Still conservative on technology stocks

US Stocks

Industrial production was a plus 6.1% y-o-y for the month of September in 2000. After a year it was minus 5.8% y-o-y, a 12 consecutive decline. Coupled with the psychological blow of the September 11 terrorist attacks and anthrax scare, the ailing economy cannot tolerate any dramatically increase in energy cost. That is why the Bush administration is pushing its energy policy to increase domestic production and alternative source (non-OPEC) of oil.

In the '60s, 80% of all imported oil came from OPEC. It declined to 60% in the booming 90s, and by the year 2000, only 50% came from OPEC, and the reliance continues to trend lower. The nation's electricity needs are being generated by coal, nuclear, natural gas, and hydro. Oil is used mostly for transportation, as well as petrochemical, and heating (Northeast). Currently, the US imports about 50% of its oil needs, and half of that (26% of total consumption) came from OPEC countries.

Coal and nuclear energy accounted for more than 70% of US electricity generation in the year 2000:

Coal - 52%
Nuclear - 20%
Natural gas - 16%
Hydro - 7%
Oil - 3%
Renewable - 2%

Total: 100%

source: US Department of Energy

The need for a stable, and low cost source of energy for the nation has been put to the forefront by the attacks on the WTC. Coal should remain as the main supplier of fuel for the nation's utilities. The administration is also pushing to renew the 40-year old licenses of nuclear power plants.

Massey Energy Company (MEE $19.86), which supplies low sulphur coal of steam and metallurgical grades, should continue to benefit from this trend. Should nuclear power plants be decommissioned or get their licenses renewed, there would be a supply of radioactive waste that needs to be shipped and store safely. This is where Waste Management Inc (WMI $28.40) comes in. Not only is it the nation's largest waste management company, it is also on the road of an earnings recovery. Last year, hefty interest expenses due to past acquisitions hampered earnings. Management has been divesting non-core businesses to pare down debt. Debt/Equity has declined from 2.1x a year ago to the latest 2Q of 1.6x. Earnings for the 1 & 2 Q of the current FY 2001 though lower than expected, but managed to be in positive territory. Estimate for the 3Q is $0.368.

US Technology

On a week-on-week basis, the NASDAQ Composite Index gained 5.8% to 1768.

Since the low of the year at 1387, established after the September 11 (21-Sep-01) attacks, the NASDAQ Composite Index has traded higher for 5 consecutive weeks. While companies have reported mixed quarterly results over the past 3 weeks, the outlook given by them continues to be the same - (1) demand weakness nearing a bottom, and (2) potential earnings improvement in 2002. If we were to adopt a positive approach to viewing such general feedback, then the year 2002 appears to be a promising environment to be invested in, and as such, we should be actively buying now. However, while we are inclined to adopt a more positive stance on technology issues for the year 2002, we remain cautious on (a) the timing of the earnings bottom - 4Q01 or 1Q02, (b) the period for an earnings rebound - 3Q or 4Q, and (c) the sustainability of earning growth ahead.

We do not expect a 'V' shaped recovery on the earnings front due to any sharp turn around in demand activity. While cost cutting initiatives over the past few months will no doubt help technology companies alleviate pressure on bottom line earnings deterioration, growth in customer orders will be a gradual process as corporations stringently migrate from 'must-have' products and services, to 'wish-list' items. We believe this demand transition has the potentials to be a lengthy episode.

The year 2001 (for NASDAQ stocks) can be categorised with the following headlines: 'Zero Demand Visibility Across All Segments' and 'We Are Approaching A Bottom'. In terms of fundamentals, nothing has changed over the last few weeks but instead have worsened. On the other hand, we believe investor psychology has adapted during this period. That is, active investors are finally adopting a long-term risk reward strategy (as opposed to a quick high-risk high-return approach) for equity investments. Furthermore, given current distressed price levels and the potentially improving outlook 2 to 3 years from now, the risk to equity prices falling further may not be as high as previously feared. From a price point of view, we believe the year low of 1387 will have the potentials to form as a firm floor. And, unless a new external unexpected shock is introduced, we look forward to the floor holding. As such, we would view any equity price weaknesses ahead as attractive opportunities to selectively accumulate technology issues.

