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