Fine tuning of forward looking expectations

US Stocks

Last week, we talked about the amount companies spent on their R&D in order to ensure their competitiveness and future growth. This time, we focus on the companies' ability to finance those spending from cash generated from their operations. The companies with the R&D-to-cashflow ratio over 100% will have to either:

· Increase operating income
· Increase financing
· Decrease R&D spending
· Lower cost

The first two options are either unrealistic or not desirable given the current market conditions. To lower R&D might cause the companies to loss market share permanently and play catch-up. Lowering cost will have its limits and may affect other business units. In the short term, these companies may rally due to their relative oversold positions. But the longer the economy stays down, the more they will have problems going forward, particularly the ones with ratio of 300% or more.

The manufacturing companies like GE, Boeing, & Eastman Kodak will not face this problem, so are the financially sound companies like IBM and Microsoft.

US Technology Stocks

On a week to week basis, the NASDAQ Composite Index fell a further 6.7% to 2262.

Continued negative news flow from "blue chip" technology companies should keep sentiment weak, but at the same time, should also help further fine-tune forward looking expectations to incorporate a feeble revenue growth regime.

Sun Microsystems' (SUNW US, $20.8125) profit warning not only confirmed the bleak revenue growth outlook within the technology hardware space, it also helped force investors to accept the reality that customer spending has slowed and that a recovery in revenue growth is still an uncertain event in the near-term. Nevertheless, we believe SUNW's downside risk in price is relatively muted at $18.00. We expect SUNW's stock price to trade in consolidation at current levels as long-term investors begin accumulating the stock for a 1H02 performance. Looking 12-months ahead, we recommend strategic investors to adopt a 3-tiered accumulation strategy for the stock. We suggest exploring a first-tier accumulation entry point at $18.00 (to capitalise on any near-term price rebound) and a second-tier buy level at $13.00 (if price continues to depreciate instead). We would hold-off the third-tier accumulation level (as a reserve) until falling prices stabilise. This accumulation methodology helps strategically position our investments in a disciplined format and at the same time capitalise on short-term sentiment.

Looking ahead, we remain focused on the downside risk of 2200 (potentially strong floor) as a possible consolidation area where (we believe) value-hunters will begin accumulating stocks. However, the risk to 2200 failing to hold will now rest with overly optimistic expectations for further interest rate cuts (time of cut and size of cut) in the short-term. Technology investors and traders have begun to price-in positive interest rate movements over the next few weeks. As such, over the near-term, we expect a rebound in price to occur. If over time, on the other hand, the Fed decides not to change the interest rate policy in their meetings, the risk will then be on short-sellers taking-over the driver's seat and navigating NASDAQ lower to 1800.

Europe

There seems to be no improvement in sight for equity markets. Economic data from the US continue to cause a state of confusion after the CPI figures re-launched the topic of inflation in an environment of rapidly declining economic growth and corporate profits. Even if the higher headline figure was distorted by one-time effects it does little good to regain confidence in equities.

European technology stocks were again badly hit as news continued to deteriorate. Motorola issued another profit warning and companies like Alcatel and Qualcomm said that telecom companies could be forced to delay their 3G networks roll-out by two years due to the lack of funds. Additionally, Kyocera and a US broker revised their forecasts of total handsets sold in 2001 down to the 450-500 million range. It seems that the rapidly declining economic situation has caused firms to stop their investment plans overnight. In such an environment rumours of profit-warnings (e.g. Nokia; though declined by management, which reiterated its 2001 forecast given three weeks ago) are the element to trigger panic selling. Should the above mentioned delays occur valuations would still be rather high and further earnings downgrades would keep the pressure on these stocks high. Even though it remains our base case scenario that the current developments are of rather short-term nature we do not consider it prudent to invest new funds in this sector since low earnings visibility increases risks significantly. That is why we reduce the equipment and semiconductor stocks to HOLD with the strong intention to upgrade them once earnings visibility improves and stocks establish a floor. We believe that our preferred stocks such as Nokia, Philips, STM, Ericsson, Infineon and Vodafone remain the top beneficiaries of the long-term technology story. Even though the actual prices are attractive from a longer-term perspective the short-term risks might force these stocks to go lower.

The dismal situation in the technology and telecom sectors started to spill over to all other sectors even though earnings reports were in line with expectations. Especially the banking sector starts to feel the negative implications of the worsening debt situation in the telecom industry.

UBS (UBSN SW; CHF 259) reported decent 4Q00 results. Net profit increased 54% to CHF 1.449bn, which was in line with expectations. However, adjusted earnings and the net new money flow remained disappointing although improving. The contribution of Paine Webber was below expectations. UBS announced a CHF 5bn share buy-back program starting on March 5, 2001. We believe that the negative equity markets and the difficult environment may cause the stock to consolidate in the CHF 250-270 range for a while. UBS' excellent credit quality and low valuation make the downside risk limited from current levels. We leave our price target of CHF 300 unchanged.

ABN Amro's (AA NA; EUR 23.58) earnings report did not yet justify the high hopes in the company's restructuring program. ABN Amro's 2000 results were a mixed bag. Operative results met consensus while costs and restructuring charges disappointed. Higher costs from the restructuring of the investment bank unit resulted in an increase of the cost-income ratio to 74% in 2H00 from 69% in 1H00. The fact that restructuring charges came in EUR 100 million higher than the earlier announced EUR 800 million will not help to increase credibility in ABN's restructuring program. However, it has been only three months since the restructuring program was announced and we believe it will take longer for concrete results to materialise. The undemanding valuation (P/E01 10.3x; P/E02 9.3x) of ABN Amro provides a decent downside cushion to the stock.

GlaxoSmithkline (GSK LN; GBP 19.22) reported an increase of 11% in 2000 pre-tax profit, which was in line with expectations. Pharmaceutical sales were strong in the US where they increased by 15%. The company's investor day provided confidence in the product pipeline and the cost-cutting program. GlaxoSmithline is aware of its constraint in the late-stage product pipeline. We expect the management to take measures here. With the excellent balance sheet in the back GlaxoSmithkline has all necessary requirements to achieve its 13% EPS target in 2001. In the current environment the stock offers a good risk/reward ratio. We reiterate our buy recommendation with a target of GBP 21.

Henkel (HEN3 GY; EUR 72.57) reported an increase of 25% in 2000 net income beating the consensus by a wide margin. The company said that the disposal of Cognis was running on schedule. Decisions will take a few months to materialise. We believe that Henkel's defensive business, its ongoing Cognis disposal and an attractive valuation compared to its non-cyclical consumer peers make the stock resistant in the current environment.

Logica's (LOG LN; GBP 13) 1HFY01 profit rose 75% on good demand for SMS software and utilities solutions. Given the very difficult situation in the industry we do not believe that Logica's growth is sustainable and hence consider its high valuation (P/E02 57x) as a threat to the stock price. The stock hit our stop-loss level of GBP 14 and consequently we remove it from our recommendation list with a loss of 28%.


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