Third Quarter 2001 Update and Company Visits

Been there, done that? Iraq's invasion of Kuwait in 1990 shattered our complacency and made us look at the world in a more pessimistic light. Investors focused on the already slowing American economy. With Americans glued to CNN, the stores, restaurants and car dealers had tough, although temporary competition. The chart below shows that the scare of military action both deepened the recession and the stock market's decline. It also shows that the stock market appreciated rapidly after American military action started, and that the market's bottom preceded the recession's trough by 6 - 9 months. Most important, it shows that the recession lasted about one year, and that the stock market recovered months before the recession was over. There is no reason to think that the current recession and market decline will be substantially different, although the war will last longer.

A perpetually important influence on the economy and the stock market is the monetary policy of the Federal Reserve Board of Governors (FRB). There has been plenty of press about interest rate reductions this year, which have acted to shore up consumer confidence and asset values. However, the FRB has a somewhat more potent, although stealthier tool, at its command. It is the injection or withdrawal of cash that truly dominates the status of the economy. After all, it's all about money, and a recessing economy with hoarding consumers needs cash to get going again. FRB investment normally leads resurgence in the economy by at least six months, while stock market recovery is even quicker. So far this year, the FRB has not exactly allowed its cash to burn a hole in its pocket. In the past 4 months, the FRB has started investing in the economy again, and we should see some improvement late this year. Follow the last two year's history of Federal Reserve System balance sheet: A large increase in cash late in 1999 pre-empted Y2K concerns, creating a very strong economy and stock market in late 1999 and early 2000. Federal Reserve Notes peaked at $601 billion on December 30, 1999. As soon as Y2K passed, the FRB embarked on a constrictive monetary policy. It withdrew money at a drastic rate, setting the stage for the current recession and market decline. Federal Reserve notes got as low as $536 billion on March 30, 1999. Two years later, the sum was $566, only modestly higher. Last week Federal Reserve Notes were back to $585 billion, but still under the year-end '99 peak. You can examine the Federal Reserve System CONSOLIDATED STATEMENT OF CONDITION OF ALL FEDERAL RESERVE BANKS at http://www.federalreserve.gov/releases/H41.

This painful period too shall pass, and if we own the right companies, we will make more money than ever. That is, has been, and always will be the way it works. Once again, companies will end up in the hands of the strongest holders. And, we do own the right companies. And, we shall be strong.

Company Visits and Analyst Meetings

Lucent (LU 7) is executing a cogent plan to turn around its business, which, with the benefit of hindsight, got way ahead of itself. Industry consultants last year were predicting that the business of supplying network infrastructure would double in the following five years. Those same prognosticators now foresee a shrinking business, and expect little to no growth for several years. In order to survive in this surprisingly poor environment, Lucent management is taking Draconian steps to cut expenses out of the business. Head count is being reduced from the earlier peak of 123,000 to about 60,000. Plants are being closed and capital committed to the business reduced. The company expects to emerge from this painful process with a narrow focus on its largest customers and the products they need. Upon self-examination, Lucent found that 50% of its revenues come from 20 customers, and that 75% of revenues come from 50 customers. Geographically, the top 30 customers operate in only 20 core countries. Lucent's goal is to have sufficient human and financial resources to handle this limited number of customers.

Lucent is reorganizing itself into two divisions: 1) wireline, to serve the big phone companies, and 2) wireless, to serve the high growth markets of 2.5 and 3G wireless communications. There is an interesting conflict between projections of service provider revenue growth and customer demand for connectivity. Despite the relatively poor capital spending predicted for big service providers, the projections for end-customer demand are pretty bullish. Yankee Group predicts worldwide wireless penetration will rise from 10% in 2000 to 20% in 2005. Cahners In-Stat projects worldwide broadband subscribers growing from 12 million people in 2000 to 84 million in 2005. McKinsey & JP Morgan forecast US backbone traffic to grow from 1.7 exabytes in 2000 to 13.8 exabytes in 2005. I'd have to guess that if the user demand grows at even half of these rates, service providers are going to have to rekindle their infrastructure spending pretty soon. That bodes well for Lucent, Nortel, Cisco, and the other infrastructure providers that survive this tough period. More important, it bodes well for investors living through shortsighted Wall Street's annihilation of these stocks.

In Lucent's analyst meeting on August 23, 2001, management projected the company to achieve break-even by the March 2002 quarter, with profitability thereafter. Better profit margins are to follow in 2003, in line with historical industry metrics. This is based on an assumption of flat industry conditions in 2002 and a small amount of industry growth in 2003. I applied this information to produce a guess of 2003 profitability. $24 billion in revenues could produce operating earnings of $2.4 billion. Earnings per share could range from $.30 to $.45, not a bad turnaround for a company some fear mongers quoted in such credible publications as the Wall Street Journal said could go bankrupt.

The technology sector has been a classic example of the human characteristic of getting too excited about things when they look good, and too scared when they look bad. In February of 2000 I said, " The downside of manias is that for each company that has succeeded, about eighteen fail. This occurs because capital flooding into the hot new industry funds the creation of more companies than can reasonably fill the space. Then, industrial Darwinism takes over, and the weak competitors fall by the wayside." Now we are at the opposite position from a year and a half ago. The stocks of the survivors are cheap. It would not surprise me to see these companies reporting "earnings surprises" a couple years from now as they scramble to meet the demand for wireless and Internet infrastructure, the demand for which has continued to grow despite the demise of many former favorite speculations.

