The New Penny Options

Tighter prices should bring more opportunity for more investors and more liquidity, as trade will require smaller market movements to be succesful," says the head of one options broker already employing some penny pricing.

REMEMBER THE HUBBUB OVER THE DECIMALIZATION of stock prices back in 2000? Well, get ready for a little deja vu, because it's coming to the options market early next year.

Options are currently priced in increments of a nickel, which means that a one-tick change in price changes the overall cost of a single contract by $5. (Each contract gives the right to buy or sell 100 shares of underlying stock.) Cutting the increment to a penny means that a one-tick change alters the price by $1,

More aggressive exchanges that help a trader get price improvement on a trade - that is, an increase in the selling price or a decrease in the buying price - are likely to find even greater flexibility in pricing when a contract is priced in the new, smaller increments. The net result should be a cost saving to investors, as well as an oppor­ tunity to turn a profit on smaller price moves.

The Securities and Exchange Commission has man­ dated that a pilot program in penny options pricing get under way Jan. 27, 2007, when 13· underlying stocks will have options offered in penny increments on various exchanges. One of those bourses is the NYSE Arca Options platform (formerly the Pacific Exchange and the Archipelago Exchange, or ArcaEx), which said in October that it would participate in the program.

Why didn't options pricing shift to pennies when the stock market decimalized? The answer is bandv\Tidth. In stocks, you have only one IBM, for example. But with op­ tions you have to contend with multiple strike prices and expiration dates, and also have to display the various puts and calls. A single stock can have hundreds of related op­ tions contracts.

The initial 13 tickers include QQQQ (Nasdaq-lOO Tracking Stock), IWM (iShares Russell 2000 Index Fund), GE (General Electric), MSFT (Microsoft) and SUNW (Sun Microsystems). The pilot program could go on fora year or longer, depending on how quickly any technical issues can be resolved.

In a statement, the NYSE said the "proposed quote­ mitigation plan will significantly reduce overall quote traffic in all of NYSE Arca's options issues, not just those selected for the pilot progTam" and that the ex­ change proposes "to disseminate quotes only in 'active' options series." Because of the smaller price increments, prices will change faster and more frequently, signifi­ cantly affecting the amount of information the bourse can provide. Five other U.S. exchanges will also partici­ pate in the penny-pricing test.

Several online brokers have· already begun to offer new ways for options traders to participate in penny options pricing. For instance, optionsXpress (w,yw.op­ tionsxpress.com) has introduced penny-increment pric­ ing capabilities on certain options spreads. Options spreads are common strategies that help illYestors bal­ ance risk and reward, and involve bU;y'ing seJ!~l1g a combination of two or more different options at once.

"Tighter prices should bring more opportLmity for more investors and more liquidity, as trades ',\,'illl'equil'e smaller market movements to be successful," says David Kalt, chief executive officer of optionsXp1'2sS Holdings.

Interactive Brokers (,vww.interactivebl'okel's.com) is taking the penny pricing a step further and allowing customers to trade options with each other on most contracts, not just the 13 in the test. Only account-hold­ ers can place trades-but even noncustomers can see what's available, since the exchanges require brokers to make the illlormation publicly available.

IE rolled out its penny options-trading system in mid-October, and it's seen a lot of volume and good liquid­ ity, according to Steve Sanders, managing director. '''I'm excited about this one," he says. "This is one of those things that really changes the industry."

Online Broker News: Fidelity Investments (v."vw.fidel­ ity.com) has unveiled its new Trading Knowledge Cen­ ter, featuring interactive video and charting as ,vell as articles, interviews and video transcripts. Paul Graham, senior vice president of Fidelity's brokerage-products group,. says, "Launching as many products as we've done over the last couple of years, we wanted to consoli­ date them and facilitate interactive learning."

The company's primary goal in rolling out the center is to help customers learn to use the new tools, but also to educate them on trading strategies, and how to em­ ploy them with Fidelity's offerings. Students can prac­ tice what they've learned at the end of each module before applying their new knowledge to their account.

The Trading Knowledge Center is accessible from Fidelity's main page by clicking on Investment Products, then on Trading. On the left side of the Trading page is a table of contents; one of the arrows says "Learn about Trading." After clicking on that, hit "Trading Kno,vledge Center" to launch the application.

"We want to give everyone a scalable, seminar-type environment to learn all these techniques and tools," explains Steve Deroian, director of Fidelity's Active Trader Group.

13 Gadgets We Love

The beautiful, the useful and the downright weird (a supersized Swiss Army knife) made the cut when we went looking for gifts that would warm the heart of a gadget freak this holiday season.

All right we acknowledge that no one can buy the ultimate holiday gadget-that cool, reindeer-borne flying sled that rockets Mr. S. Claus around on Christmas eve. But here's a baker's dozen of zippy items fort he earthbound to cons r at gift-giving time.

Sony TAV-LI



Flat-panel TVs are as hot as can be, with prices all the way up to $14,000 for a Sharp 57-inch model. While most are sleek the also is innova­ tive.lt's an all-in­ ane home the­ ater that, when not in use for TV, looks like a futur­ istic, flat speaker. In that mode, you play CDs by slipping them in the top. But press a button and the speaker panel lowers to reveal a 32-inch high-definition LCD TV. The speakers, now under thescreen, simulate surround-sound for TV and DVDs, eliminating the need for tangles of wires and separate speakers. $2,999, www.sonystyle.com



There's nothing like a portable, satellite navigation de­ vice for the car if you own or lease several vehicles. Though some are cheaper than the Garmin Nuvi 660, few are as user friendly or as attractive. The new model has a larger touch­ screen than a predecessor we viewed early this year, the 350, but it's still small enough to slip in a pocket. It comes with North American maps preloaded (foreign maps can be pur­ chased), as well as voice-guided directions, integrated Blue­ tooth for hands-free calling, an MP3 player and optional traffic congestion warnings.
$964, www.garmin.com



Digital SLR cameras-those with the looks and controls of tradi­ tional cameras-used to be horribly expen­ sive, and some still cost well above $5,000. But prices at the lower end have slid enough so that shutterbugs eager to swap lenses and select shutter and lens settings can trade up. The Canon Digital Rebel XTi is an excellent choice. Its 1 0.1-megapixal sensor captures enough detail for high-quality 18-by-24-inch prints, and most Canon lenses are compatible .•
$800 'with one lens, www.canonusa.com



The slim, brushed-aluminum iPod nano, available in a rainbow of colors, gets all the attention. But for those who crave sheer horsepower, Ap­ ple's new 80-gigbyte standard-sized iPod is the most valuable player. It holds up to 20,000 songs or 100 hours of video. Its batteries stay charged for 20 hours when playing music, and 6.5 hours for videos. That make it a good way to sample the growing selection of full-length featu res available for down­ loading at iTunes.
$349, www.apple.com



The new Jabra BT325 earphones unite two of the defining gadgets of our times-the cellphone and MP3 musIc player. Plug it into an iPod or other player and listen to music. But when a call comes in to your Bluetooth-enabled phone, simply push a button; it mutes the music and connects the Jabras to your phone jabras to your phone no wires needed. When your call ends, the music resumes. One catch: The control unit, which includes a built-in micro­phone, is a bit heavy. Unless you have a shirt pocket, it hangs uncomfortably around belly-button level; the connecting wire is too short to allow it to be stored in a side pocket.
$88.95,www.Jabl.a.com.



The man who has everything probably doesn't have a Wenger Giant Swiss Army Knife, a humongous verision of the familiar utensil, it boasts no fewer than 85 pull-out implements, including pliers, screwdrivers, a hex key. can openers, a watch case opening tool, flashlight and telescopic pointer for presentations. It's shaped more like a brick than a conventional knife, which takes some of the fun out of using its toothpick.
$1,200, www.wengerna.com



Toqay's homes tend to include a complicated cluster of different remotes to control every­ thingfromtheTV, the satellite box, the DVD player and theaudiosystem. Logitech's Harmony division makes what is far and away the best lineof universal remotes, all of which can be programmed, via a PC connection to the Internet, to control any combina­ tion of devices. In other words, it can easily do the job of three or four separate remotes. The newest and best model is the Harmony 1000,which boasts a vibrant 3.5-inch touch-sensitive screen that displays the controls.
$499, www.logitech.com



Americans drink 220 million cups of coffee a year at home. But very few of those cups are as hot as they ought to be. To bring out the full taste, coffee should be brewed with water at 200 degrees, a temperature too high for most machines' plastic components. Enter Technivorm, a little-known Dutch company. Its KBT-741 Coffe maker works at the right temperature and deposits the coffee straight into a thermal carafe, thus also avoiding the burnt flavor that comes from java sitting in a glass container on a hot plate. What we had considered an acceptable cup before was suddenly second-class.
$180, www.boyds.com



The Shun Pro line of kichen knives from Japan's Kershaw uses a proprietary blend of the best high-tech steels, coated with titanium oxide and boron carbide. As a result, the blades will hold their incredibly sharp edge for years. Handles are lightweight, com· fortable and equally strong. Just about every shape and size of kitchen knife that you could want is available, but you pay for the superb quality.
$60 for a 5.5-inch paring knife, $243 fOr an 8-inch Chef's knife , www.kershawknives.com



