Collection Of Business and Financial News

The New Penny Options

2006-12-26T02:06:00.000-08:00

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

2006-12-26T01:12:00.000-08:00

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

2006-12-22T11:12:00.000-08:00

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

2006-12-22T07:20:00.000-08:00

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

2006-12-22T06:30:00.000-08:00

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

2006-12-21T22:53:00.000-08:00

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

2006-12-21T22:23:00.000-08:00

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

2006-12-21T17:30:00.000-08:00

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

2006-12-21T17:25:00.000-08:00

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

2006-12-21T17:17:00.000-08:00

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

2006-12-21T17:00:00.000-08:00

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

2006-12-21T16:24:00.000-08:00

"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?

2006-12-21T15:31:00.000-08:00

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

2006-12-21T15:20:00.000-08:00

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

Reluctant Rally Still Has Life

2006-12-17T05:26:00.000-08:00

Interview With James Paulsen
Chief Investment Strategist, Wells Capital Management

A YEAR AGO, JAJY.IES PAULSEN, STRATEGIST FOR WELLS Fargo's institutional investment advisory firm, Wells Capital Management in Minneapolis, broke from the pack: He predicted that small-caps would extend their outperformance, oil prices would drop and stocks generally would continue to deliver superior returns. Paulsen was right, of course.Now, he expects more of the same as global growth stays strong and interest rates remain at manageable levels. A maverick throughout his nearly 25-year career, Paulsen is accustomed to making bold calls. His clients haw the pleasm'e of seeing them borne out. And we give you the pleasure of hearing his views.

Barron's: We've come 180 degrees from last quarter in terms of sentiment. What do you make of the market and the economy?

Paulsen: A couple of months ago, there was the impres sion consumers were suffering under the weight of a stock market that was down 10% and being told everyday that their house values were going to hell. Mortgage yields had risen to their highest level of the cycle, job creation seemed like it was grinding to a halt and everybody,as paying $3 at the gas pump. It was a disaster. 00W, mort gage yields are back to where they were at the end of last year, the Dow Jones Industrial Average is at an ail-time high, [former Federal Reserve Chail'm2,n] ).1an Greenspan says the housing market has bottomed, and we found another 810,000 jobs we didn't knOw we had. Last night, when I paid $2.09 at the pump, it seemed cheap.

The nature of this whole recovery has been to switch sentiment every 120 days or so from concerns about an overheating economy to one headed for recession. But the undertow of the rally has been good throughout. In the short term we've come off the market lo\vs of June and gone to new highs. Longer term, this recovery cycle started in March 2003. Before the cycle ends or truly peaks, there's got to be some increase in long-term bor rowing costs. Right now, the lO-year-yield is at 4.80%, not much different from where it's been for four or five years. Yields were up to 5.25% in June but were promptly taken down again. One of the reasons the econ omy keeps going is we haven't sat on it with any kind of force, and some of the things that were biting at it have changed of late, mainly energy.

How long do low oil prices last?

In early September, I wrote that oil was going to break down and head back into the 40s because it is fairly valued around $50 a barrel based on what other commod ities have done. Commodities are up a lot because of world growth, but oil went up a lot more than the rest of them. If it had gone up about as much as non-energy commodities, it would be around $50 now. The excess pricing of crude has come about because of speculatiw risk premiums and not fundamental supply and demand forces. As some of those risk premiums diminish, crude is going to go back to aiundamental price level and it wiiI probably overshoot on the way clmV11 just as it over shot on the way up. I might get interested in that energy complex again if we break into the 408. There is still quite a bit of risk there for equity investors, but there is nothing bad about that for the economy. The Goldman Sachs non-energy commodity price index is within 2% of breaking above its May highs and going to new cycle highs, and it has been going straight up the last few weeks. It is possible we could have a new high in non energy commodity prices at the same time oil collapses. ti Watching that develop says a lot about oil, because if it p were truly a global slowdown that is causing oil to pull- back, as many people suggest, then it would also cause a y pullback in other commodities.

A lot of these fear stories get so far ahead of them- a selves and into the pricing of the markets. There were G worries about severe oil shortages and oil going to $100 J, a barrel, and I'm not Sill'e supply and demand ever got that bad. There's been a long litany of items to derail the economy al1d the markets. Remember the bird-flu pandemic? Remember the recovery? Remember, there was going to be a major as soon as the yield curve It has been inverted for a yeal' and no one mentions it any longer. Meanwhile, it will be another double-digit year for stock-mal"ket returns, and GDP [gross domestic product] growth is at 31;2% to 4%. Job creation has been over 2% and income trends are good. That is on a domestic basis. The story gets better when you look at global trends.

Yet, investors seem cautious.

I'm looking at a corporate sector that is making profits faster in this decade than any decade in the postwar era. It makes 'the 'Nineties profit miracle look paltry. The result is tremendous excess cash flow relative to capital-spending trends-it's off the charts and has been all decade long. Corporations have never made so much money, but they are also refusing to spend it. Every quarter they beat their numbers but say the future looks tough, just the opposite of the corporate culture that existed in 1999 and 2000. They are sitting on this boatload of buying power because they are cautious.

Investors, meanwhile, are happy with 5% money-market returns. No one cares that for the last four years running the stock market has beaten bonds and CCl.."h, by two to three times. The return for stocks ofl' the cycle lows is better than 10% a year. Cash has probably averaged 3% and bonds maybe 4% in that time. So here we've got this asset class that, for the past three or four years, has beaten cash and bonds by double and yet it is still the least favored.

Are you surprised the Fed took a time out in raising rates?

For a 'Seventies economics student trained on the Phillips Curve, I never thought I would ever hear the Federal Reserve in this country use the words "patient" and "measured" in the same sen tence with inflation ever. Yet those are the buzz words around their policy, hp cause they don't want to hurt the fragile economy. Never mind that commodity prices have had their biggest move of any cycle in the'postwar period. Never mind, we've never had more global powers con tributing to global growth, ever. Never mind, we have full employment and 82% capacity-utilization rates.

So you see a tightening down the road? We have got to go highm·. We have core inflation and we are going to have a little more of that. But to go back to my last point, I think bravado and optimism beg-PIs bad times and chronic cautiousness paints a beautiful picture for the future. It is a low-risk, high-return situation created by cautious players. If businesses aren't spent out, that implies they can drive faster growth in the future. If investors are sit ting in money-market funds, they can get enticed into the stock market as they keep reading about record highs. If policy offi cials want to be patient and measured, it just means they aren't stomping this sucker down and it. can grow harder for longer than anyone thinks.

How do you square this bullishness with the massive trade deficit?

The trade deficit is real debt because it is owned by foreigners and we have to pay them back. And while the trade deficit is at record levels, the more important record in my book is the number of con secutive years we've run a deficit: 15 continuous calendar years. To me, what we've been through in the last 15 years with our trade picture is equivalent to the Marshall Plan after World War II, which was directed at rebuilding war~torn Europe and Japan. At the time, it was highly criticized as throwing money down a rate hole. But it turned out to be one of the greatest investments in U.S. history be cause it is still paying dividends today.

Today's trade deficit is exactly the same thing; it is a massive stimulative policy aimed at jump-starting economies ancl utilizing previously underutilized re sources in the world. It has been an incredibly expensive policy. It has cost us jobs. It has cost us lost domestic spending growth for a decade and a half, and it is just now starting to bear fruit. Last year, our trade deficit with Malaysia represented 18% of their GDP. We gave China 9% of their GDP. In 2001 emerging-market consumption in U.S. dollar terms was 40% of U.S. con sumption. In '05 it was more than 50%. I am not saying where the money is being spent, just that in a few years the emerging ecqnomies will exceed U.S. consumption in dollar terms.

In a few years, we will have entirely cloned the U.S. consumer. That is, we are creating a world of middle-class shoppers. The concern has been the U.S. consumer has been the sole locomotive for world growth. Well, we are no longer the sole locomotive. We are taking the Mall of America out of Minnesota and putting it in Indonesia. When we look back on this pe riocl we are going to look back on it as a stroke of policy genius.

Policy or unintended consequence?

Totally unintended consequence.
Won't that put us at the mercy of others? People subconsciously realize the U.S. is no longer the world leader. But it is far better to be the third dog on a fast sled than the lead dog on a slow sled. We need to pass the torch to the areas that have the re"OUl'ce growth to maintain fast world growth. We are doing that, and it is a hetter deal for the next generation than trying to maintain a leadership position and grind worldwide growth to a halt.

What's your outlook for the trade deficit? In the next 25 years we are going to have slow but steady improvement in our trade deficit, and that is going to be the divi dend paY9ack for the long period of in vestment we made in these other coun tries. In the past several years, let's say, our domestic demand has been growing 5% each year while we lost about 1% abroad. So our real GDP is growing at 4%. Let's say next year the trade deficit improves by a percent and our domestic demand is still growing at 5%; well, then GDP grows at 6%. We can go from 4% to 6% without any change in domestic spend ing trends. You can imagine what that does to wage demands and interest rates.

What's your view on the dollar?

The dollar is going a lot lower. The dollar is off about 30% against the developed world, mostly against the euro. It has done very lit tle against Japan. It might be done weaken ing against Europe and Canada, but we've got a lot more coming against Japan and what hasn't even started yet is a move against the emerging economies. When these small economies become bigger play ers and want to play with the G-7, they are going to be required to do things that G-7ers have to do. There is no way China can continue to be a G-7 member and have a fixed exchange rate. We are in the pro cess of forcing them to come off that stan dard, and we'll be successful. If they want to play in the G-7, not only will they have to float their cm'rency but they will have to treat their employees better and put scrubberS on their factories. When we get through telling them all they will have to do to be in the G-7, we are going to find out their competitive standing won't be nearly as great as we think it is.

If the dollar is expected to go lower, shouldn't you direct money overseas?

Yes. The biggest risk in the bond market in the coming year is if the trade-weighted dollar breaks to new lows-below its 2004 lows-because when it does, non-energy commodity prices are going to go back to new highs, and that will feed into core inflation. Core inflation has already closed in on 3%, but if the dollar breaks, we're talking 4% core inflation and the interest rate structure cannot handle 4%.

What do you make of the private-equity boom?

It tells you how much excess liquidity we have in the system. The only reason to be a public company is for liquidity purposes, and there are plenty of companies saying they don't need liquidity. We've had three decades of pretty strong merger and acqui sition activity. The 'Eighties was debt based M&A. The 'Nineties was equity based M&A. And this cycle is predomi nantly cash-on-the-barrel based. The 'Eighties ended in a debt crisis. The 'Nineties ended in an equity crisis. Now, the question is how does a period fueled by cash mergers end? It ends in too many dollars chasing too few goods, and there is a risk of a melt-up in pricing.

What about the outlook for housing?

Greenspan has said the worst might be over for housing, and I have to agree. Refi nancing applications have exploded to the upside and are at the highest levels since last year. Lumber futures are showing signs of bottoming. Mortgage yields are back down. Housing stocks have been ris ing since July even though the reports have been bad. Construction jobs have been up about 30,000 in the last two months, despite the so-called housing collapse. '

Short-term there are a number of fac tors suggesting that things get better. Housing has rolled over and the economy is OK. Real residential housing is off about 1.2% in the last year, and yet over all GDP is up 3.6%. Year-to-date real hous ing spending is down over 5% at an annu alized rate in real terms and the economy is growing 4.2% year to date. There are really two separate housing stories at work, one gets all the. play and one doesn't. As residential housing has rolled over, non-residential construction is ex ploding to the upside. This tells you the slowdown in housing isn't primarily be cause of interest rates because higher rates would have also killed off commer cial construction, and it didn't.

How do small-caps fare in your scenario?

In this decade, the leadership has moved to the emerging economies. These coun tries are comprised of small companies mainly involved in cyclical or industrial pursuits. This cycle has been led by small cap stocks and industrial cyclicals, though everyone has been waiting for a rotation to large-cap stocks. If the leadership con tinues to be emerging economies, we may be surprised by how long small-caps con tinue to lead. This could be more of a secular play than a cyclical trade. If non energy . commodities go to new highs, what that says is the emerging story is back again and small-caps will do well.

But hasn't the shift to large-caps begun? Let's talk about that becau..'le I hear and read that everywhere. The Russell 2000 has beat the S&P 500 by 2% to 3% year to date. Large beat small for a period from the May high to about the June low, but not since then. The Russell 2000 has out performed the S&P 500 since mid-June. On days when the market is rallying, small has beat large for the most part.

I'm not saying we won't have periods where large-caps do well. But if growth continues at a pretty good pitch, this envi ronmentfavors smaller companies. Large caps dominated between 1980 and 2000, and that was because there was chronic dis inflation. Large companies have got the ability to deal with excessive price competi tion because there is more bloat for them to cut. Buta period of growth and pricing flex ibility benefits the smaller company be cause it all falls to the bottom line.

Thanks, Jim. _

Chicago Hope

2006-12-16T03:02:00.000-08:00

IN 19 YEARS, A CHILD WILL GO FROM THE TERRIBLE TWOS TO HER MAJORITY. And so it has happened With financial derivatives.

Oct. 19, 1987 is a date that lives in infamy in financial history. On what came to be known as Black Monday, the Dow Jones Industrial Average shed 22% in a single session. The culprit-or scapegoat-was program trading involving the simultaneous purchase or sales of baskets of stocks against stock-index futures, then relatively new instruments. .

In 2006, derivatives have moved to the center of the financial world from the periphery, as evidenced by the Chicago Mercantile Exchange's planned acquisition of the rival Chicago Board of Trade for $8 billion. The combination will create a behemoth that trades contracts worth an average of $4.2 trillion daily, dwarfing what changes hands on the New York Stock Exchange or Nasdaq.

Without a doubt, the exchanges have come a long way since the CBOT was known for trading grai.'1s and the Merc for meats. The end of Jixed exchange rates and the advent of interest-rate volatility were the mothers of invention for interest-rate and currency futures in the 'Seventies. Stock-index fu tures took off in the 'Eighties with the bull market.

But amid all the clinking of champagne glasses, the Chicago exchanges are conspicuously absent from the biggest and fastest-growing party, credit derivatives.

These instruments-principally credit-default swaps (CDSs), which provide insurance against a borrower's going bust, and collateralized debt obligations (CDOs), which slice and dice pools of corporate bonds into pieces appealing to different cohorts of inwstors-trade over the counter. The markets are made by the giant Wall Street brokers and global banks, whose trading desks are mainly situated in New York and London. By one private estimate, the size of the credit deriva tive5 market "ill reach $20 trillion-that's trillion, with at-this year.

Not suprisingly, the Chicago Mercantile Exchange enviously eyes the
credit-derivatives business. But for at least a couple of years, the exc;,allge is unlikely to make any significant inroads into the OTC dealer "~E'ket for CDSs, CD Os and the like. That's not because of any lack of ambition but rather attributable to the differing natme of the contracts.

The success of the CME and CBOT has been in trading conmloc1ities, not in the sense of agTicultmal goods, but by the economic definition. Interest rate contracts involve the trading of money, which is as homogeneous as wheat. The same goes for S&P 500 futures.

A credit default swap essentially is an insurance policy that pays off in the event a particulm' bor rower, usually a corporation, fails to meet its debt obligations. The premium on that policy depends on the riskiness of the borrower; writing a CDS against a shaky borrower involves a higher premium. As a result, a CDS is more of a custom job than an off-the rack commodity.

Buying a corporate bond means that an investor is making two bets; on interest rates and also on that corporate credit. An investor who just wants to bet on that credit can write credit protection, just as an insurer wr:tb c, on a driver-in the hopes of collecting a premium and not having to pay a claim.

A particular company whose credit you like may not have actually issued a bond. A CDS also is far cheaper to buy than an actual bond, just as buying an option costs a lot less than buying the underlying stock.

There also are indexes of credit default swaps, which are compiled by Dow Jones, the publisher of Barron's and Barron's Online. So you can bet on an entire basket of credits with one ticket.

CDOs essentially form a queue for repayment from a pool of bonds or loans. Those at the front are most likely to get paid and get the equivalent of a high-grade credit-even from a pool of low-grade credits. At the end of the line, the risk is biggest but so is the potential payoff. In between, the pie can be carved in whatever shape desired.

Owing to their flexibility, trading in credit derivatives has eclipsed trading in actual corporate bonds. Indeed, credit derivatives are transforming the corporate credit market just as the mortgage-backed securities and deriva tives market has revolutionized home loans in America.

But the Chicago futures exchanges, which started the revolution in finan cial derivatives, now are mainly spectators to the boom in credit derivatives.

By Randall W.Forsyth

As the Industry Shows Weakness, Google Romps and Apple Shines

2006-12-15T18:21:00.000-08:00

WHAT A MISH-MASH! WHILE A MAJOR ity of tech companies hit their numbers last week, not all of then did (Hello,Moto!). In fact, a multitude of reports seemed to have come loaded with bag gage. Caveats were flying, outlooks were softened, and margins were get ting squeezed.

Enterprise-software giant SAP met its third-quarter earnings targets last Thmsday, suggesting that a weak second quarter had been just a blip (See Emopean Trader, page M6). But Chief Executive Henning Kagger mann warned that growth of the company's software-li cense revenue for this year might fall in the lower part of a range suggested earlier, which was 15% to 17%.

In a phone interview, Kagermann took umbrage with my suggestion that SAP was "toning" down expectations for the rest of the year. "I don't think that we have really toned it down. We have confirmed om guidance," Kagermann said. "It is just less likely that we will achieve the upper end of the range."

OK, but I still took it as slightly dampened expecta tions. So did the market: SAP's American depositary receipts (ticker: SAP) fell 1.7% on Thmsday's news to 50, even though the company's earnings of $486 million beat analysts' estimates by 1.8%.

Any way you ,slice it, this kind of news ain't good.
The tech market has been grinding out decent growth against a backdrop of lackluster corporate spending on gear and software. And then, only the strongest leaders in given product segments were finding success. But now there are signs that the economy is truly softening.

Detroit and Silicon Valley are laying off people in droves. Intel (INTC) is in the middle of mass layoffs, and even turnaround success Hewlett-Packard (HPQ) is still trimming thousands of employees. Yahoo!" miss-it projected fourth quarter revenue well below analysts expectation of $1.3 billion-could now be viewed as a referendum on the economiy and advertising spending. Of cource, Yahoo! (YHOO) is more vulnerable to large national advertisers than rival Google especially in the hard-hit auto and financial sectors. But Yahoo!'s revenue woes might mean the economy is under pressure.

