Beaten-down stocks start to show value

If we agree that the lesson to be learnt from the technology sell-off is that valuation is a matter of earnings and price then the current levels appear attractive for long-term investors. Admittedly that counts little in the current environment but it should make investors aware of the time horizon they choose for their investments. Under a long-term perspective investors should focus on stocks that are currently traded below their fair value.

US Stocks

Today, Feb-13-01, Federal Reserve Chairman Alan Greenspan will discuss the U.S. Economy and monetary policy in a testimony to the Senate Banking Committee. If he fails to convert the masses, then the market may trade lower or sideways until the next FOMC meeting on Mar-20-01. Meanwhile, the following is a list of stocks with cash returns of 5% or better. Free cash flow by definition is cash from operations minus capital expenditures, and the enterprise value is used as a proxy for the take over value of a firm. The ratio of free cash flow to enterprise value is known as the cash return. In an environment that rewards positive earnings outlook, free cash flow is preferred. While AE may have a liquidity problem, and for Pacificare, CSFB is looking for a loss in fiscal year 2001, the rest of the list can be considered as buys if the market corrects further.

US Technology Stocks

As anticipated, the market continued to take profits and head towards the 2300-2200 level (again) as investors revisit the earnings growth deceleration story.

Earnings release from Cisco Systems (CSCO US, $28.1875, CSFB rating: Buy) compounded negative sentiment during the week and re-ignited earning growth worries. CSCO reported weaker than expected results with 2Q01 EPS of $0.18 (First Call Consensus Estimates at $0.19 a share). Revenue grew less than expected (3.5% sequentially and 55% year-on-year) to $6.75 billion due to weak demand from US service providers, particularly CLECs and IXCs. With CSCO's management lowering guidance for 3Q01 performance, CSFB revised downwards their quarterly year-on-year EPS growth forecast for the company to be roughly flat (3Q01 EPS estimate at $0.13 vs actual 3Q00 EPS of $0.13). We expect CSCO to continue experiencing a difficult revenue growth environment over the next few quarters. However, with about $4.8 billion in liquid assets (cash and cash equivalents, plus short-term investments), a proactive management, and a strong leader in the data networking market, CSCO is well positioned to weather the "spending-slowdown-storm" and emerge as a more focused company with a broader array of energising products. While we like CSCO over the longer-term, we believe the company's stock price has the potential to continue weakening. As such, we do not recommend to buy the stock yet but suggest to wait for price to stabilise at around $25.00 before considering any accumulation strategy.

Added Oracle Corp (ORCL US, $23.5625, CSFB rating: Strong Buy) to Buy recommendation list. We like ORCL as the company's growth in database business (Oracle 8i, 9i, etc) is being driven by the explosive growth in corporate data volumes, Internet traffic, broadband and wireless communications, on-line transaction processing, data warehousing, eBusiness applications, eCommerce exchanges, and 7x24 operations. Also, we believe ORCL's vision of providing customers with an integrated stack of solutions is starting to take hold in the field. As the world's 2nd largest software company and the leading supplier of software for enterprise information management and eBusiness enablement, ORCL reported strong Nov-2Q01earnings with EPS of $0.11 (exceeded estimates of $0.10 a share). Total license revenue grew 32% yoy (vs CSFB estimates 22%). Database license revenue, which accounts for about 69% of total license revenue, increased 26% (vs CSFB's expectations of 17%), while applications license revenue (25% of total license revenue) expanded 73% (vs CSFB's 50% forecast). Though ORCL's stock price fell 13% last Friday on concerns of slower earnings as economic growth slows, we believe the downside risk to price depreciating further is relatively limited at $21.00. We anticipate the macro slowdown to provide ORCL with new growth opportunities as "off-line" companies re-engineer strategies to enhance revenue streams and reduce costs via investments into eBusiness avenues. We recommend to buy ORCL for a 12-month investment outlook and a price target of $34.00.