Squeezing orange juice is often messy and slow, but not if you turn to Breville, a company owned by Australia's Housewares International. It makes the best juicer anywhere, the Citrus Press 800. Made of die-cast stain less steel, this machine combines the traditional pull-down lever with a spinning cone that starts automatically and fits just about any sized orange, lemon or grapefruit. Works brilliantly. Looks gorgeous.
$199, www.breville.com.au



For the truly serious gamer-child or adult-on your shopping list, there's the ultimate personal computer: the Falcon Northwest MachV. Let others choose among Dells, HPs and Apples-these built-to-order machines are the fastest and most powerful available for consumers. Mach Vs come with such nice­ ties as Intel Core 2 Duo Extreme processors,two 750-gigabyte hard drives, screamingly fast video card and, on the outside,aluminum casing with automotive-quality paint in colors and designs of your choice. The Mach V's baby brother, the shoe-box-size FragBox 2, is also worth a look. Both will help anyone in need of speed, but the Mach V is clearly more impres­ sive. Up to $10,OOO for Mach V, $2,248 starting price for FragBox 2, www.falcon-nw.com



Sony's new PlayStation 3 deserves all the attention it's been getting-and it's certainly gotten a lot since its be­ lated introduction last month. Kids love it and, while the price might look steep, this machine is actually a bar­ gain. That's because the gaming console does double duty as a high-definition DVD player, using the increasingly popular Blu-ray standard, which Sony pioneered. Most of the standalone Blu-ray players sold at your friendly electronics store go for about $1,000. For those looking to get the most out oftheir new high-definition televisions, the PlayStation 3 could be the answer.
www.us.playstation.com/ps3



If you live in-or have a relative living in an area prone to hurricanes, having a couple of wind-up flashlights is a must. And the is among the best. The Freeplay Xray LED is among the best. The flashlight a "torch" in the parlance of its British manufacturer, Freeplay Energy, features a light-emitting-diode, rather than a conventional bulb. The Xray comes in a moisture-resistant (but not waterproof) plastic case, in blue or see-through clear plastic-our choice. The wind-up system can be cranked in either direction, and an LED indicator shines when you're at the optimal winding speed. A 3D-second charge pro­ vides 20 minutes of light on normal-intensity setting. The flashlight ineludes an internal battery that, when fully charged with the included power adapter, pro vides 20 hours of light at the normal setting and 3 hours and 20 minutes at the bright setting. There's also the cheaper Sherpa Xray, but it's much less capable and costs a a measly five bucks less. Our advice: Go with the big guy. $34.95, www.freeplayenergy.com

Microsoft's Bold Voyage Begins

Like the embarrassing try at moving the USS Intrepid from its Hudson River dock, previous attempts at launching the new Vista software got stuck in the mud.

ON THURSDAY, MICROSOFT SMASH­ ed champagne bottles on the bows of its two biggest product upgrades ever, with a Times Square press con­ ference celebrating the release of new versions of its monopoly soft­ ware products: the Windows operat­ ing system for PCs and the suite of productivity applications known as Microsoft Office.

Like the embarrassing try at moving the massive USS Intrepid aircraft carrier from its long-time Hudson River clock last month, previous attempts at launching the ne,v Vista version of Windows got stuck in the mud. But now operators will be standing by to take orders from Microsoft's corporate customers. At the press con­ ference, Microsoft offered up several Vista test users, including a medical researcher who essentially said that he didn't care what the product cost because it would help him conquer cancer.

Shares of Microsoft (ticker: MSFT) have risen 35% since June, to 29 on Friday, as investors in the Red­ mond, Wash.-based company anticipated the waves of upgrade revenue likely to come from Vista and Office 2007. Those waves have to be quite tall to lift a company that reported annualized sales of around $45 billion in each of its last few quarters, with cash flow bettering a $15-billion-a-year rate. Now that the shares are valued at about 20 times this year's expected cash flow, some investors remain skeptical that Microsoft can pick up enough speed to skim higher,

But the launch will probably succeed. The compa­ ny's sales campaign to drive software upgrades will be awesome-from the glimpses visible last week. And with operating profit margins already exceeding 60% on Microsoft's Windows and Office products, the upside - profit leverage will be 131'ge if the company persuades enough customers to purchase the premium-priced versions of Vista and Office 2007. The company has conservatively planned on only about 50% of purchasers buying the fancy "Professional Plus" or "Ultimate" versions of the upgrades.

Microsoft is also launching products into new busi­ness markets for the company. These new server­ based products for voice communications and collabo­ rative work could offer tough competition for rivals like Cisco Systems (CSCO). Last of all, Microsoft looks like it could finally start turning a profit on products like the Xbox 360, the videogame platform that could displace Sony's overpriced PlayStation as market leader.

Microsoft already has more- than three bucks a sh31'e in cash. It plans to use up to $40 billion in cash flow to buy back stock. The combination of share buybacks and a rise in cash flow from all these new products could get Microsoft's per-sh31'e cash flow growing at better. than 15%. That could incite Wall Street to push Microsoft stock into the mid-30s.

In an impressive piece of accounting research, Freidman Billings Ramsey hard­ ware analyst Clay Sumner asserted in a report Friday that Dell (DELL) has. been manipulating its earnings by under-accru­ ing for warranty costs. Sumner says his research finds that under-accruals have led EPS.to be overstated by two to eight cents a share in five of the past 12 quarters.

Writes Sumner: "First, it appears that Dell regularly uses warranty accruals to materially manage margins and earnings, rendering the reported results less useful for gauging actual margin trends. Second, as of the last quarter for which a lO-Q is available, the cost of actual claims as a per­ centage of product sales was rising steadily-up 30% [year-aver-year] in [fiscal 2006], reducing cash gross margins by 60 [basis points]-and costs may be heading higher. Third, Dell's warranty disclosure is unusual, possibly unique, making it difficult to identify Dell's warranty accruals using only Dell's SEC filings. For this reason, we believe this information is not in the cons en­ sus, and that restatements of earnings may be coming if this turns out to be one of the issues currently under SEC investigation."

Sumner notes that while Dell's war­ ranty claim rate has been relatively stable, the accrual rate tends to vary widely, "a strong indicator of earnings management." Sumner notes that Dell, like many compa­ nies, "tend to underaccrue when times are tough and over-accrue when business gets better," but that the overall trend since 200:3's third quarter has been toward under­ accrual, and "thus overstatement of gross margins." He says Dell's warranty costs were recently running at 46% of its war­ ranty reserve, up from from 28% in 2003's third quarter, and well above the 26% re­ ported by Hewlett-Packard (HPQ) and the 13% reported by EMC (EMC).

Sumner says that Dell's reserve should be higher than HP's, since 85% of Dell's PC customers are corporate buyers, who tend to get three-year warranties, while HP's customer base is 80% consumers, who gen­ erally get one-year warranties. He thinks EMC is more comparable than HP in this case; he notes that EMC is essentialy re­ served for about 23 months of warranty expenses, versus 6.5 month for Dell.

Warranty reserves aren't simply a wise form of insurance against future claims; they are mandated by FASB accounting guidelines.

Sumner also contends that Dell has a confusing approach to disclosing its war­ ranty costs, lumping together both stan­ dard warranties-the kind that come with every PC at no extra charge-and ex­ tended warranties, for which customers pay extra. The two kinds of warranties are accounted for differently: Costs for stan­ dard warranties are expensed up front, while for extended warranties they are spread our ratably over time, like a service contract. "If one doesn't know how large Dell's extended warranty business is, it looks like Dell has a huge reserve for stan­ dard warranties, and hugely conservative standard warranty accruals, while pre­ cisely the opposite is true," he maintains.

Sumner concludes that earnings restate­ ments could be coming if this turns out to an issue in the current SEC investigation of Dell's accounting. As for Dell shares, he doesn't recommend them.

- Eric .T. Savitz

The Secrets of Good Giving

WILLIAM H, GATES SR, CELEBRATED HIS 81ST BIRTHDAY Thm'sday by telling an audience of heavy-hitting philan­ thropists, nonprofit executives and private bankers that idolizing the super-wealthy as supremely talented or intel­ ligent is nothing more than "unadulterated nonsense."




Coming from the father of the wealthiest citizen of them all,' Microsoft founder and multibillionaire Bill Gates, that might sound more than a little disingenu­ ous. But the elder Gates, who serves as co-chairman of the Bill & Melinda Gates Foundation, was making a point: Om home-grown billionaires "are rich ... because they are Americans," he declared American society, offering citizens everything from funding for techno­ logical development to· the rule of law, "made their comfortable lives possible." The clear message:

Wealthy Americans have not only the means but the obligation to help others, and in a big way.