It is the rare tech company that can manage to defy economic trends. For now, that list is short. Google and Apple Computer, and perhaps a few others. Google (GOOG) on Thursday reported quarterly profits that nearly doubled from a year ago, sending its shares up 7.4% in after-hours trading to $457.65.

How much longer can Google pull this off? When Google ultimately misses its numbers, the overvalued tech tape could finally meet its match.

Broad consumer resilience certainly seems absent when Motorola (MOT) misses its third-quarter revenue estimate-about $11 billion-by a full $1 billion, as it did last week. In previous quarters, Motorola has succeeded where others failed, largely on the strength of the RAZR sales, which are no longer growing at an exponential rate. But Motorola has been a consumer darling compared with its enterprise-tech brethren. The company has intro duced new models, such as the media-rich KRZR, to take the RAZR's place, but the jmy is out. Meanwhile, profit margins for both Nokia and Motorola will remain under heavy pressme as the two fight for global mm'ket share. (See Tech Trader; page 33.)

Then there is Apple. It continues to amaze and defy. The staying power of iPod sales growth is smprisingly impres sive, especially against criticisms that the latest upgrades to the iPod line may not have been dramatic enough to maintain consumer enthusiasm. Plus, there was the launch of Mi crosoft's Zune MP3 player, which is not a positive develop ment for Apple. Ipod sales of 8.7 million units sm'passed lofty expectations by about 100,000 devices.

On top of that, new Intel-powered Macintosh sales set records by shipping 1.6 million units during the quarter, up 30% from a year earlier and about fom' times the personal computer market's growth rate, notes Needham & Co. hard ware analyst Charles Wolf. Wolf has predicted that Macin tosh sales could fuel future growth of Apple based on high expectations for Windows users to switch to Macs using Apple's soon-to-be-released Boot Camp operating-system software. Customers seem to be snapping up the Intel Macs as a result of aggressive pricing and anticipation of the new software, Wolf muses.

Apple's shares (AAPL) shot up nearly 6% the day after the earnings report, to 78.99. That's up 56% from when Bar ron's ran an upbeat cover story on the company just a few months ago ("Mac Attack," July 17, 2006). Wolf sees the shares going to about 90.

Apple did say last week that it might have to eventually re statl~ the quarterly results owing to an investigation into stock option hack-dating, but the market barely flinched. I'm sure ~AP'H Kagermann wonders why his company's shares didn't benefit 1'1'0111 Hllch investor benevolence.

By Mark Veverka

Nokia Will Be Back in Style

2006-12-15T17:49:00.000-08:00

A QUARTER-INCH HAS HELPED TURN THE shares of Nokia, the world's largest cellphone makel; from a highflier into some thing resembling a value stock.

That's the difference in thickness be tween Nokia's chunky 8800, one of its slim mer phones, and the ultra-svelte Slvr from Motorola (ticker: MOT), the world's sec ond-largest cellphone manufacturer.

Investors, worried that Nokia's clunki ness can't withstand Moto's stylishness, are valuing the Finnish giant way below Moto, assigning its stock a multiple of 13 times· next year's expected per-share profits-below both Motorola's and the S&P 500's 15.

Both Nokia and Motorola shares were battered last week after the two handset makers disappointed investors by reporting a third-quarter drop in earnings. But the company with the most cutting-edge phones lnight not have the most upside.

For four years, Nokia (NOK) repeatedly has lnissed the latest trends in cellphone designs-first clamshells, now thinness. Nonetheless, it has hung on to its dominant 36% global phone-market share.

By sidestepping the costly battle to cre ate the hippest mobile handset, and instead cutting prices in Asia, a boolning market,Nokia has kept operating profit in its mo bile-phone division higher than Moto's-but not as high as inwstors would like. In the third quarter, unit sales were up 33%, to $88.5 lnillion, but net profit slid 4%, to $1.065 billion.

Still, Nokia's long-term financial outlook is brighter. Next year the company's net is expected to rise about 18%, versus 15% at Motorola, according to Thomson Finan ciallBaseline's survey of Street forecasts.

Moto's thin phones didn't help the com pany's profitability in the third quarter, when it sold 54 million units, 39% above the year-earlier level but below some analysts' expectations. That boosted its global mar ket share a bit, to 22.4% But its profits-down 45% to 39 cents a share-fared far worse than Nokia's.

''What's important to shareholders is having a reasonable operating profit, and that's what Nokia has focused on," says Albert Lin, who follows both Motorola and Nokia for American Technology Research in San Francisco. He has a Buy rating on Nokia and thinks it could hit $25 (more than 25% above recent levels) over the neA-t 12 months. He rates Motorola a Hold.

Concerns about Nokia haven't changed much since Barrons wrote bullishly about the company last November.

To be sure, Nokia's profit on each de \ice. on average, has slipped, and investors worry that without the latest cutting~edge phones, the Finnish concern is being forced to slash prices to hold share against Motorola and third-place Samsung Elec tronics (SSNLF.PK),

Nokia is indeed the low-price leader in phones, with an average price of $117 ver sus $131 for Motorola and $154 for Sam sung, according to analysts.

But it's not as simple as all that. The battle to produce the slickest phone isn't helping Samsung and Moto's profits, nor is it slowing Nokia's terribly. Motorola is sell ing its new KRZR in the U.S. at a price (before subsidies from the carriers) of $425-$75 less than the company had ex pected, says AmTech's Lin.

And Samsung is selling its ultrathin X820 at a loss of $10 to $20 per unit, after the cost of shipping and servicing the phone, estimates Lin.

Moto's personal~phone unit has an oper ating profit in the 11% to 12% range as it spends R&D money to spin the snazziest phones; Nokia's operating profit was 15% in the third quarter.

Nokia is trying to make up in volume what it gives up on some low-cost phones.

Phones with an average price under $63 represented more than 40% of Nokia's sales in the second quarter. They helped the Eu ropean manufacturer increase its share of China's cell phone market by a couple of per centage points, to 35%, in the third quarter, wrote Piper Jaffray analyst T. Michael Walkley in a note to clients on Sept. 27.

Meanwhile, Nokia is taking steps to trim operating costs even fm'ther. It has built five new manufactming facilities around the world in the past few years, allowing it to secure better deals for its products with shipping firms, says Lin.

Nokia's chief executive, Olli-Pekka Kallas vuo, says his company will cut more operat ing costs as it winds down agreements to use technology from chip maker Qualcomm (QCOM), which owns rights to patents on next-generation cellular transmission.

That could hurt Nokia in the U.S., where Qualcomm's technology is heavily deployed by the Verizon Wireless venture ofVerizon Communications (VZ) and by Sprint (S), the NO.2 and NO.3 cellular operators. But Nokia's payoff in Asia could be a lot more important, as increasingly affluent consum ers there grow up with the brand. "There's a middle class of 200 million people in China that is frankly a much bigger opportunity than the entire U.S. population of 300 mil lion," says Ittai Kidron, the Nokia watcher at CIBC World Markets. Kidron nonethe less thinks Nokia generally will trade with the market until it comes up with slimmer phones.

Despite the threats from Moto and Sam sung, and fifth-place Sony-Ericsson, Nokia's valuation is out of whack with the most con servative expectations. Cut Nokia's earnings growth rate by more than half, to 8%, and give the company a forward PIE multiple of 15-the same as the S&P's-and the shares should still be worth at least $21. They closed Thursday at $19.35, off 2.62%.

The dip in Nokia could be short-lived. The company dominates its industry, has shown an ability to withstand shifts in fashion and is positioned for growth in many ofthe world's fastest-growing and largest markets, includ ing China and India. Eventually, Nokia inves tors will ring up nice gains._

The GOP Victory, Survivor!

2006-12-15T15:15:00.000-08:00

Cover Story
Why the Republicans will hang on to both the House and Senate on Nov 7 - and what it will mean for stocks.

Jubilant Democrats should reconsider their order for confetti and noisemakers. The Democrats, as widely reported, are expecting GOP-weary voters to flock to the polls in two weeks and hand them control of the House for the first time in 12 years - and perhaps the Senate, as well. Even some Republicans privately confess that they are anticipating the election-day equivalent of Little Big Horn. Pardon our hubris, but we just don't see it. €) Our analysis-based on a race-by-race examination of campaign-finance data-suggests that the GOP will hang on to both chambers, at least nominally. We expect the Republican majority in the House to fall by eight seats, to 224 of the chamber's 435. At the very worst, our analysis suggests, the party's loss could be as large as 14 seats, leaving a one-seat majority. But that is still a far cry from the 20-seat loss some are predicting. In the Senate, with 100 seats, we see the GOP winding up with 52, down three We studied every single race - all 435 House seats and 33 in the Senate - and based our predictions about the outcome in almost every race on which candidate had the largest campaign war chest, a sign of superior grass-roots support. We ignore the polls. Thus, our conclusions about individual races often differ from the con ventional wisdom. Pollsters, for instance, have upstate New York Republican Rep. Tom Rey nolds, trailing Democratic chal lenger Jack Davis, who owns a manufacturing plant. But Rey nolds raised $3.3 million in cam paign contributions versus $1.6 million for Davis, so we score him the winner.

Likewise, we disagree with pollsters of both parties who see Indiana Republican Rep. Chris Chocola getting whomped by Democratic chal lenger Joe Donnelly, a lawyer and business owner from South Bend. Chocola has raised $2.7 million, versus $1.1 million for Donnelly. Ditto in North Carolina, where we see Republican Rep. Charles Tay lor beating Democrat Heath Shuler, a former NFL quarter back, because of better financ ing. Analysts from both par ties predict a Shuler upset.

Is our method reliable? It certainly has been in the past. Using it in the 2002 and 2004 congressional races, we bucked conventional wisdom and cor rectly predicted GOP gains both years. Look at House races back to HJ72 and you'll find the candidate with the most money has won about 93% of the time. And that's closer to 98% in more, recent years, ac cording to the Center for Re sponsive Politics. Polls can be far less reliable. Remember, they all but declared John Kerry president on Election Day 2004.

Our method isn't quite as ac curate in Senate races: The cash advantage has spelled vic tory about 89% of the time since 1996. The reason appears to be that with more money spent on Senate races, you need a multi-million-dollar ad vantage to really dominate in· advertising, and that's hard to come by.

But even 89% accuracy is high compared with other gauges. Tracking each candidate's funding is "exceptionally valuable because it tells you who has support;" says William Morgan, executive director of the renowned Mid-West Political Science Association in Bloomington, Ind. The cognoscenti, he says, give the most money to the candidate they believe has a good chance of winning.

We found no shortage of people to challenge us. They argue that money doesn't make a difference when the elector ate is as worked up emotionally, as it is this year. John Aldrich, a professor of political science at Duke University who writes ex tensively about elections, says that a candi date really doesn't need the most money to win; he merely requires enough cash to get his message across. Aldrich believes Demo crats will win this year with less money because they won't have to. spend so much to persuade voters to switch horses.

"The support for the president, the Con gress and incumbents is relatively low by historical standards," he says. In fact, a new Wall Street Journal/NBC News Poll says voter disgust with Congress is the low est in the survey's 17-year history.

It's true that our formula isn't fool proof. In 1958, 1974 and 1994, the wave of anti-incumbent sentiment was so strong that money didn't trump voter outrage. We appreciate that voters in 2006 are hop ping mad at the GOP because of the war and because of scandal. We just don't agree that the outrage has reached the level of those earlier times. The reason is that the economy in 2006 is healthier. And the economy is the only other factor that figures in our analysis

In 1958, in sharp contrast to now, the country was in a deep recession. Though the Democrats controlled the House. vot ers blamed their pain on Republican President Dwight David Eisenhower, and it cost the GOP 48 seats. In 1974, a Watergate year, inflation and an Arab oil embargo pinched household budgets and helped fuel voter anger at Republi cans. In 1994, though the economy was improving, unemployment was above 6% and personal income began to fall in the quarter prior to the election, souring the mood of the electorate. People blamed their pain on high taxes, which they asso ciated with Democrats, and ushered in Newt Gingrich & Co.

Though the current economy is slowing, unemployment remains rel atively low, at 4.6%, and dispos able-income growth is positive. While GDP figures will be re vised downward in coming weeks and unemployment fig ures could edge up, it may not matter. Those numbers are "interesting stuff for economists, but voters will continue to focus on pocketbook issues like the price of gas and the value of their 40l(k)s," says GOP in sider Rick Hohlt. Pump prices have been falling and the Dow Jones Industrial Average has been on a tear, reaching 12,000 last week.

Hohlt and analyst John Morgan say Republicans will have unusually tough election day challenges from Demo crats in more than 50 races - a high number. They recall no more than 20 highly competi tive races in 2004. All but 10 of this year's contested seats are held by incumbents, and Hohlt and Morgan aren't predicting an outcome.

If we're even half right, and the GOP retains control of the Senate but loses the House, then there would be important ramifications for the stock mar ket. Since traders often have clis dain for Democrats, there could well be a relief rally, at least in the short tel111. "It would force investors to rethink some over zealous discounting of stocks," says Chuck Gabriel, chief politi cal analyst for Prudential Equity Group.

Fear of Democrats,he suggest, be playing a role in the weakness in energy and pharmaceutical stocks, with in ve"tOl'" bracing for a populist backh'ih against profits. "Elections may 01' may not be a driver, but it would not hurt to remove that headwind," says Gabriel.

Share of student lender Sallie Mae also may also be feeling the weight of the presumed Democrat victory. The theory is that Democrat would reduce student-loan rates if they control both ends of the Capitol, hurting' profit margins for parent SLM (ticker: SLM). It's unlikely Democrats could succeed with the Senate in GOP hands.

Gabriel adds that shares of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), which have gained since Mark Foley resigned on Sept. 29 amid a sex sca nal, might decline with even a partial GOP victory. Republicans are considered less friendly to the quasi-governmental agencies than pro-housing Democrats.

President Bush certainly would have to rethink his approach to Congress if our scenario plays out either in full or in part. The GOP majority in Congress would be so slim that the president would have to live up fully to a promise he made during his first election campaign to be a "uniter," not a "divider." He'd have a mon strously difficult time getting Congress to make his tax cuts permanent. His desire to reform Social Security with private investment accounts likely would remain unfulfilled.

The scandals and the unpopular war are not all that are propelling Demo crats this year. The party has fielded candidates who are more attractive and better financed than in many past cam paigns.

There are nine House races where the GaP's funding advantage is mini mal, allowing for upsets. However, we don't think the Democratic pockets are deep enough to bring about a rout in these contests. There are nine other races where Democrats have very nar row funding advantages-but the Re publican Party has ready money to pour into such contests. Sara Taylor; director of the White House Office of Political Mfairs, says the Republican Party has a $56 million cash advantage over Democrats going into the final wppks of thp campaign. That's a lot of TV ads.

Many on Wall Street believe the Democrat." will triumph this yeal; too. "I'm not a big believer in generic polls, but the2:~-point lead that Democrats have over the GOP in the recent USA TO DAY/Gallup Poll is about as wide as it gets," says Grpg Valliere, chief political strategist for the Stanford Washington Research Group, a leading adviser to the Street. The poll Valliere des showed 59% of respondents favoring Democratic candi dates, 36% favoring Republicans and 5% undecided. "I threw in the towPi for the Republicans a day or two after the Foley scandal broke," he says.

Even the "investors" who buy con tract." on the Iowa Electronics Market aloe down on the Republicans for the first time in memory. Contracts that will be worth $1 if Hastert & Co. end up retain- " ing control of the House on Nov. 7 are trading for around 30 cents - hardly a vote of confidence.

You hardly can blame Democrats for feeling giddy as the mid-term contest approaches. The GOP Congress has proved more adept at producing scan dal than legislative reforms, and the un relenting bloodbath in Iraq doesn't in still strong public confidence in our com mander-in-chief. Maryland Democratic Rep. Chris Van Hollen contends the GOP's old trump card, terrorism, no longer has an effect on voters because they perceive America's pacification ef fort in Iraq "is a mess and in chaos because of gross incompetence by the Bush administration."

There's no denying that the Demo crats have fielded stronger candidates this time around. The effects of that will be on display throughout Election Day in close races around the country. Here's a rundown on some of the tight est.

In Connecticut's fourth congres sional district, Republican Rep. Chris Shays is in a bruising rematch against Diane Goss Farrell, whom he narrowly beat in 2004. He's raised $3.2 million to her $2.5 million. That put.." her within reach of an upset, but we reckon Shays' funding advantage will help him keep his seat, even though the district voted against Bush in the past two presiden tial elections.

In New Hampshire's second district, incumbent Republican Rep. Charlie Bass, who was elected in 1994, has raised a total of $918,789. The chal lenger, lawyer Paul Hodes, whom Bass beat handily in 2004, has raised about $1.1 million. Although Bass is the incum bent and within striking distance, it looks as though he's going to be knocked off, based on the money.

In Indiana's 9th district, in the south eastem part of that state, Republican in cumbent Mike Sodrel looks as if he will survive a spirited challenge by Baron Hill. Sodrel unseated Hill in 2004 after losing to him in 2002. Sodrel has raised $2 mil lion versus $1.2 million for Hill, a comfort able funding advantage.

When Ba,rron's visited the 9th dis trict in July, we wrote that Sodrel would face an uphill fight because Republicans there were angry at Bush for running up the deficit and for mismanaging the Iraq war. Not only is Bush unpopular in the district; so is GOP Gov. Mitch Daniels. The fundraising numbers tell us that the GOP base might have had second thoughts about voting for a Dem ocrat. Still, we expect Democrats to un seat Republicans in two other Indiana congressional districts.

In Pennsylvania, pundits have written off Republican Sen. Rick Santorum, who has raised $i7.3 million. His Democratic challenger, Bob Casey, who has raised $15 million, has a large lead in the polls. This is the fIrst serious challenge for Santorum since he was elected in 1994. We see him defying the pollsters on Nov. 7 and hang ing on to his seat, with voters from the Western part of the state riding to his rescue.

In Rhode Island, we predict Republi can Lincoln Chafee will lose to demo cratic challenger Sheldon Whitehouse, a former U.S. attorney. Whitehouse has raised more than $4 million versus about $3.5 million for Chafee. According to the Center for Responsive politics, nearly 80% of the challenger's money comes from individuals as opposed to political committees. Chafee has raised about 50% from individuals. Clearly Whitehouse has a better organization.

With only two weeks to go, a barrage of contradictory poll fIndings is apt to con fuse the oddsmakers, not to mention vot ers. But we're sticking with our numbers, and they say one thing: The Democrats don't have quite enough heft to push aside the elephant.

Yen,Carry Traders Get Carried Away

2006-12-15T15:06:00.000-08:00

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity. But the tide could recede quickly if the dollar declines.

