Citibank Market Review 10-15

See Appendix A-1 for Analyst Certifications and Important Disclosures. Portfolio Strategist October 13, 2005 Volume 23, No. 40 A W E E K LY F O R I N V E S T O R S Editorial Overview Fed Inflation Comments Rattle Markets ............................................................................. 2 Must Read: IBM Corp. ........................................................................................................... 45 We are upgrading IBM to Buy, with a new target price of $95. Services bookings are on track to rise 10%–15% in 2005, and IBM continues to gain share in servers thanks to a superior microprocessor architecture versus HP or Sun. Spotlight Health Care Policy Proprietary / Proactive Industry Industry Medicare “Part D” Ready for Takeoff: New Drug Benefit Impact Heldman / Boorady / Grofik .................. 3 Banks Madan / Horowitz Why We Are Bullish on Trust and Processing Banks .............. 29 Multi-Industry Jeffrey T. Sprague Survey: Contrary to Fears, Industrial Markets Strong ............ 31 Macro / Commentary U.S. Equity Strategy On the Contrary Large-Cap, Growth Foreboding Fed Fears ........................ 7 Tobias M. Levkovich Large-Cap, Growth Industry Industry Electronic Arts Inc. Elizabeth Osur Up to Buy as Cycle Transition Nears ...................................... 33 Harley-Davidson, Inc. Gregory Badishkanian Still Plenty of Gas Left in the Tank; Upgrading to Buy ............ 35 Homebuilding Stephen Kim Buy on the Hype, Not into It .................................................. 37 Integrated Oils Doug Leggate Opportunity or Risk: Catching the Falling Knife — Upgrading MRO .................................................................... 39 Meredith Corp. William G. Bird Good Growth and Attractive Valuation; Up to Buy .................. 41 Index Targets & Portfolio Weighting ... 12 Recommended List ............................ 13 Economic & Market Analysis Hold Off with that Bear Suit ............... 15 Steven Wieting Economics This Week ........................... 17 Fixed Income Strategy Mid-Cap Taking a Stand in a Very Different Rate Cycle ...................................... 19 Friedlander / Brandes Small & Mid-Cap Strategy Insights Large-Cap, Value Large-Cap, Growth Industry Mid-Cap, GARP ConAgra Foods, Inc. David Driscoll Risk/Reward Balance Tips to Reward: Initiating with a Buy .. 43 IBM Corp. Richard Gardner Now Our Top Pick in Large-Cap Hardware: Target Price $95 ... 45 Semiconductors — Specialty Craig A. Ellis NAND Flash: Lowering Ratings on Share Appreciation ......... 47 StanCorp Financial Group, Inc. Walsh / Devine Initiation of Coverage with 1L Rating and $92 Target Price .... 49 Insurance Focus: Replacing HCC with UNM ............... 21 Albert D. Richards SmMid Portfolio ................................. 25 Small & Mid-Cap Focus List .............. 26 Quantitative Research In Style: 2005 Style Strategy Performance Update ...................... 27 Miller / Cox Global Focus The Globaliser Bruce Rolph .............................................................................. 51 Citigroup Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Non-US research analysts who have prepared this report, and who may be associated persons of the member or member organization, are not registered/qualified as research analysts with the NYSE and/or NASD, but instead have satisfied the registration/qualification requirements or other research-related standards of a non-US jurisdiction. Customers of the Firm in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at http://www.smithbarney.com (for retail clients) or http:// www.citigroupgeo.com (for institutional clients) or can call (866) 836-9542 to request a copy of this research. US10P048 Citigroup Global Marke Citigroup Global Markets Editorial Overview Fed Inflation Comments Rattle Markets Inflation fears are back and are well discussed by our strategists this week. In the face of these renewed concerns, they present a calming message. Tobias sees equity market trends as still constructive, Steve warns that inflation anxieties may be exaggerated by the media, and George and Michael tell fixed income investors that long-term yields are not likely to head substantially higher. I This week, Chief U.S. Equity Strategist Tobias Levkovich tells us that the Fed’s recent inflation-speak has helped to spook the markets (interestingly, the equity markets more than the bond markets). What concerns, exactly, are behind the Fed’s vocal stance? Tobias reviews the many theories on the Fed’s motivation but points out that, in the end, his basic valuation work and upcoming earnings are still supportive. Once investors have climbed these “cliffs of concern,” Tobias writes, they may see a rally on the other side. After raising his estimate of the fed funds peak last week (to 4.5% from 4%), economist Steve Wieting writes that inflation risks have emerged, but are often exaggerated by the media. Natural gas and heating costs will be heavier this winter — but not nearly as burdensome to the consumer as gasoline prices this past summer. Fixed income strategists George Friedlander and Michael Brandes acknowledge Steve’s new “base case” 4.5% fed funds peak, but are concerned that investors will use the latest Fed-speak as a reason to stay in cash “foxholes.” But they argue that notched-up fed funds expectations will not push long-term rates substantially higher, as many fear. If yields do get bumped up on short-term jumpiness, George and Michael see buying opportunities, not danger. In small & mid-cap strategy, Albert Richards asks: After a great run this year, are the Insurance stocks now peaking? Following his pattern of recent weeks, Albert tested for the best stock-picking factors for the group and finds trailing P/E has the strongest record. After reviewing the current rankings of stocks based on this measure, he removed HCC from his focus list — but added UnumProvident. In quantitative strategy, Keith Miller updates his style strategy performance numbers. The numbers, however, do not paint a clear picture: Although value stocks bested growth this year, it was only by a small margin. And although small-caps are ahead of the large-caps, mid-caps have beaten them both. I I I I Editorial Board, U.S. Portfolio Strategist Your comments and suggestions are welcome; please email “USPortStrat@Citigroup.com” Private Client Group Asset Allocation* Equities Bonds Cash & S-T Inv. Index Targets 2005 2006 Citigroup Benchmark Weights *Reflects changes from June 29, 2005. 