Judging from the applause that rang through the rotunda of New York's Guggenheim Museum, his call to action fell on receptive ears. But the gathering, organized by Morgan Stanley and including donors with collective giving power of $60. billion, also under­ scored the questions and challenges faced by big phi­ lanthropists today. For starters, should their founda­ tions last forever or spend down all their assets within a defined period in order to have the biggest impact on urgent problems? Gates Sr., the keynote speaker, came down firmly in the latter camp, disclos­ ing that the Gates Foundation will spend all of its assets within 50 years of the death of its last trustee.

One of the most controversial questions was raised during a panel discussion and continued to be debated among small groups during a gourmet lunch: What type of cause most merits support'? What, the attend­ ees wondered, is the appropriate weight to give to funding for the arts and other "quality of life" causes in a world where a sixth of the population is teetering on the brink of survival? One audience member argued his personal approach was about addressing human pain and suffering rather than spreading joy-but the response from panelists was mixed. "It's not my belief that you start [your philanthropic giving] purely with the greatest amount of suffering," argued William Ran­ dolph Hearst III, president of the William Randolph Hearst Foundation.

William G. Bowen, former president of the Andrew W. Mellon Foundation and former president of Prince ton University, pointed out that funding he oversaw for budding opera singers in Cape Town killed two birds with a single stone. It opened new career op­ tions for recipients and helped those who, under the apartheid regime, were discriminated against and could not have pmsued this kind of opportunity.

Columbia University's Jeffrey Sachs, author of the influential The End of Poverty, summed up his view bluntly: "All of you have the capacity to save thou­ sands of lives, perhaps even millions of lives," he said. looking around his audience. Crop yields in Mril'a continue to languish at about a third of the level they could reach, he says, while two million children die each year fo1' lack of $5 anti-malaria bed nets. "We are leaving people to die for no reason."

Despite the disagreements, some general rules-of· the-road for effective giving emerged from the discus­ sions:

Rule 1: Choose your causes carefully. "Something r did at Mellon was to kill off things we didn't have enough knowledge to do," Bowen said. Scattershot gifts aren't helpful, he argued. Nor, said Rita Eo Hausel; a lawyer and president of the Hauser Founda­ tion, are donors who aren't informed about or passionate about the causes they support.

Rule 2: Donors have power-and should be prepared to use it. "They don't put you on the board of the local museum because they like your blue eyesl" said Hauser, referring to expectations that board meri/­ bel'S make large gifts. But board members certainty can say how their gifts should be used,and organizations will likely be willing to accommodate those preferences.

Rule 3: Keep an open mind. Hearst said the found~­ tion started by his grandfather keeps a small part of i annual giving budget for what he calls "strange" phil a ­ thropy: oddball ideas that are high-risk, but that m­ end up transforming the world. Keeping an open mil also means being flexible about the kind of accountah ­ ity you demand from a nonprofit organization. "In the nonprofit world, there are 10 different kinds of bottom lines" Hearst said. "If I'm not willing plan for failure, then I'm not doing it right."

Rule 4: Two can be strong~' than one. "No problem can l~ solved by anyone solo," sar-' Sachs. Philanthropists can bal together, whether on a project-by­ project basis or in a more compr¢­ hensive way, as Warren Buffett has done in structuring his relationship with the Gates Foundation. William Gates Sr. said he wouldn't rule out the foundation accepting other significant grants from philanthropists in the future, assuming that their inter­ ests tied in with the foundation's mission.

But, be careful who you invite to join you in your mission. Sachs cautioned that private donors can be more agile and creative than "lumbering" organizatio~s like the World Bank. "I wouldn't give them the fil'$t call," he said.

Giving money away, as any serious philanthropist will tell you, is every bit as hard as making it. Maybe even
harder. _

The New IBM

Cover Story
IBM shareholders have been blue for the past few years, as the tech giant's stock has stalled. But they'll be smiling again. Big Blue's new strategy is working.



A quiet revolution is under way at International Business Marchines, and it's being led by an unlikely revolutionary:Chief Executive Samuel Palmisano, an IBM lifer who few though would so radically depart from the blueprint drawn by his predecessor, Louis Gerstner, when he took the reins at Big Blue in March 2002.

In its most recent querter, software accounted for a fifth of IBM's revenue and surprisingly for the bulk of its eraning-some 40%, up from 29% five years ago. Under Palmisano, IBM is reinventing itself again. It's shed its disk-drive and personal-computer business to focus on less volatile operations with fatter margins, and has boosted productivity by slashing costs and spreading facilities around the globe.

Welcome to the New Big Blue, the world's second-largest software company-quite a change from the hardware giant that invented the disk drive 50 years ago and lived high on the mainframe, or the service outfit it successfully morphed into under Gerstner-one whose revenues had stalled in recent years. "We have globelly integrated the supply chain, software development, services delivery," says Palmisano. "I would say we're just two or three years into a multi-year journey, with ongoing productivity gains to be had. As a result of all this work, IBM today is much more focused than we were-four years ago."

This year, IBM's revenues are expected to clock in at $90.7 billion versus $91.1 billion last year and $96.3 billion in 2004, when it had the PC operation, which was sold to China's Lenovo last year. Earnings are expected to grow 12%, to $5.98 a share, from $5.32 last year, and then by an­ other 9%, to $6.54 in '07. There are also signs of an incipi­ ent revival in the services division, whose top-line growth has failed to hit the Armonk, N.Y.-based company's 6%-to-8% annual target. (Last year, services accounted for 53% of IBM's revenue; hardware and financing, 27%, and software, 20%.)



But Big Blue's stock (ticker: IBM) hasn't kept pace. IBM's largest shareholders are mostly index funds that must own the shares to meet their investment mandate. The roster of bulls on the stock has shrunk since the hon'ible first quarter of 2005, when the company badly missed earnings forecasts, O\ving to weakness in Europe and slower-than-expected service­ contract signings. The bad news clobbered IBM share­ holders, wiping out more than $11 billion of stock-mar­ ket value overnight.

Today, even after a hearty rebound from its sum­ mer low of 72.73, IBM trades at 15 times earnings, for a ~arket cap of $137 billion. Compare that with 25 times for storage king EMC (EMC), 23 for PC behe­ moth Dell (DELL), and 20 for Microsoft (MSFT) -the only software company larger than IBM. Grat­ ingly for IBM, Hewlett·Packard (HPQ) will become America's largest tech company this year, with an estimated $97 billion in sales. IBM shares are well below their 2002 high of $126, . reached just before Palmisano took the helm.

There's no dearth of disbelievers. "IBM is in a long­ term decline, and now they're talking about being a soft­ ware company. This is my problem: They're still a massive services company," says Fred Hickey, editor ofthe High­ TechStrategist newsletter. "And buying back shares, gen­ erating 'other income' and enforcing patents is not, to my mind, a good long-term story."

Palmisano and his lieutenants aim to change that perception, in part by emphasizing strong profits, even in an environment where infonnation-technology spending growth has slwnped to single digits. The plan is to sell corporate "solutions" that integrate offerings from all three of IBM's massive product lines. They're aiming for double-digit per-share earn­ ings growth: five to six percentage points from reve­ nue growth (from acquisitions and existing opera­ tions); three to fow' points from productivity gains, and two points from share repurchases, fueled by the consistent growth of cash.

IBM has $10 billion in the till, and that's allowed it to sharply boost its dividend each year while indulging in a blizzard· of software acquisitions over the past couple of years and making more speculative investments, includ­ ing an ownership· stake in China's Guangdong Development Bank through a Citigroup consortium last month.

IBM today is "a high-torque engine," says Palmis­ ano, who answered Barron:~ questions bye-mail be­ tween business trips to China and Europe. Higher-mar­ gin businesses and lower costs "allow us to generate significant profit earnings and cash flow, even in this more moderate growth environment. Simply put, we generate more profit from every dollar of revenue than most of om" competitors .... Some people say that IBM is a services-led company. That's wrong."

Key to the growth strategy is software. A decade ago, IBM's software was just the stuff that ran on its main­ frames. IBM dumped that business under Gerstner, in­ stead pursuing "middleware" - software that connects complex applications or systems at big corporations, let­ ting them exchange data, or allowing new applications to link to older legacy systems and multiple applications to create larger ones.

Middleware operates on non-IBM computers, too, and lets IBM team up with vendors such as GerITIa­ ny's SAP (SAP). Today, IBM is the world's largest middleware vendor. Last year, about half of its soft­ ware revenue of $15.8 billion came from middleware sold under the WebSphere, Lotus, Tivoli, Rational and DB2 brands; And the company's legacy software busi­ nesses, which sell programs such as the operating systems for IBM mainframes and servers, don't blow anyone's doors off, but they're big money makers.

Middleware is a key element in IBM's strategy of selling "solutions" to corporatiens to help them integrate their husinessefo\.

IBM's gross profit margin for software in the third quarter was 85%-nearly triple that on services. And its pretax margin on software is expected to clock in at 31.3% this year, up from 22.8% in '01.

If that level is indeed reached, it should command a higher stock-market valuation. Just ask Banc of America Securities' Keith Bachman, who wrote re­ cently: "Software will increasingly become a key cata­ lyst for the stock as it becomes a higher percentage of IBM's revenues, led by its acquisitions and solid organic growth in key branded middleware. Ulti­ mately, as software grows as a percentage of revenues and profits, we believe that investors will gradually afford IBM a higher multiple."