WHILE THE TALKING HEADS WiLL BE chattering this week about the Federal Open Market Committee's meeting, the real monetary intrigue is taking place in Tokyo.

The U.S. central bank's policy-set ting panel is certain to hold its federal funds rate target steady again Wednes day at 5Vt%, leaving Fed watchers nothing to do but parse the words ofits statement, which similarly is likely to be little changed. "Inflation is too high, and we think it's coming down but we're still on the case, yadda, yadda, yadda," or some thing to that effect will emerge from the confab.

Since the FOMC called a halt to rate hikes two months ago, the bond and stock markets have enjoyed sweet little ral lies. You may have read somewhere that the Dow Jones In dustrial Average crossed the 12,000 mark last week, a nice rise from 11,173.59, where the Blue Chips closed after the Aug. 8 FOMC meeting. In the bond market, the lO-yearTrea sury-note yield is down to 4.78% from 4.92% on Aug. 8, al though it's backed up from a low of 4.54% in late September.

The plunge in oil prices has been arguably a bigger factor than the Fed's move to the sidelines. Despite output cuts an nounced last week by OPEC, crude fell to $56.82 a barrel, down 27% from its August peak and close to a setting a 52-week low, notes Paul Hickey of Birinyi Associates. In deed. if clUde futures hit $56.14, it would be the first time they\\ill haye set a 52-week low since N ov.15, 2001-when oil bottomed out at $17.45.

One other factor appears to have been at work in the mar kets' adyance oYer the past couple of months-the return of the yen-carry trade. That involves bon'owing yen, which costs a fraction of a percent, to buy higher-yielding assets.

The strategy backfired earlier this year when the Bank of Japan ended its so-called Quantitative Easing, which in volves stuffing the channels with trillions of yen of excess liquidity to stimulate the domestic econ omy. That helped precipitate the spring selloffs in everything from the Icelandic krona to the U.S. stock market.

Expectations that the Japanese central bank would take the next step, to lift rates from zero, helped push the yen up sharply, to about 110 to the dollar by mid-May from around 119. And that's what put the kibosh on the markets. Even if the BOJ jacked up rates all the way to 1 %, it still would be the cheapest money in the world. But the Japanese currency's rise would mean nearly a 10% increase in the dollar value of a yen loan, a crushing blow to a levered speculator.

The yen has since gradually receded back to the 118-119 leyel to the dollar, and despite expectations of an eventual rise in Japanese short-term rates, theBOJ is still stuck at zero. Giyen the irresistible prospect of free money, the yen carry trade resumed in mid-summer, which Charles Dumas of London-based Lombard Research writes "is the chief ex planation of Wall Street's recent bull run."

Last Wednesday. however, the Nihon Keizai Shimbun re ported the Bank of Japan plans to increase its monitoring of the yen-carry trade because of its concern the tactic was pressuring the yen lower. The Japanese central bank quickly denied the report, telling Dow Jones Newswires it has not "strengthened its stance monitoring the yen-carry trade."

Taking the BOJ at its ,yard, one still wonders how Japan's leading business newspaper would run a story that named no sources if it didn't trust the story's veracity. A cynic might think the Japanese central bank would want plausible deni ability against accusations it was encouraging a cheap yen.

Japan's domestic economy has been showing signs of soft ening, writes Jonathan AllIDl of KEC Financial Products in The Blah!, his daily newsletter out of Tokyo. "The BOJ, in particular, seems in denial on this, arguing that the apparent signs of slowing/weakness are either a function of inade quate data or the weathel;" he writes. Absent support from domestic demand, Japan's economic recovery is heavily de pendent on capital spending and exports, adds Stephen Roach, chief economist of Morgan Stanley. In that case, the Bank of Japan would appear to be in no hurry to raise rates, which would boost the yen and hamper exports.

With the yen and Japanese interest rates capped, lever eraged speculators have been piling back into the yen-carry trade. ''What better way to add a little oomph to your year end performance than lever-up-borrowing at [0.25%] ina cw'rency that is all but guaranteed to remain weak?" writes Stephanie Pomboy of MacroMavens in her weekly missive.

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity, observes F. Mark Turner, head 6fPentagram Partners, a Milton, Mass., global hedge fund. But, Pomboy warns, that tide of liquidity could recede quickly if the dollar falls, and by extension, the yen rises. The reversal of the yen-carry trade then could cause all sorts of havoc.

E-mail: randall.forsyth@barrons.com

Measuring Up

2006-12-15T12:29:00.000-08:00

Agilent Technologies isn't one of tech's glamour queens. But its solid businesses and strong outlook make its shares enticing.

TEST AND MEASURE, MEASURE AND TEST. THAT COULD BE THE MOTTO of Agilent Technologies' business, as well as its management philoso phy.

Agilent (ticker: A), the top producer of testing equipment for the elec tronics and biotech industries, has honed its focus since it was spun off by Hewlett-Packard (HPQ) in 1999. Though HP's roots lay in electronic-test ing geal; Agilent was viewed as an expendable grab-bag of ancillary busi nesses.

Today, through several divestitures and a pending spinoff, Agilent consists of two divisions, electronic measurement and bio-analytics, serving lal'ge markets in the wireless-communications, chemical and life-sciences industries. The company is in several nicely growing, less cyclical businesses, governed by a stated management goal of achieving a 20% return on invested capital over an economic cycle.

Agilent generates impressive wads of cash, which along with it~ deal proceeds, should help it repurchase $2 billion worth of its shares over the next two yeal's-a sizable chunk of its current $14 billion mal'ket value. This comes after a $4 billion buyback in the past two years. Agilent shares are roughly nat on the yeal', at about 34.81, but they' have rebounded from a summertime low around 27.

Given Agilent's strong free CCl.'Jh flow of $750 million, and earnings that ' could approach $2 a share in fiscal 2007 (ending October), the company's stock could rise 15% or more, based on the cash-flow and earnings valua tions of peers such as Tektronix (TEK) and Thermo-Electron (TMO).

Investor-relations chief Hillial'd Terry says Agilent's goal is to pro duce average annual revenue growth of 10% through new-product intro ductions, market-shal'e gains and acquisitions. That would trump the overall market's typical 6% yearly sales gain.

While not ten'ibly cheap at more than 18 times expected fIscal 2007 earnings, the stock could enjoy multiple expansion over time as the Palo Alto concern continues increasing margins by outsourcing manufactm'ing, shrinks its share base, trims inventories and acceler ates receivables collections. Other companies in this steady, high-re turn industry routinely sport premium valuations.

Agilent's long-running restructuring involved selling some $3.7 bil lion of non-core units, including its semiconductor-products division. The company also took public Verigy (VRGY), its chip-testing arm, over the summer, and will distribute its remaining stake to Agilent sharehold ers Oct. 31. The Verigy stake is worth about $2 per Agilent share. Only Agilent holders of record on Oct. 16 will receive Verigy shares.

Newly streamlined, Agilent's challenge is to build upon its leading mar ket positions. The company's single largest market is wireless communica tions. Among its priorities is to increase its high-tech defense and aero space sales.

Bio-analytics is a faster-growing business with higher retm'ns, serving pharmaceutical, genomics and chemicals customers. Companies in this area tend to garner higher stock-market multiples, so Agilent's goal of accelerating growth here, in part through acquisitions, also should boost its valuation over time. The company has extraordinary geographic bal ance, with 40% of its sales in the Americas, 36% in Asia and 24% in Europe.

The risk that Agilent might deploy some of its growing free cash flow into expensive or risky acquisitions may worry some investors and analysts. But Terry says: "The most important thing is that acquisitions not destroy shareholder value. Om' sweet spot is smaller, gap-filling technology acquisitions."

Wall Street is somewhat lukewarm on the stock, with five Buy ratings and five Holds, and an average price target of 37. This should cheer contrarians. One fan, Robert W. Baird analyst Richard East man, thinks Agilent eventually might initiate a cash dividend to go with its large repurchase program. He has a conservative target of 39 on the shares.

Not much about Agilent sounds dazzling, but therein lies its quiet appeal. Rather than betting on which new gizmo or highly-touted drug might be a blockbuster, why not bank on the company that sells technol ogy prospectors vital tools? That's a thesis you can test-and measure .•

By Michael Santoli

The New Cisco - ISSUE 1ST-WEEK DECEMBER 2006

2006-12-15T11:44:00.000-08:00

The New Cisco

As technologies like Internet video take off, Cisco Systems, the king of computer networking, will be among the biggest winners. Why its shares could rally another 15%.

The New Cisco
As technologies like Internet video take off, Cisco Systems, the king of computer networking, will be among the biggest winners. Why its shares could rally another 15% ....

Energy Coup
Icahn delivers for shareholders ....

Alan Abelson What's powering the big rally?

Review -Tom Sullivan China's rising auto profile....

New SpinoffWestern Union's steller long-term growth prospects will become more apparent once the shadow US immigration-policy debate passes.Western Union:wired for success ....

Online GamingOnly the House Wins. Naught player cashed out in time ....

Oil OutfitsA gusher of takeover plays ....

In SeasonTechs to buy for a fall upturn. Why iShares Goldman Sachs Technology Fund could beat the market into year-end. Is this a private-equilaty buble? Quote.com's reincarnation. Plus Our Gadget of the Week: Logitech MX Revolution mouse ....

Electronic InvestorHealth-savings accounts ....

Economic BeatGene Epstein.The real labor picture ....

Economic Beat

It's in the Footnotes

Electronic Investor

Here's to Your Health

Follow Up

Icahn's Energy Coup

Head Line News

Target: Energy Takeovers

Last Woman Standing

Western Union Calling

Cisco's Bundle of Joy

Review & Preview

China's Spies Size Up The World's New Cars

Technology Trader

Playing Tech's Rise in the Fall

Up & Down Wall Street

Ho Hum, Another Scandal

For Jones Investors, The Price Is Right

2006-12-15T10:57:00.000-08:00

Jones Apperal Group put itself up for sale this year, but buyers balked at paying $35 a share. If the company can revamp its aging brands, it may be worth even more.

WHEN JONES APPAREL GROUP OFFERED ITSELF FOR sale earlier this year, bidders including Bain Capital and Texas Pacific Group browsed through its closets, but balked at the company's asking price: at least $35 to $36 a share. Jones wasn't seeking much of a premiml1 to its stock price-then, as now, in the low 30s. But buyout firms line up financing on the basis of past profits, not promises, and Jones' earnings have been slipping for several years. Mter five months on the auction block, the company gave up its search for a buyer, notwithstanding the private-equity market's keen interest in retail and ap parel concerns.

A humiliating out come? To be sure. But the dress ing-doW11 has given Jones, a stalwart or> the middle-to-"better"-priced women's wear market, even greater impetus to remake itself, and quickly. The Bristol, Pa,-based company, which owns more than 35 brands, including Jones New York, Anne Klein and the luxury retailer Barneys; is overhauling the management of some divisions in a bid to lift profitability. If it takes these and other steps to rejuvenate its largely tired labels, Jones could get its price in either the public or private market, And, if it beats Wall Street's consensus earnings forecasts-a subdued $2.22 a share for 2006 and $2.54 for .'07 -the shares, over time, could rally to ward 40.

Jones has jumped more than 11%, to 33 a share, since management's hopes for a deal collapsed in August. The smge stems in part from money rotating into consumer stocks as oil prices retreated in recent weeks, though it also demonstrates a measm'e of hope for the company's planned tmnaround one that mirrors Jones' confidence in rejecting lowball offers.

At a current 13 times '07 estimates, Jones Apparel Group (JNY) trades in line with rival Liz Claiborne (LIZ). Its shares aren't cheap, but Lazard Capital Mar kets analyst Todd Slater thinks the multiple can expand if the company manages sustainable top-line growth; revenues have been relatiyely flat for several years. Jef frey Edelman of l'BS mges investors to focus on 2007 and beyond, when margin improvement is likely to be come more apPal'ent. Edelman is one of only two Wall Street analysts with a Buy rating on the stock.

Lastweek. Mood's Investors Service also casta vote of confidence for Jones b:: confmning its investment-grade rating on the company's dE' be after an eight-month review, and pronouncing the outlook stable. The rating agency said in a statement that it expects Jones' financial metrics to improve as the company executes a strategic plan.

The challenges facing Jones help explain why ealings from operations sank to $2.48 a share last year from as much as $2.84 in 2002. The consolidation of department stores in recent years has boosted their clout vvith vendors and reduced the in-store real estate allotted to Jones' apparel and footwear brands. The growth of private-label merchandise and newer, hotter labels also has crowded out older names.

While Jones owns other stores in addition to Bar neys, its wholesale business contributed about 75% of last year's $5 billion of revenue. Federated Department Stores (FD), which operates Macy's and Bloomingdale's and recently merged with May Department Stores, accounts for 20% of the company's sales. This pits Jones "against an 800-pound gorilla at a time when I don't think it has much leverage," says an executive at a buyout that looked at the company.

When Jones reports third-quarter earnings Wednesday, investors woll be able to gauge this threat better but may find it overblown. In the wake of the Federal stores with insufficient traffic has removed a drag on margin. Analysts expect the company to post revenue of $1.24 billion, claW'll from $1.33 billion a year ago, and operating earn ings of 66 cents a share, duwn from 76 cents last year.

In the aftermath of Jones' failed sale, speculation on Seventh Avenue and Wall Street has swirled about the company's futme. Much of the talk centers on the futme of CEO Peter Boneparth and the sale or spinoff of assets such as Barneys and Nine West, a footwear brand the company acquired in 1999 for $1.4 billion.

For now, however, the board's directive to manage ment seems straightforward, according to people briefed on the board's thinking: Till'n around the flailing wholesale segments; and improve' growth enough to boost Jones' bargaining power with both retailers and futme suitors. Evidently this plan will buy time for Boneparth, 46, the former head of Jones' McNaughton Apparel Group subsidiary and head of the parent com pany since 2002. Through a Jones' spokesman, Boneparth declined to comment.

In truth, there is much Jones can do to spruce itself up, and dare we suggest it? - become fashionable again. For one, Jones must expand its store base to gain more control of its retail destiny, says Stevan Buxbaum, exec utive vice president of the Los Angeles retail and apparel consultant Buxbaum Group. The com pany plans to open 15 Anne Klein stores a year in the next few years, starting with eight this fall, and the revenue contribution from all its retail operations is projected to rise to 32% of sales in 2007. Still, criticssay the pace of retail expansion could be quick ened.

In the view of Morgan Keegan analyst Brad Stephens, Jones also must broaden its international footprint to reduce its reli ance on U.S. shoppers and spread economic cycle risk. Currently less than 10% of the company's revenue comes from overseas, compared with an average of 28% for the 13 retailers he studies.

Equally important, say apparel-industry insiders, is the need for Jones to diversify its customer base. Over many decades the company has built a faithful following by dressing women in clothes that are long on forgiveness though short on buzz. But those core customers are aging, and many are succumbing to the lure of value shop ping. Jones has yet to woo their children -and grand- children -the way Liz Claiborne has with its purchase of hip brands like Juicy Couture and Lucky Jeans. Small wonder Jones' gross margins, at 36.5%, trail those of Liz, at 47.4%, and Polo Ralph Lauren (RL), at 54%, based on Credit Suisse calculations.

Jones has spent nearly $2.5 billion in recent years on a series of acquisitions including Gloria Vanderbilt Apparel, suit maker Kasper and Maxwell Shoe-that lifted top-line growth by only half that amount. Andrew Jassin, a former Jones ex ecutive who is now managing director of the New York fashion-consulting firm Jassin-O'Rourke Group,. says the company must alter its acquisition model to look for "small, hip brands that aren't traditionally on its radar" and that appeal to younger generations, not just in apparel but also in accessories and even home furnishings.

Too, the company would be wise to ex ploit the fashion sensibility of hipper-than thou Barneys. Th[organ Keegan~ Stephens calls Barneys, with its Th[adison Avenue flag ship, a "learning lab" for Jones; he suggests the company could adapt the store's de signer fashions at moderate price points, and perhaps buy for itself up-and-coming designer labels.

Jones picked up Barneys in 2004 for $397 million, to the bafflement of many. Iron ically, it's the only business segment boast ing revenue growth today. Barneys sales at stores open at least a year rose 8.9% in the second quarter, following a 6.6% increase in the first. Earlier this year, Credit Suisse analyst Omar Saad estimated Barneys could fetch $634 million if sold, assuming a purchase price of 10 times 2006 earnings before interest, taxes, depreciation and am ortization. Jones has given no indication that it plans to part with the retailer.

Jones' centralized business model, in which a back office distributes and sup ports multiple brands, allows it to keep costs low. This was a negative to potential buyers, who saw fewer cost savings with which to boost earnings. But it could be a plus for shareholders, as improved sales would flow quickly to the bottom line. An other plus: Jones pays a quarterly dividend of 12 cents a share, for a 1.5% cm'rent yield.

At Jones, as at other apparel outfIts, the future rides on appealing fashions as well as profItable distribution. With the right design and marketing, the company could turn its anchor brands into names that shop pers covet again. Chances are, when it does, investors will covet its shares.

By Kopin Tan

Windfall in the Windy City

2006-12-15T09:49:00.000-08:00

FOR 157 YEARS, THE CHICAGO BOARD OF TRADE existed as a member-owned market for trad ing agricultural and financial fu tures. Last week, just in time to celebrate its first anniversary as a publicly traded company, it agreed to be sold to the Chi cago Mercantile Exchange for a price three times tha;t at which it made its de but. You can say it was a very good year.

The year ahead doesn't look half-bad ei ther. The $8 billion deal unites the two big gest U.S. futm'es markets, spawning a $26 billion colossus that lists durivatives on for eign exchange, interest rates, stocks and commodities. The underlying value of the contracts traded each day is a staggering $4.2 trillion,

Because the two markets tra
So are the potential savings from com bining two trading floors and operations situated just an easy stroll from one an other. And because the CME already clears and guarantees contracts traded at the CBOT, and the two know each other as intimately as only arch rivals can, the usual integration hazards are minimized.

A CME-CBOT deal has long been the subject of happy-hour jabber in the Windy City, and its logic was flagged here when the two talked just before the CBOT went public ("Harvesting Value," July 4, 2005).

Given the public market's rabid appetite for exchange stocks, CBOT members were right to hold out. The stock came public last October at 54-near the CME's then-offer of about 60- but quickly climbed above 120. Last Wednesday, after the sale was an nounced, it rose 13%, to about 152.

