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. ----------------------------------------------------------- -----------------------------------------------------------
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.
---
--- 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 ---
|