Yes, technology stocks are still relatively expensive when current price levels are benchmarked against earnings growth potentials in the short-term (6 to 12 months). However, if we believe forward looking statements (2 to 3 years out) by analyst and company officials to be credible, then accumulating at around current levels may not be too expensive and unrewarding. With demand visibility limited, everyone (corporate planners and investment analyst) is partially blind at the moment and as such, we believe earnings estimates past 2002 should not be relied on too strongly. Rather than taking an earnings guess into the clouded future, we prefer to focus on companies with the following visible attributes: (1) established leaders in their industry, (2) a sustainable competitive advantage, and (3) minimal long-term debt exposure. With this, our preferred stocks are follows:

Stocks to accumulate on price weakness
EBay Inc (EBAY, $57.00, CSFB: Strong Buy)
Openwave (OPWV, $10.01, CSFB: Strong Buy)
Xilinx Inx (XLNX, $33.33, CSFB: Buy)
JDS Uniphase (JDSU, $8.77, CSFB: Buy)
(source: CSFB)

If we were to assume that the birth of the BULL trend on the NASDAQ Composite Index was on 9th October 1998 (at 1357), then the prevailing BEAR has so far consumed nearly all positive gains (+278%, from 1357 to the high of 5132 on 10-Mar-00) within 18-months. In terms of price, we are back close to square one. But, in terms of the technology frontier, we have evolved. End-users, both at home and in the office, have become more reliant on technology to provide speedier execution of tasks and real-time demand access to information. In August 1998 AOL-Time Warner (AOL US, $33.50, CSFB rating: Buy) had 13 million online members while today, the company's AOL-branded subscribers have reached 31.3 million!

We believe that the technology cycle has yet to peak. We continue to maintain that we are still at the early stages of the technology cycle and that our present woes are only a short 'pit-stop' before taking off on the technology race again. Nevertheless, our bigger picture scenario is void of time and thus on the day-to-day level, we are still conservative on technology stocks as we are still marking time in the 'pit'.

Europe

Despite many equity strategists questioning the latest strength of the rally markets post almost daily gains, totally ignoring very weak economic data, such as the US durable goods orders that declined 8.5% vs. estimates of -1.3% or weak leading indicators. Last week's corporate results mostly met the market's expectations. While only a few (DaimlerChrysler, Atlas Copco and Sanofi-Synthelabo) exceeded expectations the big bunch either missed estimates or if on target, warned of low visibility ahead and/or even reduced forecasts for 4Q01 and 2002. One might wonder why markets remain so resilient to all this bad news. There is a combination to three factors that warranted a certain rally in the market after the lows of September 21. Firstly, panic was replaced by cautious optimism, secondly, the low level of interest rates caused bottom fishing and lastly, fund managers being underweight in certain sectors put their high level of cash back to work. While we do not question these factors it is the magnitude of the rally and the lack of improving fundamentals that concerns us.

In fact, at the current valuation levels there is no room for disappointment regarding next year's recovery in corporate profits. We find this very challenging as earnings estimates for next year remain too high and need to be downgraded, making valuations even more compelling. Optimism among investors has risen too far over the past weeks. Taking into account the weak fundamentals the current rally could as well be a repetition of the April-May 01 rally. Even though next year's recovery scenario remains our base case and some more optimism for equity investments for the next 12-24 months is justified we expect investors to be get better opportunities in the weeks ahead. We recommend taking some profits at current levels. Alternatively covered calls offer an additional source of income for investors who do not want to sell their positions but would not mind doing so at higher levels.