60% 55% 35% 35% 5% 10% S&P 500 Dow Jones Industrial 1,300 11,050 1,400 11,900 CITIGROUP PORTFOLIO STRATEGIST 2 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Industry Spotlight Health Care Policy Paul Heldman / Charles Boorady / George Grofik Medicare “Part D” Ready for Takeoff: New Drug Benefit Impact I Medicare, which accounts for 17% of U.S. health spending, will become a major payer of prescription drugs January 1 and provide new incentives for its nearly 43 million elderly and disabled enrollees to get all their health benefits from managed-care health plans. Managed-care plans, which will begin enrolling new beneficiaries November 15, will likely grow their Medicare Advantage business by more one million members, or 17%, next year and double to 24% penetration by 2009. Drugmakers should benefit modestly overall from the drug benefit due to near-term volume gains, but future pricing risks longer-term will likely mitigate if not eliminate the sales benefit. Beneficiaries may also sign up to get all their benefits through a managed-care plan, with some or all of their part B premiums going to the plan. They can do so at the county level or through preferred-provider managed-care plans (PPO) offering drug and other benefits in one of 26 regions. The law requires these plans to offer a single part A/B deductible and to cover catastrophic costs — a protection that doesn’t exist in traditional Medicare. The Bush Administration estimates that a beneficiary in a Medicare Advantage program currently saves an average of $100 a month in lower out-of-pocket costs in comparison to what he or she would have paid under Medicare. The tradeoff for the patient care is narrower choice of physicians and other health providers. Beneficiaries signing up for a preferred-provider managed care plan would get a broad choice of doctors, but would pay more to see a doctor out of the a plan’s network of physicians. The many choices of drug coverage may provide incentive for some beneficiaries to collapse their health coverage into a single Medicare Advantage plan covering their drug and other benefits. For 2006, Citigroup Investment Research estimates that Medicare Advantage plans will add more than 1 million customers at an average of $812 per member per month. That includes the new drug benefit payment. Based on the average premium of $32.20 a month, the government and elderly will pay $92.30 per member per month ($126.28 when including estimated catastrophic coverage reinsurance) to provide drug benefits. Managed-care plans in 44 states, however, are offering drug benefits with zero premiums. Further, prescription drug only insurance plans for under $20 a month will be available in every state except Alaska. I Medicare Basics: The Single “Medicare Advantage” Card Verses Multiple Coverage Sources About 37 million Medicare beneficiaries get their benefits through the traditional government-run fee-forservice program. About six million receive their health benefits through managed-care health insurers in the Medicare Advantage program, known as Medicare Part C. Medicare pays the plans a fixed fee per patient of approximately $728 a month to provide health benefits to the elderly, per our estimates for 2005E. Beginning Jan. 1, Medicare beneficiaries will be able to sign up for a voluntary Medicare drug benefit, known as Medicare Part D. They will get their drug benefit through either a prescription drug only private insurance plan (PDP) if they choose to continue to get the rest of their benefits through traditional government Medicare, or through a Medicare Advantage plan offering drug and other medical benefits. Ten companies are offering prescription drug-only plans nationally. Others are providing coverage in one or more of 34 regions created by Medicare. Some Medicare beneficiaries have as many as 40 to 50 choices of plans. Beneficiaries in the traditional program will continue with their Medicare hospitalization coverage (part A) and pay the $88.50 premium in 2006 out of their monthly Social Security check for part B doctor care. They will also pay from their Social Security check the premium for a prescription drug only plan. As many as 10 million people will also pay for commercial supplemental coverage (known as Medigap) to cover various Medicare out-of-pocket costs. Medicare patients in the traditional program next year will pay a $952 inpatient hospitalization deductible for part A care and a $124 deductible for part B. CITIGROUP PORTFOLIO STRATEGIST 3 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Industry Spotlight Figure 1. Summary of EPS and Target Price Revisions AET CI CVH HNT HUM PHS UNH WC WLP Rating 1L 2H 1M 1H 1M 1M 1L 1L 1L Price* $82.75 $112.42 $85.50 $48.32 $45.77 $79.00 $55.18 $75.18 $73.82 Target Curr. Prev. $96 $96 $134 $124 $102 $88 $58 $54 $64 $64 $91 $91 $67 $63 $90 $91 $104 $102 Target Multiple LTG 05E-08E Curr. Prev. Curr. Prev. 17 x 17 x 16% 16% 16 x 15 x 11% 10% 18 x 16 x 15% 14% 18 x 17 x 20% 19% 22 x 22 x 25% 25% 19 x 19 x 21% 21% 22 x 21 x 18% 17% 21 x 21 x 17% 17% 21 x 21 x 19% 18% Curr $4.60 $7.45 $4.75 $2.50 $2.11 $3.61 $2.47 $3.39 $4.01 2005E Prev. $4.60 $7.45 $4.75 $2.50 $2.11 $3.61 $2.47 $3.39 $4.01 St. $4.58 $7.44 $4.73 $2.38 $2.11 $3.69 $2.47 $3.41 $3.99 Curr $5.50 $8.40 $5.65 $3.20 $2.90 $4.75 $3.05 $4.30 $4.95 2006E Prev. $5.50 $8.25 $5.50 $3.15 $2.90 $4.75 $3.00 $4.35 $4.80 St. $5.40 $8.00 $5.43 $2.76 $2.81 $4.64 $2.90 $3.88 $4.71 2007E Curr $6.30 $9.25 $6.45 $3.75 $3.50 $5.55 $3.55 $4.90 $5.80 Prev. $6.30 $9.10 $6.30 $3.70 $3.50 $5.55 $3.50 $4.95 $5.65 2008E Curr Prev. $7.15 $7.15 $10.15 $10.00 $7.20 $7.05 $4.30 $4.25 $4.10 $4.10 $6.35 $6.35 $4.05 $4.00 $5.40 $5.45 $6.80 $6.65 Source: Citigroup Investment Research *As of close 10/11/05 Source: Citigroup Investment Research and First Call Companies Will Target Market Share in First Year We believe drugmakers, managed-care health plans, and PBMs recognize that Medicare represents a major new business opportunity. Thus, the plans and drugmakers seem more concerned with ensuring that they gain market share in the first year of the benefit than with growing their profit margins. In fact, the health plans bid lower than expected to provide drug benefits. Who Wins and Who Loses? The U.S. drug-spending shift under the Medicare drug benefit will create new winners and losers in the drug industry, and also among the major PBMs. Total average payment to the plans for the prescription drug benefit (including reinsurance and beneficiary premiums) will be about 14% lower than expected by the government. That suggests the plans may give up profit margin in the first year in exchange for market share growth, and/or that drugmakers are providing higher-than-expected concessions on price to drug insurance plans. It also suggests that several plans may not survive past the first year while others will seek a sharp boost in premiums for 2007 to cover costs they are willing to absorb in 2006. More Data to Come — Over the next two weeks, Medicare and the health plans will release more information on drug formularies, cost-sharing, and prior authorization requirements that will help determine the business rationale for the wide range of drug premiums. In addition, the privatization of Medicare represents an opportunity for managed-care plans to significantly expand their share of the $400-billion-a-year (includes drug benefit) Medicare program in 2006 and subsequent years. The percentage of Medicare beneficiaries enrolled in managed care health insurance will grow to 24% to 25% by the end of 2009 from about 14% now, according to Citigroup Investment Research projections. For 2006, we project Medicare enrollment in managed care will grow by more than 1 million, or 17%. Medicare managed-care revenue for medical benefits other than outpatient prescription drugs is projected to rise to $49.4 billion in 2006 from $44.4 billion this year, according to the CBO. Medicare managed care revenue will rise to $105.2 billion by 2015, according to the CBO. In comparison, private health insurance currently finances $691 billion, or 36%, of U.S. health spending. Part D Round 2: Models and Methodology Behind Our 2006 Projections Charles Boorady Plans may have also taken additional steps to guard against losses due to higher-than-anticipated utilization. We understand that Medco (MHS, Not Rated) has structured its contracts with drugmakers to make the manufacturers assume some risk for over-utilization of drugs in the PBM’s Medicare prescription drug plans. If a class is over-utilized, the manufacturers under