CBOT stockholders will swap each of their shares for 0.3006 of a CME share, although they can elect to receive a pro rated amount of cash (up to $3 billion to tal). The CME will control the combined company. While the concentration of so much pricing power in one hand will worry customers-both exchanges have raised fees in recent years-industry ex perts don't foresee major regulatory hur dles, given the lack of overlapping prod ucts, and competition from overseas and over-the-counter markets.

Until the merger's expected mid-2007 close, CBOT shares will trade in tandem with their acquirer's. At 501, CME stock has soared more than 1,330% since the ex change went public at 35 nearly four years ago.

The shares are by no means cheap at 39 times future earnings. While the entire sec tor has rallied -the Dow Jones Global Ex changes index last week hit a record high and was up 54% this year-the CME com mands a premium even within this exalted group, partly because trading volume in U.S. futures and options is growing at more than 25% a year. The CME and CBOT also enjoy virtual monopolies in theU.S., with exclusive rights to trade many key products. The stock could fall hard if growth slows or the favorable regulatory climate cools, but neither is likely to happen soon.

On the other hand, CME profits can climb further. The exchange earned $8.81 a share in 2005 on a pre-tax margin of 52%, and analysts expect $11.44 this year.

Management's forecast of post-merger savings seems modest. Keefe Bruyette & Woods analyst Richard Herr expects the CME to save 20% of the projected com bined costs, or $175 million, versus the 14%, or $125 million that the CME an nounced. He says his estimate "may still be too conservative."

Less tangible is the advantage of having one concentrated li quidity pool to which risk managers will flock. Herr raised his earnings per-share forecast for the CME to $15.50 from $14.50 for 2007, and to $20.50 from $17.50 fOr 2008. He also bumped up his price target for CME shares to 600 from 500.

The deal spurred yet another wave of speculation. The New York Mercantile Ex change saw increased interest in its pend ing IPO, as chatter grew about a potential takeover once it is listed. And at the Chi cago Board Options Exchange, seven seats were sold at record prices near $1.5 million the very day the CME deal was announced-compared with 104 seats for all of last year at prices no higher than $S75,000.

Oracle's Second Wind

2006-12-15T09:26:00.000-08:00

Follow-Up: A Return Visit to Earlier Stories
ORACLE CHIEF EXECUTIVE LARRY Ellison is taking a victory lap this week at Oracle OpenWorld, his company's big sales conference in San Francisco. After successfully deploying his controversial takeover and consolidation strategy ear lier this decade-against a barrage of naysayers - his giant software company finally has been re,nu:ded handsomely for its efforts: Oracle shares are up more than GOo/c, to $18.94,Jrom their 52-week low of nearly a year ago.

The stock could get another lift in com ing weeks, ,vith analysts predicting a hefty 38% earnings jump in the quarter ending Nov. 7, to 22 cents a share, thanks in part to a weak year-earlier period. Over the next 12 months, some Ellison fans say, the shares should climb 20% to 25%. That would leave it far ahead of where it stood when we laid out Oracle's leading role in the software industry's consolidation ("Soft Sell," Aug. 29, 2005) and followed up with a positive piece on Oracle's shares after the $5.9 billion Sie bel deal ("Will Oracle's Win Aid Stock?," Sept. 19, 2005).

There are, however, some real risks.For one thing, the benefits from Oracle's big acquisitions of PeopleS oft and Siebel Systems now look priced into the stock. While fans bet on Ellison doing another successful deal, he might also do a ques tionable one, hurting the shares at least temporarily. Speculation has centered on developers of so-called business-analytic software, which helps corporations track their performance. But these companies, such as Business Objects (BOBJ) and Hyperion Solutions (HYSL) are relatively expensive and thus could take longer to fuel growth.

Cowen & Co.'s software analyst, Pe ter Goldmacher, thinks that Oracle should look for on demand software companies, such as WebEx (WEBX), which provides Internet conferencing and instructional ser vices. Trusting that Oracle ,vill go for sen sible deals, he sees the stock hitting the low 20s in 12 to 18 months.

Acquisitions aren't the only issue for investors. It may be getting harder to tell exactly where the enterprise-software leader gets its gJ.'ovith. While the com pany posted a blowout Augnst quartel~ some analysts maintain that revenue from software applications - a prox-y for the success of the PeopleSoft and Siebel deals - has been inflated by the inclnsion of some revenue from Siebel "middle ware," integJ.'ation software generally con sidered distinct from an application. If that's true, favorable judgments on the acquisitions may need some revision.

And, if following the money is a smart course. Oracle President Charles Phillips recently gave investors cause fo~' COLeern. On Oct. 6, he exercised options and sold 1.87 million shares, for a ne: pre,fit of about $13 million, according te' research firm InsiderScore.

When Phillips, a former enterprise somq'J'e analyst, left his cozy perch at Morgan Stanley in 2003 to help Ellison with his takeover spree, many on Wall Street thought he was crazy to take a man agement job in the seemingly moriblmd enterprise-software indnstry. Phillips was crazy like a fox, judging by this month's payout. Plilllips declined to comment.

While the stock now has more yellow flags than investors might like, the com pany's business does look to be on the rise. Initially, enstomers of PeopleSoft and Siebel were uncertain about Oracle's commitment to improving products. Now that Oracle has shown a resolve, customers are loosening their purse strings. Re sult: Some observers see revenues growing by about 20% in the fiscal year ending next May.

That has clearly helped the shares. "Oracle is being rewarded right now for a thoughtful and well-executed merger and acquisition strategy," Goldmacher says.

Oracle probably can cut some more costs over the next couple of years and, in 2008, it should get a boost from Fusion, its next-generation enterprise software. Fu sion will meld all the applications Oracle has created and acquired into one brand.

Oracle's stock, meanwhile, looks attrac tive compared with that of SAP, the Ger man software maker. Even after far out pacing SAP's shares (SAP) this year, Oracle trades at about 19.5 time estimated year-ahead earnings, versus 23.5 for SAP.

Oracle's stock probably won't repeat this year's surge anytime soon. But, if Elli son steers clear of dumb deals and the corporate software market holds up, in vestors could still have reason to cheer.- MARK VEVERKA

Preview 2 - Value Investing: Taking It on the Road

2006-12-15T09:16:00.000-08:00

Boss Tweedy on Stocks
As investors delight in the Dow's new record, one of the deans of value investing says his work has got ten a lot harder. Christopher BrO\Vl1e, who has man aged money at Tweedy, Browne since 1969, says the business of finding good companies at cheap prices is "dicier these days" because stocks are fairly valued.

That's not to say he's throwing inthe towel on bar gain hunting. To the contrary, he has recently come out with a book on the subject, The Little Book of Value Investing, publisher by John Wiley & Son. And he's funding ways to puts itsprinciples to work around the world.

Browne is actively trolling for foreign stocks, though he avoids emerging markets. He sees opportunity in South Korea. "Love the country, hate the neighborhood," he quotes a colleague saying, in reference to North Ko rea and its nuclear sabre rattling.

At home, he says big banks like Bank of America aren't bargains but can offer a "14% embedded yield"-counting dividend yields and earnings growth. ''That's OK these days," he says.

Even if the domestic market isn't teeming with op portunity, Browne is unwavering in his belief in value investing. While the Dow Jones Industrial Average has finally recovered from the tech wreck of more than six years ago, "average value funds are up 50% to 80% to 100%" during the same time frame, Browne points out. And while they underpelformed in the late 19908, "they didn't lose money," he says.

But, he confesses, he did break a sweat during those go-go years. "I'm convinced if the market hadn't busted in March 2000, we'd have lost half Our clients," Browne says.

Who said to beware the Ides of March?

Preview 1

2006-12-15T07:34:00.000-08:00

Wednesday 25
The Federal Open Market Committe concludes a two day meeting. It's expected to keep the fed-funds rate at 5.25%.

Monday 23

The Treasury Department con ducts an auction of $7 billion of re-opened Treasury Inflation Protection Securities, or TIPS.

Former Enron Chief Executive Of ficer Jeffrey Skilling faces sen tencing on 19 counts of fraud, con spiracy, insider trading and lying to auditors for his role in the 2001 collapse of the energy trad ing company. His boss, Ken Lay, had his convictions expunged due to his death.

Tuesday 24

The Federal Open Market Com mittee, the policy-making arm of the Federal Reserve, begins a two-day meeting to discuss inter est rates and the economy.

The Treasury sells $20 billion of two-year notes.

European Union Mfairs Minis terEmma Bonino and World Trade Organization head Pascal Lamy hold a news conference in Rome.

The Muslim holiday of Eid al-fitr, depending upon the appearance of the new moon, ends the fast ing month of Ramadan.

Belgrade hosts an international book fair.

Wednesday 25

A fresh look at the slumping housing market \"ith a report on existing-home sales in Septem ber is expectd.

The Treasury sells $14 billion of fiye-year notes.

The NASA Stereo twin spacecraft, which will study the sun, are scheduled to be launched from Cape Canaveral, Fla.

Thursday 26

The parade of corporate earn ings reports continues, with NIl Holdings (formerly Nexte1) ex pected by analysts to announce third-quarter net 41 cents a share.

The government releases orders for durable goods in Septem ber.

The latest data on new-home sales will be disclosed.

New York Fed President Timothy Geithner speaks about central banking in the global economy at a conference on the Japanese economy at Columbia Business School Center.

A World Trade Organization group is expected to approve a draft treaty allowing Vietnam's entry.

The New York Society of Security Analysts hosts its 13th annual Fi nancial Reporting Conference.

Ocean Tomo hosts its Fall 2006 Live Intellectual Property Auce tion at Capitalein New York

City, including Jimi Hendrix properties.

Friday 27

The Commerce Department re ports on third-quarter gross do" mestic product.

The University of Michigan re" leases its latest reading on con sumer sentiment.

Industrial & Commercial Bank of China's $19 billion initial pub lic offering of shares begin trad ing in Hong Kong and- Shanghai. The IPO is the largest ever, ac cording to market-data provider Dealogic.

Minneapolis Fed President Gary Stern gives a luncheon address at the 43rd annual meeting of the Missouri Valley Economic Associ ation.

The Wharton School of the Uni versity of Pennsylvania hosts its 9th annual Wharton Investment Management Conference in Phila. delphia.

Saturday 28

The Museum of American Fi nance sponsors a walking tour of Wall Street's history on the anniversary of the stock market crash of 1929. It will meets at 1 p.m. at the museum's gallery, 28 Broadway, New York City. $15 per person; $10 students/senior citizens.

Sunday 29

Fall back: DaYlight Sa\ing8 Time ends. Clocks get 8et back by one hour.

Brazil President Luiz Inacio cla Silva faces Geralc10 AlckIl-2l in a presidential election run-off.

Review (Dow Indicator) 2

2006-12-15T07:14:00.000-08:00

Dow Indicator

Dow Record

The Dow Jones Industrial Aver age hit and closed above the 12,000 mark last week, a new all time high. A strong third-quar ter performance by IBM helped to boost investor confidence in blue-chips stocks. But Caterpil lar cast a pall on the occasion with disappointing results on Friday.

Ford Strikes Back

Ford Motor launched its Edge crossover utility vehicle, as it seeks to regain lost North Amer ican market share and go head-to-head with Toyota's crossovers.

Going Shopping

Wal-Mart Stores agreed to ac quire a hypermarket chain in China for about $1 billion. The chain, made up ot giant stores that sell a wide range of general merchandise and food, could give Wal-Mart the biggest store net work in China.

Debtor Nation

Net foreign purchases of U.S. se curities reached an all-time high of $116.8 billion in August, accord ing to the Treasury Department. Japan remained the biggest sin gle holder of U.S. Treasuries, 'kith China second.

Tracking Inflation

The underlying U.S. inflation

rate accelerated to 2.9% in the 12 months ended September, the highest annual rate in over a de cade. But consumer prices fell 0.5% in September; the Labor De partment said.

Hot Commodities' Chicago Mercantile Exchange Holdings said it would buy CBOT Holdings for about $8 bil lion. The deal will create a huge global derivatives exchange \vith combined daily trading of about nine million contracts. (See star:." on page 19.)

Bringing Up Barbie

Barbie the doll did her bit for Mattel, helping the company post a 6% jump in third-quarter profits. The toy maker credited a rejuvenateci Barbie line and strong early shipments of TMX Elmo, the Sesame Street character.

Fitch Pitch

Fitch Ratings launched Derivative Fitch, the first rating agency to provide the $33 trillion credit- deriva tives market with ratings, research, analytics and evaluation services.

OPEC Meets

OPEC agreed to reduce crude oil output by 1.2 million barrels a day-a 4.3% drop from Septem ber's levels - at an emergency meeting to prop up faltering prices. But the New York crude oil futures market was unim pressed, as contracts fell below $57 a barrel Friday, their lowest level since November 2005.

Home Alone

The National Association of Home Builders' index for sales of new single-family homes rose one point in October, to 31, ending an eight-month string of declines. The increase this month followed an unrevised September reading of 30, the lowest monthly index in 15 years. The government re ported housing starts in Septem ber rose by 5.9%, after three monthly declines.

Grasso Cut

A New York state judge ordered former New York Stock Ex change Chief Executive Richard Grasso to return tens of millions of dollars of his $187.5 million pay package. The executive-com pensation case was brought by New York State Attorney Gen eral Eliot Spitzer, who is running for governor.

Overseas Package

UPS and Paste Italiane an nounced the completion of an agreement for UPS to carry the Italian postal service's interna tional express shipments. Ser vice starts Nov. 27. UPS also re ported better-than-expected third-quarter earnings of 96 cents a share, about a 9% gain from a year ago.

Odds In' Ends

- Adopted: Davie Banda, a 13-month-old baby boy from Malawi, by pop star Madonna and her husband Guy Ritchie.
- Filed: divorce papers from Heather Mills McCartney claim ing her estranged husband, pop icon and ex-Beatle Sir Paul Mc Cartney, abused her.
- Victorious: The St. Louis Car dinals, outlasting the New York Mets 4 games to 3 for the ~'ight to face the Detroit Tigers in the World Series.

Review (Dow Indicator) 1

2006-12-15T06:44:00.000-08:00

Dow Indicator

Dow Industrials 12002.37 +41.86
Dow World Index 262.26 +2.10
10-Year Treasury Bonds 4.79 -0.02

- Richard Bernstein

Chief investment strategist. Merrill Lynch

"I would doubt that. However, larger-cap tech compa nies are well worth looking at. FDr the past four months, we've been big fans of larger-cap, higher quality tech companies."

- Jason Trennert

Founder. Strategas Research Partners

"There was an intergalactic bull orbit in tech stocks in the late 1990s that was a once-every-three-genera tions event. I don't think there's any hope that we get back there. But are tech stocks likely to outper form? My answer is yes."

- Keith Wirtz

President and chief investment officer. Fifth Third Asset

Management "The Nasdaq had its moment in time, almost an anomaly moment, and we don't have those frenzied moments very often. We \vill reach 5000 at some time ... maybe within the next decade. But slowly, on fundamentals, and a very different PIE ratio than 6lhyears ago."

- Ken Tower

Chief Market Strategist. CyberTrader, a unit of Charles Schwab

"I'm very impressed by the fact that the Nasdaq could get back to its April high [of 2370.88J. I wasn't sure we'd even get that far."

Strike Up the Band

2006-12-15T05:27:00.000-08:00

The prophetic pair of scholar who, when the Dow last flew into the wild blue yonder, predicted that it would hit 36,000 are now only 24,000 points away from being right.

DOW 12,OOO

How important is it, really, that the Dow Jones Industrial Average, the granddaddy of all stock . indexes - it's 110 years old and remarkably spry, a heck of alotmore so, in fact, than some ofthosewhippersnap per averages a quarter of its age-closed above that nice, round number last Thursday for the first time ever?

To the blase blokes of whom Wall Street has more than its quota (they think feigning perpetual indiffer ence makes them appear ultra sophisticated), nothing shy of a 9.6 earthquake on the Richter scale is worth so much as batting an eye. And to the bruised, battered, beleaguered and badly bereft bears, consumed by grief at failing to take early hibernation, Dow 12,000 is merely fm"ther evidence of the madness of crowds, particularly crowds of well-heeled, gain-gaga investors.

The world at large, moreover, paid little heed. Congress, whose energies these days are totally directed to avoiding further disclosure of its crimes, did not even propose a sim plegesture of recognition that Dow 12,000 doesn't happen ev~ ery day, like the minting of a commemorative gold coin, with a picture of Messrs. Dow and Jones on its face and a button wood tree on the tails side, that would be officially valued at $12,000.

Mayor Michael Bloomberg, who owes his ample for tune and present eminence to. Wall Street, somehow did not see fit to order up a. ticker-tape parade, something he has no hesitation doing when one of the Big Apple's major-league sports teams wins a championship. (Al though perhaps' his honor has no hesitation in doing so because the teams, whichever their sport, of late have thoughtfully saved the city the trouble and expense of a ticker-tape parade by scrupulously avoiding involvement in a championship, much less winning one.)

Outside these blessed shores as well, the response to the Dow's extraordinary performance has been similarly muted. Did, for example, the North Koreans on hearing the news pause for even a second in their evil pursuit of more nuclear bombs? Quite the opposite. Indeed, it's not inconceivable that hostile as heis toward this country, Kim Jong II, North Korea's Great Leader (which President Bush, apparently flu ent in Korean, translates into English as Mighty Midget), was short the market and freshly enraged, rather than en thralled, by the Dow's historic achievement.

Now, to be sure, the Dmv's splendid ascent did get a lot of ink and air time, but no more, say, than if some body had snapped a photo of a pig flying. And, in any case, the coverage was largely devoted to the event itself-the doughty old average reaching 12,000-while its significance was unfortlmately scanted. Yet, in truth, Dow 12,000 is chock full of import.

Not the least of which is that the prophetic pair of scholars who, when the Dow last ventured into the wild blue yonder back at the turn of the centm"y, predicted that it would reach 36000, are now only 24,000 points away from being right. Since we must confess to having been among the doubters of that forecast from Day One, we feel 5 :nk seven years later to atone for our initial skepticism. For, to judge by the pace of its progress since that fateful forecast, it should take, om" trusty researcher Teresa Vozzo calculates, only 168 years to reach 36,000. Barring, needless to say, any unforeseen extended bear markets.

Dow 12,000 hasn't set investors to dancing in the Street not only because the traffic is simply awful in Lower Manhat tan these days, but also because, as intimated, the market as a whole has palpably lagged behind the Dow. The Nasdaq, which as even a casual observer of the investment scene is likely aware, bore the brunt of the vicious selling that started in 2000 and went on for several dark years, has yet to recover even half the ground lost in its dizzying descent from the top. The Wilshire 5000, as its name implies the most inclusive of the stock indexes, last we looked was still some 7%, or roughly $1.2 trillion, below its March 24. 2000, peak.