The vision now? ·To make the services division look more like software. Obviously, increased software sales will bring commensurate service contracts; a sale of a computer program is often accompanied by a service contract that could be five times as large. But IBM wants to transform services altogether.

Middleware is the software that helps companies ap­ ply what is called "Service Oriented Architecture." SOA has become a buzzword for the growing trend through­ out the IT industry to make computer systems more flexible and adaptable to changing business needs.

IBM's SOA custOlners can even purchase "service products," just as they can buy hardware and software. Example: Computer security involves a variety of time­ consuming processes around identity management, net­ work monitoring, distributing and installing patches, fixes and the like. Lots of these traditional, time-consuln­ ing and labor-intensive tasks can be automated. Further more, the software that replaces labor can be used re­ peatedly, at much lower cost than having the same tasks done manually, and is clearly mor~ profitable than selling labor. HDFC Bank, India's second-largest financial institution, chose IBM -not an Indian company-for a software project to identify new business opportunities by monitoring customer feedback from e-mails and phone calls.

Right now, IBM sells more than three times as much in SOA product" and services as anyone else. It has 46% of a market that is expected to jump to $34 billion by 2010 from $8.6 billion now. Sales of IBM's WebSphere software, a major component of SOA solutions, grew 30% in the third quarter.

IBM is also making inroads in another service-like soft­ ware area, the market for information on demand, which the company thinks could reach $69 billion in the next three years. (It doesn't break out current revenues from this area.) One example is the Crime Information Ware­ house, an organization that stitches together hundreds of databases with information about crime patterns and po­ tential suspects and their addresses, and uses satellite im­ aging and mapping of cities by precinct to make informa­ tion available to detectives speeding to crime scenes. A big customer: the New York City Police Department.

IBM argues that packaging software and services can dramatically change the growth and profit potential of its service business. Says Steve Mills, head of IBM's software division: "My business model is a very attrac­ tive one, but it's based on delivering licenses to custom­ ers. In a labor-centric business, you'd like to have a lot of customers, but you're limited by the amount of labor. If you carry the assets through, the benefits begin at the bottom line. You have certainty of outcome and the abil­ ity to execute with greater speed, helping ensure greater profitability. Does it have a top-line contributory effect? Yes, if you pick up the pace."

Acquiring the software expertise is key.
Since Palmisano took over, IBM has bought 51 compa­ nies, 31 of them in software, for $11.5 billion. The acquisi­ tions center on SOA, information on demand or service management-managing a client's computers and inter­ nal business services. In recent months, it purchased In­ ternet Security Services, a software-based computer secu­ rity ·outfit; File Net, an information-on-demand service, and MRO Software, a service-management specialist.

IBM generally buys a dozen companies a year, and Mills & Co. look at many others. Big Blue is also an active venture-capital investor.

For all that critics carp at the small size of IBM's acqui­ sitions, the deals have filled technology gaps and given the company a foothold in emerging markets. They've been re­ markably successful, partly because many companies are already writing software for IBM hardware or are famil­ iarwith IBM's services division and because, once the com­ panies are acquired, IBM's sales force and consulting-and­ services division have new reasons to call on customers to introduce their latest products. From 2002 through 2004, Big Blue completed 24 acquisitions priced below $500 mil­ lion, two-thirds of which were software vendors. On aver­ age, revenue grew 25% a year at these new units, and the deals were accretive in the second year af­ ter they closed. The pretax margin went from minus 6% in the first year to plus 12% in the third.

After a disastrous first-quarter performance in 2005, IBM radically restructured its service unit, splitting it into two parts and shaking up its management. The changes are beginning to pay off, although the operation still is not performing as well as Wall Street would like it to.

Clearly, software could overtake ser­ vices as the largest part of IBM soon. Mills won't say when, but he's trying to boost software revenue by 6%-to-9% a year, which he figures results in 10%-12% earnings growth.

Still, much depends on the perform­ ance of the service division, which ac­ counts for more than half of IBM's reve­ nue, but is growing at just 3%, well be­ low the target of 6%. Signs of revival have emerged: Contract signings have bounced off a four-year low, but in the third quarter still were 5.4% below the $11 billion year-earlier level because of deals that didn't close. In a recent re­ port, Cowen & Co. pointed out that IBM's $109 billion order backlog is 10% below its peak, which was hit in 2004, and has been flat for eight quarters, while growth has lagged its rivals.

Blame competition: In a stagnant mar­ ket, IBM has heen attacked by tlw likes 01' Ae('('nt.ure (ACN), the former Andpl'­ sen (~onsulting, and HP, and is battling Indian rivals, such as Infosys Technolo­ gies (INFY), Wipro Technologies, a Wipro Ltd. (WIT) unit and Tata Consul­ tancy (TCS.Mumbai), which provide ser­ vices at lower cost and without any bias toward IBM products.

The Indians are moving into lucrative consulting contracts. And even though sal­ aries and attrition.rates are rising on the subcontinent, they're still five times cheaper than in the U.S. Tata Consultan­ cy's revenue surged 42% in the Septem­ ber quarter. Says Rusi Brij, CEO of Mum­ bai-based Hexaware Technologies (HEXWMumbai), which provides IT and process outsourcing: "IBM and Accen­ ture will not bill for less than $150 an hour on PeopleSoft [enterprise programs]. We do it for $80 to $90."

Indian businesses are likely to keep gaining share. And in the next couple of years, some $110 billion in outsourcing deals will be up for renewal, according to Technology Partners International. Says Pip Coburn, the well-regarded technol­ ogy strategist who steers Coburn Ven­ tures: "Services is too big to grow effec­ tively. It's slow growth, managed excep­ tionally well, but I doubt we'll ever see a meaningfully larger multiple."

However, after the disastrous first­ quarter performance in 2005, IBM radi­ cally restructured the service unit, split­ ting it into two parts and shaking up its management. The first unit, led by Mike Daniels, works on technology infrastruc­ ture, data outsourcing, business process outsom'cing and business-transformation outsourcing. The second, headed by Ginni Rometty, focuses on global business ser­ vices and consulting. (IBM bought Price­ waterhouseCoopers consulting in 2002.)

And IBM is taking the fight to the sub­ continent itself. Last summer, it held an analysts' meeting in Bangalore, attended by a score of senior executives, including Palmisano and Bob Moffat, whose mission is to cut costs from IBM's suppliers and to boost productivity. Big Blue plans to invest $6 billion in India over the next few years.

While IBM has de-emphasized hardware over the years, it still is one of Big Blue's cash cows. The company is No. 1 in one of the hottest sectors: blade servers.



In 2004, it bought outsourcing outfit l>ak,dl, allli is I'llmored to he hunting for an­ other Indian firm. Today, it has 4:1,000 em­ ployees in India, but itl' capabilitiel' are glo­ bal. Moffat points out that, when the lion­ ized Indian actor Rajkumar died on April 12, sparking riots, IBM's broad reach let it shift data-center operations to Brazil and Colorado. And, he says, India is only one of the places where IBM will profit: "I can tell you five other centers with lower costs, in­ cluding Vietnam and China."

Today, IBM says, shorter-term sign­ ings are improving. Service-oriented ar­ chitecture sales are generating big con­ tracts. Indeed, IBM's service operation is the software division's second-largest sales channel. Daniels says the company is focusing on gaining business from firms that want to outsource depart­ ments other than IT, including finance,

procurement, human resources and call centers.IBM is also walking away from insufficiently profitable contracts.

The services operation, he adds, has had "nine consecutive quarters of margin expansion," even as top- line growth has been sluggish. Offshore sites go a long way to reducing costs. For a labor-based service contract. the gross margin is about 40%. For a software-based security service package, the figure can top 60%.

Daniels says the company's target of 6% top-line growth is "very realistic." IBM il' focusing at last on smaller- and medium-size businesses in the developed and emerging worlds, which don't need the giant multi-year contracts associated with Fortune 500 clientl'.

This quarter, contract growth il' healthy: IBM won a $300 million contract to help revamp Scotland's public health ser­ vice, a seven-year $863 million deal to run a data center for the State of Texas, and is ex­ pected, with Siemens (S1), to sign by year end a lO-year contract worth €6.5 billion ($8.45 billion) to modernize technology for the German military.

Says Daniels: "All the things I de­ l'cribed to you are necessary to take us from $50 billion to the next $50 billion. The service business had to be revital­ ized. We've responded boldly and we're focused on markets with significant growth opportunities."

Meanwhile, the cash-cow hardwaredivi­ sion keeps ticking, with growth in the third quarter spm·ting by 8.8%, versus 5% in 2005, as mainframe revenue shot higher and because of gains in IBM's Technology Collaboration operation. Mainframes and servers account for 60% of hardware sales, and IBM has been gaining share in recent years in the server market from Sun Mi­ crosystems (SUNW), HP and others. Margins have fattened after IBM dumped the PC business.