contract to provide drugs in that class must pay additional rebates to Medco. If drug use in a class comes in below the utilization target, Medco will receive credit from the manufacturers for future transactions. This shows that the drugmakers are willing to reduce their profit to win a place on Medco’s Medicare prescription drug plan formulary, creating or ensuring continued brand loyalty among senior citizens. Citigroup Global Markets Inc. is an advisor to UnitedHealth Group Inc. in its proposed merger with PacifiCare Health Systems Inc. The combination of Medicare Expansion (Part D) and Privatization (Medicare Advantage) remains one of the best investment opportunities in the Managed Care sector since the 2000 peak in NASDAQ. We believe the timing is especially attractive coming at the tail end of an elongated commercial business cycle and period of record growth from Medicaid privatization. As Medicare becomes a major payor of Rx drugs on January 1, the two main channels for new growth are the stand-alone prescription drug plan (PDP) and the more comprehensive Medicare Advantage (MA) plan that covers hospital, outpatient/physician, and 4 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. CITIGROUP PORTFOLIO STRATEGIST Industry Spotlight prescription drug costs. The Centers for Medicare & Medicaid (CMS) release of plan bids for Medicare Part D and Medicare Advantage with PDP plans on Sept. 23, 2005 provided insight into the players in the ongoing privatization of Medicare. Below we provide a thorough analysis of the EPS impact of the plan bids on companies in our coverage space. Changes to Company Estimates (See Figure 1) Based on our new Medicare Part D enrollment numbers. We are raising our 2006E-2008E estimates for Cigna, Coventry, Health Net, UnitedHealth and WellPoint on stronger-than-estimated enrollment growth from enrollment of dual eligibles, MA w/ PDP and standalone PDP. We are lowering our WellChoice estimates for 2006 by five cents due to more limited growth for the company in Medicare Part D. Medicare comprises roughly 40% of an average hospital’s revenues. Privatizing Medicare would finally put the private payers, i.e., Managed Care, in a position of great leverage over their suppliers, i.e., the providers of healthcare products such as drugs and services like hospitals. I Health plans with high MA concentration can subsidize growth in commercial products, thereby funding new entrants such as Humana that will enter new markets for its commercial business on the back of strong Medicare growth. The new commercial growth of MA plans could drive down commercial pricing for others. To put the size of MA in perspective, Medicare is big enough that revenue opportunity for the private sector may ultimately surpass Commercial revenues if Medicare fully privatizes from 12% MA penetration today. I Note that the revisions we make here are “Round 2” or adjustments to our original estimates, “Round 1,” established during the summer 2005. However, the changes we are making do not reflect the full impact of Medicare to our models. Our next round of adjustments, “Round 3,” will include more precision on formulary and other cost-related data. We highlight our current estimates in Figure 1. There are two ways health plans are looking at the Part D opportunity. I Drugs: A Short-Lived Benefit to Pharma George Grofik / Paul Heldman Health plans with large MA footprints (HUM, PHS) see Part D as a leader to more profitable MA business where the acquisition costs are very high. Health plans with large books of Medigap business (UnitedHealth, WellPoint) are treating Part D PDP as a profitable extension and easy cross-sell to their existing customer base. I New Drug Benefit is Big, but Medicare Advantage Even Bigger — The new $45–$50 billion/year federal subsidy to buy drug insurance will contribute to Managed Care earnings and provide greater leverage over prescription drug manufactures and retailers. However, MA has the potential to be 9x bigger and increase Managed Care leverage over providers of almost all healthcare products and services. I Senior enrollment will be crucial to the program’s success. Interestingly, a 2004 Kaiser poll showed that 34% of seniors had an unfavorable impression of the drug benefit, 21% were favorably disposed, and 25% held a neutral view. Nevertheless, we believe enrollment will be in the range of 28–30 million, including about 9–10 million retirees who will continue to receive coverage through their former employers (with comparable or better benefits). We underscore that, if enrollment falls above or below projections, the downside and upside impact to the pharmaceutical market will be muted. Given these sensitivities around enrollment, we conclude the following (excluding any government pricing intervention): I In our view, the MA plans will yield 8x-10x the revenues and probably higher profit margins than stand-alone PDP. Growth in MA increases the leverage that Managed Care organizations have over providers of healthcare products and services, thereby making Managed Care stocks a good hedge in a healthcare investment portfolio in our view. For example, 5 I Our base case assumes Part D will have a +1% impact to market growth in 2006E–09E, with a range of -1% to +3%. Importantly, the dual eligible population (6.3 million seniors) will have an immediate favorable pricing (and possible volume) benefit to pharma, as they will automatically enroll on January 1, 2006. The biggest detractor from this growth is expected to be the conversion of retirees from employer-based coverage (due to unfavorable volume/price implications); however, given the slower ramp-up in enrollment for this subcomponent, this will only likely have a modestly negative drag on elderly drug expenditures. Since high enrollment for Part D is a priority for MCOs and the government, we do not expect to see an October 13, 2005 CITIGROUP PORTFOLIO STRATEGIST See Appendix A-1 for Analyst Certification and Important Disclosures. Industry Spotlight overly challenging pricing environment for drug manufacturers in 2006E. I Our base case anticipates Part D will have a negative impact to pharma growth beginning in 2010E. In 2010E, our base-case scenario projects a –1% impact to pharmaceutical market growth (excluding any government price intervention); our scenario analysis ranges from a –4% to +3% impact. Again, the most significant negative influence on growth in the out-years is the conversion of retirees into Part D. We consider the “Ripple Effect” of Part D to be a significant, longer-term wildcard in our calculations. With more lives under coverage and an expected uptick in utilization of many beneficiaries, MCOs may have modestly increased pricing leverage on their commercial business. . (thus limiting pricing pressure). As a result, we calculate a substitutability score for BMY drugs to be reimbursed by Part D of 2.2, which compares favorably to the industry average of 3.2; I Pfizer’s substitutability score of 3.7 (only Part D reimbursed drugs) is below average, implying more negative than industry trends for the company in the out-years years from this legislation; Schering-Plough (SGP–$19.84, 2H) and Wyeth (WYE–$45.29, 1M) have less exposure to Part D reimbursement with products representing 27% and 38% of their 2006E pharma sales, respectively, eligible for reimbursement under Part D. I I Modest Drug Stock Rally Conceivable in First Half of 2006… As part of the drug benefit, MCOs will have increased influence over drug utilization and pricing, with more lives