Which explains, too, why, apart from the Investors Intelli gence sm'Veys of advisers, "'hich haw been increasingly bull ish, other sentiment measures haw displayed at least a trace of caution. But, even as we scribbled that last sentence, those measures began to change as the hubbub occasioned by Dow 12,000 was, inevitably, starting to prove infectious. Whether that's for the better or worse depends on how you size up the prospects for the market beyond the next few weeks or months. We have a sneaking suspicion we needn't tell you where we come down.

What especially bothers us is that, to no mean extent, the Dow's run has been powered by herd instinct. Mutual funds and their more adventurous, far more addicted to debt and often more feckless younger kin, hedge funds, have piled into the big caps because the con sensus has opined that the big caps arethe place to be. This has proved rather a self-fulfilling analysis since their very piling in has been very much one of the reasons. the big caps have been the place to be.

In the process, opinion has rapidly become investment writ, further enriching big~cap performance. How long this ring around-the-rosy, Wall Street-style, can go on before it all falls down is anybody's guess; Ours is: not very long.

For one thing, the very unanimity about big caps, as una nimity on Wall Street about almost anything, is more than a trifle disturbing, since it's invariably wrong. Nor do the ratio nalizations offered by their new best friends as to why the big caps are destined to do well hold up under even modest scrutiny. Rationalizations that smack of whatever - has-be en will-be such as: expectations of another big year for COl"PO rate earnings (doubtful); a buoyant economy ( more doubt ful); consumers will spend with their customary abandon thanks to the windfall created by the drop in gasoline prices.

That last notion in particular has gained enormous cm" rency. Yet it strikes us as anything but a lead-pipe cinch. For openers, we're not convinced gasoline prices won't go back up once the elections are out of the way. Or that OPE Gwon't manage to reduce production; yes, we realize that many of its members truly excel at cheating and production limits give them plenty of opportunity to show their devious skill. But we also suspect that with the Saudis on board, output will be curbed, even if not as much as advertised, and the effect at the pump will be quite noticeable.

And, even if gasoline prices don't re bound, with the collapse in housing, an in creasingly limp job market and a negative savings rate, will consumers have the wherewithal, even if they summon up the will, to splm'ge? Put us down as just plain dubious.

There's an old Wall Street aphorism that our pal, great investor and valued Roundtable member, Archie MacAllaster, likes to quote. It goes something like:

"When the paddy wagon comes, they take the good girls with the bad." We might paraphrase that to this effect: When the paddy wagon comes, they'll take the big caps with the small.

Over the years, as we trod through this vale of tears, we've had plenty of epi thets thrown v.t us. No one, though, has ever accused us of be ing a gold bug. And with good reason we've never been one. In truth, we've

always had a wary attitude toward gold, which as an economic indicator struck us as kind of the Dow Jones Inde~ of Misery. And, frankly, it didn't help that not a few of the gold bugs we've run into have been a bit bugs about the metal.

We guess we've mellowed some or, per haps, the gold bugs aren't flapping as vigor ously as they did, say, in the early 'Eighties,· when gold fever was rampant and the end of the world seemed at hand (owning gold was guaranteed to secure you a privileged seat for that grand event). Anyway, for any number of reasons-not least among them the peril to the dollar from our humongous trade deficit and wildly spendthrift fiscal policies and a world generally that ReemR to get ever more unhinged with every passing day-we've g~ined a better, if still re strained, appreciation ofthe metal's invest ment virtues.

Obviously, no matter how precious, gold, we're very much aware, is a commod ity, more durable than pOl~k bellies, but a commodity nonetheless, with all the invest ment risk that noun connotes. And we're also cognizant there's a cost-of-carry to owning bullion: ingots are inconvenient to lug around and have to be stored in a safe place at your expense, and they pay no divi dends like a stock or interest like a bond to help defray that cost.

All of which may seem like a grudging prologue to saying some nice things about Newmont Mining, but those reRf~rval:iom\ are rooted in our abiding Kaflmesque fear of being mistaken for a gold bug.

Newmont is certainly not unknown to Barron's readers: Rhonda Brammer has written acouple of stylish and penetrating features on the company the past few years. The latest, in the July 3 issue, de scribed the remarkable awakening of gold

after its 20-year slumber and, in some de tail, recounted the noteworthy strides Newmont has been making in turning it self into the planet's premier producer of the yellow metal and, for that matter, a first-rate company by any standard.

She pointed out that Newmont was the only pure-play gold stock in the S&P 500. With a market cap of $23 billion, it enjoys admirable size and liquidity, has a global portfolio of first-rate properties and has been steadily discovering more gold than it mines. That's no small consideration for a market where supply Reems deRtined to be tight.

Without blinking sonw unexpected headaches-a dt"llllght. in Ghana that forced Newnwllt to shm'ply reduce its min ing I:hl'l'(', I'xpl"opriation in Uzbekistan (gc'.t.ting I,ieked out of that loony country strikl's liS as a badge of honor)-that provl'd a drag on this year's performance as w('11 as on the stock, Rhonda's piece was a highly persuasive argument for New IllOIlt'S shares as an investment.

What prompts us to take a quick look at N I'Wlllont is that gold, down from a peak of $71[, an ounce in May, is hanging in there a few bucks below $600 but is distinctly not a hot topic these days in Wall Street. Fur ther, Newmont's stock, which has ranged in the past 12 months from slightly under 40 to a hair under 63, has been mired for a fair stretch in the low 40s.

Yet the company boasts, among its vari ous and sundry attributes, an exception ally sturdy balance sheet, buttressed by an investment portfolio that's a true thing of

beauty and generates oodles of lovely cash, and a classy management, which, inci dentally, promises that any future sur prises will be on the upside.

As it happens, while in the midst of working up this note on Newmont, we re ceived an e-mail from Darren Pollock, who's with a West Coast investment advi sory dubbed Cheviot Value Management. Mr. Pollock obviously knows his way around a financial statement and has a sea soned investment eye. And, this won't sur prise you, we imagine, he's high on New mont.

Not the least of the attractions he cites is that the stock is selling a good piece be low what its business is worth. More specif ically, he reckons the company's true net as set value is 20% to 50% greater than its share price. He also points out that the stock is now selling where it sold back in 2003. Yet the price of gold has risen since then by a full 50%.

In her July article, when Newmont was changing hands around 50, Rhonda ven tured that the stock in the fullness of time might well climb to 75-80. Despite its re cent laggardly action, that still seem to us quite reasonable. The breakout year for the company's mine production shapes up as 2008. But sometime before that year rolls around, we have a hunch the stock will discount Newmont's improving prospects· in earnest.

And, as Mr. Pollock points out, also much in its favor is that a majority of the an alysts who follow Newmont rate it as a Hold or Sell. What more can you ask? .

It's in the Footnotes

2006-12-12T10:09:00.000-08:00

THE STUNNING BIT OF NEWS IN THE SEPTEMBER EM ployment report, released Friday by the Bureau of Labor Statistics (BLS), was not in the headline numbers but in one of the footnotes: The B LS made the confidence-shaking announcement that it would soon make the largest upward revision to payroll employment in recent history, if not ever.

But first the headline numbers themselves, which con tained a revisionist mare's nest of their own.

The unemployment rate was essentially unchanged in September, at 4.6%-01' as the markets prefer, it ''fell'' by a statistically meaningless tenth-of-a percentage point from the month before. The disappointment came with the payroll employment nun1ber, which rose only 51,000 in September, well below the consensus expectation of 120,000. On the other hand, upward revisions to July and August were also reported, with the net result that payroll gains over the past three months averaged 120,000 per month almost exactly.

And here's the irony: The September increase in payroll employment probably would have come in at lOO,DOO-plus, or nearly the consensus figure, if the BLS had still been reporting the monthly figures the way it used to.

The change in method, which seemed little-noticed by the markets, is known as "concillrent seasonal adjustment," and was introduced "in May 2003. It lends greater accuracy to the monthly estimates. Before conCillTent seasonal adjustment, however, the September increase probably would have been reported at more than 100,000, with virtually no revision to prior months. With conCillTent seasonal adjust ment, the increase is distributed more evenly over the full three months.

The only problem with this sort of accuracy, however, is that it's wasted on the markets, given their obsession with the most recently reported figm'e. In this case, the revisions to the two earlier months did have an impact, but the psycho logical effect is not quite the same. The irony, then, is that the improvement in accuracy can sometimes make traders less accurate in the way they interpret the numbers.

As for the unemployment rate, it first hit a 58-month low of 4.6% in May of this year. That it was back at 4.6% in September further confirms that payroll gains are both slow enough to stop the unemployment rate from falling, and fast enough to prevent it from rising. At this unemployment rate, the labor market is tight by almost any standard, with wages rising smartly. The increase in wages is clear even from a popularly-followed but flawed indicator, average hourly earnings, which tends to under state wage gains. It's even more apparent from the BLS' far more accurate measure of "hourly compensation," found in its data on productivity.

As of the second quarter, hourly compensation in the nonfarm business sector-which includes almost all forms, including benefits-ran 7.7% higher than a year ago. That's the fastest rate of increase since third quarter 2000, when the labor markets were even tighter.

And speaking of accuracy, the reason I called the planned upward revision of the payroll employment data "confidence-shaking" is that it shakes our confidence in the Bureau of Labor Statistics' ability to avoid the sort of errors it used to make. What used to happen is that it would generally overstate employment gains in a slow or contracting economy, and overstate them in an expanding economy.

But over the past few years, various improvements in technique were introduced that seemed to usher in a newera of greater accuracy. Those hopes were blasted away, however, when the BLS announced last week that the March 2006 tally of payroll employment would be upwardly revised by more 0.8 million. In proportionate terms, that's even larger than the huge upward revisions of 1997 and 2000, when the agency's statistical techniques were far cruder, and when gains in employment were truly going gangbusters.

The upward revision means, in effect, that from April 2005 through March 2006, payroll gains actually ran 40% higher ilian cillTently available estimates. Among other results, that closes much of ilie unexplained gap between payroll employment conventionally measured and as measured by the "payroll-compatible" data from the Household Sill'Vey (see "Missing from ilie Books," Economic Beat, Sept. 11).

It also makes you wonder if the BLS isn't underestimating gains in payroll employment right now.

By Gene Epstein

Here's to Your Health

2006-12-12T09:17:00.000-08:00

For those who get sick occasionally and don't have access to a full corporate health plan, these savings accounts offer a possible remedy. Increasingly, they require investment choices, too. Just be careful about the banks service fees.

A FEW YEARS AGO, A FRIEND CONFIDED THAT SHE and her husband, who were both self-employed, were shelling out about $1,000 amonth in health-insurance premium. I was suprised, because my husband and I were paying hundreds of dollars less even though we did't have regular corporate gigs, either: Today however-despite our attempts to police these costs we're paing a good deal more than $1,000 a month for our health benefits.

Of course, you can opt out of insmance and just hope you don't get sick, but new programs like health-savings accounts, or HSAs, are a more practical antidote for the high cost of health insmance, particularly for workers who are self-employed or toil for small companies.

HSAs are tax-exempt accounts held at a qualifyingfi nancial institution. You contribute to the account and, when you incur a qualified medical expense-most any thing you could claim on your 1040 as a medical or dental deduction (see Publication 502 on the IRS Website, www.irs.gov)-youwithdrawfundstopayforit. The pay ments are usually made by writing a check or using a debit card or withdrawal form your financial institu tion/administrator provides.

HSAs, which were created as part of a Medicare bill signed by President Bush in 2003 and enacted by Congress in 2004, are portable; that is they go with you if you change jobs. And yom money rolls over every year. Contributions are tax-exempt up to a pre set maximum, even if you don't itemize deductions. Increasingly, the accounts include investment options aimed at helping them grow.

To receive the tax-exemption, an HSA must be ac companied by a high-deductible health plan (HDHP) from an insurer; some financial institutions sell them as a package. The IRS sets the annual tax guidelines for these plans. In 2006, the minimum deductible for a single person is $1,050 and $2,100 for a family plan. In theory at least, the high deductible means the insurer can offer a better rate, and this savings, plus any additional contribution you can afford, should be enough to fund yom HSA.

Note: You can't contribute more than the amount of your HDHP deductible each year, or the IRS maximum ($2,700 for individuals and $5,450 for families),whichever is lower.

Here are some of the HSA programs and investment options we turneg up on the Internet.

In August 2006, Golden Rule (www.goldenrule.com). a UnitedHealthcare company, introduced mutual-fund investment options to help its HSA customers build their balances. Golden Rule, which helped pioneer HSAs when it introduced an antecedent, the medical-savings account, over a decade ago, is working with Exante Bank (w\vw.exantebankhsa.com) to provide HSA custom ers with an account, accompanying debit card, online account management and bill-paying services.

Golden Rule is one of the companies that provide both HSAs and HDHPs, although it doesn't offer coverage in all states. Participants earn 4% to 5% in an FD I C-insmed savings account. But once their accumulated funds reach $2,000, they can invest any excess in a choice of eight no load mutual funds. All the funds, including the Vanguard 500 Index and John Hancock Classic Value, have at least fom-star Morningstar ratings. Clients are said to squir rel away an average of more than $2,400 a year.

Sterling HSA (www.sterlinghsa.com).anindepen dent HSA specialist, has one of the most liberal invest ment selections we found: You can invest your HSA money in any IRS-approved vehicle. You can even work through your own broker, or use a program Sterling has with discount brokerage Partnervest Securities. Sterling HSA's own savings account tops out at 4.855% for accounts with more than $10,000.

HSA Bank (\vww.hsabankcom) has been in the medi cal-account market since 1997, and today is a unit of Qon necticut-based Webster Bank It rewards big savers with rates as high as 4.75% for accounts of $15,000 and above. Clients ofHSA can buy and sell stocks through TD Ameri trade Corporate Services, with which it has set up a special program: Yom money must first be deposited with HSA, then it goes to a money market account at Ameri trade, which you can use to buy stocks. Links to compa nies offering HDHPs are provided.

First American Bank (www.Jirstambankcom) offers the Health Savings NOW account, whose interest rates range from 3% for under $1,000 to 4% for $5,000 and up. Account holders get free online banking and billpay, and a debit card.

The best place we found to search and compare HDHPs is eHealthInsurance (www.ehealthinsmance. com). There, we researched health plans for a middle aged couple in Minnesota (like my husband and I), and found 13 plans. Deductibles ranged from $2,400 (Health Partners: $536.55 monthly premium; the insurer pays 80% of costs after the deductible is met and you are on the hook for 20%) to $10,000 (Blue Cross Blue Shield of Minnesota: $267.50 monthly premium; you pay nothing after deductible is met). You can click on a link to find eligible HSAs from other institutions.

Many HSA administrators offer typical online bank ing services-and sometimes, lots offees. Be sure to read up on any extra expenses before you choose an HSA.

Remember Quote.com? The stock-quote pioneer dis appeared into Lycos (www.lycos.com) for a few years, but was acquired by real-time financial-information pro vider eSignal (www.esignal.com) last spring. It was re cently redesigned and relaunched under its old address (www.quote.com).It·s now a free financial portal, devoid of pop-up and full-page advertisements.

There's a lot to like about this reincarnation. News coverage is voluminous, originating at places like Real TimeTraders.com (www.realtimetraders.com). Business Wire (www.businesswire.com) and the Associated Press (www.ap.org). Both breaking headlines and full stories are posted. Commentary at this early stage is options heavy, courtesy of Schaeffer's Investment Research (www.schaeffersresearch.com). There's also a smattering of global-market news and index quotes.

U.S. indexes and markets, of course, are quoted, and in dividual stock coverage is solid. You can do pasic technical analysis and read related Raging Bull message boards, view a company profile and SEC filings, and review in sider and institutional trading. There's also good mutual fund and ETF coverage. Yahoo!Finance it ain't, but it's good to see Quote.com back and off to a great re-start.

The Web is full of stock picks from pros, but ama tern's often claim they can do better. The Motley Fool (www.Jool.com) is offering them a chance to prove it with a new service launched October 3:

CAPS (capsJool.com) assesses.investor predictions for more than 1,200 individual stocks over a variety of time periods relative to S&P 500 performance. It also monitors the forecasts of more than 125 Wall Street firms and analysts. The site has been in beta test for a year or so, and a number of participants, with track records of just a month or two, have been 100% accmate. A fun site, well-designed and packed with picks and the reasoning behind them. Better yet, it's free.

By Kathy Yakal

Playing Tech's Rise in the Fall

2006-12-12T09:02:00.000-08:00

IT HAPPENS EVERY AUTUMN. LEAVES CHANGE color and fall to the ground, jack-o'-lanterns ap pear in windows or on front porches and investors start surveying tech shares.

That's because technology stocks generally beat the market over the final three months of the year. In each of the past five years, the Nasdaq Compos ite Index, a tech benchmark, has outpaced the Stan dard & Poor's 500 in the fourth quarter. And over 10 years, the Nasdaq has trailed the broader stock market only three times, in the fourth qmu'ters of 1996, 1997 and 2000 (the latter reflecting the great dot-com implosion), according to data trom Thom son Financial/Baseline.

Tech's fourth-quarter outperformance may stem from the increasing seasonality of the busi ness. Years ago, technology was dominated by cor pOl"ate purchases of computers, and so sales were spaced almost evenly throughout the J'ear. But con sumer pm"chases of PCs and consmner electronics now account for half of semiconductor sales, accord ing to the Semiconductor Industry Association, which makes tech much more dependent on certain periods, such as the U.S. holiday shopping season.

Whatever the reason, there seems to be a solid chance the phenomenon will occur again this year.

Despite concerns about consumers having less money to draw down from a cooling housing mar ket, there should be vibrant competition in elec tronic gadgets to woo their dollars this quarter, such as the battle between Apple Computer's (ticker: AAPL) iPods and Microsoft's (MSFT) new gizmo, Zune.

On the corporate side, there's the ritual known as the fourth-quarter budget flush. IT departments with unspent money must use it or lose it before the year ends.

And tech shares have lagged this year. The in formation-technology sector of the S&P 500 is up just 3.3%, versus 8.4% rise in the total S&P, making it the worst-performing group.

In the past 16 years, the market's worst-performing sector in the first three quarters of the year has produced the best retums in the fourth - a 12.34% rise, on average, ac cording to research firm Birinyi Associates.