Technology Collaboration is IBM's R&D and semiconductor-design unit. Through it, IBM partners with variow; in­ dustries and has even allowed its partners to build on once-secret IBM patents. (IBM spends about $6 billion annually on R&D and boasts 40,000 patents worldwide.) IBM processors are the core chips in all the major videogame consoles, including Sony's new PlayStation 3. Bob Djurdjevic of Annex Research in Scottsdale, Ariz., a long-time IBM watcher, predicts that Tech­ nology Collaboration "will become so large that it deserves comparison to IBM's shift to services several years ago."

Even if you don't buy the entire IBM turnaround story, the company's "tack needs only part of it to work to show significant improvement.

Thanks to divestments and the move to more annuity-like revenues, "IBM has certainly become a more stable and more predictable company. That would argue for a higher-than-historical multiple," says A.M. Sacconaghi, Sanford C. Bem­ stein's technology analyst. In the past cou­ ple of years, IBM has generally bounced between the low 80s and high HO". Histori­ cally, it has traded at a market multiple. Give the shares a market multiple on next year's earnings, and you get a price of $105-15.7 times Sacconaghi'" estimate of $6.70 a share for '07. That's about 15% above its recent price of 91.

In fact, Sacconaghi maintains, IBM "is even cheaper than it appears" because earnings this year are being depressed by an unusually large pension-related cost of 86 cents a share. That should moderate because IBM is ending its defined-benefit programs, as of 2008, and moving to de­ fined-contribution 401(k) plans.

IBM could boost its share price by exit­ ing the capital-intensive, cyclical chip busi­ ness, Sacconaghi says.

Another bull on the stock is David Go­ erz, chief investment officer at HighMark Capital Management. "Looking out into '07 and particularly into '08, consulting services should do particularly well," he says. "IBM is remaking itself and the question is whether it deserves to be reratedat some point. Right now, I'm will­ ing to give them the benefit of the doubt. They should grow faster than the market. This isa good long-term investment that will benefit from a stronger cyclical economy. The stock is an outperformer by at least 10% to 15% over the market."

The market's disdain for IBM shares dismays Palmisano. "We have a top share in servers and Linux, NO.1 in blade serv­ ers, which is a huge growth area-ana­ lysts say the worldwide blade market can grow from $2.2 billion in 2005 to more than $11.2 billion by 2010- NO.1 in supercom­ puting, NO.1 in SOA, where the bluning of software and services is evident. We're NO .1 in middleware." And he declares:
"IBM is a stronger company today than it was four years ago, with stronger margins, solid cash and earnings."

You don't need a computer to know what that trend could do for IBM's shares._

At Duke, a Powerful Idea

Breaking up is easy to do when you unlock shareholder value. That's the animating notion behind Duke Energy's pending spinoff of its natural-gas-distribution assets into a new company, Spectra. Why the sum of the parts is worth more than the whole.

UNDAUNTED BY THIS YEAR'S MEGA-MERGER WITH fellow power producer Cinergy, Duke Energy already is plotting another transformative transaction: the spinoff in early January of its natural-gas opera­ tions into a new, publicly traded entity called Spectra Energy. Next week Duke executives are expected to hit the road to talk up the plan, and investors ought to listen.

Designed tounlockvalue, the spinoff is likely to render both companies worth more-in time, perhaps, much more­ than the consolidated whole. Based on valuations of similar utilities and pipe­ line concerns, Nathan ,Judge, an analyst at Atlantic Research in London, wagers it could produce about $37 a share of value,. some 17% above Duke's current share price of 31.50. "There are catalysts to release this value," he says. "Gas and field-transmission assets will be revalued upward as they deliver accelerated growth."

Judge Jigures Charlotte, N.C.-based Duke (ticker: DUK), one of the country's five largest electrics, could command a price of $23.60 a share as a standalone company, assuming it trades at a peer­ groupaverage of8.4 times Ebitda (earnings before inter­ est, taxes, depreciation. and amortization.) Spectra (SE), one ofthe nation's largest pipeline utilities, could trade for
$16.45, he says.

Viewed another way, investors who own Duke at to­ day's price theoretically will get stock in Spectra for only $8 or so per share. Duke holders are expected to receive one Spectra share for every two shares of Duke common.

John Bartlett, a utilities analyst with w.H. Reaves in Jersey City, N.J., calls an investment in Duke's stock "an excellent way to capitalize on both the need for new en­ ergy infrastructure and the potential for a higher valua­ tion as the market recognizes the strength of the underly­ ingutility business." Reaves Utility Income Fund (UTG) owned 1.95 million of Duke's 1.25 billion shares out..'ltand­ ing as of July 31.

This year, Duke is expected to earn $2 billion, or $1.81 a share, on revenue of$15.4 billion. In 2007, Bartlett expects the utility to earn $1.20 a share, and Spectra $1.45. Com­ bined, the companies will continue to payout $1.28 a share, for a yield of 4.10% based on Duke's current price.



The Duke/Spectra spinoff is the brainchild of Duke Chairman Paul Anderson, 61, a no-nonsense executive and motorcycle enthusiast who joined the company through its merger with PanEnergy in 1997. He left to help resuscitate Australian natm'al-resources giant BHP Billiton, only to return in 2003, at Duke's darkest hour, when the company was reeling from an ill-starred foray into merchant power. Hailed at the time for refusing to cut the dividend, he calls Duke's makeover a "labor of love."

For the past year or so, Duke has traded for 16-17 times 2006 estimates, roughly in line with other utilities. Ander­ son, who will become non-executive chairman of Spectra, believes the utility wasn't getting "fuil value" for its gas as­ sets, which include 17,500 miles of pipeline. "The market places more value on pm'e plays than on energy super­ stores," he says. "Pure-play businesses create a kind of gTanularity that increases management's focus, and are easier for investors to understand."

In addition, the two businesses trade differently, gas companies for multiples of cash flow and electrics for multi. pIes of earnings. Gas concerns command richer valua­ tions, in part because they make use of master limited part­ nerships, which allow them to pass through cash to inves­ tors on a tax-free basis. The average pipeline company trades for 10.9 times 2007 Ebitda, well above the 7 times Atlantic's Judge assigns to Spectra.

Spectra has underappreciated assets it could shel­ ter in MLPs, and fewer regulatory hurdles than elec­ tric utilities. (Pipeline outfits are regulated by Washing­ ton, but not by state and local governments.) With a spin-off, says Fred Fowler, 60, head of Duke's gas prop­ erties and the future CEO of Spectra, "you end up with an investor base that understands and appreciates such vehicles better than the typical utility investor."

Fowler also sees "an unusual number of expansion op­ portunities" for Spectra, due to underinvestment in pipe­ lines and storage, and rising demand. In the Northeast, for example, gas usage until recently was highly seasonal and consumer-driven. Soon, utilities will demand a steadier supply, owing to renewed gas-fired generation.

To be sure, the success of Duke's spinoff will depend as much on the continued growth of its electric arm, run by former Cinergy CEO James E. Rogers, 59. The utility, which primarily serves five states, should continue to en­ joy good relations with its customer base, and see high-sin­ gle-digit earnings gains.



Rogers has 2.2 million reasons for making the deal work, while Anderson has 1.4 million an&Fowler 1.2 mil­ . lion. That's the number of Duke shares owned by each. If all goes according to plan, the value of their holdings­ and all Duke investors'-will surge. _

Tracking the Smartest Money

Appaloosa, Greenlight, Lone Pine, ESL Investment and Icahn Partners are five of the hottest hedge-fund firms around. Other managers, hoping to gain an edge, keep close tabs on what they're buying and selling. Here's what they own now.

IN THE INVESTMENT BUSINESS, THERE ARE LEADERS and followers. Certain top-notch money managers are closely watched -and often imitated by their peers. This is particularly true in the hedge-fund industry, where thousands of managers need to keep generating good returns or risk losing their in­ vestors and their jobs.

Who matters? Based on discussions v,ith many institutional investors, we've identified five well-re­ garded hedge funds whose investment moves are closely scrutinized. These leaders are Appaloosa Management, run by David Tepper; Greenlight Capital, managed by David Einhorn; Lone Pine Capital, run by Steve Mandel; ESL Investment Management, run by Ed Lampert, and Iealm Partners, managed by Carl Icahn.

The table below shows the five managers' tnree largest holdings on Sept. 30, as well as" one sizable purchase and one sale in the three months ended Sept. 30. (Some portfolio buys and sales reflect changes to existing positions.) These investments and transactions offer a glimpse of what the smart money is doing. The managers' holdings include some well-known names such as Time Warner (ticker: TWX) and Oracle (ORCL), as well as Ameriprise Fi· nancial (AMP), Sears Holdings (SHLD) and Brook­ field Asset Management (BAM).

In the. past two weeks, institutional investors in search of investment ideas have been poring over the third-quar­ ter holdings of these and other managers with strong stock-picking skills. Other closely watched hedge funds in­ clude Blue Ridge Capital, Atticus Capital, Perry Capi­ tal, Caxton Associates, Maverick Capital, Tontine Management, Highfields Capital and Alson Capital. In the mutual-fund industry, other managers watch Bill Miller of Legg Mason; Southeastern Asset Management's Staley Cates and Mason Hawkins, and Dodge & Cox, led by John Gunn. .