under coverage (at least 10% more) and controlling incrementally more volume per beneficiary. This dynamic will continue to add elasticity of demand to the pharma market as consumers make more rational economic decisions in drug consumption. An October 2002 study in concluded that doubling co-payments resulted in a 22–33% reduction in drug expenditures. In an environment of more MCO influence, we believe the winners will be companies with the most novel product lineup. We Cost leverage from restructuring programs recently announced, coupled with the likely favorable influence of Part D in the near term, could result in improved pharma earnings trends. As a result, it is possible the sector may experience a modest, yet short-lived, rally in the first half of next year as evidence of improved financial performance becomes emerges. In 2006, Drugs EPS growth could accelerate 900 bps year over year (from –4% to +5%) versus a 400 bps deceleration in the S&P (+13% to 9%); historically, relative EPS growth acceleration has been the primary determinant of stock price performance for the drug group. ...But Pfizer Lipitor Win Would Be Crucial assessed the maximum theoretical percent of each company’s product portfolio reimbursed under Part D as well as the relative degree of “substitutability” (for Part D reimbursed drugs) of their product portfolio. I We believe Bristol-Myers Squibb (BMY–$22.56, 3M), Merck (MRK–$26.75, 2M), and Pfizer (PFE–$24.30, 2M) have the most to win or lose from reimbursement under Part D; each company has a product portfolio, which represented 40%+ of 2006E pharma sales (includes non-elderly use), eligible for reimbursement under Part D; Of these companies, Bristol-Myers Squibb appears to be best positioned to benefit from the Part D; 50% of this exposure is derived from Plavix, which is utilized primarily by the elderly, has a clear medical benefit, and has few direct competitors I Importantly, a PFE win in the Lipitor patent challenge will be integral to a sector rally; although we view the risk of a loss as 50%/50%. We also expect longer-term question marks over the financial health of Medicare, political rhetoric over drug pricing, and several company-specific issues to keep a lid on any sustained drug stock rally and limit P/E expansion, despite our expectation of a near-term favorable benefit from the legislation. All considered, we believe it is conceivable drug valuations could approach a modest premium to the S&P from their current 5% to 10% discount. Accordingly, we continue to hold a neutral view on the sector, but reiterate our Buy (1M) rating on shares of Wyeth. — October 3 and 4, 2005 CITIGROUP PORTFOLIO STRATEGIST 6 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary U.S. Equity Strategy U.S. Equity Strategy Tobias M. Levkovich Foreboding Fed Fears I I Investor fears regarding Fed governors’ comments seem overdone. Inflation concerns appear to be bothering the equity market far more than the bond market — even though fixed income investors generally are more focused on inflation prospects. The earnings environment does not support this anxiety around corporate profits. I the prices-paid element of the ISM services index (see Figure 1) and a sharp spike in the prices paid component of the ISM manufacturing index (see Figure 2). These two items appeared to frighten investors — although, surprisingly, they still contemplate economic stagnation even as the ISM’s overall figures were well above 50 (indicating expansion). Thus, one can surmise that the thought processes were not entirely consistent, but they rarely are when fears enter the equation. Figure 1. ISM Non-Manufacturing Prices 85.0 80.0 75.0 70.0 65.0 60.0 55.0 50.0 45.0 40.0 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Nov-97 Nov-98 Nov-99 Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Jul-05 The equity markets clearly have been spooked lately by Fed fears, sparked by various speeches from Fed governors warning that inflation is near the upper end of the central bank’s tolerance limit and that the “inflation virus” has to be stopped. In addition, investors have, for the first time, heard terms like “fiscal predicament” mentioned as an issue for Fed policy. The combination of these unsettling comments, the major earnings miss by technology bellwether Lexmark, and lowered EPS guidance from Procter & Gamble, to cite a couple of examples, probably accounted for the stock market’s slump last week. In addition, some investors we talked to wondered if some late-September portfolio “window dressing” helped sustain the major indices at the end of the third quarter, especially in “winning industries” such as Energy, Utilities and Technology. When those trades were taken off in early October, they may have pulled down the averages. To be fair, all of the above issues (and maybe one or two more) contributed to the sell-off, but the key question is not what caused the market to drop off sharply, but rather whether it is the start of something more sinister. Is “stagflation” back with all of its dire 1970s-like consequences? Should investors rush in to real assets from financial ones? Isn’t gold telling us that inflation is back while consumers are tapped out because of the now-negative savings rate, an apparent cooling of the housing market, higher energy prices, and rising interest rates? Is the Fed, in its determination to maintain its inflation-fighting credentials, willing to risk an economic downturn? These appear to be the critical concerns facing investors, in our opinion. Indeed, when thinking about inflation fears, it may be one thing to worry about speeches by Fed governors, but it is something entirely different when they are backed up by record highs on CITIGROUP PORTFOLIO STRATEGIST Source: Institute for Supply Management Figure 2. ISM Manufacturing Commodities Prices Index 120.0 100.0 80.0 60.0 40.0 20.0 0.0 Jan-48 Jan-51 Jan-54 Jan-57 Jan-60 Jan-63 Jan-66 Jan-69 Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Source: Institute for Supply Management In a recent meeting with a major client’s chief investment officer, we heard this inflation worry expressed clearly — a relatively new one in the past month. Similarly, a leading hedge fund strategist communicated his qualms about “ugly talk” (his term) from the Fed, overwhelming the market’s many 7 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Jan-05 Macro / Commentary attractive qualities (including the compelling valuation we find in a number of our proprietary valuation approaches). However, we heard Fed chairman Greenspan discuss “irrational exuberance” back in 1996, after which equity markets boomed for almost four more years. Real estate “froth” has been discussed for more than a year, and home prices have yet to fall in any meaningful way. Therefore, while one should not ignore “Fedspeak,” we doubt that equity investing solely on the basis of Fed commentary makes sense. On the subject of inflation anxiety, we would highlight a few issues. Economists seem particularly troubled by the data in Figures 3 and 4. In Figure 3, we see that “headline inflation” (measured as the reported consumer price index [CPI]) has been leading “core inflation” for almost three years. This suggests a more insidious trend: the possibility that the normal volatility of food and energy prices will feed into core CPI. Figure 4 indicates that the prices of goods have rebounded sharply since the deflation days of three years ago. Figure 3. Headline CPI vs. Core CPI 4.0% 3.5% 3.0% 2.5% 4.5 U.S. Equity Strategy more serious