"Technology, which is this year's worst performer thus far, should continue higher for the remainder of the year," writes Biri nyi analyst Justin Walters in a recent note.

But where to look amid all the potential _ tech picks is a puzzle. During the fourth quarter of 2005, while the Nasdaq beat the S&P's 1.6% return by almost one percent age point, 460 of 969 information-technol ogy companies traded flat or declined, ac cording to Baseline.

A smart way to go may. be exchange traded funds, or ETFs, which either hold shares in a broad swath of tech names or focus on a specific industry within tech.

A very broad-based tech ETF, such as iShares Goldman Sachs Technology Fund (IGM), can beat the broader market in the quarter. Last year, the IGM returned about 2.9% during the fourth quarter, higher even than the Nasdaq's 2.5%.

The IGM holds shares of the usual sus pects: among them, Microsoft, IBM (IBM), Intel (INTC) and Cisco Systems (CSCO).

It's also possible to play a corner of tech with ETFs. Here there are two choices: either go with a winner, or bet on an underpelformer.

The victorious industries this year have been communications and' software, both up more than 12%.

The iShares Goldman Sachs Network ing Fund (IGN) has a nice cross-section of all the important networking-equipment companies, such as Cisco, and Juniper Net . works (JNPR). So does the PowerShares Dynamic Networking Portfolio (PXQ).

On the software front, Oracle (ORCL), the second-largest software ven dor in the world after Microsoft, has beaten sales and profit. estimates handily the past two quarters. If that means soft ware's a strong point in the economy, the industry could be a big beneficiary of this year's corporate-budget flush.

PowerShares does a nice job with its PowerShares Dynamic Software Portfo lio (PSJ), balancing Oracle with up-and comers . such as Hyperion Solutions (HYSL). Merrill Lynch's Software HOLDRs (SWH) holds Microsoft, pluS' smaller stocks that might be on an up swing, such as Symantec (SYMC), the secu rity-software vendor.

If betting on the underdog has appeal, the worst-performing industry was Inter net Software and Services, down more than 25% this year. The Internet HOLDRs (HHH), sponsored by Merrill Lynch, has ~ eBay (EBAY) and Yahoo! (YHOO), but no Google (GOOG). For that, the best bet is to stick with a general tech ETF, such as the iShares Dow Jones U.S. Technology Sec tor Index (IYW), which puts Google in with Microsoft.

Semis are the second worst perform ers, off 8.1% this year. The iShares Gold man Sachs Semiconductor Fund (IGW) is fairly spread out among several semi names, not just Intel and Advanced Mi cro Devices (AMD).

Just don't forget to hand in these shares once fall has ended. Come the first week of January, many turn back into lumps of coal. For tech, the magic often disappears with the singing of

~ Auld Lang Syne._ By Tiernan Ray

Target: Energy Takeovers

2006-12-12T08:17:00.000-08:00

AT THE RISK OF BUTCHERING A ROLLING STONES lyric, acquisitive energy companies that can't get what they want can buy what they need.

With the cost of production rising, as oil and gas become more difficult to find and get out of the ground, smaller exploration companies have their hands tied. But larger players, which still have access to cheap capital, can grow by buying reserves.

There's been near-term uncertainty created by the big drops in petroleum and natural-gas prices; on several days recently, oil has fallen below $60 a barrel and the outlook is clouded (see page M13). Neverthe less, the amount anted up this year on energy merg ers and acquisitions could rival the more than $160 billion spent worldwide last year.

Canada's oil sands could look attractive to big for eign oil companies. And U.S. exploration companies could consolidate.

"A falling [price] environment ... still can spur M&A activity," says Rick Roberge, an energy merger-and acquisition consultant at PricewaterhouseCoopers. "Larger companies are very anxious to add to their asset base ... and sellers are anxious to sell out and get a good price."

State oil companies, especially China's, could be big players in global energy M&A in the coming year because demand for oil and gas so significantly out strips supply in that giant Asian nation, says Mitchell Silk, a partner at Allen & Overy, a law firm assisting Chinese companies in energy acquisitions.

Chinese oil outfits "will buy anything that equates to a price per barrel lower than what present prices are," Silk says.

Addressing a recent energy conference, Gregory Pipkin, the co-head of investment banking at Lehman Brothers' Houston office, said that Russian energy companies are looking for ways to sell their oil and gas production on a long-term basis in Europe. In addition, national oil companies in China and India "are acquiring reserves from all over the world to solve their domestic energy needs," he noted.

Canada's oil sands are. one place where national energy companies might look. Working the sands is costly because natural gas is needed to get the thick oil out of the ground. But big companies that consoli date smaller players in Canada or amass some proper ties there might find significant cost savings.

"My bet is, one giant company is going to say, 'We don't have enough oil sands in our portfolio,'" says Arthur Smith, the head of John S. Herold, an independent energy research and consulting firm.

Smith has three favorite oil-sands takeover targets, all with cheap valuations: EnCana, Canadian Natu ral Resources and Suncor Energy.

All three conduct exploration in the oil sands, and each has a stock-market value that exceeds $20 billion.

Suncor (ticker: SU), the most established player, produces and distributes gas and refines oil.

Canadian Natural (CNQ) conducts exploration in the North Sea and off the west coast of Africa.

EnCana (ECA) has a competitive cost advantage over its North American peers because it owns mil lions of acres of land, according to Stansberry & Associates Investment Research. It also has explora tion operations in the Middle East, Chad, Brazil, Greenland and France.

Shares in all three of these companies have dropped significantly since oil prices fell from their July highs. They now look cheap.

EnCana and Canadian Natural are the least expen sive. Divide the value of their assets by their cash flow (as measured by Ebitda-earnings before inter est, taxes, depreciation and amortization) and you get 5.9 and 6.7, respectively. Those are relatively modest numbers in their industry.

Buyers might be interested in purchasing assets or entire companies. Interested parties could include ConocoPhillips (COP), which has a significant pres ence in oil sands; Royal Dutch Shell (RDS-B), which has been buying leases in the region; and national oil companies, including ENI (E), the Italian oil giant, Smith says.

The potential to be acquired, of course, usually shouldn't be the only motive to buy a stock because even the most logical takeovers sometimes don't materialize.

C. Scott Baxter, the portfolio manager of Green River Energy Partners in New York, first ·looks for undervalued energy companies.

Three names that he thinks that are cheap and could be acquisition targets are Edge Petroleum (EPEX), Newfield Explora tion (NFX) and Grey Wolf (GW).

Edge is a small onshore exploration outfit with re serves in Texas and the Fayetteville Shale, a hot drilling play, mostly in Arkansas. Other firms with greater Fayetteville exposure trade at much higher valuations than Edge, he says. .

Newfield Exploration is another exploration company, and Grey Wolf is an onshore driller that owns rigs.

If a larger driller bought Grey Wolf, it would acquire rigs at a time when they're scarce and leasing rates remain high. And the purchase could pay for itself in less than three years, Baxter figures.

Newfield is a different story. It hasn't been generat ing the kind of returns that investors want to see, despite its significant reserves and profit potential. But a larger exploration and production company might jump at its bargain price with the possibility of improving production ilnd profitability.

Newfield and Grey Wolf each are trading around four times their enterprise value (stock-l1.1arket value, plus net debt), divided by Ebitda.

"A business peer could acquire these companies, fold them in, and it would be accretive to cash flow, given how cheap they are trading," observes Baxter.

Of course, with volatility in oil and natural-gas prices, some sellers might decide to hold out for better offers. That could slow M&A.

But the Exxon Mobils and BPs of the world, with very long-term views on commodity prices, won't let short-term blips affect acquisition decisions, says Rob erge at PricewaterhouseCoopers.

Comments Christopher Sheehan, director of M&A research at John S. Herold: "In a business where you need to keep replacing reserves, you need to turn to acquisitions."

by Dimitra DeFotis

Last Woman Standing (Part 2)

2006-12-12T07:33:00.000-08:00

More trouble may lie ahead: Gamblers anxious to clear out their accounts could cause a run on the bank at PartyGaming. The company, with cash of $133 million, owes clients $193 million.

ernment would likewise find all but impossible to access.

But the Leach,Kyl measure hits the Internet gam, ing industry where it hurts the most. It effectively cuts the companies off from all U.S. wagering, the very lifeblood of the business. The bill makes any transfer of U.s. funds for the purpose of wagering or settling accounts illegal. Among other things, financial .institutions will receive ongoing assistance from the Treasury, the Fed and the Department of Justice to identify new domain names and other conduits used by online'gaming companies to circumvent the rules for U.S. funds. A fairly ironclad "coding and blocking"

Party's Over

Shares of ,once-promising online gambling concerns have been under increasing pressure this year as legal and regulatory woes have mounted. Congress' move-banning the transfer of U.S. funds for betting-was the capper.

system will be capable of identifj-ing and thwarting III
Internet-gambling transactions. -

For example, PartyGaming of late has directed U,S. P; gamblers to send money to a phone-card company front tu called PccPay.com, apparently to disguise the real pur- SJ1 pose of the transfer requests from U.S. financial institu- Ir tions. Other companies that probably will be targeted vi: are such offshore "electronic wallet" concerns as Ne- in teller and FirePay, which have become popular payment If conduits for the offshore gaming industry since eBay's PayPal service, under regulatory pressure, stopped facili-
tating such transfers.

The legislation also will impose severe civil and crim- g< inal penalties on online-gambling companies and officials accepting illegal U.S. wagers. Seizing executives I Dr gaming-company assets in their offshore redoubts will, as always, be difficult. But any major U.S. legal action against industry players, particularly those publicly held, would severely damage the companies' repu tations and force them to incur heavy legal expenses.

At a minimum, U.S. authorities under the new ban would be able to easily win injunctions and default judg ments in U.S. courts against offending gaming compa nies that fail to close down their U.S. operations, virtu ally eliminating the companies' abilities to advertise or maintain a U.S. Web presence. U.S. officials are also exploring whether international tax treaties might allow regulators to go after companies and executives on their home turfs for U.S. tax evasion.

Under the Internal Revenue Code, there's a 2% excise tax imposed on all wagers not authorized by state law. Such an imposition on PartyGaming last year on the U.S. portion of its $48 billion in wagering would come to about $800 million before penalties and interest. That alone would've nearly wiped out its net revenues of $977.7 mil, lion for the year.

Representative Leach, for one, thinks that the indus' try's prospects have been blighted by his legislation. "This may well be the death knell of offshore Internet gam, bling," he tells Barron's. "Only time will tell, however."

The dominant figure in the online'gaming business remains the 39'year'old Ruth Parasol. In this month's Forbes 400 Richest Americans list, she and her husband, J. Russell DeLeon, are shown to have a combined net worth of $3.6 billion, which exceeds that of even longtime Las Vegas gambling mogul Steve Wynn, who weighs in at $2.6 billion. The magazine hit the newsstands just the week before the collapse in the stock, which lopped an estimated $1.5 billion off the couple's net worth.

Parasol has long shunned the spotlight and today lives a quiet life with her husband and two kids on Gibral, tar. A PartyGaming spokeswoman told us curtly that Parasol doesn't grant interviews.

Too bad. For hers is one fascinating life story. An excellent profile from the Los Angeles Times last year describes her unconventional upbrinbring in San Fran, cisco's Marin County as the daughter of a holocaust survivor, Richard Parasol, and his Swedish wife.

Ruth-Parasol went to an exclusive private school in the area where in her senior year she posed in a fur coat, with the caption underneath ·proclaiming that "Dia monds Are a Girl's Best Friend." Then it was on to the Jesuit-run University of San Francisco, followed by law school at Western State University in Fullerton.

Her father, according to The New York Times, had a long career in the porn industry, starting out with a chain of successful San Francisco massage parlors. The apple didn't fall from the tree: Shortly after her gradua tion from law school, Ruth joined her father as a legal adviser to his phone-sex billing operation. And soon she branched out into her own business, investing in, among other things, a porn Internet site that made a killing in 1996 by distributing a sex video featuring actress Pam ela Anderson and her then-husband, rocker Tommy Lee, in jlagmnte delicto.

As regulators turned the heat up on the sex industry, Parasol diversified into online gambling in 1997. Her ven ture, Starluck Casino (now PartyGaming), was strictly small potatoes until she teamed up with a bright young Indian computer programmer, Anurag Dikshit, who de vised the software for online poker players to join remotely in games involving literally thousands of other players. Internet poker exploded in popularity, creating a tidal wave of demand that the company has ridden ever since.

But if Parasol hu.., learned nothing else operating in the demimonde of the business world, no good thing goes on forever. One must always have an exit strategy to get out of Dodge before the regulators m"rive. Thus, she and her husband have been monetizing their owner ship in PartyGaming as fast as possible in recent years, even with the company's booming business and succu, lent operating mm"gins of about 60%.

The yem" before the company's IPO, PartyGaIning bought an entity called ElectraWorks for $826 million . While ownership of Electra Works wasn't revealed at the time, Parasol and her husband were clem"ly major hold, ers of the unit. The transaction was similaI' to the way private-equity firms often pay themselves huge special dividends before taking their controlled company public.

Then, in the IPO last year, which raised £1 billion, Parasol and her hubby sold 40% of the shares in the offering, reaping 436 million British pounds, or $815 mil lion dollars at current exchange rates. The IPO was fol lowed in June of this year with another insider sale of 200 million shares of PartyGaming stock for £232 million. In that sale, Pm"asol and DeLeon dumped exactly 66,666,666 shares for €77.3 million, or $145 million. The shaI'e tobil implies a certain puckish, if not devilish, intent. The in sider secondary issue would have been fm" larger if mar ket conditions had permitted.

So all in all, it appears that there will be no tag days for Pm"asol and her husband, even as PartyGaming shm'ehold ers are suffering huge losses. The pair has already cashed out an estimated $1.5 billion from the company. That cer tainly reduces much of the pain of the $1.5 billion loss they've taken on their remaining 30% stake.

More trouble could lie ahead for PartyGaming. Gam blers anxious to clear out their accounts could cause a run on the bank. For according to the company's June 30, 2006, balance sheet, PartyGaming owes its clients $192.6 million in liabilities and prize pools, while having only $132.9 million in cash and cash equivalents to meet that obligation. And those cash holdings are likely to have fallen sharply, because of $130.5 million of cash spent on an acquisition in August. Meanwhile, The Financial Times reported the cancellation of a $500 million bank credit line that the company had made some use of. PartyGaming recently cancelled a $115 million special dividend to shore up its cash.

The problem all this poses for gamblers is that, unlike the brokerage industry, customer accounts aren't segre gated and insured. Your money and the house's money tend to be one.

Several phone inquiries by Bar-ron:9 to PartyGaming on its cun'ent cash situation went unanswered.

Of course, the company could make good on its obligation with its retained earnings and shareholders equity, if there were any. But unfortunately the com pany has a negative tangible net worth of minus $53 million. And after what happened in Washington, one can bet that its servers and other physical assets are no longer worth the $58.3 million shown on the bal ance sheet. Nor are its goodwill and other intan gible assets likely worth any where near their $144.4 million balance-sheet value.

Not when the business has just gone up in smoke.

PartyGaming offers a sad tableau. Investors have already lost a ton. Its players may have their money fro zen, or never get all of it back. There are no winners in this sordid tale, except Parasol and the other insid ers. You don't beat the house.

Last Woman Standing (Part 1)

2006-12-12T07:25:00.000-08:00

The stocks of online-gambling outfits have crashed and probably won't recover, now that Congress has passed restrictions on the industry. As investors weep, the founder of the leading company may walk off with winnings of about $1.5 billion.

LAST MONDAY WAS BLACK MONDAY FOR THE internet-gambling industry on the London Stock Exchange. Industry giant PartyGaming lost about $5 billion in market value as its stock plummeted 58% to 45 from 107 pence. Falling more than 60% were the listing of Sportingbet and online-gaming cash-transfer services Neteller and FireOne Group.
The cause of the debacle was the passage on Sept. 30, during the waning hours of the U.S. congressional session, of a law to make it illegal for banks 01' credit-cm"d compa nies to process payments to online gambling outfits. The measure, spon sored by Republican Rep. James Leach of Iowa and Republican Sen.
John Kyl of Arizona, had been knock ing around for months, stymied by vm'i ous internal congressional squabbles and special interests such as the horse-betting industry's request for special exemptions. Finally, however, the ban made it, heaving across the fin ish line as a rider to the port security bill.
President Bush is expected to sign that into law in early November.

The immensity of the disaster to the on line-gambling industry is readily apparent:the majority of its business comes from U.S.
gamblers even though the companies are all domi ciled in offshore tax havens like Gibraltar, Antigua and Costa Rica. Some 80% of PartyGaming's revenue, for example, originates in the U.S., mostly from poker play ers attracted to the site's 24/7 card playing. Now, most of the online companies have announced plans to pull out of the American market voluntarily.

Some investors, of course, will try to find bargains amid the wreckage, perhaps thinking the companies could excel as vehicles for foreign betting. Fat chance. In fact, the outlook for this sector may well get worse in the months ahead, as the implications of the U.S. ban play through financial statements. One of the few investors likely to get out alive is PartyGaming's founder, a one time backer of the porn industry named Ruth Parasol. She and her husband had the good sense to start cashing out more than a year ago. More about them later.

If nothing else, the collapse in the gaming shares bespeaks an obtuseness on the part of investors in the stocks. First of all, it's no secret that the Justice De partment has long considered companies offering on line gaming to U.S. residents to be violating existing federal laws, such as the Wire Act and the Illegal' Gambling Business Act. Moreover, some eight states have specific bans on online gambling and most other states prohibit all forms of unlicensed gaming (need less to say, none of the Internet-gambling companies has such a license).

Perhaps PartyGaming (ticker: PRTY.London) posed the issue most starkly-and brazenly-in its prospectus for its initial public offering of stock in 2005: "Offshore gaming companies rely on the appar ent unwillingness or inability of regulators generally to bring actions against businesses with no physical presence in the relevant country."

Likewise, there have been plenty of warning signs of a coming U.S. crackdown. In July, BetOnSports chief executive David CmTuthers, a British citizen, was ar rested by federal agents in a Dallas-Fort Worth Airport lounge during a short layover en route thnn London to the company's headquarters in Costa Area.

The company fired him irnlllPdiat.ely for his blunder.
And Carruthers waH lIPId on a JlJ"(~viouHlY-Hl~ale, St. LouiH, sans passport and sporting an ankle hracell~L, ,grimly awaiting his next hearing date in federal court in that city_

Last month, Peter Dicks, non-executive chairman of SporLingbet, waR likewise mTested at JFK Airport when he nonchalantly showed up in the Big Apple to attend a directors meeting of a tech company. His mTest was a result of a sealed wm"rant issued by Louisiana state au thorities, charging him with "gambling by computer" of fenses. Louisiana is rumored to have dozens of other sealed WmTants covering virtually the entire executive rosters of the online-gambling industry.