Institutional investors must disclose their U.S. equity holdings in a regulatory filing called a 13- F report within 45 days of the end of a quarter. Most managers submit their 13-Fs as late as possible because they don't want to tip off rivals about what they're doing. The September figures became available in mid-November.

Our table has its limits. The information now is two :;,omhs old, and it's possible the managers listed have scslecl back or sold certain stocks that they held on Sept 30. We've tried to lower the chances of that by focusing on managers with low to moderate turnover and rela tively concentrated portfolios.

Another caveat: The trend toward hedge funds investing in stocks held by other hedge funds has intensified in recent years, prompting some managers to avom stocks held by too many funds. The fear is that these stocks, known in the business as hedge­ fund hotels, could be vulnerable to shatp declines if bad company news prompts many managers to sell. Goldman Sachs publishes a widely followed quarterly report analyzing which stocks are favored and shunned by hedge funds.

By looking at the top holdings of some top man­ agers, investors can put together a best-ideas portfo­ lio without paying management fees. Most of the larg­ est and best-run hedge funds are closed to new inves­ tors, and ewn if they were to open their doors, fees can be steep. Hedge funds generally cmTY base man­ agement fees of at least one percentage point and typically take 20% or more of profits.

Yet an investment strategy that borrows the best ideas of some top hedge funds may not come close to matching the funds' retmns because of a small sample size and the timing of trades. Hedge funds also make investments that don't show up in qum'terly filings, such as purchases of bonds and foreign equities, and short sales of stocks.

Many equity-oriented hedge funds engage in short selling in an effort to deliver positive retmns in both rising and falling markets, thereby justifying their incen­ tive-fee structure. Short selling generally is a tougher way to make money, however, because of the market's upward bias and the danger of "squeezes," or trading by others aimed at forcing up the prices of stocks that are popular with "shorts." Reflecting these difficulties, some hedge-fund operators have begun long-only funds.

The $4 billion Appaloosa fund built its reputation as one of the best investors in the debt of financially dis­ tressed companies, but the fund's strong returns in the past two years are the result of David Tepper's underap­ preciated stock~picking skills.



In 2005, Appaloosa did well with resource stocks, and this year it has scored with technology shares, including Oracle, Cisco Systems (CSCO) and Microsoft (MSFT). Both Oracle, Appaloosa's top equity holding, and Cisco have risen more than 50% jn 2006. The Appaloosa fund recently was up about 25% year-to-date.

On Sept. 30, Appaloosa held other tech issues, includ­ ing Micron Technology (MU), Applied Materials (AMAT) and Texas Instruments (TXN). Its largest holding was the Nas­ daq 100 Trust Shares (QQQQ), an ex­ change-traded fund dominated by tech stocks.

Last w:ek Tepper said the Nasdaq 100 index, now at 1760, isn't as cheap as it was in the summer at 1450. "There'snoth­ ing to jump up and down about," Tepper said, though he noted "equities are as good as any other asset class now."

Oracle, at 19, isn't the bargain it was in January, at 12, and the same is true of Cisco, which has rallied to 27 from 19. Appaloosa also has scored with airline stocks AMR (MIR), UAL (DADA) and Continental (CAL), all bought in the third quarter.

Einhorn is known as an astute stock­ picker and a patient investor. His Green­ light fund has generated annual returns of 27% since its founding a decade ago; through November, it was up 23% year-to­ date. Einhorn declined to comment.

Spinoffs have long been a fruitful area for investors, and Einhorn has done well with them. The fund's largest holding, Freescale Semiconductor, a Motorola castoff, was bought Friday for $40 a share in a $17 billion leveraged buyout, the largest ever in the tech sector. Free­ scale accounted for 30% of Greenlight's equity holdings on Sept. 30, and rose 58% this year before going private.

On Sept. 30, Greenlight's other top holdings were Ameriprise Financial, Mi­ crosoft and Hog: pira (HSP). Ameriprise was a 2005 spinoff fi'om American Ex­ press (AJtP) and Hospira came out of Abbott Labora­ tories (ABT). With the Freescale sale, Einhorn will have a lot of new money to invest, and his fans will be looking closely at his fourth-quarter filing.

At a New York charity lunch in May, Einhorn talked about his affinity for Mi­ crosoft; He made a fantasy baseball anal­ ogy, saying that buying Microsoft, then trading at 23, was like getting Alex Rod­ riguez, the New York Yankees star, for a merely average price in a fantasy-base­ ball draft. Microsoft is now at 29.

Steve Mandel is another stockpicker other hedge-fund managers watch. His $8 billion Lone Pine Capital fund has a strong record over eight years, returning about 25% annually. Through November, it was up about 11 % year-to-date.

Mandel's reputation has been en­ hanced ",rith scores in Google (GOOG) and Apple Computer (AAPL) in the past few years. Google was Lone Pine's second-largest holding at the end of the third quarter, but Mandel cut the firm's position by nearly 25% in the period, to 1.1 million shares from 1.46 million, after reducing the position by almost 500,DOO shares in the second quarter. This suggests Goo­ gle may be getting too rich for Man­ del, who declined to comment.

Lone Pine added to its holdings in Corneast (CMCSA) and Qualcornrn (QCOM) in the third quarter while establishing a position in Schlumberger (SLB). The fund was a seller of Re­ search in Motion (RIMM) and Amer­ ica ModI (AMX) in the quarter.

Ed Lampert's success and wealth have made him the Warren Buffett of the hedge-fund industry. Lampert is both an investor and corporate strate­ gist, having played a key role in engi­ neering the turnaround of the formerly bankrupt and seemingly hopeless Kmart and then orchestrating a win­ ning merger with Sears Roebuck.

His ESL Investment owns over 40% of Sears Holdings, worth $10.3 billion. Sears Holdings, at 170, is up ten-fold in the three years since Kmart emerged from bankruptcy. In. the Kmart/Sears merger, Kmart stock was the cmrency for the deal.

Lampert, Sears' chairman, is a re­ tailing maverick who stresses profit­ ability, not grmvth. He feels many re-, tailel~s focus too much expanding their store bases rather than maximizing profits from existing locations. This is a controversial strategy that worked at another ESL holding, AutoZone (AZO). Lampert has been \villing to harvest profits at Sears and Kmart and tolerate declining sales.

Lampert, who idolizes Buffett, has developed a cult following. Many hedge­ fund managers own Sears because they admire his retailing skills and view the company as a vehicle for Lampert to make acquisitions. Lampert does little trading, and ESL's equity portfolio at the end of the third quarter consisted of just three stocks: Sears Holdings, Auto­ Zone and AutoNation (AN). With Sears up almost 50% this year and con­ stituting nearly 75% of ESL's portfolio, Lampert's fund could be up about 40% before fees. The feIDd's pelformance isn't available.

When Carl kahn started Icahn Part­ ners two years ago, some wondered why, then at age 68, he wanted to .manage other people's money when he already had so much or his own ~ he's worth more than $10 billion. He since has emerged as one of the leading activist investors, and his hedge fund is up about 30% year-to-date.

Icahn doesn't think much of the man­ agement of many U.S. companies, and through his hedge fund has taken posi­ tions in some he views as managed partic­ ularly poorly, where he presses for change. He's done that with KelT-Mc­ Gee, Time Warner, Blockbuster (BBI) and ImClone Systems (IMCL).

Icahn scored with Kerr-McGee, tak­ ing a position in the energy producer in 2005. He urged management to break up the company, which it did by spinning off its chemical operations. Earlier this year it was sold to Anadarko Petroleum (APC) for a substantial premium.

Icahn unsuccessfully took on the man­ agement of Time Warner, which rejected his proposal for a spinoff of its cable divi­ sion. His largest holding, it's up 16% this year.

Following the investment moves of Icahn and other notable hedge-flmd man­ agers may not be an original strategy. But it could prove profitable if these in­ vestors retain their touch.

By Andrew Bary

Static - Free TV

DIRECTV GROUP HAS RALLIED MORE than 60% this year, to 23, amid talk the satellite operator might merge with rival EchoStar Communications (ticker:

DISH), or find itself the subject of an asset swap between 38% holder News Corp. (NWS) and Liberty Media (LINTA). De­ spite the run~up, it may be too soon to sell the shares (ticker: DTV), as the company continues to generate cash and post higher earnings, much as we predicted last year ("Beam Me Up," April 11, 2005).

Indeed, DirecTV has generated about $1 billion of free cash flow before interest and taxes this year, doubling last year's output, and analysts expect earnings per share to jump 21% next year, to $1.31.

In the third quarter, DirecTV's cus­ tomer churn rate was a higher-than-ex­ pected 1.8%, and the company added fewer new subscribers than expected. But it was able to boost its percentage of higher-qual­ ity customers while containing subscriber­ acquisition costs. Also, satellite-TV play­ ers continue to win "eyeballs," despite in­ tensifying competition from cable. Di­ recTV has 15.68 million subscribers, up from 14.9 million last spring.