if it persists. It has taken the U.S. central bank 25 years to beat inflation into submission, and they don’t want to let Pandora out of the box again. Hence, the harsh tone in the rhetoric. It would seem that the Fed will not let up on pushing down inflation expectations, and the market is pricing in a 4.50% fed funds rate by next spring. Figure 4. CPI Goods vs. CPI Services 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jul-05 CPI - Services CPI - Goods Source: Economy.com Figure 5. University of Michigan Five- to Ten-Year Inflation Expectations 5.0 2.0% 4.0 1.5% 3.5 1.0% Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 3.0 CPI CPI 3.59%; Core CPI 2.18% Core CPI 2.5 2.0 Source: Economy.com 90 92 94 96 98 00 02 04 5-10 Year Inflation Expectations To some degree, the Fed’s comments about a fiscal predicament may also reflect heightened worry that the proposed $200 billion in Gulf Coast reconstruction aid will put further upward pressure on material costs — and at a time when shipping those goods costs more due to the higher energy bill. In addition, President Bush’s remarks about the federal government spending “whatever it takes” to rebuild New Orleans and other affected towns may look like a blank check to Fed governors. Indeed, such talk has caused angst amongst legislators on both sides of the aisle who wonder how it will all be paid for. Thus, the Fed’s comments seem pretty much aligned with the views of both conservative Republicans and blue dog Democrats. Probably the most troubling issue facing the Fed has been the uptick in the very recent inflation expectations survey (see Figure 5) that could bubble into something CITIGROUP PORTFOLIO STRATEGIST Source: University of Michigan However we also believe that, to some degree, investors need to get a grip on their emotions. In 2002, the Street was focused on deflation, as goods prices were negative and cheap labor from China and India was going to kill pricing power forever. We suggested then that investors look at the Cleveland Fed’s median CPI data (see Figure 6) for a better take on inflation trends. As can be easily seen, the median CPI was near 4% at the time, not even close to going negative. On the other hand, today’s readings seem well contained in the 2%plus area, with no substantial upward shift. Still, we must admit to being fascinated with all of the inflation talk in the equity markets — especially since bond market investors have taken the Fed talk and the ISM data in much better stride. One measure that 8 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary investors consider when trying to gauge inflation is the differential between 10-year Treasury yields and inflation-indexed (or TIPS) yields. While imprecise, Figure 7 does not suggest the bond market is “freaked out” by long-term inflation prospects, possibly because of the Fed-speak and its reassurance that the Fed is ready to nip any longer-term inflation potential in the bud. Figure 6. Cleveland Fed Median CPI 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% U.S. Equity Strategy We would argue that the Fed may be burnishing its inflation-fighting credentials prior to the selection of a new chairman. With Mr. Greenspan saying that he intends to step down on January 31, 2006, there is clearly some debate around how the central bank will operate thereafter. By talking up its inflation-fighting prowess now (particularly given the inflation expectations threat), the Fed may be signaling that no changes in policy are likely regardless of who is selected, thus providing assurance to investors globally. Figure 8. 10-Year Treasury Yield 4.90% 4.70% 4.50% 4.30% 4.10% 1.5% 3.90% 1.0% Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 3.70% 3.50% 11/1/2003 11/1/2004 7/1/2003 9/1/2003 1/1/2004 3/1/2004 5/1/2004 7/1/2004 9/1/2004 1/1/2005 3/1/2005 5/1/2005 7/1/2005 9/1/2005 Median CPI 2.34% Source: Economy.com Figure 7. Spread Between 10-Year Treasury Yield and 10-Year Inflation Protected Securities (TIPS) Yield 2.90 2.80 2.70 2.60 basis points 2.50 2.40 2.30 2.20 2.10 2.00 20May04 19May05 12Aug04 4Nov04 30Dec04 11Aug05 25Mar04 24Mar05 22Apr04 21Apr05 15Jul04 2Dec04 14Jul05 9Sep04 26Feb04 24Feb05 29Jan04 17Jun04 27Jan05 16Jun05 8Sep05 1Jan04 7Oct04 6Oct05 Average 10-year yield Plus 1 S.D. Minus 1 S.D. Source: Bloomberg Source: Economy.com Some believe that the Fed was trying to push up 10-year yields via moral suasion in an attempt to avoid an inverted yield curve. By talking up longer-term yields, the Fed can continue raising fed funds rates to at least 4.25% now without inversion and may get to 4.5% by spring. Note that in three of the past four rate cycles, the Fed stopped lifting rates within two months of inversion. Thus, there may be some desire on the part of the Fed to give itself rate-hike flexibility and not be dictated to by the markets. However, we are most intrigued with an idea expressed by an astute client a few weeks ago. He suggested that the core CPI would begin to reflect the effects of the Fed’s actions — meaning that the Fed knows that core numbers truly may be headed higher. In particular, there has been much discussion around the Street about the validity of the CPI data, with skeptics arguing that the Bureau of Labor Statistics has purposely understated inflation figures — the idea being that everything is going up in price, such as college tuition, health care, transportation, and does not seem to be reflected in the CPI numbers. Furthermore, these skeptics argue that housing, which accounts for 40% of core CPI, is also understated since the government uses the cost of housing (which is affected by interest rates) rather than home prices, which have soared. 9 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Moreover, if one looks at bond yields over the past two years (see Figure 8), it is interesting to note that the current bond yield is only moderately above the average yield — which also suggests that inflation fears are overblown. Indeed, Figure 7 highlights the competing inflation-versus-slowing growth worries over the past couple of years, which have proven to be emotional responses without much real data supporting them. Thus, if bond market investors seem fairly comfortable with inflation prospects and such traders focus almost exclusively on inflation since it can destroy real returns, why are equity investors that bothered? (Especially when they have so many other things to consider, such as corporate profits, market share, valuation, cash holdings and uses.) Moreover, all of the data discussed above is well known to the Fed — so what, exactly, is its rationale for being so vocal? CITIGROUP PORTFOLIO STRATEGIST Macro / Commentary We consider such conspiracy arguments faulty in that the prices of many goods have declined (such as electronics and apparel), as have those of services like telecommunications. The comment about housing costs, however, is quite intriguing. Given the increases in the fed funds rate since mid-2004, affordability indices have fallen (see our August 18, 2005 “Homesick?” research note). Thus, the cost of housing is likely to creep higher as a result of Fed actions over the past 15 months. Hence, it may simply be that the Fed is talking about possible core inflation rising to uncomfortable levels since they may be part of the root cause. Indeed, if inflation worries were centered only around energy costs, the past week’s declines in oil, natural gas, and gasoline prices should have calmed the Fed and equity investors — they did not. In our opinion, equity investors