to count the costs of stock options. Few issues affect tech-industry

profits as broadly as option accounting. Without the padding of reported profits

that current rules allow, tech-stock valuations would look very pricey.

Wednesday, Democratic Sen. Carl Levin of Michigan, Republican Sen. John McCain

of Arizona and several other senators introduced a bill that would force

companies either to recognize the cost of stock options on the income statement,

or to give up option-related tax deductions.

  The option-accounting war has another active front. The International

Accounting Standards Board, in London, is considering an option-expensing rule

as one of its first initiatives to teach the world to ka'ching in perfect

harmony.

  Eight years ago, when accounting rulemakers first suggested the expensing of

options, they were bullied into retreat by New Economy executives, financiers

and their political allies, who included such erstwhile do-gooders as Democratic

Sen. Joe Lieberman of Connecticut and former Sen. Bill Bradley. A compromise

rule, grudgingly issued in 1995 by the Financial Accounting Standards Board, has

allowed firms to expense options if they choose, or merely to disclose in a

footnote how option costs would have nicked the income statement. Guess which

presentation they choose.

  When a company pays employees with stock options, instead of just cash, the

firm still incurs a cost, because options represent dilutive slices of the

business. By leaving that cost out of earnings reports, firms overstate their

profits. A Bear Stearns study says that if companies in the Standard & Poor's

500 had expensed their options in the year 2000, reported earnings would have

been 9% lower. And Merrill Lynch figures that tech company earnings in 2000

would have been 60% lower because of their hefty option programs. If tech firms

are forced to report option expenses, Merrill Lynch tech strategist Steven

Milunovich thinks tech-stock valuations will suffer. Tech stocks already look

expensive, he told clients Thursday, and option expenses would make them look

dearer still.

  Investors like Warren Buffett long have urged firms to recognize options as an

expense. A worldwide survey of more than 1,900 analysts, reported in November by

the Association for Investment Management and Research, showed that 83% wished

that options were expensed on income statements. Perhaps that's because only

two-thirds said they bothered to look for option information in an obscure

footnote.

  For the benefit of the other third, I studied the footnotes of some celebrity

firms. Counting options as an expense would have trimmed Microsoft's reported

earnings for its June 2001 fiscal year to $5.1 billion, or 91 cents, from $7.3

billion, or $1.32 a share. At the time it reported, Microsoft shares would've

been valued at 77 times its option-accountable earnings, instead of 53 times.

Cisco Systems, instead of reporting a loss of $1 billion, or 14 cents, for its

July 2001 fiscal year, would have shown a loss of $2.7 billion, or 38 cents.

  Not counting option expenses, Hewlett-Packard reported October 2001 year

earnings of $624 million on continuing operations, or 32 cents. Counting

options, H-P had a loss of $65 million, or 3 cents. Sans options expense,

Applied Materials reported $508 million, or 60 cents. Counting options, Applied

earned $291 million, or 24 cents, and the semiconductor equipment firm would've

been valued at 163 times earnings, instead of 65 times.

  Brocade Communications Systems, the leading-edge networking vendor, reported

October year earnings of $2.8 million, or one cent. But if Brocade counted the

cost of stock options, it would've shown a huge loss of $592 million, or $2.68 a

share, and the trailing earnings multiple on Brocade's $30 shares would go from

astronomical to incalculable. Tony Canova, Brocade's chief financial officer,

says his firm's October 2001 year option awards were exceptionally large, with

half issued to replace higher-priced options awarded when Brocade enjoyed a

bubble market share price above 100. Brocade hired most of its employees before

the stock market peaked, and Canova says Brocade issued new options in its

October 2001 year to retain those workers.

  Before Enron gave ammo to accounting reformers, Big Business was massing for

an assault against the option expensing proposal of the International Accounting

Standards Board. In December, IASB chairman David Tweedie got a critical note

from the trade association of U.S. venture capitalists, co-signed by tech firms

from Broadcom to Xilinx, and groups from the Biotechnology Industry Association

to the U.S. Chamber of Commerce. Expensing options would hurt workers, high-tech

firms and the world economy, said the letter. Besides that, added the critics

with a genteel threat to the IASB's life, "the debate on this one issue could

endanger the current consensus supporting the IASB."

  Members of the IASB know the options score. One of them, Stanford accounting

professor Mary E. Barth, looked at the relation between share price and the

option costs disclosed in the footnotes of nearly 900 firms. A

yet-to-be-published study by Barth, Stanford colleague Ron Kasznik and UCLA

professor David Aboody suggests that investors indeed consider options to be an

expense, because firms disclosing higher option costs suffered lower stock

valuations.

 

  The Sun Also Rises

 

  At a recent 9 bucks, Sun Microsystems shares have fallen hard from the $65

levels of Sun's dot.com glory. A week ago Thursday, the Santa Clara firm tried

to shake things up by announcing midyear plans to ship computers with the Linux

operating system and Intel-compatible microprocessors. On the announcement,

Merrill's Milunovich upgraded his long-term view of Sun. Merrill surveys report

that a quarter of big companies have started to use Linux, the "open source"

operating system that costs nothing and whose instructions are open to

inspection. Milunovich's colleague, Peter von Schilling -- who hopes the Sun

announcement will enhance prospects for Linux software supplier Red Hat -- says

that the last 12 months have seen Linux embraced by leading computer makers. The

next 12 months will see strong Linux offerings from software leaders like

Oracle, SAP and Veritas Software.

  Milunovich thinks Sun is facing up to the competitive threat from Microsoft

Windows and Intel hardware vendors like Dell Computer. But he says that

investors aren't yet convinced that Sun can maintain profits amid the upmarket

moves of Linux and Windows. To succeed, says Milunovich, Sun needs to offer

higher level software that's comparable with offerings from BEA Systems, IBM and

WebLogic.

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-------------------------