In any event, Dicks was able to beat the Louisiana warrant in late September when New York Gov. George Pataki refused to order his extradition. Perhaps this was because Dicks had already resigned his position. He's now safely back in Great Britain.

The arrests followed a heady growth spurt for the industry (see "Full House: Suddenly, the Whole World is Playing Online Poker," the Ba'rron's cover story of Feb. 21, 2005). And they quickly changed the behavior of executives. A number of industry figures, including Par tyGaming chairman and English "suit" Michael.Jackson, disclosed that they no longer planned to travel to the United States. World Gaming Chairman James Gross man and Director Clare Roberts both resigned their positions with the London-listed and Antigua-based con cern. Both had business interests in the U.S. that re quired continued access to America.

Likewise, CryptoLogic, a provider of online-gam bling software, saw fit to announce plans to move its headquarters in January from Canada to Ireland. At the same time, its Canadian CEO announced he was step ping down ''for family reasons." The company said that the change of domiciles was dictated by the need to be nearer to its customers. No mention was made of the U.S. regulatory mortar fire that seemed to be landing steadily closer to the company's quarters.

Offshore Internet-gaming companies and their m~\ior operatives had long lived in a world of denial, assuming that their operations were beyond the long reach of U.S. regulators. For one thing, such industry figures as Par tyGaming's Parasol and BetOnSports founder Gary Ka plan, an ex-New York bookmaker, were assumed to be extradition-proof. After all, they were living in domi ciles - Gibraltar in the case of Parasol and Costa Rica for Kaplan -where online gaming is legal. Moreover, all their company computer servers, cash balances and other assets are also in offshore locations that the gov-

Western Union Calling

2006-12-12T06:41:00.000-08:00

The money-transfer giant, newly spun off from Fist Data, could deliver some nice reward for investors. But expect some short-term bumps: The company's brisk business with migrant workers has pilled it into the debate over immigration policy.

WESTERN UNION'S BUSINESS IS ALL about fast money-cash zapped around the globe in a flash. An investment in the stock, how ever; may require some patience.

The company, spun off from First Data on Sept. 29, does a brisk business handling money transfers for the world's migrant population. While that service presents tremendous opportunity for the long term, it puts Western Union uncom fortably close to America's debate over immigration policy. The rhetoric and the uncertainty could put a damper on the the company's profit outlook, at least through the November elections.

Chances are, though, that investors who hang tough will be rewarded. Mter all, the company has an umivaled global franchise, a strong market, a highly prof itable business model and a freshly moti vated management team.

Western Union (ticker: WU) traces its history to the dawn of the Telegraph Age in the mid-19th century. It was an original Dow Jones Average member in 1884, and introduced the first consumer charge card (1914) and the first singing telegram (1933).

It was spun off from First Data (FDC) after more than a decade as a subsidiary of the data-processing giant. With the stock trading recently around $19.75, the company has a market value of $15.1 billion and is already a member of the Standard & Poor's 500 Index.

Today Englewood, Colo;-based Western Union is focused almost exclusively on money transfers. It has over 270,000 agents in 200 countries, making it more than three times as large as its nearest competitor, MoneyGram International (MGI).

Essentially, Western Union is a play on increasing cross-border emigration and immigrants' propensity to wire money home. The global migrant population last year numbered 191 million, according to the United Nations, and is projected to gTOW to 280 million by 2050.

The overall market for cross-border remittances, mean while, grew an average ofS'l a year from 2003 through 2005, a period in "which VI'estern Union increased its mar ket share from 10% to 1.Se::. This has enabled the company to grow faster than the industry, ylith revenue, operating profits and operating cash flmy each climbing an average of 12% annually from 200:3 t:ll'ough 2005.

Western Union has emiab;:,~ high profit margins, above 25%, thanks to its ability to charge relatively high prices for money transfers. Those margins should help produce about $1 billion in annual operating cash flow that can be used to reduce its $3.5 billion in debt and repurchase stock.

Still, there's no denying the political risks. As First Data was on its road show to discuss the spinoff, it 100vered revenue and profit guidance for the remainder of the year and for 2007, blaming a sluwdown in U.S.-to Mexico transfer volumes amid talk of a crackdown on illegal immigration. Immigrants, eyen legal ones, evi dently shied away from sending money home for fear of government scrutiny.

At the moment, Mexican business accounts for about 10% of revenue. A Jp Morgan analyst figcu'es that-as a worst-case scenario-19-to25cents in earnings per share could be at risk related to "consumer fears surrounding immigration reform". Those are significant sums: The consensus earnings-per-share forecats for 2006 and 2007, reflecting the new company guidance, are now at $1.06 and $1.10, respectively. (The numbers aren't directly comparable, because the '07 forecast includes the added costs of operating as an independent public company.)

As immigration concerns heated up, the Arizona attor ney general last month subpoenaed the company's records on transfers from Arizona and 28 other states to the Mexican s ta te of Sonora, reportedly seeking informa tion about the smuggling of immigrants and drugs. Last week, Westen, e nion won an order staying the request un til a hearing Oct. 16.

At a miniJmm1, Western Union, will need to spend money to "in back loyalty in immigrant communities and assure customers that they are not at risk. And the stock could ,yell proye volatile in the weeks ahead.

The fixation on immigration-policy risks has overshad owed Western Union's stellar long-term growth pros pects, globally diversified business and fairly attractive equity valuation. Key markets like Asia, India, Mrica and Russia, while much smaller than Mexico, are grow ing briskly. Following the 2007 adjustments to a public company cost structure, earnings should resume their 10% or better growth path.

At the Clll'rent share price, Western Union trades for just under 18 tin1es expected 2007 earnings. That might not seem cheap, but steady, low-capital-intensity businesses like transaction processors tend to fetch premium multi ples. MoneyGram also garners a 2007 multiple near 18.

But Jp Morgan's Tien-tsin Huang notes that 25% of MoneyGram's profits come from its payment-systems unit, essentially a bank-like business which earns an inter est-rate spreacl on a check and money-order portfolio. Place a bank-like multiple on those earnings, Murphy says, and MoneyGram's core money-transfer earnings are given a 21-22 multiple on 2007 earnings. At 21 times its 2007 forecasts, "'.'estern Union would be worth 23, or 14% higher than the stock's current level. And that wouldn't account for its superior network and market share.

What's more. established businesses that are spun off have a strong tendency to have their shares outperform once liberated. "Vestern Union management has been freshly loaded "ith stock options, most of them profit able only above the current stock price. You don't need to receive a singing telegram to recognize that company executives have strong incentives to enrich themselves and shareholders by confounding the doubters.

Cisco's Bundle of Joy (Part 2)

2006-12-11T16:55:00.000-08:00

sition of Scientific-Atlanta, a supplier of cable-television equpment.

Today almost 40% of Cisco's revenue comes from the sale of switches, the basic movers of data packets through electronic networks. Routers-the brainy parts of a network, which control and direct traffic chip in a bit more than 20%. Around 20% comes from new technologies like Internet telephony and video, on which the com panyis pinning much of its hopes for future growth. Services account for the remain ing 15%. Total revenue topped $28 billion in fiscal '06 and is expected to rise to $33 billion in the current fiscal year.

A few years back, Cisco's router sales flattened when Juniper Networks (JNPR) seized the high end of the market with powerful routers designed for the core networks of telephone-service provid ers like Verizon Communications (VZ). The competition forced Cisco to spend $500 million to develop a new router,the CSR-1, which could carry 100 times more traffic than Juniper's. Since its launch in 2004, the CSR-1 has stormed the market, forming the core of new networks at Sprint (S), Comcast (CMCSA), British Telecom (BT) and Japan's Soft- Cisco Product Segments bank BB, while Juniper has strug- Past five quarters: sales in billions gled to come up with a response. Ac cording to the Dell'Oro market-re search group, in Redwood City, Ca lif., Cisco now enjoys about a 60% share of the router market for such customers.

The development of the CSR-1 helped place Cisco once more on the ground floor of a revolution, this one involving the delivery of multiple services over a single network. Un til now, telephone, cable and satel lite television each has been deliv ered via a different network technol ogy. Now, companies in all three in dustries are gearing up to offer cus tomers a "triple play" ofvoice, high speed Internet and television service-and, before long, wireless and wireless TV -over a single network that uses the Internet Protocol technology that is Cisco's forte.

Similar efforts are unfolding abroad, where upstarts like France's N euf and Ita ly's Fastweb are challenging their coun tries' former telecom monopolies. CEO Chambers says Cisco designed products like the CSR-l with a vision of the coming convergence. "We did not build the CSR-l to do a billion phone calls," he says. "We built it to do 100 million videos."

Suppliers of traditional telecommunica tions equipment, such as Lucent Technol ogies (L U) and Nortel Networks (NT), have seen flat or falling demand from their phone-service customers in recent years. But spending on Internet equipment by phone and cable operators is growing by 17% a year, says Mike Volpi, who runs Cisco's router and service-provider busi nesses. Volpi views his business unit as the arms merchant in a war of competing com munications companies. But unlike the net work spending of the 1990s, which was fi nanced by stock sales, today's outlays are funded by these companies' copious cash flow.

The Spending iH likely to increase.When Verizon began instralling its FiOS fiber-optic network in Massachusetts last year, Comcast countered by boosting the download speed of its cable-modem ser- vice. That required the cable company to upgrade its routers.

Volpi is encouraged by Cisco's win rate so far. "When we do a goodjob as a vendor, we get 80% ofthe business and the second source gets 20%," he says. "When we don't do a good job, it's 50/50."

In the triple-play race so far, cable com panies have had great success selling tele phone service. They can charge a low fixed price because they run calls over Internetstyle routers, most provided by Cisco. Within about six months, Volpi says, Cisco routers also will incorporate digital-video technologies. Internet Protocol-based tele vision, or IPTV, is the delivery technology of choice for new providers of TV service like AT&T, Verizon and Italy's Fastweb.

The technology also will enable Cisco to bring the home-alarm industry into the dig ital age. Indeed, the company thinks it could create a billion-dollar market for gear thattransmits video from your baby's crib to your cell phone, or from a break-in to the local police station.

Best of ail, the "data packets" carrying video are bigger than other kinds of net work traffic, and would require networks to upgrade their switches and routers. High-definition video conferencing, for in stance, might use 10 times the network bandwidth of other network traffic. "The more bits, the better for Cisco," Volpi says.

To beguile enterprise customers· with the virtues of video, Cisco soon will unveil a sophisticated high-def video-conferencing system. Companies such as Polycom (PLCM), Radvision (RVSN) and Nor way's Tandberg have been selling video conferencing products for years, but Cisco could quickly become the market leader. Bob Hagerty, CEO of Pleasanton, Ca lif.-based Polycom, guesses there have been around a million video-conferencing systems installed around the world, about half sold by his company. In May Polycom introduced its latest $250,000 video-confer encing set-up. In coming months it will up grade its product to high-definition.

Competing with a high-def product of its own will be Fair Lawn, N.J.-based Rad vision, whose video-conferencing gear has been sold under the Cisco label. Video transmission over Internet-protocol net works means video calls no longer need be a luxury for CEOs only, says Radvision's chief executive, Boaz Raviv. His company created a consumer video-calling product for Fastweb that uses the living-room television as the conference-calI's video monitor. With Cisco and Northrup Grum man (NOC), Radvision is building the world's largest video-conferencing, by linking 1,500 meeting locations for the U.S. Defense Department.

Cisco's Chambers has used current-generation video-conferencing products to confer with other execu tives, such as IBM's Sam Palmisano. Chambers says he can barely tell who's who on the TV screen, and that he'd never use itto talk to customers.
But next-generation products are an other story, capable of delivering a - 0.5 "telepresence."

"It's video conferencing and data conferencing and IP telephony con ferencing,"says Chambers. "You can play Texas Hold'em with three other groups at the same time in different locations, as if you were all at' the same table."

Time permitting, you could also get some work done, and Chambers believes collaborators would work 20% to 30% more productively. He's got a credible record in productivity improvement; Cisco pulls in more than $700,000 in revenue for each em ployee, triple its nearest competitor.

Cisco will roll out its telepresence prod uct to its 70 sales offices next year, and esti mates it will break even on the investment in less than nine months. It expects to save an annualized $100 million in travel ex penses by year-end 2007.

Cisco's video plans are but a piece of a larger ambition to lead in all forms of com munication. In the same way that a phone company can run ail communications over a single Internet-Protocol network, a large business now can use one IP network to unify its various systems for e-mail, in stant-messaging, project collaboration, physical security and PBX phones. Cisco believes the annual market for "unified communications" solutions will reach $10 billion within three to five years.

The company's first communications products have been successful. In just a few years, Cisco grabbed the lead in the market for PBX [private branch ex change] internal phone switches, winning a 23% market share with its Voice-over-Internet-Protocol systems, according to fig ures from Synergy Research Group. In the July 2006 quarter, Cisco shipped more than a million VoIP telephones. For a branch office or a medium-sized business, getting a PBX can be as simple as adding a card to Cisco's Integrated Services Router, a Swiss Army knife-style product that also can become a network firewall and a Wi- Fi network base station, also by inserting new cards. Video surveillance soon will become another add-in feature.

Cisco sells tens of thousands of ISR routers every quarter; the ISR ramped to a $1 billion annual sales rate within its first year, faster than any other Cisco product.

Voice-over- Internet-Protocol solutions have dominated the PBX market with Sill' prising speed, forcing incumbent vendors like Avaya (AV) to revamp their product lines. In 2002, VoIP products were about 15% of all PBX phone lines sold, says Avaya CEO Lou D'Ambrosio. This year, he expects IP products will be 60% of PBX in dustry sales. The computer-like IP-PBX systems save companies money by letting them use cheap Internet links, instead of expensive trunk lines. They also allow third-party software writers to invent clever new applications. At the Wynn Las Vegas resort, for example, an Avaya IP phone lets guests use many ofthe casino's services from their night tables.

D'Ambrosio concedes that Cisco enjoys an advantage in selling IP products, as most large organizations own Cisco switches and routers. So PBX incumbents like Avaya and Nortel strive to compete on the quality of their software applications. Many customers want their mission-eriti calphone systems to remain separate from their networks, says Avaya's CEO.

The University Hospitals Health Sys tem in Cleveland, Ohio, is not one, however. The hospital complex has hired Cisco to re place its existing PBX, cable TV and com puter networks with a grand, unified net work, in an 18-month project costing tens of millions of dollars. The hospitals' phone center will feature triple-redundant sys tems, says the system's chief information officer Ed Marx. Medical records will be ac cessible instantly to authorized people any where. Intercom announcements of the "Code Blue, Unit 5700" variety will be a thing of the past as the network wirelessly summons the required doctors and nurses.

The Cleveland system did not solicit a network vendor other than Cisco, satisfied with the company's promise of a certain level of network peIformance, with finan cial penalties if the service fell short.

Indeed, many Cisco customers make just that one call, instead of soliciting com petitive bids. In a survey of 500 informa tion-technology buyers conducted in March by SG Cowen, 35% of respondents indicated they planned to move more of their network spending to Cisco, while only 4% expected to shift more to competi tors. Customer satisfaction is one reason why strong challengers, such as China's Huawei, have yet to crimp Cisco's 67% gross profit margins.

If Cisco is leaving most of its traditional networking rivals in the dust, there's anew competitor looming: Microsoft. The Red mond, Wash., software behemoth (MSFT) has its sights set on the same unified-com munications market that Cisco is target ing. In June Microsoft announced several products planned for late 2007 that would handle VoIP phone calling, instant messag ing and video conferencing. Microsoft plans to take advantage of its huge in stalled base by bundling some of the new communications features into its ubiqui tous suite of PC applications, Microsoft Of fice, while adding other features to its popular e-mail-server software, Microsoft Exchange. There are more than 400 million users of Microsoft Office and over 100 mil lion workers with mailboxes on an Ex change server.

Communications is a natural next step for Microsoft, says Anoop Gupta, a vice president of the company's unified commu nications group, "What are the key pain points that information workers have?" he asks. "Twenty years ago, it was creating documents and spreadsheets. Today, it's how worldwide partners can collaborate."

At the June announcement, Mi crm\oft demonstrated how a worker on the road could phone into the Exchange e-mail server and tell it to read aloud from the text of freshly arrived e-mail messages. A writer could click on a per son's name where it appears in a Word document, and instantly be able to phone or e-mail that person. A video conference demo featured a tabletop gadget with a 360-degree camera at the top of a six-inch stalk. This "Round table" video-conferencing device sends a panoramic view of everyone assembled, and can zoom in on any speaker.

But apart from devices like the Round table camera, the Microsoft unified commu nications solution is all software -with soft ware's attendant economies. "In om' ap proach, there is no PBX," says Gurdeep Singh Pall, another Microsoft VP. "It's a to tally distributed architecture."

If Microsoft sees communications go- I'. ing from computer to computer, Cisco foresees communications functions run ning on its network gear. One Cisco I advantage is its head start; it has been , selling communications products for a l1 few years, and can deliver solutions that work out of the box. Microsoft plans to start selling its software around the middle of 2007, and its third party hardware and software partners may need more time to get everything working. Microsoft and Cisco products may compete with each other, but at least they'll be able to talk to each other; the two companies say they'll work to ensure compatibility. Gupta says it's a huge market they're both chasing: perhaps as large as $40 billion in annual sales.

While these new technologies are giv ing Cisco's current customers reason to up grade, Cisco also is seeing growth of nearly 50% a year in its sale of networking systems in emerging markets like Saudi Arabia. That growth results from sales in vestments Cisco made in the past couple of years, just as it had done previously in In dia and China. A large sales force of Cisco representatives is now making the case for oil-rich nations to invest in networks as a way to improve health care in those coun tries and create high-value jobs. Today such countries represent 10% of Cisco's sales, but Chambers thinks they will con tribute 30% to 50% of future growth.

If Cisco revs up its sales growth with products for unified business communica tions or consumer quadruple plays, its gross margins should remain in a range of 64% to 66%, says Dennis Powell, the company's chief financial officer. That's because the value added, in most Cisco products, is software, whether it's embedded in com puter chips or part of the company's net work operating system.

