Year End 2001 Update and Company Visits

2001 is a year we would prefer not to repeat, what with the tragedy of 9/11, the Enron accounting fraud, the S&P500 Index' 13% decline, and the NASDAQ Composite Index' 40% decline. So, what can we expect from our investment future? Long-term investment performance is largely determined by the growth rates of earnings from operations of the companies owned. How do our major positions look?

Despite the bumps on the road last year, our long-term account performance has significantly exceeded that of the S&P 500 index. And, if the growth rates in the right column of the table prove to be at least moderately accurate, our account performance over the next five years is highly likely to handsomely exceed the S&P 500. Peter Lynch has said that if a long-term investor buys 10 stocks, two will significantly outperform, two will be dogs, and the rest will be in the middle. Because outperformers should more than double in five years, and the dogs can go no lower than zero, this is a simple formula for beating the performance of the S&P 500. I am optimistic about our future, and hope it gets here soon!

Company	Last five years	Next five years' First Call estimate
Cardinal	21.2%	20%
Cisco	17.2%	25%
Coca Cola	1.2%	12%
Church Dwight	20.6%	12.5%
Disney	0.5%	12.5%
Equifax	3.1%	12%
Intuit	31.5%	25%
Gillette	.3%	10%
Guidant	31.1%	15%
Medtronic	16.4%	17%
Monsanto	N/A	10%
Pfizer	18.6%	20%
Pharmacia	N/A	20%
Qualcomm	55%	25%
Wrigley	7.7%	10%

Cisco Systems (CSCO 20) is the worldwide leader in networking for the Internet. Cisco's Internet Protocol-based (IP) networking solutions are the foundation of the Internet and most corporate, education, and government networks around the world. Cisco provides the broadest line of solutions for transporting data, voice, and video within buildings, across campuses, or around the world.

Cisco is the first of the networking infrastructure companies to see its business return to linearity. In other words, Cisco's revenues have been flat for the last two or three quarters, while those of its competitors, including Lucent, Nortel, Juniper, Ciena, Sycamore, etc. have continued to decline. Thus, Cisco's market share gains are currently the largest in Cisco history. Cisco continues to be the best managed first choice supplier of infrastructure. Largely responsible for this has been the relative strength of Cisco's customer base, the "enterprise segment" (large industrial corporations). Capital expenditures by service providers (telephone companies) have been relatively weak, and those companies form the customer base of Cisco's competitors. Now, Cisco is taking advantage of its strength to take business away in the service provider segment of the market. Therefore, CEO John Chambers is planning for industry growth over the next five years in the lower range of analyst estimates of 15-25%, but faster growth for Cisco because of market share gains.

As impressed as I am with the terrific management track record at Cisco, and the way Cisco continues to roll over its competition like a Sherman tank, I am cautious about over-optimism with Cisco's growth rate. Incorporating a conservative assessment of long-term growth into an intrinsic value calculation, based on what a rational buyer of the whole business would pay, yields an estimate of intrinsic value in the mid to high teens. At this price level, I consider Cisco an attractive acquisition. This excellent company is certainly the one leading the networking infrastructure business out of the past year's depression.

Avanex (AVNX 6) is an extremely interesting technology company with a small market capitalization. It has some similarities to the pre-growth-explosion QUALCOMM of the middle 90's. Just as QUALCOMM's CDMA increases the number of phone calls that can be carried over a wireless system, Avanex' DWDM (Dense Wave Division Multiplexing) increases both the quantity of data that fiber optic telephone infrastructure can carry, and the distance over which it can be carried. However, Avanex' total ownership of the technology is not possible, while QUALCOMM's now undisputed ownership of CDMA intellectual product rights is a large component of the stock price. Like QUALCOMM, Avanex, its scientists, and its science are very well thought of in the optical networking industry. Its biggest customers are Cisco, Alcatel, Nortel, Worldcom, and Fujitsu.

Avanex' innovative technology signals a paradigm shift in optical networking. The networks in big cities have not yet been upgraded to the high data capacity of DWDM. These "Metro Area Networks" are the intermediate networks connecting access equipment, like the phone and Internet connections of homes and businesses, to the long-haul network in and around major metropolitan areas. This segment of the non-wireless communications market shows the highest growth potential. The timing is the question, because large phone companies are slow to warm up to new technologies. Like all new technologies in the early stages of selling, the economies of scale are lacking. It costs a lot to build Avanex' all-optical networks, a potent negative when phone company capital expenditures are down 15-30%. However, all-optical networks are much cheaper to operate, and, in time, this will make buyers out of phone companies that need to stay competitive. Avanex is burning cash at the rate of $10 million per quarter, so it is fortunate that it put $200 million in the bank when the stock was at a higher price. The stock ranged in the last 2 years from $3 to $273 (not a misprint). Now, with a total market capitalization of less than $400 million, half of it cash, we are really paying $200 million to buy a potential leader in the future of optical networking.

Avanex can be summarized as a very risky play on a technology innovator, which, if successful over the next five years, has multiple return potential. Exciting? Yes! But these thrills are not suitable for most investors.