Selected company December-quarter earnings release for the week of February 12 to February 16:

Stock Date First Call Estimate

Sycamore Networks (SCMR, $22.438) 13/02 0.05
Hewlett-Packard (HWP, $33.50) 15/02 0.37
Dell Computer (DELL, $23.50) 15/02 0.19
CIENA Corp (CIEN, $79.875) 16/02 0.15

Europe

When two of the world's biggest technology companies in the world (Cisco & Nokia) lower their growth perspectives within a few days only very few companies can escape the downtrend. We are concerned that technology spending has declined much further and faster than expected as companies can afford to scale back on these investments for some time after a long period of above-average investments. Given the declining pace of demand the inventory adjustment period could also take longer than expected. Consequently, earnings estimates continue to drop at an even faster pace than in the weeks before.

We believe that this scenario delays the recovery in technology stocks until the positive impact of the lower interest rates feeds through to improving business sentiment and a confirmation that earnings stop declining. It seems obvious that we are still at some distance to this point and hence recommend waiting to buy stocks that have not bottomed and consolidated yet and instead focus on defensive sectors.

However, if we consider the current earnings downturn to be temporary and look at stocks from a long-term point of view using consistent valuation proxies such as the Dividend-Discount-Model (DDM) we find that some of the beaten-down stocks start to show value even if we reduce the long-term growth rates drastically. If we agree that the lesson to be learnt from the technology sell-off is that valuation is a matter of earnings and price then the current levels appear attractive for long-term investors. Admittedly that counts little in the current environment but it should make investors aware of the time horizon they choose for their investments. Under a long-term perspective investors should focus on stocks that are currently traded below their fair value.

Stocks like Nokia have fallen almost 50% since early December 2000. At the current price of EUR 30.30 our DDM model assumes a five-year earnings growth rate of only 15% p.a. (97-2000; 66% p.a.), which we believe is too low for Nokia. However, in order for such a stock to rally fundamentals need to stabilise first and the stock has to go through a period of sideways consolidation, which will form a solid bottom for a future uptrend, which brings us back to the time horizon of investments. While we do not expect a short-term recovery in stocks like Nokia, Philips, Infineon and STM we believe that they have reached attractive long-term entry levels.

A stock that has bottomed out at current levels since April 2000 is Cap Gemini (CAP FP; EUR 189.4). Cap Gemini is the world's no. 5 IT consultant. The company reported better than expected 2000 earnings and said that the merger with Ernst & Young made better progress than expected. We believe that after the failure of many '.coms' big companies will come back to IT consultants that have the ability to perform large back-end related projects on a global scale. We expect news to improve in 2001. Over the last few weeks we noticed a shift out of hardware to software and IT consultant stocks. Consequently, we have deleted Siemens (SIE GY; EUR 143.05) from our recommendation list. Siemens' outlook for 2001 was not very exciting and hence we believe that there is better upside in Cap Gemini.

Philips (PHIL NA; EUR 36.43) reported earnings of EUR 0.61, which were short of the expected EUR 0.75. The company gave a rather depressed outlook for 2001 blaming oversupply in telecoms and PC. Philips' shortfall was not really a surprise after several competitors had reported earlier and hence the market had already priced it to a big extent. We believe that the short-term outlook for Philips remains very uncertain as for all semiconductor stocks. The new profitability targets announced make the stock attractively valued and hence well supported on the downside assuming the current weakness is temporary. We lower our price target to EUR 50.

Zurich Financial Services (ZURN SW; CHF 825) hit the market by a surprise profit warning. The company said it had to make provisions worth CHF 400 million for weather related casualties and reinsurance risks. Zurich expects earnings for 2001 to remain at the level of the previous year, which would be CHF 44 per share. As consensus forecasts are in the mid-50's analysts will have to adjust their figures and we expect the stock to remain volatile. At the current point in time we would hold on to the stock and use the weakness to buy once prices have stabilised.

Henkel (HEN3 GY; EUR 72.40) confirmed that it has hired an international investment house to look for interested buyers of its chemical unit Cognis. This is an important first step to implement Henkel's promise to focus on consumer products. Due to Cognis Henkel is still valued at a substantial discount to its peers such as Unilever, L'Oreal etc. We expect Cognis to be disposed in the medium term and consequently see the stock re-rated over time. Additionally, defensive stocks might benefit from the current uncertainty about profit growth.

As a general short-term strategy we recommend being cautious on growth in favour of insurance, retail and selected healthcare stocks. Stocks that we expect to outperform in the short-term are Carrefour, Rhodia and GlaxoSmithkline.


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