remain very much on edge; a view supported by the State Street Investor Confidence Index (see Figure 9). The list of worries continues — from inflation one day to the dollar the next, to high margins to cost pressures to government deficits. While some believe that the market climbs a “wall of worry,” we prefer the term “cliffs of concern,” since cliffs are more daunting than walls. Our analytical work on sentiment, earnings, and valuation continues to support a bullish view of the markets. We also would expect general investor sentiment to be far more bullish should the S&P 500 begin to break out to the upside (as investor sentiment tends to follow market direction). In short, we need to worry when investors appear ebullient, not when they seem beat up. Figure 9. State Street Investor Confidence Index 110 105 100 95 90 85 80 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 U.S. Equity Strategy With earnings warnings from Lexmark, Clorox, Alcoa, and Procter & Gamble, there is clearly concern that third quarter profits will be under severe pressure, yet Thomson First Call still shows consensus S&P 500 EPS growth in the mid-teens, led by 70% or so growth in the Energy sector (see Figure 10), while only one sector, Materials, is expected to show EPS declines. Moreover, despite a disheartened feeling, the negativeto-positive pre-announcement data has not been discouraging, with current readings still below average (see Figure 11). Thus, while there does seem to be a depressed tone around earnings, the data is less convincing — and we tend to look more at real numbers and less at how people feel, since reality always trumps near-term (and often inaccurate) perception. Figure 10. Estimated Earnings Per Share Growth for S&P 500 Sectors as of October 7, 2005 Sector 1Q05A 2Q05 3Q05* 4Q05E 1Q06E 2Q06E -9% 0% 1% 10% 21% 20% Consumer Discretionary Consumer Staples 8% 6% 6% 6% 9% 9% 41% 42% 71% 46% 41% 17% Energy Financials 10% 2% 16% 16% 2% 9% Health Care 12% 10% 5% 7% 9% 10% Industrials 19% 20% 16% 17% 13% 12% IT 15% 15% 13% 18% 20% 17% Materials 64% 26% -9% -2% -3% 0% Telecom Services 10% 17% 7% 3% 9% 0% Utilities 12% 11% 15% 15% 11% 16% S&P 500 13.9% 11.7% 16.4% 16.2% 12.8% 11.8% *35/500 companies had reported for 3Q05 as of Oct. 7, 2005 Source: Thomson One Analytics Figure 11. S&P 500 Negative-to-Positive Preannouncement Ratio 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 3Q05 TD 1Q96 3Q96 1Q97 3Q97 1Q98 3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 State Street Index Average +1 Std Dev -1 Std Dev +2 Std Dev -2 Std Dev Source: State Street Global Advisors and Bloomberg S&P 500 Pre-announcement Average Source: Thomson One Analytics CITIGROUP PORTFOLIO STRATEGIST 10 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Finally, recent ISM readings add to our comfort level on EPS prospects. Figure 12 illustrates a fairly close yearover-year relationship between ISM index trends and S&P 500 EPS changes. Given recent readings, it looks like third quarter profits should be fine despite the hurricane hits. While we still think that some earnings expectations for the consumer sectors are high going into 2006, the overall outlook into next year does not seem ominous. Indeed, our Leading Profits Indicator is signaling an uptick in profit growth by the second half of 2006. In many ways, higher short-term interest rates now seem very much priced into equity markets, and thus we would be buying stocks especially given recent weakness. U.S. Equity Strategy Figure 12. S&P 500 Operating EPS vs. ISM Manufacturing Index 50% 40% 30% 20% EPS yr/yr 10% 0% -10% -20% -30% -40% -50% 1Q81 3Q82 1Q84 3Q85 1Q87 3Q88 1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 3Q03 1Q05 20 40 30 50 70 60 ISM index 80 S&P 500 EPS ISM Mfg Index Source: FactSet and Institute for Supply Management CITIGROUP PORTFOLIO STRATEGIST 11 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Index Targets and Portfolio Weighting 2005 Targets: DJIA - 11,050 Sector Industry Group Tobias M. Levkovich 2006 Targets: DJIA - 11,900 S&P 500 - 1,400 S&P 500 - 1,300 Actual Weight (% CIR Rec'd of S&P 500) ating Weight Citigroup Strategist's Rationale R 11.3% 0.6% 1.4% 1.8% 3.6% 4.0% 10.3% 3.0% 5.2% 2.0% 9.6% 9.6% 20.0% 7.0% 7.8% 4.5% 0.8% 13.3% 5.2% 8.1% 11.2% 8.8% 0.7% 1.7% 15.3% 3.1% 5.4% 6.8% 2.9% 2.9% 2.6% 2.6% 3.5% 3.5% + 0 0 0 + 0 0 0 + 0 + 0 + 0 + 0 + + + + 0 11.9% 0.6% 1.4% 1.8% 4.1% 4.0% 9.8% 3.0% 5.2% 1.5% 7.7% 7.7% 21.3% 7.0% 9.2% 4.5% 0.6% 14.5% 5.2% 9.3% 10.8% 8.8% 0.8% 1.3% 17.0% 3.8% 6.4% 6.8% 2.3% 2.3% 2.1% 2.1% 2.6% 2.6% Consumer Discretionary Autos & Components Consumer Durables & Apparel Consumer Services Media Retailing Consumer Staples Food & Staples Retailing Food Beverage & Tobacco Household & Personal Products Energy Energy Financials Banks Diversified Financials Insurance Real Estate Healthcare Healthcare Equipment & Services Pharmaceuticals & Biotechnology Industrials Capital Goods Commercial Services & Supplies Transportation Information Technology Semiconductors & Semi Equipmen Software & Services Technology Hardware & Equipmen Materials Materials Telecom Services Telecom Services Utilities Utilities Legend: + = Overweight 0 = Marketweight - = Underweight Fuel, interest rate risk; attractive valuation; upward EPS revisions rising Fuel, interest rate risk; neutral valuation and EPS revisions trends; apparel has easier comps; cautious on homebuilding High valuation; lowered earnings expectations are a positive; pricing power and supply constraints are positives for lodging Attractive valuation; low earnings expectations; value in broadcasters and radio; out of favor Fuel and interest rate risk; neutral EPS estimate revision trends; easier same store sales comps; neutral valuation Fuel and interest rate risk; easier same store sales comps; attractive valuation; lowered EPS expectations Prefer tobacco given better fundamentals; high valuation; lowered EPS expectations; fundamentals mixed among groups Valuation unattractive; upward EPS estimate revisions rising again; consumer concerns and materials cost pressures Worrisome earnings revisions trends; high valuation; statistically improbable high oil prices; insider selling Expensive valuation; anticipate EPS surprises given lowered expectations; overall bond yields not major threat; dividends Promising fundamentals given deal activity and improving stock market; attractive valuation; beta Attractive valuation; expectations lowered; overall ibond yields not major threat High valuation; fundmamentals worrisome; strong deposit franchise Medicare growth story intact for managed care, but well disseminated; neutral valuation; EPS revisions trends are intriguing Compelling valuation and div yields; risks seem priced in; near term volume benefit from Medicare drug coverage Earnings revisions trends not compelling; potential ISM rebound bodes well; expensive valuation; cost pressures Valuation is attractive; labor market strength should benefit employment services; revisions trends intriguing Attractive valuation; supply constraints help pricing, but fuel remains a risk Improving capacity/pricing environment in 2005; neutral valuation; beta; revisions trends have climbed, not peak like Attractive valuation; Vista upgrade cycle felt in 2006; overall, firm capex growth expected Fairly valued; beta; firm capex environment anticipated; gradually declining EPS revision trends On upgrade watch Valuation still high; upward EPS revisions starting to climb again; cost pressures remain; demand story unclear Valuation is attractive but fundamentals