Cisco generated free cash flow of $7 billion in its July 2006 fiscal year. Financial chief Powell says the company wants to give shareholders the cash it isn't investing in new ventures or acqui sitions. Since September 2001 Cisco has shrunk its shares outstanding by about 25% through $35.4 billion in stock buy backs. It still has $4.6 billion of fire power left under its share-buyback au thorization. Sooner or later, Powell expeets Cisco will start paying a dividend, but there has been no groundswell of shareholder demand yet. When Cisco does initiate a dividend, Powell would like it to be more meaningful than the token 1.5% yield paid by Microsoft (not including its special dividends).

Investors probablyvvill be happy to con tinue betting on John Chambers and his team. "We were $1 billion in sales when I took over, ten years ago," he says. "We now move into new markets and do $1 billion in each of them. No company in the history of IT has ever done that in more than a couple of product and we're doing it repeatedly. We're in the right spot at the right time, and we're trying not to mess that up".

Chances are, it won't.

Cisco's Bundle of Joy (Part 1)

2006-12-07T16:42:00.000-08:00

Cover Story

For Cisco, the bundling of voice, video and Internet service heralds the dawn of a new, more profitable age.

Getting the World Wired
by Bill Alpert

In recent years, Cisco Systems Chief Executive John Chambers has had trouble persuading investor that data-networking still is a growth business. The company's routers and other networking gear lia at the heart of the Internet and most of the world's large organizations. But does all that electronic plumbing ever need upgrading? After all, a notebook computer cracks when you drop it, but network switches rarely wear out. As 2006 began, Cisco's sales were rising by less than 10%. With its annual revenue around $30 billion, the San Jose, Calif based company needed to find new sources of growth, and in very large increments. Apparently, it has. At a meeting with Wall Street analysts last month, Cisco said that several markets look ripe enough to nourish its next growth spurt: oil-rich nations looking to wire their people; telephone and cable providers locked in an arms race for Internet gear; corporations bundling e-mail and voice messaging on their networks and a coming flood of Internet video traffic. Any one of those new markets could be worth $10 billion in annual sales to Cisco within five years.

Cisco CEO John Chambers says even he is surprised by the company's early suc cess in these new ventures. "We are win ning almost all the new jump balls," he says. "We ",ill become the leading com pany as the network enables all forms of communication."

In appreciation of these prospects, analysts have been raising their sales growth forecasts for Cisco from the low teens to 15% or more per year. As for profits-which totaled $6.8 billion, or $1.10

a share in the fiscal year ended July 2006- the Street sees $1.27 a share in fiscal i '07, and $1.47 in fiscal '08. Cisco, like most technology companies, reports earnings before option expenses.

Investors seem to have marked up their opinions of Cisco, as well. Since early Au gust, the company's shares (ticker: CSCO) have risen almost 40%, to a recent 23.90. Yet, at 18.8 times next year's estimated earnings, the stock sports a lower price/earnings multiple than most other networking shares. As sales and profits be gin to flow from new customers and new markets, like Internet video, Wall Street is likely to raise its stock-price targets. A number of analysts think the shares easily could tack on another 15%.

Cisco didn't invent the Internet, butfew other companies did - as much to help it come of age. In the 1990s, as the dot-com bubble was inflating, Cisco's sales in some years grew more than 50%. Revenue growth since has slackened to a comfort able low-to-mid-teens pace. Fiscal '06 sales rose 15%, bolstered by the February acqui-

Icahn's Energy Coup

2006-12-07T12:32:00.000-08:00

BIILLIONAIRE CARL ICARN CON . tinues to deliver for sharehold ers of American Real Estate Partners, a low-profile, mini conglomerate controlled and managed by the master investor.

Icahn's forte is buying undervalued assets, often in bankruptcy, and then selling them when business conditions improve.

A month ago, he pulled off a coup by agreeing to sell the energy assets of American Real Estate Pcutners (ticker: ACP) for $1.5 billion, an impressive multiple of what Icahn paid to assemble those properties a few years ago.

The well-timed energy deal-coming before the recent dmvndraft in oil prices - has helped lift the company's thinly traded shares to a record 60 on Friday from 48 when the energy deal was announced. Icahn controls 90% of the 62 million outstanding shares.

BaTTon's has written favorably sev eral times on American Real Estate Part ners in the past decade and our last cu'ti cle ("Icahn's Alternative Asset," Feb. 6, 2006) ran when the stock traded at 34.

In that story, we argued that the company's assets - energy, casinos, real estate and textiles-were worth about $46 a share. That estimate has proven conservative, partly because we valued the energy assets at $300 million less than what the company received.

However, American Real Estate Partners shares are a bargain no longer. Our analysis of the firm's bal ance sheet and remaining assets sug gests the company is worth about $3.4 billion, or $55 a share.

The sale of the energy business roughly coincided with the disposal of Icahn's Atlantic City casino assets, nota bly the Sands, for $250 million. The two deals could leave American Real Estate Partners with about $1.4 billion of net cash and secm"ities (after subtracting debt).

The remaining casino properties, in cluding the Stratosphere in Las Vegas, may be worth $1 billion, or about 10 times annual cash flow. American Real Estate Partners also owns real estate, including a valuable development in Cape Cod, Mass., that could be worth $500 million.

Pricey Property

Our analysis suggest American Real Estate Patners is worth about $55 a share a discount to its current price near $60.

Asset Value(bil)
Casinos $1.0
Textiles 0.5
Real Estate 0.5
Net Cash 1.4
Total Value 3.4
Value Per Share 55.0

Amer Real Estate Ptnrs (ACP - NYSE) Monthly close on Oct. 5

It also has a majority interest in WestPoint Stevens, the textile company that emerged from bankruptcy last year. American Real Estate Partners' paid about $500 million for that stake.

As a limited partnership, American Real Estate Partners pays less in taxes than a corporation, which is a benefit for investors. Investors do pay taxes annu ally on the partnership's income.

The tax bill this year is likely to be heavy because American Real Estate Partners earned nearly $2 a share in the first half of 2006 and probably realized big gains on the energy sale. The com pany pays a nominal dividend of 40 cents annually.

One of the benefits of investing with the 70-year-old Icahn in this vehicle rather than through his hedge fund, Icahn Partners, is lower costs. The boss takes no salary or management fee. This contrasts ,yith Icahn's hedge fund, which charges a 2% base fee and 25% of the profits to its well-heeled investors. The hedge fund is said to have posted a solid 15% gain so far this year; the partnership, however, has risen nearly 60%.

The hedge fund showcases the activ ist Icahn, who has tangled with manage ments at Time Warner (TWX) and most recently, Imclone Systems (IMCL). He's been in the news mostly recently for seeking regulatory approval to build a bigger position in Federated Depart ment Stores (FD). American Real Es tate Partners owns shares of both Time Warner and Imclone.

American Real Estate Partners' main focus is to "acquire undervalued compa nies in distressed or out-of-favor indus tries." There has been periodic specula tion that Icahn, whose wealth recently was estimated at $9.7 billion by Forbes magazine, will buy out minoruty holders.

Icahn, however, has had ample opportunity to do so at lower proces and has passed up the chance. This suggest he likes having a public company that offers the significant tax benefits.

Investors have done well to ride with Icahn. The stock is up five-fold in the past three years. American Real estate Partners may reap additional profits as Icahn capitalizes on new opportunities, but the shares aren't cheap anymore.

China's Spies Size Up The World's New Cars

2006-12-07T12:16:00.000-08:00

I first met the young Chinese lady inside a Volvo C30, a new two-door baby hatchback, as, she politely leaned over and pushed my feet away from the floor pedals. I was at the Paris Motor Show to take in the scene; she was there to snap digital photos of window latches, push-buttons and other interior fIx ings. I bumped into her again-quite literally-in the new Lexus LS600 hybrid. And I saw her and several others like her taking photos inside a Citroen Picasso minivan, a Bentley Con tinental GTC convertible and even a tiny Smart. Naturally, I was getting curious, so I asked her what she was up to. With a What were those broad grin and perfect English, she sai she had been brought to Paris by her employel; one of the larger China's car makers makers, though which one she wouldn'tsay. Her company planned to launch cars in Europe and the U.S. and wanted to knowwhat the competition was up to.

She and her colleagues, all clad in brown smocks, then con tinued on their errands-the latest sign of China's rising pro fIle in the auto industry. Honda already has begun e},,-porting Chinese compact cars to Em'ope, and cars from China's Chel'J! Automobile may be headed to America via a joint ventm'e \vith DaimlerChrysler. My new friend promised we'd meet again ~in 2008 or 2010. By then, she said, she would be in sales, promoting her company's cars.

Other countries were represented amply at the show.

France's home teams had the flashiest displays, led by Citl'Oen and its concept C-Metisse with gull-wing doors; they open to re veal the entire interior. Peugeot's new top-of-the-line 908RC also attracted big crowds. Though BMW's redesigned X5 was ab sent, its new-looking 3-series and Mini Cooper were winners.

As for the U.S. entries, the new Dodge Nitro, a souped-up cousin of Chrysler's Jeep Liberty, clearly won fans. That was a ' surprise, given that a fIll-up in France can cost 80 bucks or more.

Source: Barron's-JAY PALMER

Ho Hum, Another Scandal

2006-12-07T11:50:00.000-08:00

HOUSE OF ILL REPUTE?

Sorry about that, but obvious as it is, it just seemed too apt to resist. So why don't

* we try another catchy phrase to launch this screed (catchy phrases are so called - we're probably revealing a trade secret here-because they're supposed to catch the reader's attention). Okay? So how about this: The only injury he ever sustained in his wrestling days was a permanent headlock.

The "he," of course, is Del)"nis Hastert, and the head lock reference is prompted by the fact that in words and deeds he comes across as a tad slow, even after making due allowance for the fact he's a congressman. And some years before he became Speaker of the House of Repre sentatives, he was a high-school wrestling coach, a job he snared, we suspect, mostly because of his bulk (he loomed large as a wrestling coach should).

In fact, either catchy phrase would do fine as a grabber, since Mr. Hastert is the nominal boss man of the House of Representatives, which, we blush to re mind you, is the site of the blossoming page scandal. From that lofty position, with an eye on next month's elections, he allegedly sought to sweep the dastardly behavior of Mark Foley, the disgraced and very much ex congressman, under the rug. Mr. Hastert's efforts on this sCOre came to naught, because it was so crowded under that rug there was, alas, no room for Mr. Foley.

Quoting Harry Truman (but not by name; he identi fied the late president as "someone"), Mr. Hastert told a press conference that he was "taking responsibility be cause, as someone once said, the buck stops here." As it turns out, for Mr. Hastert, not only does the buck stop there, but so do any consequences, and he resolutely refused to step down as speaker. And we sympathize with him: it isn't as if, on Mr. Hastert's. watch, Mr. Foley had been appointed co-chair of the House unit charged with looking after the well-being of the country's last group of indentured servants-congressional pages.

Besides his unnatural interest in teen-age pages, Mr.

Foley suffered a more common malady that in the end proved his undoing-a compulsion to communicate his unwholesome interest to his intended targets via e-mail. As more than one former executive of Hewlett Packard could tell him-to say nothing of any number of errant corporate types whiling away their days in the slammer-the "e" in e-mail stands not for electronic but for exposure. We're all very lucky, really, that the criminal mind can't seem to grasp the notion that e-mail doesn't disappear forever with a tap of the delete button.

~Ir. Hastert blamed a truly evil combo-the media, ,he Democrats and George Soros (riot necessarily in that order. we hasten to add)-for all the fuss over the able passion for drink; so we can only assume that in claiming such an addiction he hopes to expiate his de praved actions by giving alcoholism a bad name.

The question, of course, is what impact-if any-the Foley scandal will have on next month's elections, whose outcome is fraught with potential to exercise a mighty influence on ,yhat happens the lie:\1: couple of years, not only in the real world, but even in places as far removed from the real world as Wall Street. One lmintended effect that should provide some ruefuL comfort to the Republicans is that it has tended to elbow Iraq off the front pages, and Iraq, if the polls are right (always a dubious proposition) seems of no little concern to the voters. That the administration felt the need to dispatch Secretary of State Rice on another of her unscheduled drop-ins to Iraq speaks to its worry about how the war is going and possible repercussions in the voting booth.

Frankly, though, we have our doubts that the Foley dis closure will have very much impact at all. That strictly non partisan conclusion is based in part on the ease with which the citizenry shrugged off Mr. Clinton's dalliance ",ith Mon ica Lewinsky. Granted that there were differences, not the least of which were the sexual preference of the exploiters and the ages oUhe exploited. Too, the affair with Monica was ostensibly consensual, although how an affair between a president and a star-struck intern qualifies as truly con sensual eludes us.

And we have a sneaking suspicion that had Mt. Clinton been running for reelection, the electorate might not have been so forghing. But there's no arguing the fact that his pop

ularity never dimmed very much, nor that he has had the most in credibly prosperous post-presi dential career.

But the strongest reason for our belief that the tawdry Foley episode will not change too many minds or, more to

the point, votes, come the first Tuesday in November is our· sense that increasingly nothing that Washington, and especially the Congress, does can possibly surprise, much less shock, the citizens of this great land.

SCANDAL, SHMANDAL. Wall Street, we're happy to report, reacted to the Foley fracas as it reacts to just about every disturbance outside its special ambit these days - by ignoring it. Instead, much to its credit, it kept on doing what it has been doing so strikingly for the past six weeks or so-enthusiasically buying stocks. Last week, moreover, as we have a hunch you may have noticed, the Dow soared from one newall-time high to the next, before taking a bit of a breather on Fridav.

a surprise, since that's what the Dow's made of), but small-caps, which have taken a back seat in this latest upswing, finally joined the party, if some what disappointingly, without then erstwhile elan.

It was, by any standard, a splendid week in the stock market and left all the major stock indexes palpably higher on the year.

So what exactly were investors cele brating? Well, we suppose you can cite the seeming disposition of Bernanke & Co. to cease tightening and the inevitable heightened expectations that they'd soon be cutting interest rates. Or, anticipation that third-quarter corporate earnings, the massive flood of reports on which is just beginning to trickle in, would make very stimulating reading. The rather sud den and sharp reversal in the price of crude-and commodities generally helped by sending the always scary spec tel' of inflation back into the shadows. And, of course, despite every chance to do so, the world hasn't come to an end.

What's more, as the astonishing growth in hedge funds and private-eq uity outfits illustrates, there's a lot of loose change out there, eager or even desperate to be put to work. By its very nature, it's oYel'\\"helmingly restless and demanding money. and what it demands most of all are high returns, unmindful of economic or investment trends. It sure isn't smart mone:.~ but it's undeniably big money and there's umelenting pres sure on its managers to invest. It has been great for the market, adding huge gobs ofliquidity via takeovers and lever aged buyouts and the like, but it's intrin sically bad for the market when the tide runs out; just how bad will only become evident during the next serious break.

When searching for the answer to the inevitable and unanswerable question as to precisely why a market suddenly takes off in the absence of any signal trigger, you can't underestimate the market it self: nothing more tickles the speculative fancy than rising share prices. And this bull move, coming as it did amid growing skepticism about the investment outlook, is a perfect example of the power of conta gion in coaxing investors off the sidelines and dissipating fear and ultimately pru dence.

Since our crystal ball is in the shop for repairs, we're unable to tell you how ex actly far this rally can carry or what will bring it up short. But we can venture that since it's being propelled more by money than mind and more by emotion than fun damentals, it's not for long, let alone for ever. So enjoy it while you can.

WHAT WE ESPECIALLY like about Fred Hickey, apart from the fact that he's the smart est tech analyst ex tant, 'is that he's nothing if not forthright. Ask his opinion and you get a swift and unedited response. Here's a for instance: in the course of chatting with him (which usually means listening to him) last week, we asked how he's doing. Unhesitatingly, he owned up to having had a truly punk September (his put options went the wrong way), turning his best-ever year into merely a good one.

Fred puts out an absolute gem of a monthly newsletter, The High-Tech Strategist, which at hundred and twenty bucks a year is a steal (he lives in New Hampshire, so he can afford to be a bit more restrained in what ,he charges; anyway, that's the end of the commer cial). He also, of course, graces our Roundtable. The secret of his success is twofold: he's smart as as a whip and he a fiendish worker. On the latter score, there's no better proof than that he rou tinely listens to and reads the transcripts of dozens on dozens of tech company con ference calls, a tribute both to his stamina (they can bore you to death) and dedica tion. Thanks to such onerous labor, he's able to extract nuggets of invaluable in formation from the torrent of blather.

Thus, in monitoring the Q&As with analysts and other semi-awake inter ested parties he discovered that the ap parently strong quarters of the elec tronic retailing giants, Best Buy (ticker: BBY) and Circuit City (CC), were not so very strong after all. Rather, the two companies turned to some ex traordinary measures to cut costs and help the bottom line, like mandating less corporate travel, cutting down on mar' keting expense and, even, in the case of Circuit City, delaying deployment of a new point-of-sale IT system.

As a result, they were able to beat an alysts' estimates lor the quarter, even though foot traffic and sales growth in their stores were not up to snuff. More importantly, it told Fred the excitement on the Street over supposed upbeat re tail business, which presumably re flected strength among high-end con s umers, was so much piffle. In fact, he re lates, demand for flat-panel TVs, whose price tags run in the thousands and have

* been a very hot item, is noticeably ebb ing. A trend confirmed by last week's dis mal quarterly report by another nation wide chain, Tweeter, whose comparable store sales dropped 13%.

And Fred points out that the loss of appetite for these big-ticket electronic items is symptomatic of what's happen ing in home improvement ( Home Depot and Lowe's) and new cars (GM and Ford) as well. He scornfully suggests that the Street has been mistaking good comps by "the sweater sellers," occa sioned by fortuitous weather, for strength in retailing as a whole that's strictly a mirage.

The reality, he contends, is that "we're likely at an exciting inflection point in the economy, where the long running U.S. consumer binge has come to a halt." And he fingers the collapse of housing and the drying up of the vast res ervoir of cash via equity withdrawals houses provided as the culprit.

As a kind of unrelated ES. here, we'd like to note that another valued Round table stalwart and valued old friend, Art Samberg, of Pequot, disclosed that the SEC has essentially dropped its probe of his and his fund's trading. No surprise, since there was never any reason in the first place for the SEC to investigate, aside from wild accusations by an overzealous SEC staff lawyer who was canned, pres sure by a few silly senators (is that redun dant?) and the hyperventilating coverage by our olleagues at the New York Times.

The New IBM

2006-12-02T10:44:00.000-08:00

The New IBM

Big Blue's shareholders have been blue for the past few years. But the tech giant has a new strategy, focused on software. Best of all, it's working.

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