Merck (MRK 59) reported at its December 11, 2001 analysts' meeting that earnings from operations, adjusted to provide comparability, would actually be lower in 2002 than in 2001. Although the 10-point decline in the stock evidenced some surprise, it did not surprise me. I stated in my August 2000 report,

"Merck (MRK 72) chairman Ray Gilmartin spoke optimistically about this great pharmaceutical company's future. But to me, it just did not feel right. Mr. Gilmartin was reluctant to detail the basis of his optimism, especially in view of the relatively short patent lives remaining on many of Merck's big drugs."

My opinion is still the same: great company, but not enough success in its R&D effort to drive double-digit growth of such a large company. However, Merck-Medco, Mercks' pharmaceutical distribution and pharmaceutical benefits management business, based on the Medco acquisition of 1993, continues to provide low teen revenue growth. Merck-Medco margins are low compared to those of Merck's pharmaceutical business. The faster growth of the lower margin business has driven a continued erosion of Merck's profit margins. In 1997, Merck's gross margin was 53.7% compared to 37% projected in 2002!

The only way to stabilize the margin decline is for Merck to hit on some blockbuster new drugs. Unfortunately, 40% of 1998 pharmaceutical sales are at risk of patent expiration by 2003, opening them up to generic competition, forcing prices to be cut to fractions of patent drug prices. Merck spends about 6% of sales on R&D.

Merck does have some great drugs still on patent: Zocor for arteriosclerosis, Singulair for Asthma, Vioxx for chronic pain, Fosamax for osteoporosis, and Cozaar/Hyzaar for hypertension.

And, Merck has a satisfactory new product pipeline. Drug launches for 2002 include Singulair for allergic rhinitis, Arcoxia second-generation COX-2 inhibitor pain medication, and Invanz for hospital infections. Prospects for 2003 and later include Zetia cholesterol absorption inhibitor, which can be prescribed with Zocor for conjunctive therapy, a new osteoporosis drug to replace Fosamax, phosphodiesterase-4 inhibitor for asthma, Cozaar for renal protection for diabetics, KRP297 for diabetes, MK-869 for depression and chemotherapy induced vomiting, GABBA-A for anxiety, Human Papilloma Virus vaccine to prevent infection that can lead to cervical cancer, Rotavirus vaccine, and HIV vaccine.

I estimate Merck's intrinsic value at $52 per share. I am not comfortable buying at that price, because I am dubious that 2002's marketing investments and new product introductions will be sufficient to facilitate management's projection of double digit earnings growth in 2003.

Pfizer (PFE 40) is the world's foremost pharmaceutical company. Patent expirations are not significant until 2006, giving credence to management's projection of 20% earnings growth in 2002 and 15% or better in 2003 and 2004. Actually, I think the high teens are possible for the next five years. R&D expenditures of $5.3 billion, 15% of sales, indicate Pfizer is driven to replace expiring patents, and its pipeline is the pharmaceutical industry's richest. The company has 162 prospective drugs in various stages of development and targets 15 New Drug Application filings between 2001 and 2006. Profit margin expansion continues, driven by new product introductions, productivity growth, and divestiture of low growth, low margin product lines.

Pfizer has eight products with sales exceeding $1 billion:

· Lipitor is the world's number one cholesterol-lowering medicine and the world's largest selling pharmaceutical.

· The category leading anti-hypertensive Norvasc continues to demonstrate strong growth with estimated 2001 revenues of $3.6 billion. Norvasc recently received a six-month patent extension based on additional clinical experience in a pediatric population.

· Celebrex, co-promoted with Pharmacia, is the number-one-branded anti-arthritic in the world.

· Zoloft is the number-one-prescribed SSRI antidepressant in the U.S.

· Viagra is the world's most recognized pharmaceutical brand.

· Neurontin is the world's leading acute epilepsy drug.

· Zithromax is the number-one-branded antibiotic in the U.S.

· Zyrtec, co-promoted with UCB Pharma, is the fastest-growing second-generation antihistamine in the U.S.

The near term growth of Pfizer will be driven by:

· Geodon, an atypical antipsychotic for the treatment of schizophrenia,

· Bextra, a second-generation COX-2 inhibitor for the treatment of osteoarthritis, rheumatoid arthritis (RA) and menstrual pain, with no increase in renal or cardiovascular risk compared to similar "cox inhibitors" from Merck,

· Vfend, for serious fungal infections,

· Spiriva, for the treatment of chronic obstructive pulmonary disease,

· Relpax, a treatment for migraine headache,

· Capravirine against various strains of HIV, including those that are cross resistant.

· Lasofoxifene for osteoporosis, a frontal assault against Merck's Fosamax.

· Exubera inhaled insulin for the treatment of diabetes,

· Darifenacin for overactive bladder,

· Pagaclone for panic disorder and anxiety,

· Pregabalin for neuropathic pain.

Pfizer's new drug pipeline appears to be packed with blockbusters. Management is guiding 2002, 2003, and 2004 earnings per share estimates to $1.60, $1.84, and $2.11. I estimate intrinsic value at $36 - $40, and feel that Pfizer is one of the most secure double-digit earnings growth opportunities available.

Steven L. Ré, CFA January 14, 2002

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.