August 2001 Update and Reports on Guidant, Gillette, and QUALCOMM

I will repeat a commentary from our May, 2001 report:

"I believe we have seen the bottom of the market's recent decline. To clarify, we have seen the market's bottom, but we have yet to see the bottom of this economic contraction. So, do not be surprised if the market's return to health continues, even as you read bad economic news in the newspapers. Most importantly, I am delighted with how our portfolios are positioned and look forward to the next five years with a very high degree of optimism."

That quote still applies. The economy's decline continues and hopefully will bottom in the fourth quarter. The lows probably have been seen in the broad stock market. In the last 12 months the S&P 500 has declined about 20%, even after recovering about 10% from the April low. The tech sector has performed much worse than the S&P 500, with the comparative valuation of all tech stocks declining dramatically. I am still very optimistic about individual companies we own, while the broad market will probably have to wait awhile for sustainable improvement. One benefit of the slow economy is the accompanying weakness of the US dollar, which will be a big help for companies with large foreign revenues like Coca Cola and Gillette. Those companies have endured 5 years of devaluation of their foreign revenues, damaging their growth.

Guidant (GDT 32) must have credibility with the FDA. The Contak CD implantible CHF device is getting a deeper look from the agency than it received a month ago from an FDA sponsored review panel. I am cautiously optimistic that this life saving product will be approved. Another Guidant product on the FDA's 2001 calendar is the GALILEO™ Intravascular Radiotherapy System. If approved, this will be the first radiation-emitting stent used to treat restinosis, the recurring blockage of coronary arteries.

Gillette (G 30) appointed a new Chairman and CEO, James M. Kilts, who was chief executive officer of Nabisco up until its acquisition last year by Philip Morris. His life's work is brand building, and Gillette owns category leading brand name icons. The most important of these categories, blades and razors, is growing. Oral B is growing. But Duracell batteries, Gillette toiletries, and Braun appliances are all declining. Mr. Kilts promises to balance reductions in operating expenses with increases in advertising spending. Advertising spending in the early 90's was 9% of sales, while last year it was only 6.5%. Competitors, seeing opportunity, increased their advertising expenditures over the same time period, explaining in large part the erosion of market shares for all Gillette products other than razors and blades. I don't think I have seen a Duracell ad in the last two years. I've seen Ray-O-Vac and Energizer, but where's Duracell? Gillette's old management just focused the ad budget on introducing two new shaving systems, Mach 3 and Venus, and left the other categories to fend for themselves.

Mr. Kilts has announced some objectives. Manufacturing and distribution costs are being cut. A slimming of the working capital required to run the business is to be attained by reducing inventories and accounts receivable (yeah, we've heard that before.) Capital expenditures are to be cut from 10% of sales to 6%, producing a substantial increase in free cash flow. The pre-tax return on sales target is 30%, compared to 22% last year. Sounds good.

I know that there are a lot of "ifs" here, and that management has not gotten good results for the past 3 years. However, even in Mr. Kilts' first full quarter at Gillette, several metrics are improving. Gross profit margin increased from 62.6% to 64.1%, offset by a 23% increase in advertising expense. Cash flow from operations increased 27% year over year due to a marked decline in receivables and inventories. Capital expenditures declined 18% year over year and net debt declined $400 million from the December 31, 2000 figure. Stock will probably be repurchased this quarter. 2001 is likely to provide a low earnings base (eps estimate of $1.00) for easy comparisons in 2002.

Wall Street's consensus is pessimistic, so there is little risk in waiting to see if new management can reinvigorate Gillette's great brand name products and pervasive worldwide distribution system. If revenues grow 5% a year for the next five years and the 30% pre-tax return goal is approached, return on capital will soar and the earnings per share math works out to about $2.00. That would bring a lot of investors back to the stock, and should be accompanied by share price appreciation.

QUALCOMM's (QCOM 65) CDMA2000 is on the verge of enabling applications and services never before imagined by wireless phone users. It will also enable revenue growth for carriers due to vast increases in efficiency. CDMA2000 accommodates 396 circuits per base station compared to GSM's 48. That's 396 paying customers vs. 48. Profitability derives from the competitive efficiency of businesses, and prospective profitability drives infrastructure investment.

QUALCOMM believes that access to GSM intellectual property obtained when Nokia signed the 3G CDMA royalty agreement will allow it to produce CDMA/GSM multimode chipsets. This is extremely important for the proliferation of CDMA2000 around the world. Because 3G upgrades using CDMA2000 do not require wireless carriers to acquire new spectrum, the evolution of GSM to CDMA2000 is significantly less expensive than building all new W-CDMA networks. Chipsets available solely from QUALCOMM will enable phone users to travel between GSM, cdma2000, and analog geographies without interruption. In fact, this gives QUALCOMM's chip division entrée to the vast GSM chip market. Economies of scale make it likely that CDMA2000 handsets will eventually cost users less than GSM handsets, while handsets with the capability to operate on both networks could be only modestly more expensive than GSM-only handsets.

Countries announcing CDMA2000 deployments represent over 800 million pops (people covered by the network), and countries able to deploy CDMA2000 in existing cdmaOne spectrum represent over 4 billion pops. Meanwhile, countries with W-CDMA spectrum cover only 670 million pops. Claims by the likes of Nokia that W-CDMA will be the 3G standard of choice are losing credibility. CDMA2000 already operates successfully in Korea and Japan, and will be deployed in the U.S., Canada, Mexico, Malaysia, and Brazil by year-end. W-CDMA appears unlikely to operate successfully anywhere this year. China Unicom has taken the lead in the quest for the holy grail of worldwide roaming, announcing agreements with 13 carriers covering 9 countries, including Korea, Japan, Hong Kong, the U.S., Canada, Mexico, Brazil, New Zealand, and Australia. It is looking like Europe could become an island of GSM. To quote LG Telecom spokesman Lim Byong-yong's comments in Total Telecom Asia, "the consortium plans to build partnerships with operators in North and South America, Japan, China, Australia, India and Southeast Asia to create a "CDMA Belt." ("The consortium" is a group of companies bidding on a 3G spectrum license in South Korea.)