Ericsson (ERICB SS; SEK 49.40) reported 3Q01 figures well below our expectations. Ericsson posted a SEK 4bln net loss or SEK -0.50 per share. Sales in the Systems division were down 11% yoy and 15% sequentially. Despite higher cost savings the operating margin was only 1% (in line with expectations though), which could well be negative excluding the currency effect. Ericsson expects 4Q01 losses to be somewhat lower than in Q3 and sees next year's sales flat to -10% and operating margins greater than 5%. What the market seemed to forget is that this is a downward revision from the guidance given only seven weeks ago, when the company said that sales would be flat to 5%. Despite this gloom there are a few, rather minor bright spots that let us assume that Ericsson is on the verge to slowly get its act together. These are positive cash flow, higher than expected cost savings and the replacement of Chairman Ramqvist by Michael Treschow, the current CEO of Electrolux. The arrival of Mr. Treschow might not entirely change the company's strategy but with his more active role and focus on costs he might take on the public role that Ericsson was missing so far. We do not expect Ericsson to recover quickly and expect another tough year. However, we believe that Ericsson will benefit strongly from the current restructuring program once the industry improves. This might be some time away though.

Syngenta (SYNN VX; CHF 83) reported a decline in 3Q01 sales of 8% to USD 1.1bln, which was in line with expectations. The company expects EPS for the whole year to be slightly below 2000 EPS. Syngenta does not expect a quick recovery in the market and remains concerned with the weak situation in Latin America. However, the company reiterated its synergy target of USD 525 million until 2003, which remains our key investment point in Syngenta for the time being. Syngenta remains our sector favourite as the agrochemical industry is driven by factors unrelated to industrial production is hence is more resilient to recessionary environments.

Lafarge (GL FP; EUR 100.70) reported 9-month sales figures slightly above expectations at EUR 9.769bln. The good news was the detailed expectations for the profit attribution of Blue Circle. Lafarge initially expected Blue Circle to generate synergies of EUR 100 million in the years of 2002-2004. The company now expects 107.5 million for next year, 172 million in 2003 and 215 million in 2004. We believe that this will enable Lafarge to generate EPS growth that is about twice as strong as the sector average. We think that the current premium of approx. 15% to the sector does not warrant this well enough. We remain buyers of the stock.

Pechiney (PEC FP; EUR 49.52) reported an increase in 3Q01 net profit of EUR 56 million, which was broadly in line with expectations. The company expects operating profit to remain close to last year's level excluding the effects of aluminium prices and the EUR/USD exchange rate. Pechiney expects the recovery of aluminium prices to take longer than previously expected but believes that most of the bad news is in the price now. We continue to rate the stock hold. Pechiney is an attractive and inexpensive play on the economic recovery. Things can hardly turn worse from now. However, as long as we see no evidence of a sustained economic recovery the stock might go sideways. We lower our price target to EUR62.

Results from GlaxoSmithkline (GSK LN; GBP 18.67) were right in line with expectations posting an EPS of 5.8 pence. The quality of the outcome though is higher than anticipated due to the lower than expected contribution from other operating items. The group's pharma revenue growth of 13% remains in the upper quartile of the industry. However, during the press conference there was some confusion over the launch timing of Dutasteride, a drug for prostate enlargement and the discontinuation of GI262570, (diabetes), which has been dropped for its potential use but may still be developed rapidly for other uses. This might cause the stock to remain under slight pressure in the short-term. We continue to see the stock as an attractive defensive growth holding as the company offers secure growth, which cannot be said of the overall stock market.

Serono (SEO VX; CHF 1400) declined 6% in very volatile trading after the company's PR firm started calling analysts enquiring about their estimates for 3Q01 figures, which are due to be released on October 30, 2001. The company denied the rumours that it might report lower than expected earnings due to lower financial income. We believe the underlying business remains very strong and hence we consider the current weakness as a buying opportunity. We would buy half the position in the current weakness and the other half after the results are out. Alternatively selling a Put Dec. 1400 at a price of CHF 90 would result in a cost price of CHF 1310.