As Ban'on's Mark Veverka recently pointed out, DirecTV has customer-service problems ("I No Longer Want My. Di­ recTv," Nov. 13). And a merger might not oc­ cur. But, at about 18 times estimated '07 earn­ ings. DirecTV "is undervalued," says Tem­ pleton Investments analyst Matthew Na­ gle. Longer-term, he says, the stock is worth at least 10% more than its current price.

-ccw

Polo: Still in Style

POLO RALPH LAUREN'S WEBSITE OF­ fers fashionistas smart advice on how to wear this season's hot item, super-skinny denim jeans: Pair them with a cropped jacket, or tuck them into thigh-high boots. The metaphor is apt. Despite a 44% run-up in the company's shares (ticker: RL) in the past 12 months, to Thursday's all-time high of 78.75, Polo is likely to stay in fashion and make a fine tuck-in to an investment portfolio.

Although the stock has soared 188% since Barron's wrote a positive piece on the company three years ago ("The Lat­ est Fashion," Sept. 29, 2003), earnings continue to grow at an impressive rate. Analysts expect earnings per share to rise 21%, to $3.63, in the year ending March 2007. The shares could advance into the mid-80s in the next year or so.

Polo isn't as cheap· as it was in Sep- . tember 2005, when we wrote a fol­ low-up ("In the Black," Sept. 12, 2005), urging investors to hang on after the stock had risen to 49-and-change. But, at 19 times analysts' fiscal 2008 earn­ ings estimates of $4.08 a share, neither is it expensive. Its price-to-earnings­ growth ratio is an appealing 1.18.

Some critics, like Douglas Kass of Seabreeze Partners, think the shares will unravel as consumer" rein in spend­ ing.Kass says he has been "shorting Polo aggressively" on a bet that it will retreat to the low 60s. The hedge-fund manager expects Polo and other upscale retailers to face a downbeat Christmas, as a slowdown in cash refinancing of home mortgages curtails the purchase of high-priced items.

Kass also cites "enormous" insider selling, by Chairman Ralph Lauren, among others: Insiders unloaded more than 300,000 shares over the past six months, according to regulatory filings.



Polo senior vice president Nancy Mur­ ray says most of the transactions are programmed and tax-related selling. "We think the stock is just beginning to enter its appropriate valuation level," she says. ''And I stress 'beginning.'''

The company is a smooth operator, with a keen fashion sense. The compa­ ny's operating margins continue to rise. and its products, which include apparel. accessories, housewares and linens, com­ mand full price in both the wholesale and retail markets. An expanding inter­ national presence also has contributed to the company's growth.

Polo could be energized by new store openings, which are expected to jump to 40 to 50 a year, from 20 to 25. "We firmly believe that [company-owned] re­ tail represents the company's largest growth opportunity," says Credit Suisse analyst Omar Saad, who has an 87 price target for the shares.

Some investors might be tempted to follow Lauren's lead and take some prof­ its at current levels. But the fabled Polo pony has proved to be a long-distance runner, and isn't tired yet.

~CHRISTOPHER C. WILLIAMS

Sunny Skies-for Insurers

MANY PROPERTY AND CASUALTY INSURers are likely to see triple-digit growth in earnings this year, as they recover from weather-related catastrophes that pum­ meled profits in 2005. Their shares, too, have rebounded nicely in recent months from the beating they took last fall, al­ though more gains lie ahead, particularly for the industry's biggest players.

In July, we suggested that investors load up on P&C a.nd reinsurance stocks, notwithstanding predictions from weather experts that nine or more hurri­ canes, including at least five with roof­ lifting winds of 111 to 130 miles per hour, would batter the Caribbean and U.S. this fall ("Fair Weather's Friend," July 10, 2006). That forecast, as well as last year's devastating storms, including Katrina, Wilma and Rita, had led most investors to dump the group last fall, leaving many stocks temptingly cheap.

Because the insur­ ers bled so much money in 2005, state regulators allowed them to hike rates sharply and increase de­ ductibles to build reserves. A more benign season, we reasoned, would cause industry earnings and stock prices to rise.

Lo and behold, the 2006 hurricane season proved to be one of the mildest on record, with just five storms, none of which made landfall in the U.S. While strong storm systems have dumped rain on areas like western Washington state, none had an impact comparable to the 15 hurricanes that roared ashore last year, causing $58.7 billion of damage across nine states.

Analysts are split on the prospects for the stocks in 2007. Mark Lane of Chicago's William Blair says he's neutral on the insur­ ers because most of their shares now are fairly priced, and he considers this year's mild season a one-time event.

Because competition for other lines of business is placing pressure on premiums, he predicts the group's earnings overall will be flat. Bigger companies, such as ACE (ticker: ACE), still have some upside, he says.

Rohan Pai and Alain Karaoglan at Deutsche Bank still like the group, and see return on equity increasing to 18% to 20%, assuming an average rate of catastrophes. That could translate into share-price increases of 25% to 30%. The analysts contend insurers will be able to charge higher premiums in 2007, because almost everyone assumes '06 was a fluke and that future hurricanes will be more frequent and severe.

If the consensus is wrong again, how­ ever, and next year proves to be mild, "in 2008, there will be significant de­ creases in the pricing of insurance and reinsurance, because everyone will ques­ tion whether the assumption of in­ creased frequency and severity was valid," says Karaoglan.

Although the stocks have run up, the pair still likes Aspen Insurance (AHL), Endurance Specialty (ENH) and Axis Capital (AXS), as well as Montpelier Re (MRH) and RenaissanceRe (RNR). Says Karaoglan, "RenaissanceRe is already up 30% this year, but over a long period of time, it's the best reinsurance company, and should do well."

RenaissanceRe currently trades for 58.80; the analysts have a price target of 65, which would represent a gain of more than 10%.

Earnings for the three quarters be­ tween now and the next hurricane season should be excellent for the P&C companies - but that assumes that there .' are no major earthquakes. "That's the thing that worries us most, because we haven't had one in a while," Karaoglan says. 'We don't know the impact an earth­ quake would have on the insurance compa­ nies."

Perhaps, then, investors ought to treat the insurance rally like good weather. Enjoy it while it lasts.




-JIM McTAGUE

Dems Unlikely to Dim Nuclear Plants' Future

A Democratic takeover of Capitol Hill shouldn't doom the U.S. nuclear-power industry's resurgence.

Utilities and their partners intend to file applica­ tions in 2007 and 2008 for up to 31 new reactors, says Adrian Heymer, the Nuclear Energy Institute's senior director for new plant deployment. The first should come on line around 2014. The plans are a re­ sult of a program Congress passed in 2005 that offers generous production tax credits to nevv plants in opera~ tion by 2021. The legislation was approved with bipar­ tisan support by a Congress seeking to cut U.S. depen­ dence on foreign oil.

Five of the proposed reactors are rated at 1,600 megawatts. Their combined capacity is 1,191 mega­ watts greater than the three power plants at Washing­ ton state's mile-long, 700-feet-tall Grand Coulee Dam, which holds back a man-made lake 150 miles long. The total capacity of all the proposed new reactors would be 40,000 megawatts, versus the 200,000 additional megawatts experts say the nation will need by 2024. The U.S. now has 103 operating nuclear reactors in 31 states, with a capacity of 99,988 megawatts. They pro­ vide 20% of the nation's electricity.

Meanwhile, Nevada's Harry Reid, who will become Senate majority leader in January, staunchly opposes a plan to store 77,000 tons of nuclear waste from around the country in a 1,000-foot-deep vault at Yucca Flat, an old nuclear-bomb testing site about 90 miles from Las Vegas. The waste would stay lethal for 10,000 years. Reid and state officials say the facility is geologically un­ sound. He suggests storing spent fuel at reactor sites.

Reid could block the project indefinitely. But Heymer points to alternate plans for the spent fuel. One possibility: moving it to an interim site for partial recycling, to reduce its lethality before it is buried at Yucca Flat. That could keep the building on track.

-JIM McTAGUE

ASMI Beats Hedge Fund

"So maybe now they will go home and let us get on with our busi­ ness, " crowed Arthm" del Prado, CEO of ASM International, . a Nasdaq-listed Dutch maker of computer chips q,nd equipment-after shareholders on Monday rejected, by a 2-1 ratio, a U.S. hedge fund's plan to break up the company.

Del Prado, who founded ASMI (ticker: ASMI) in 1968 and owns 22% of its stock, was referring to Mellon HEV Alterna­ tive Strategies, a unit of Mellon Financial (MEL), which had forced an extraordinary shareholders' meeting to consider its demand that ASM spin off its chip-making operation, which has lost money in recent years, from its highly profitable semi­ conductor-assembly and packaging-equipment division in Hong Kong. The Mellon fund needed at least 16 million votes to get majority support for its breakup plan, but could only muster a little over 11 million out of more than 32 million cast.