I would not want underestimate, as I admittedly did on Microsoft, just how big the buildout of a global technology franchise can be.

An article from the Financial Times that complements this discussion is included below. Also, a new slide presentation from the CDMA Development Group (CDG) will be enjoyable viewing to QUALCOMM shareholders: http://www.cdg.org/3GPavilion/Detailed_Info/cdg_3g_presentation.pdf

Feeling the squeeze
by Alan Cane, Financial Times, London
Published: May 31 2001 16:50GMT | Last Updated: June 4 2001 18:45GMT

Europe's proudest technological boast is its leadership in mobile telephony. Of 700m cellular subscribers worldwide more than two-thirds use the GSM (global system for mobile communication) standard created, adopted and nurtured in Europe.

The economic consequences for the region have been profound. Companies such as Nokia of Finland, the leading handset maker, and the UK's Vodafone, the world's largest mobile operator, are the powerhouses of the wireless economy.

Europe's leadership may not, however, survive the move to the next generation of mobile phone technology. The efforts of regulators, vendors and operators to ensure Europe stays ahead of the pack as the world moves to third generation (3G) services could inadvertently cost the region its dominance.

Its chief competitor, the US, is snapping at its heels. San Diego-based Qualcomm recently secured a licence for 3G in Australia in what many see as a gauntlet-hurling exercise designed to show its version of the code division multiple access system, CDMA2000, works best.

Third-generation services are due to be launched in Europe next year. But all the 3G base stations and telephone handsets have had to be created from scratch because of Europe's insistence on following its own version of the CDMA technology, known as w-CDMA.

Irwin Jacobs, Qualcomm's chairman and chief executive, and inventor of the 3G technology, has already cast doubt on whether Europe can meet its self-imposed target. He has even suggested that US carriers could get to 3G before their European rivals - and at lower cost.

The European specification, called UMTS (universal mobile telephone system), is still undergoing radical revision. There are already worries that handsets will be delivered late and will perform worse than the GSM phones which they are to replace. Critics say a complex development such as UMTS requires hugely more time to be tested and completed than the Europeans have allowed.

The European Commission has also given warning: "Product development for 3G terminals has not in the main progressed beyond proto-typing, pending verification of the key applications which these handsets need to serve."

Meanwhile, the rest of the world is moving fast. At the time of writing, the largest Japanese mobile operator, NTT DoCoMo, was saying it would launch 3G services by October of this year. In the US, Verizon and Sprint are both planning to offer 3G services later this year-although neither has set a date for launch.

If, then, manufacturers fail to provide Europe's mobile companies with working equipment on time, the region's operators face the prospect of falling behind their international rivals.

Last February in Cannes, France, a conference saw Qualcomm demonstrate a working 3G system. Admittedly, this involved transmitting data to a personal computer rather than to a phone, but the significance was not lost: Qualcomm's technology, CDMA2000, works - today. Sprint says it will use CDMA2000 for its launch. Although Verizon has yet to make a decision, it is resisting pressure from Vodafone, its partner, to adopt the European standard.

Europe's leading manufacturers remain confident. Tapio Hedman of Nokia's mobile division says the company is on track to launch 3G handsets in the third quarter of 2002 and to be making them in millions by the end of the year.

Arja Suominen, representing Nokia's infrastructure division, said deliveries of pilot commercial systems would start next quarter with volume deliveries in the second half of the year. And even if 3G is late, the Europeans can, they say, deploy GPRS (general packet radio service), a souped-up version of 2G known as "2.5G". This standard offers many of the advantages of 3G, such as being "always on", but without 3G's huge expense.

Why, then, do the worries persist? Qualcomm has been developing CDMA over many years. Its version of 3G has been adopted by operators in the US, Japan and South Korea.

Nevertheless, in the late 1990s, when standards for 3G were being agreed, the European authorities were determined to repeat the success of GSM. So, rather than accept a US CDMA they opted for w-CDMA, a home-grown version.

A key point, however, was that while GSM operates at frequencies of 900MHz and 1,800MHz, the European authorities insisted that w-CDMA ran at 2.1GHz. While there are some technical advantages in using this region of the spectrum, most observers believe creating a European standard was above all a political move. "[T]his was a conscious effort to force operators to invest in a technology that would recreate the success of GSM and create a new export engine for Europe in the process," says one manufacturer.

But choosing 2.1GHz has drawbacks. First, manufacturers had to start from scratch to design, build and test the system. Thus, operators have been unable to use their existing GSM spectrum to introduce or test-market the new services.

Second, many more networks of base stations will have to be built because the signal propagates poorly. This represents a huge investment on top of the colossal sums many operators have already paid for 3G licences.

Third, because there will be, to begin with, only islands of 3G in a sea of GSM, handsets will have to be able to operate seamlessly in both modes, switching spontaneously from 3G to GSM according to the area. These phones represent a significant technical challenge.

The continent is on a knife edge. If the technology is delivered on time, Europe will maintain its leadership position. If not, the initiative will inevitably pass to the US, which will become the source of the most advanced business and leisure applications for mobile phones, just as it is for personal computers.

Steven L. Ré, CFA August 15, 2001

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