Remain cautious until growth in top line sales improves

US Markets
US equity markets saw a continuation of the rally that started in the second half of the previous week, with the S&P 500 running up 5.89%, as earnings reports brought some upbeat results. In fact we had several big names releasing surprising numbers. Microsoft, Citigroup and General Dynamics were among the highlights. But taking a closer look at the figures shows that the quality of earnings across the board was not as good as the earnings per share figures would suggest. Several companies, which reported net income growth, saw their revenues decline. This clearly shows that companies have been cutting costs and capital expenditure, and have been streamlining their business due to lower demand and also poor growth prospects in the near-mid term.

In the case of Citigroup it was the consumer who held up the numbers, as consumer loan and credit card profits rose to a record high of $2.2 billion with consumer taking advantage of the low interest rates. This increase in consumer debt is somewhat worrying, given the current economic environment and could potentially pose a problem to the US banks, if the economy remains slow. Citigroup has increased its loan loss reserves to $10.7 billion, due to the expectation of further losses from non-performing loans mainly in the telecommunication sector. Citigroup's size and its strong presence in retail banking provide certain stability against the volatile investment banking unit. Citigroup share price should appreciate as investors start to become more selective on the bank stocks and start to see seek value.

The oil sector continues to perform relatively well, helped by strong oil price. The fact that we continue to see prices in the $29-30 levels at the NYMEX, should continue to lend support to the share prices of the recommended stocks in the sector. These are Exxon Mobil (XOM, CSFB rating: Neutral), Noble Corp (NE, CSFB rating; Neutral) and Schlumberger (SLB, CSFB rating: Neutral). The oil price could see a decline if the US accepts the two step process in the UN resolution on Iraq, which would lower the risk of an imminent military intervention. There is also the possibility of OPEC raising its output If the basket of oil prices currently trading at $28.05, which is above the $25-28 target range, stays above this target range over an extended period. A possible moderate increase would be an adjustment to the seasonally growing demand in the Northern Hemisphere and should not lead to substantial weakness in the oil price. It is still very difficult for the OPEC to find the right balance in production and demand, due to the uncertainties on the demand side. Meanwhile we believe that positive momentum in the sector is likely to continue. The S&P oil sector sub-index has outperformed the broader S&P500 by 15.28%, losing 6.72% YTD and is likely to continue to do well with the perspective of crude oil prices remaining around the levels it currently trades at.

After last week's rally, we have issued a short note on Noble Corp, where we advise trading oriented investors, who have bought the stock at the $30 levels to consider taking partial profit, given the 20% share price increase the stock had over the last couple of days.

We maintain our cautious stance on the technology sector. The semiconductor book-to-bill ratio, which gives a view over the relation between products shipped and newly booked orders fell to 0.84 in September, from 1.22 in the previous month. This decline is mainly due to an almost 20% fall in bookings. The lack of top line growth we have seen during the earnings release from Intel (INTC, CSFB rating: Neutral) and the very conservative guidance clearly point towards further weakness in this sector. Given Intel's CEO statement that he does not expect growth to resume before early 2003 we believe that the share price increase that some of the chip stocks saw over the last week were not justified. Visibility has not improved at all and it does not seem that corporate IT spending will pick up soon, given the weak top line figures reported by the companies in their earnings releases. A recovery of the IT spending and though of broad areas of the technology sector would lag a pick up in the overall economy by one quarter, which gives time enough to reassess the positions in the sector, while staying on the sideline.

Last week, Southwest Airlines (LUV US) reported 3Q02 earnings, which came in largely at a penny above the street. However, unit revenues were weaker than expected as due to heavy discount offers used in order to increase volume. We still maintain that LUV remains one of the premier US carriers out there and has thus far performed tremendously. However, the stock seems to be running out of steam. As mentioned, its operating costs remain well below its industry peers, but have after a considerable period showed some signs of expanding. This has been in large part due to increased labour costs and a 12.6% increase in depreciation expenses. However, given that unit revenues have been showing signs of weakness, the increase in operating costs have not been mitigated.

The company in its conference call last week mentioned that the prospects for a 4Q profit seem somewhat uncertain.

We feel that there is a good chance that LUV may well trade in line with the market or continue to fall, given weak economic data and the chunky rally witnessed last week.

Here is our stance. We have faith in the long-term prospects (12 month) for LUV and the US airline industry. However, we feel that the near to mid term growth will remain uninspiring. We shall be removing LUV from our recommendation list today and recommend that investors take their money out of the stock.

