Mixed expectations in the US for the earnings season ahead

US Stocks

The stock price of IBM (IBM $97.25) is approaching its September-11 low of $93.00 as the market braces itself for the upcoming 1Q-result announcements. The following developments certainly played a part in the stock's current negative performance: Lower pension income, declining share buyback, higher tax rate, higher provision for bad debt.

All the above will affect earnings in the short term. But at $97, the price has reflected a low single digit growth for the next 5-yr with a discount rate of 8.50% (based on a DCF calculation). Despite recent downgrade in earnings, the consensus is still looking for 7% growth for this year. We would definitely recommend our client to accumulate the stock at current levels.

Microsoft (MSFT $55.87) is also heading south as software sector weakens due to weak earnings outlook. Latest survey showed MSFT is gaining market share from Linux in the web server market. MSFT racked up a market share of 34%, while Linux lost 5% to 53%, and SUN Microsystems dropped to 2.33%. It also announced that it would restructure its business units. The new structure will give the core leaders of the different units a deeper control and accountability in the way they run their businesses. The President and COO of the company, Rick Belluzzo will leave the company by September, as in the new structure the heads of the business units will have to report to CEO Steve Ballmer, who likes to exercise more direct control. We still like the stock for the long term and would accumulate at current levels.

The recent rally in the oil price took an abrupt end when OPEC makes it clear that its members will not cut production as a countermeasure for the pro Israeli stance the US has in the current conflict in Israel. Oil-service companies have a strong correlation to the oil price, as they can expect higher capital spending by the integrated oil companies, which see a better return on their investment, while the oil price is high. So it is not surprising, when Schlumberger Ltd. (SLB US: $54.39) saw some weakness in its share price. We expect this weakness to continue, as the strong oil price was more sentiment driven, than demand driven. We have indeed not seen signs of significant output cuts. Recently we have advised investors to reduce their positions in Schlumberger and would like to reiterate this advice.

US Technology

Over the week, a string of negative company pre-announcements hit share prices and have further dampened sentiment on technology issues listed on NASDAQ. The software sector was especially affected, as several companies within the segment warned of weaker earnings that would fall short of the analyst's estimates. The result was a series of earnings revisions and downgrades by analysts. We did not expect the quarter to be that bad. We were indeed hoping for some indications of a recovery but the recent warnings have curbed our optimism on software companies.

Business software makers continue to experience a hard quarter in achieving their numbers as customers are still delaying investments in large IT projects. Peoplesoft Inc. (PSFT US: $25.17; CSFB rating: Hold) fell more than 30% as the company announced it would miss its forecast due to the negotiations of some bigger discounts by the clients. Those price cuts indicate the shape of corporate IT spending environment which continues to be disappointingly tight. On the Peolpesoft announcement share prices of Oracle Corp (ORCL US: $12.13; CSFB rating: Buy) and Siebel Systems Inc. (SEBL US: $27.88; CSFB rating: Buy) slid on this news.

Siebel Systems fell sharply during two consecutive days, first on the Peoplesoft announcement and then as a renowned analyst cut her earnings estimates for the company. The business software segment seems to be in for some difficult times ahead. We believe the pricing power for software companies will be hard pressed to recover after an exceptionally weak and prolonged period of price cuts and discounts. We anticipate operating margins for the business software companies will most likely remain relatively low over the near term. We recommend not buy further into the sector yet.

New trading buy recommendation on Dell Computers (DELL US: $26.42; CSFB rating: Buy). DELL held an analyst meeting recently whereby, in summary, the company expects the PC business to remain weak for 2002 (the company doesn't even expect PC sales to pick up in the second half of the year). So far, DELL has not been hurt as much as other PC makers by the downturn as it continued to grow its market share and reduce costs. Michael Dell sees his company as the 'lucky third' - regarding the merger of Hewlett-Packard Co. (HWP US: $16.99; CSFB rating: Hold) and Compaq Computer Corp. (CPQ US: $9.56; CSFB rating: Buy), as DELL benefited from new offers to bid for corporate IT projects. DELL expects to double its revenue to $60 billion over the next four to five years, which could then potentially propel the company into the same league as with Sun Microsystems (SUNW US: $8.71; CSFB rating: Buy) or IBM Corp. (IBM US: $97.25; CSFB rating: Hold). The strategy to achieve this ambitious goal is to bring the DELL business model for PCs into the field of the data centres.