troublesome; rally underperformer; upward EPS revisions trends may highlight risk Extremely high valuation; earnings revisions data and insider selling is worrisome; but pricing strong; dividend appeal S&P weightings as of 10/11/05 Sum of industry group weights may not equal sector weights due to rounding. *Numerical recommendation may fluctuate due to minor day to day changes in weights of constituent groups. Sector weights are sum of industry group weights. Source: Citigroup Investment Research U.S. Equity Strategy CITIGROUP PORTFOLIO STRATEGIST 12 See Appendix A-1 for Analyst Certification and Important Disclosures. October 13, 2005 Citigroup Investment Research Recommended List YTD Through Oct. 11, 2005 -2.23% -0.85% 8.33% 9.20% 1.14 Statistical Overview Perf. Mkt Price Since Cap (mil) 10/11/2005 Added $61.48 $64.02 $78.60 $40.46 $31.18 $72.06 $61.78 $13.40 $41.88 $60.25 $73.82 $76.34 $45.29 $61.29 $70.08 $39.23 $24.41 $17.19 $23.42 $11.77 $16.83 $55.22 $49.96 42.74 % -15.49 % 0.06 % -3.16 % 27.01 % $13,323 $11,003 $14,314 $54,758 $3,861 Analyst Ratings, Targets & Estimates Perf. YTD -2.38% 10.78% -6.78% -30.45% 20.15% 17.94% 57.44% 12.04% -10.87% 0.80% 28.38% 19.00% 6.34% -3.36% -5.04% -10.56% -8.65% -11.02% 0.13% -14.83% -1.58% 5.50% 13.37% Fiscal Year End Dec Jan Dec Dec Feb Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec May Jun July Dec Mar Oct Dec Dec Price Target $85.00 $105.00 $96.00 $49.00 $39.00 $80.00 $75.00 $17.50 $57.00 $73.00 $104.00 $100.00 $52.00 $80.00 $87.00 $51.00 $31.00 $22.00 $32.00 $17.00 $22.00 $67.00 $60.00 EPS Estimates Next Cur. $3.15 $7.00 $4.83 $0.99 $1.77 $5.62 $3.45 $0.70 $4.55 $5.60 $4.95 $3.66 $3.15 $3.83 $5.20 $2.26 $1.51 $1.10 $1.60 $1.09 $1.11 $4.66 $3.40 $2.80 $6.00 $4.35 $0.79 $1.68 $5.11 $3.00 $0.56 $4.39 $4.85 $4.01 $3.19 $2.91 $3.46 $4.15 $1.96 $1.31 $1.00 $1.43 $0.85 $0.64 $7.64 $3.10 P/E Next Cur. 19.5 9.1 16.3 40.9 17.6 22.0 10.7 18.1 51.2 18.6 Attributes 2004 8.99% 10.88% 24.14% 25.92% 2003 26.38% 28.68% 43.01% 44.85% Tobias M. Levkovich S&P 500 Performance S&P 500 Total Return Recommended List Index Equal Weighted Performance Recommended List Index Equal Weighted Total Return Recommended List Portfolio Beta Date Added CONSUMER DISCRETIONARY Marriott International (MAR) 11/6/2003 Federated Dept. Stores (FD) 7/22/2005 Omnicom (OMC) 6/24/2005 eBay (EBAY) 8/1/2005 GTECH Holdings (GTK) 4/22/2005 CONSUMER STAPLES Altria Group (MO) 4/5/2004 ENERGY Halliburton (HAL) 5/6/2003 FINANCIALS Charles Schwab Corp. (SCH) 4/1/2005 Bank of America (BAC) 10/7/2005 Merrill Lynch (MER) 4/22/2005 HEALTH CARE Wellpoint (WLP)* 1/15/2004 Amgen (AMGN) 1/10/2005 Wyeth (WYE) 1/28/2004 Johnson & Johnson (JNJ) 11/22/2004 INDUSTRIALS Textron (TXT) 8/10/2005 Cintas (CTAS) 1/26/2005 INFORMATION TECHNOLOGY Microsoft (MSFT) 5/3/2004 Cisco (CSCO) 2/21/2005 Intel (INTC) 2/21/2005 Flextronics (FLEX) 6/3/2005 Applied Materials (AMAT) 1/26/2005 MATERIALS Nucor (NUE) 9/9/2005 UTILITIES Exelon (EXC) 9/9/2005 Price Added $43.07 $75.75 $78.55 $41.78 $24.55 $54.87 $22.16 $10.45 $42.27 $53.18 $38.03 $62.97 $41.05 $60.54 $74.90 $43.00 $26.13 $17.30 $24.02 $13.01 $16.12 $60.27 $55.66 Rating 1M 1M 1M 1H 1M 1H 1H 1M 1M 1M 1L 1M 1M 1L 1M 1L 1M 1H 1M 1H 1H 1M 1M 5-Year Div. Beta Yield Drivers, Fundamentals & Valuation 1.15 1.34 1.18 1.47 0.60 0.48 1.02 1.85 0.87 1.52 0.41 0.87 0.83 0.49 0.81 0.99 1.12 1.72 1.62 2.49 1.80 1.34 0.33 0.7% 1.6% 1.1% 0.0% 1.1% Improving corporate travel, unit growth, valuation Valuation, strong free cash flow, potential asset monetizations Valuation, earnings growth prospects Share gains, revenue growth drivers Compelling valution, solid fundamentals 31.33 % $149,518 178.79 % $31,322 28.23 % $17,431 -0.92 % $168,220 13.29 % $55,812 94.14 % $45,274 21.23 % $93,975 10.33 % $60,776 1.24 % $182,289 -6.44 % -8.77 % $9,374 $6,600 12.8 14.1 17.9 20.6 19.1 23.9 9.2 9.5 10.8 12.4 14.9 20.9 14.4 16.0 18.4 23.9 15.6 17.7 4.4% Dividend yield, potential break-up catalyst 0.8% Resolution of asbestos issue, energy prices, margin improvement 0.7% Rising equity market expected, strong upside earnings leverage 4.8% Attractive div yield and valuation; strong deposit franchise 1.3% Capital markets exposure 0.0% 0.0% 2.2% 2.2% Customer growth and reduced competition Strong pipeline & financial position, large-cap growth story Earnings potential Growth in MD&D business, strong drug pipeline 13.5 16.9 17.4 20.0 16.2 15.6 14.6 10.8 15.2 11.8 18.6 17.2 16.4 13.8 26.3 7.2 2.0% Strength in corporate profits/free cash flow story 0.8% Improved hiring intentions 1.3% 0.0% 1.4% 0.0% 0.7% Style (large cap), dividends/share buybacks Beta Improving capacity/pricing environment expected for Semis group Low cost producer; building sales and earnings momentum Expected outperformance for semi equipment names -6.58 % $261,431 -0.64 % $108,830 -2.50 % $142,698 -9.53 % $6,727 4.40 % $27,307 -8.38 % $8,627 1.1% Stronger steel pricing, strong co. cost structure, dividends 3.2% Pricing power, low interest rates, dividends growth, merger benefits -10.24 % $33,503 14.7 16.1 *Anthem acquired Wellpoint and took on the Wellpoint name on December 1, 2004. The stock was added to the Recommended List as Anthem on January 15, 2004. Note: Portfolio performance based on daily index level as calculated by S&P/Citigroup Global indices; index performance incorporates historical constituent changes and is measured using daily close prices. Price added is prior day's close when stock is added b/f market open. Price added is same day close when stock is added after market open. Source: Citigroup Investment Research U.S. Equity Strategy and FactSet CITIGROUP PORTFOLIO STRATEGIST 13 See Appendix A-1 for Analyst Certification and Important Disclosures. October 13 2005 CITIGROUP PORTFOLIO STRATEGIST 14 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Economic & Market Analysis Economic & Market Analysis Steven Wieting Hold Off with that Bear Suit for a Minute I We believe a number of risks have emerged or intensified over the past month. In particular, Fed officials have made it clear that a marked improvement in financial conditions that boosts demand is out of line with the its current goals. But a renewed sense of risk often brings with it exaggeration. Some in the media have portrayed the pending crunch in natural gas and heating oil costs as a catastrophe. Yet we find that the hit to incomes this winter will be less than two-thirds, at most, as large as it was for gasoline this summer. In addition, wholesale gasoline prices fell 30 cents in the past week on expectation of restarting refineries. This has occurred while investor expectations dimmed. I I In anticipation of the negative inflation news (including the prospect of rising input costs seeping through to core prices), fixed income markets now fully price in a 4½% fed funds rate, likely in three 25bp moves by Spring 2006. Partly in response, stocks cheapened by 2.8% in the past week. To be sure, Fed officials have made it clear that the recent rise in consumer inflation expectations will not be endorsed, or accommodated. Depending on the economy’s response, I Investors seemed to go from complacent to panicked over the past week. While we do believe a number of new risks have emerged (and old ones have intensified) in the past month, a renewed sense of risk often brings with it exaggeration. In addition, the little improvement in news flow cannot be entirely ignored; consider: I tightening will be used to try to slow demand and thus stabilize prices. A marked improvement in financial conditions that boosts demand is out of