We do not at present have any clear switch ideas. Furthermore we would not want to rush into one at this stage given our call to reduce US equity allocation. As we have said, we view LUV as a strong long-term candidate and shall be keeping a close eye on the stock.

European Equities


• ING (INGA NA; EUR 17.75) and AXA (CS FP; EUR 14.32) gained 13 and 19% respectively over the week and we would advise trading oriented clients to start taking profit.


• We use the current rally in Philips (PHIA NA; EUR 17.58) to reduce the stock to a HOLD as we believe the rally was overdone and the outlook for 4Q is rather disappointing.

The eyes of investors were all focused on the earnings results of Philips (PHIA NA; EUR 17.58), SAP (SAP GY; EUR 72.65) and Nokia (NOK1V FH; EUR 16.60) this week. Investors wanted to get reassured that earnings were recovering at electronics and computer-related companies. A narrowing of a loss in the case of Philips, results meeting analyst's expectations mainly due to cost reduction and efficiency improvements in the case of SAP and Nokia's EPS exceeding its own forecast (however, pro forma EPS) were all rewarded in a big way. Consequently, the technology sector was the best performing sector of the week returning 16%. Despite the recent rally, we believe the underlying picture has not yet improved significantly to justify these gains and we would see the gains during the last week rather as a rebound from technically oversold positions. We would still be cautious on the earnings guidance given as the biggest drivers were cost cutting and not top line sales growth.

Last week, we mentioned the technology and insurance sectors as sectors, which started to gain the attention of value investors. ING (INGA NA; EUR 17.75) and AXA (CS FP; EUR 14.32) gained 13 and 19% respectively over the week and we would advise trading oriented clients to start taking profit.

Philips' (PHIA NA; EUR 17.58) net loss narrowed mainly because of rigorous cost cuts. During the last 2 years the company shed 15% of its workforce partly by selling unprofitable businesses in order to focus on higher growth products. In the third quarter, Philips made money on an operating level in its units that make light bulbs, coffee machines and TVs. Components and Consumer Electronics were weaker than expected, Medical was disappointing and Semiconductors were in line with previously lowered guidance. Chip sales fell 12% from 2Q after the company adjusted their prior guidance of a decline of 0-5% to a decline of 13-15%. Philips also cuts its chip forecast and expects 4Q sales to be flat. We believe the current rally was overdone and given the rather disappointing outlook for 4Q, we reduce the stock to a HOLD.

A confirmation of how dull the outlook is came from SAP (SAP GY; EUR 72.65). The company abandoned its full year revenue forecast. The company still expect its operating margin to increase by 1% to 21% for this year. This increase will however be achieved mainly by cost reduction and efficiency improvements. License revenue - a measure of SAP's growth declined 2.7%. Although the share price rebounded sharply since the first week of October, we are still concerned about the low visibility in the coming months ahead as companies will not commit money for new projects until earnings start to pick up. We maintain our HOLD.

LVMH Moet Hennessy Louis Vuitton (MC FP; EUR 42.37), the largest and most liquid luxury good maker reported 3Q sales in line with consensus. The company also confirmed to deliver a very significant operating profit for the full year. Although the company kept up relatively well compared to the broader market, investors should keep in mind that the management has no control over current macro and geopolitical risks, which dominates the business environment.

Roche (ROG VX; CHF 107.5) received FDA permission to sell the hepatitis C treatment Pegasys, which is one of Roche's most important drugs. Pegasys is already sold in Europe. However, the US approval was only expected towards the end of this year. Peak sales of Pegasys are estimated to reach CHF 1.5bn. In 2002, pharma division sales growth is still expected to be in the mid single digit range but this news should be the base for double digit sales growth in 2003. We reiterate our positive stance on the pharmaceutical sector in general and our long-term positive call on Roche in particular.

Vodafone (VOD LN, GBP 0.9925) got one step closer in owning a controlling stake in France's mobile market by acquiring BT Group's and SBC's stake in the French telecom company Cegetel, which owns 80% of SFR France. SFR France is the no 2 operator in an attractive three player French market. Vodafone agrees to pay a total of EU 6.3bn in cash and made also a cash offer of EUR 6.77bn for Vivendi's 44% stake which is open until the 30 October.

The CEO Christopher Gent mentioned that he has no intention to offer a higher price. However, it was reported that Vodafone might raise its overall bid to a total of EUR 14.3bn. Investors, which expected the company to use its cash reserve to finally buy back its own shares, fear that the company will overpay a possible acquisition. We expect the stock to remain in a range between GBP 0.80 and GBP 1.00 and would use any pull back to the low 0.90 to accumulate.