Lucent is the leader in CDMA infrastructure, the build-out of which will be huge. Lucent will emerge from this period as the largest provider of communications infrastructure to service providers around the world. In that vein, here is an excerpt from article from Shanghai I found on PR Newswire.

China Unicom and Lucent Technologies Demonstrate CDMA 1X High-Speed Wireless Data Technology in China

Demonstration Achieves Data Transmission Speeds of up to 153 kbps, Supporting A Variety of Mobile Devices and Applications

Lucent Is the First Foreign Vendor to Complete CDMA 1X Data Call in China

SHANGHAI, China, Oct. 15 /PRNewswire/ -- China Unicom subsidiary Shanghai Unicom and Lucent Technologies today completed CDMA 1X voice and data calls in China at a special demonstration held in Shanghai. Lucent is the first foreign vendor to accomplish this in China. Advanced mobile Internet services, including wireless Web browsing, e-mail and video streaming, were sent and received via laptop computers and personal digital assistants (PDAs) at speeds of up to 153 kilobits per second (kbps), about 10 times faster than what is available today.

Cardinal Health (CAH 76) is one of the world’s best-managed corporations. The concept of return on capital permeates employees of the company. They identify with the company’s expectation to consistently grow quarterly earnings at a 20% annual rate. In short, employees think like shareholders, and are incented to behave like owners. The result is a 15-year history of 20% earnings per share growth accompanied by an improvement in return on capital from 22% in 1997 to 30% last year. These trends are expected to continue by 1) optimizing asset utilization, 2) leveraging competitive scale, 3) increasing capacity utilization, and 4) monetizing low return assets.

Cardinal is the largest and best capitalized pharmaceutical and medical products distributor. Management has positioned the company right smack in the middle of healthcare’s superb demographics. The American population is aging. People 50 years old and over consume 50% of the $1.4 trillion healthcare budget, 74% of all pharmaceuticals, 65% of hospital beds, and 42% of doctor visits. 75 million people in the US in year 2000 were aged 50 or older, with a projected 85 million in 2005, 96 million in 2010, and 106 million in 2015. Adding to this volume growth is an unrelenting increase in medical prices, as all Americans assume access to that cutting-edge medical science is their unalienable right.

Cross-selling between divisions is another growth driver at Cardinal. Cardinal can manufacture and package drugs for pharmaceutical companies, then distribute them to pharmacies and hospitals. It assists hospitals by controlling drug consumption, “shrinkage”, and billing to patients through Pyxis machines. It provides pharmaceutical consumption data to pharmaceutical manufacturers and consumers, and develops new pharmaceuticals under contract from pharmaceutical manufacturers, including biotech pharmaceuticals. When Cardinal bundles these services and delivers them to customers via the Internet, the customer benefits. Cardinal is one of the biggest Internet revenue earners, as it automates its relationship with customers, improving the efficiency of both the customer and Cardinal, creating customer dependence in the process. This bundling and Cardinal’s massive scale allows it to avoid the overriding weakness of its disarrayed competitors, that of having its services priced as individual commodities.

The opportunity we had to purchase Cardinal a couple years ago was golden. If an investor is patient enough, Wall Street can be relied upon to annihilate the price of excellent companies for short-term reasons. Cardinal is not cheap right now compared to my calculation of an intrinsic value of $64. However, I see a similar situation in Guidant right now. It reminds me of Cardinal a couple years ago, when we stole it for a split-adjusted $25, down from a previous high of $60! My high expectations, birthed in a discussion with Chairman Bob Walter two years ago, when he could recall from memory all the detailed numbers needed to calculate the return on capital of an acquisition made 5 years earlier, have been attained. I expect continued growth from this company, most impressively managed at all levels.

Starbucks (SBUX 17) is a top quality brand name with lots of growth yet to come. Growth historically has been derived primarily from opening new stores. Management’s stated objective is to establish Starbucks as the most recognized and respected brand name in the world. In pursuit of this goal it projects 10,000 stores worldwide by the end of the September 2005 fiscal year, compared to about 4,500 stores today. This will generate about $6.6 billion in revenues compared to the $2.7 projected for fiscal 2001. Although the growth is at a pace one would expect for a technology company, the reliability is much higher. Growth comes from replicating a time-tested template of opening new stores and maintaining product quality. And, regarding quality, we know from experience how great the quality is, and believe that it is consistent in Starbucks stores worldwide. The stores seem to be enjoying surprising success even in cultures less addicted to coffee than our own. People really do get hooked on the powerful and complex flavor of Starbucks' coffees.

My Starbucks visit was prompted by recent weakness in the share price, down from a high of $25.65 this year. Management pursues the global franchise opportunity so relentlessly that it will take some short-term risks. I believe this golden opportunity is so rare and valuable that management is right to drive the company hard. However, there are subtle indications in last quarter’s earnings that tell me there is a possible disappointment brewing in the September quarter, although management gives no such warning. This is the type of economy that depresses same store sales, creating disappointments in growth. Because of historically rapid and exceptionally consistent growth, Starbucks has long been a high P/E stock. Fiscal year operating earnings per share were .36 in 2000, estimated .46 in 2001, and .57 in 2002. A guesstimate of 2005 eps is $1.15. Intrinsic value is currently about $15, by my estimation, and growing rapidly. An opportunity to add long-term positions below that price would be very exciting. I can feel very comfortable owning this company for a long time.

Steven L. Ré, CFA October 22, 2001

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.