Michael Dell is focusing on an industry standard running on Intel chips and Microsoft programs (or Linux-based systems), which he expects will replace functions currently handled by rival computers running UNIX and mainframes. Prior to the analyst conference, the company gave a positive guidance for the current quarter, saying its revenues would be slightly ahead of its earlier forecast at $7.9 billion (only down 2% from a year earlier). Our trading price target of $32.00 offers a potential 21% capital gain and a stop-loss at $23.50 provides an 11% potential loss scenario (last done price at $26.42).

Europe

We are about to enter a critical period for equity markets in our view. Even though the sentiment towards equities has improved over the past two months as investors started to bet on an economic recovery, valuation has increased as well and does not leave much room for disappointment. Based on 1Q02 guidance it would be wrong to have too high expectations about the upcoming earnings reports. We do not believe that these figures will move the market in any direction. What the market wants to see now are more reassuring company statements that visibility has improved, demand is picking up and corporate earnings are recovering from deeply depressed levels. There, our concerns come into place and the market seems to share them with us. If we are right and the positive economic figures out of the US are distorted by the unusually mild winter it might well be that earnings recovery in the months ahead might be slower than some optimists would like to believe. Therefore we recommend investors to keep a close eye on companies' outlooks.

Despite our base case scenario that a US recovery will cause Europe to follow suit, we expect uncertainty to remain high. Under this aspect we think it makes sense to increase the focus on less economically sensitive sectors such as pharmaceuticals. After a series of negative patent issues and profit warnings from US pharma giants such as Merck and Bristol Myers, this sector is currently the most unwanted sector among strategists. While we do not expect these concerns to disappear over night, we expect the market's focus to shift to the companies' earnings power in the months ahead. Pharmaceuticals declined almost 13% year-to-date. The global pharmaceutical industry is generating a reliable earnings growth in the mid-teens.

These growth rates are not really dependant on economic growth. The main driving force behind earnings is demographics, which is very much in favour of pharmaceutical companies and explains why we consider this industry as a portfolio hedge against most of the uncertainties that currently affect the stock market.
CSFB's valuation approach compares the prospective rolling P/E's or EV/EBITDA ratios relative to the benchmark, which is the domestic equity market (i.e. the CAC40 for Aventis or Sanofi). Based on this approach US pharmaceuticals currently trade at a 9% premium and European companies trade about 13% above benchmark. The historical range over the past 22 years has been a premium of 20%-100%. Hence, pharmaceuticals valuations are currently at levels they were trading at the end of the technology bubble (when they were as disliked as now).
Our analysts believe that the patent threat is overrated for European pharmaceuticals.

GlaxoSmithkline (GSK LN; GBP 16.30), Aventis (AVE FP; EUR 76.60) and Sanofi-Synthelabo (SAN FP; EUR 69.50) have been penalised over the past months on concerns about generic competitors challenging the patent protection of their best selling drugs. While CSFB attaches a slightly higher risk to GlaxoSmithkline's patents, they see very little chance of a successful challenge of Aventis' and Sanofi-Synthelabo's patent protection. Both of the latter are expected to grow well ahead of the global pharma industry in the years to come. At the same time Aventis has a broad product mix and is valued at a 30% discount to the industry while Sanofi-Synthelabo trades at industry levels.

We believe it will pay-off taking a counter-cyclical stance on pharmaceuticals with a 12 - 18 month investment horizon. Aventis and Sanofi-Synthlabo remain our top picks from a fundamental approach while we like Roche (ROG VX; CHF 131) for its restructuring story.

Sanofi-Synthelabo (SAN FP; EUR 69.50) was one of the hardest hit pharmaceuticals last week, losing 5.57% for the week after Bristol-Myers' profit warning (declining sales and inflated inventories). The inflated inventories might be of relevance for Sanofi-Synthelabo since Bristol-Myers is distributing Sanofi-Synthelabo's two best selling drugs in the USA. Sanofi-Synthelabo denied these concerns and said that there was no reason to revise earlier earnings growth forecasts of 25% for the year. The company said they prefer to keep low inventories and as such, Bristol Myers' profit warning was not a problem for Sanofi-Synthelabo.

Pechiney (PEC FP; EUR 58.90) launched a EUR 450 million convertible bond. The aggressive pricing caused hedge fund managers to sell the stock and buy the convertible, which is a common practice. We do not believe that this changes anything about Pechiney's fundamentals. The stock declined 4.17% for the week.

Software stocks came under pressure after cautious comments from US analysts. Additionally, SAP (SAP; EUR 160.10) suffered from a warning of Commerce One that revenues could fall up to 83% revenue in 1Q02. We expect SAP to remain under short-pressure in the days ahead. However, for investors who are willing to take a 12-month view we see the current weakness as a buying opportunity. Prices in the mid-to-low EUR 150s are a buying opportunity.