"Naturally we were disappointed," says fund manager Mickey Harley. "But we still strongly believe that additional changes are needed to maximize value for all ASMI sharehold­ ers, and will continue our efforts to this end." ASMI's common, which had risen in the week leading up to the vote, was briefly hammered after it, but by late week had revived to near the 21.34 it had closed at the Friday before the shareholders' meeting.

While she opposed a breakup, Caroline ven del' Giesen, a Dutch Investors Association attorney, said she was disap­ pointed·by management's failure to bring company bylaws into full compliance with U.S.-style rules, as Mellon had also m"ged. "Shareholder trust needs to be restored," she said of ASMI, whose management says both its units now are in the black.

As Barrons has noted (''A Battle Dripping "yvith Irony," Nov. 27), Mellon itself has been under shareholder attack for corporate"governance issues and alleged lack of synergies in its business. At the meeting, Jeffrey L. Farni Sr., a financial consultant representing Minneapolis-based RBC Dain Raus­ cher, an ASMI shareholder, cited the Barron's article.

Opined Farni, "People who live in glass houses shouldn't throw stones. Management ,has done a great job, and we see long-term benefits ahead for us and other shareholders."

- NEIL A. MARTIN

Another Rum's Rush?

Iraq's prime minister can't be feeling too comfortable, what with the very uncivil war at home and a less-than-ringing endorsement vioced by his US sponsors.

WATCH YOUR BACK, NOURI.
And your front and sides. That, unfor­ tunately, is good advice for anyone in . iraq, but especially fm' its prime minis­ ter, Nouri Kamal al-Maliki. Mter last week's summit in Jordan, President George W. Bush called Maliki the "right guy for Iraq."

This ringing endorsement of the beleaguered Iraqi leader had a rather familiar sound to it. Rather like Bush's declaration that Defense Secretary Donald Rumsfeld would be staying on for the duration of his administration. Asserting in an interview with the Associated Press Nov. 1 that Rummie and Vice President Dick Cheney would stick around for the remaining two years of his presidency, Bush declared, "Both those men are doing fantastic jobs and I strongly support them."

Scarcely a week later, and less than 24 hours after GOP candidates took their "thumping" in the mid-term congI'es­ sional. elections, the Pentagon chief got what might be called the Rum's Rush.

There's no sign that the U.S. administration is about to orchestrate a similar exit strategy for Maliki. Yet the prime minister can't be feeling too comfortable, what with the very uncivil war at home and a less-than-ringing endorsee ment voiced by his U.S. sponsors last week.

In a classified memo leaked to the New York Times just ahead of Bush and Maliki's scheduled confab, Stephen J. Hadley, the U.S. administration's national security adviser, expressed severe doubts about the Iraq leader's ability to stabilize the ever-worsening situation, adding that Maliki depended on Shiite extremists for political support.

"His intentions seem good when he talks with Ameri­ cans, and sensitive reporting suggests he is trying to stand up to the Shia hierarchy and force positive change," as the Times quoted the memo's assessment of the Iraqi leader. "But the reality on the streets of Baghdad suggests Maliki is either ignorant of what is going on, misrepresenting his intentions, or that his capabilities are not yet sufficient to turn his good intentions into action."

Talk about the pot calling the kettle black!

Mter reading this wonderfully laudatory description from his allies, Maliki decided he'd rather go duck hunting with Dick Cheney than have a sit-down just then with Dubya & Co. But after a day's delay, the U.S. and Iraqi leaders had their tete-a-tete, during which President Bush told his coun­ terpart that his administration would resist calls for a "grace­ .ful exit" from Iraq. As if that were possible at this point.

The bipartisan Iraq Study Group, led by former Secre­ tary of State James A Baker III and former Rep. Lee Hamil­ ton, is due to release its long-awaited report. According to various press accounts of the report, it sounds as if the panel headed by the Bush family cOl1sigliere will recommend a gI'adual, if not gI'aceful, withdrawal over the next year or so.

The Times quotes people familiar with the report as saying that it favors some 15 U.S. combat brigadesgI'adually being pulled back from Iraq but doesn't specify any specific timeta­ ble, which the administration has opposed. For its part, the Washington Post also quotes people familiar with thl? report saying that it v,ill recommend nearly all U.S. combat units be withdrawn by 2008, leaving only troops to train, advise and support the Iraqi forces. (We're notfamiliarvvith the people fa­ miliaI' with the document, so we can't say if they're all the same folks familiar to these Beltway denizens.)

The U.S" efforts in Iraq "might have been a turning point for the Middle East and another positive for the global economy," writes Michael CosgI"oye in his Econo­ clast monthly newsletter. "But to date it has turned out that the Iranian, Syrian and Russian axis has won while the U.S.-U.K. axis appears to have lost. And Saudi Arabia to date has also lost since Iran won."

While Cosgrove optimistically opines that a gI"OUP friendly to the U.S. could still gain power and vindicate Bush, he worries that an international perception of a weak Ameri­ can foreign policy could spark the sille of dollar assets.

Cosgrove points out that net capital inflows have totaled some $4.1 trillion since the March 2003 Iraqi invasion, which he deems a sign of foreign investors' confidence in the U.S. That could reverse, he adds, if the "solution" to the Iraqi situation is perceived by foreign investors to be a " sign of U.S. policy weakness, as in the 197013.

Not that the dollar needs much inducement these days to decline. The euro soared past $1.33 last week, which was less than three cents shy of its peak in its relatively short existence, which was touched on New Year's Eve of 2004. The British pound, whose history goes back a bit further, was closing in on two bucks at $1.98, the highest since George Soros made· his killing when sterling was kicked out of the Exchange Rate.Mechanism in September 1992.

While the greenback's swoon no doubt is causing a bit of pain to American tourists traipsing across Europe, travelers to these shores are all smiles. Manhattan seems to be teem­ ing with tourists these days, not just to see the sights and the shows, but to snap up bargains at prices that seem half of what they pay at home.

But the stock market didn't appear to take the. dollar's sudden, steep drop with such equanimity, especially in the two sessions following the Thanksgiving holiday. Part of that might have reflected bad memories of October 1987, when a dollar crisis culminated in a 22% one-day Dow debacle. In­ stead of threatening to send in­ terest rates soaring, as they did in 1987, this dollar decline threatens to choke off exports, on which the global economy has come to depend.

"We believe the world wants a weaker U.S. dollar about as much as U.S. consumers want to pay more at the pump for gasoline." writes Joseph Quinlan, chief market strate­ gist for Bank of America's Investment Strategies Group. "Despite all the chatter about global imbalances and the need for a correction in the gI'eenback, the world, in our opinion, just isn't ready for a sizable, secular decline in the buck. Such a move would undercut the primary source of gI"owth of many nations: exports."

The rest of the world has gotten hooked on exports, especially those shipped by the container-full to America.

By Randall W.Forsyth

Survivor! GOP Will Hang On - ISSUE 2ST-WEEK DECEMBER 2006

Survivor! GOP Will Hang On

Despite a profusion of predictions to the contrary, the Republicans will keep control of Congress through just barely. So says our highly reliable seat by seat analysis of local political funding.

Up&Down Wall Street
Why is everyone so blase about Dow 12,000? Herd instrict and the stampede into blue chips ....
Review &Preview
What's next for the Nasdaq? Finding value in US banks and South Korea ....
Software Giant
Why Oracle's stock will keep rising ....
Option Deal
Big windfall in the Windy City ....
Spiffing Up Jones, Priced Right
Sprucing up Jones Apparel.Jones Apparel Group got a dressing-down when it was passed over by buyers earlier this year. But if it can rejuvenate its tired labels and lift profitability, its stock will likely come into fashion and get the price it deserve. The Barney's advantage ....
Agilent Tech
So boring, so beutiful ....
Current Yield
The yen holds the key ....
The GOP Will Hang On
Campaign money often speaks louder than polis in determining which candidates win elections. Our race-by-race review predicts that Republicans with fat war chests will carry ....
Technology Week
Cutting-edge design aren't helping Motorola's profitability or its ability to dent Nokia's market share. Google and Apple continue to defy economic trends and amaze investors. ETF Guide puts a new twist on model Portfolios. And, Our Gadget of the Week: BlackBerry Pearl 8100 ....
Mobile Wars
Don't count out Nokia ....
Enjoy The Ride
An Interview with James Paulse: Caution among investors and companies is one reason to be optimistic about stock; the cloning of the US consumer is another. A maverick's views on housing, the dollar small-cap stocks and why America should quit trying to be top dog ....

Current Yield

Yen-Carry Traders Get Carried Away

Follow Up

Windfall in the Windy City

Oracle's Second Wind

Head Line News

Reluctant Rally Still Has Life

The GOP Victory, Survivor!

Measuring Up

For Jones Investors, The price Is Right

Review & Preview

Value Investing: Taking It on the Road

Preview 1

Review (Dow Indicator) 2

Review (Dow Indicator) 1

Technology Trader

As The Industry Shows Weakness, Google Romps and Apple Shines

Nokia Will Be Back in Style

Up & Down Wall Street

Chicago Hope

Strike Up the Band