line with the Fed’s current goals, especially if the economy behaves as if it is operating near full capacity. But signals from energy markets suggest that the supply/capacity situation isn’t entirely hopeless. A further rise in inflation expectations and stepped-up core prices remains a key risk. But a near-term settling back in energy costs and weaker financial markets may help stabilize, or even roll back, the recent rise in long-term inflation expectations (see Figure 2). Figure 1. NYMEX Wholesale vs. Retail Gasoline Price average unleaded, all grades, cents per gallon 275 255 235 215 195 175 155 135 115 95 75 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 220 200 180 160 140 NYMEX Spot Gasoline (Left) Retail Regular Gasoline (Right) Note: Weekly Data. Last Quotes are Oct 3 for Retail Gasoline; Recent High and Latest (Oct 7) for NYM EX The Energy Information Agency notes that 20 oil refineries remain shut following hurricanes Rita and Katrina. But Citigroup’s oil and gas research team informs us that perhaps 16 will be restarted within the next six weeks, several very soon. Wholesale gasoline prices, which have been on a rollercoaster, fell 30 cents last week, an annualized equivalent of over $40 billion in consumer energy costs. Spot heating oil dropped just 11 cents, but it should be remembered that heating oil can serve as a partial substitute for natural gas, which might otherwise remain in scarce supply. Crude oil, meanwhile, fell below our baseline expectations for 2006. We expect CPI to rise 1.1% in September in the upcoming report on Friday (October 14). If retail gasoline prices mirror the recent pullback in wholesale prices, the headline CPI will be reduced by 0.3–0.4 percentage points in each of the next two months (see Figure 1). 320 300 280 260 240 I Source: Energy Information Administration, Haver Analytics, and Bloomberg I Inflation Risks Have Been Exaggerated We have heard some in the media portray the pending crunch in natural gas and heating oil costs for consumers as a catastrophe. Yet, as Figure 3 shows, the underlying commodity price is more than twice as volatile as the total cost of the service for consumers. If we assume natural gas prices stay near recent peaks, we would expect natural gas outlays in the first quarter of 2006 to be $33 billion (annualized) above year-earlier CITIGROUP PORTFOLIO STRATEGIST 15 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary levels. Compare this to an increase of $84 billion (annualized) for gasoline in this recent second quarter. Even with the much higher winter demand for gas and heating oil, we have difficulty “forcing” higher natural gas and oil costs to have even two-thirds of the impact of gasoline cost increases this past summer (Figure 4). Figure 2. Real Oil Price and Five- to Ten-Year Inflation Expectations $ 80 70 60 50 40 30 20 10 70 74 78 Oil (Left) 82 86 90 94 98 02 06 Long-Term Inflation Expectations (Right) 9% 8 7 6 5 4 3 Economic & Market Analysis make it look “disappointing” versus last year’s sales. But should a rise of, say, 3% in same-store sales be considered a catastrophe? While the rise in energy costs (and other bottlenecks in the pipeline) will hurt industrial sector profit margins, a lean and cautious corporate sector has left businesses well-positioned to handle a moderate deterioration in consumer spending growth. (see Figure 5). In summary, the U.S. expansion has entered a riskier phase after 10 quarters of real growth in excess of 3%. But a rockier expansion doesn’t mean a non-existent one. Figure 4. Energy Spending as a Percentage of Total Disposable Income by Type 9 8 7 6 2 9 Gasoline Fuel Oil Natural Gas Electricity 8 7 6 5 4 3 2 1 0 5 4 3 2 1 0 60 65 70 75 80 85 90 95 00 05 Source: Haver Analytics, Bureau of Labor Statistics, University of Michigan, and Citigroup Figure 3. Natural Gas: Services Outlays vs. Spot Price year-over-year percentage change 300 Note: Estimates For Sep-Mar 2005 250 Source: Bureau of Economic Analysis and Citigroup 200 Natural Gas Sales Natural Gas Price 150 Figure 5. Real Inventories and Production vs. Consumer Goods Demand (Jan’00 = 100) 100 50 130 124 118 2001 2002 2003 2004 2005 2006 130 Real Consumer Spending on Goods Real Business Inventories, Including Imports Manufacturing Production 0 124 118 112 106 100 94 -50 -100 2000 112 106 Source: Bureau of Economic Analysis, Haver Analytics, and Citigroup What if Energy Prices Bounce Back Again? If energy prices rebound again to recent peaks (a possibility if repairs to energy infrastructure fall short), consumer energy costs would be roughly $140 billion (annualized) above year-earlier levels in the NovemberJanuary period — the holiday sales season for U.S. retailers. That increase, representing nearly two percentage points of disposable income, should be enough to dampen holiday retail sales growth — and 100 94 2000 2001 2002 2003 2004 2005 Source: Bureau of Economic Analysis, Federal Reserve Board, and Census CITIGROUP PORTFOLIO STRATEGIST 16 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Economics This Week Economics This Week Steven Wieting U.S. Economic Forecast Citigroup Forecast Last Update: October 7, 2005* Percent Change from Preceding Quarter at Annual Rate or Percent Change from Year-ago Quarter Pct Change in Annual Avg Levels Real GDP (Q/Q) —Y/Y % Change Personal Consumption Expenditures (Q/Q) —Y/Y % Change Gross Private Domestic Investment (Q/Q) Equipment & Software (Q/Q) —Y/Y % Change Residential Fixed Investment (Q/Q) —Y/Y % Change Change in Private Inventories ($bln) —contribution to GDP Net Exports ($bln) —contribution to GDP Exports (Q/Q) Imports (Q/Q) Gov't Consumption & Investment (Q/Q) Final Sales (Q/Q) —Y/Y % Change Nominal GDP (Q/Q) —Y/Y % Change GDP Chain-type Price Index (Q/Q) Consumer Price Index (Y/Y %) Producer Price Index (Y/Y %) Federal Funds (%, End of Period )* 10-year Treasury Bond (%, Period-Avg ) Industrial Production (Y/Y % Change) Unemployment Rate (%) Assumed WTI Price ($/bbl, Futures Mkt) Federal Budget Balance ($bln, FY, Unified) % of GDP S&P 500 Oper EPS Pre-writeoffs ($/share) S&P 500 Oper EPS Pre-writeoffs (Y/Y %) S&P 500 GAAP EPS ($/share) S&P 500 GAAP EPS (Y/Y %) S&P 500 Dividends ($/share) S&P 500 Dividends (Y/Y %) S&P 500 Dividend Payout Ratio (%) 2004.1 2004.2 4.3 3.5 4.7 4.6 4.7 1.9 4.3 3.9 10.1 20.9 12.0 15.2 9.8 11.9 5.1 17.8 11.9 13.9 41.9 65.6 0.5 0.9 (563.0) (601.7) (1.2) (1.4) 5.1 6.9 12.0 14.5 3.3 2.3 3.8 2.6 4.5 4.0 8.1 7.5 6.9 7.6 3.6 3.9 1.8 2.8 2.2 4.1 1.00 1.25 4.02 4.60 2.8 5.0 5.7 5.6 35.3 38.3 15.87 26.3 15.18 27.3 4.55 16.1 28.7 16.74 24.7 15.25 37.4 4.66 13.9 27.8 History Forecast History 2004.3 2004.4 2005.1 2005.2 2005.3 2005.4 2006.1 2006.2 2006.3 2006.4 2003 2004 4.0 3.3 3.8 3.3 3.6 2.4 3.5 3.5 3.6 3.6 3.8 3.8 3.6 3.6 3.5 3.3 3.2 3.3 3.3 3.5 2.7 4.2 4.4 4.3 3.5 3.0 3.1 1.7 4.1 3.4 3.4 3.5 3.5 3.8 3.5 3.8 3.5 2.8 3.0 3.1 3.2 3.6 2.9 3.9 4.6 6.8 8.6 (3.3) 11.1 10.0 1.0 4.1 5.1 5.0 3.9 11.9 15.5 12.4 8.3 10.4 13.7 5.9 7.9 8.2 8.6 9.0 12.0 13.8 12.8 11.6 11.2 9.5 9.4 8.9 7.7 8.4 3.2 11.9 2.6 1.6 9.5 9.8 4.2 (1.0) (2.7) (1.0) (1.2) (0.6) 9.1 6.6 7.7 5.8 6.2 5.5 2.5 (0.2) (1.5) (1.4) 8.4 10.3 50.4 50.1 58.2 2.6 17.5 52.4 43.4 44.9 50.2 52.4 15.5 52.0 (0.6) (0.0) 0.3 (2.0) 0.5 1.2 (0.3) 0.1 0.2 0.1 0.0 0.3 (606.5) (634.1) (645.4) (611.2) (619.7) (637.0) (641.5) (642.0) (642.8) (645.4) (521.4) (601.3) (0.2) (1.0) (0.4) 1.2 (0.3) (0.6) (0.2) (0.0) (0.0) (0.1) 0.0 (0.7) 5.4 7.1 7.5 13.2 1.5 4.7 6.7 8.5 8.7 8.1 1.8 8.4 4.7 11.3 7.4 0.5 2.9 7.0 5.3 5.7 5.9 5.9 4.6 10.7 1.8 0.9 1.9 2.7 (0.5) 1.0 3.3 2.3 2.1 1.9 2.8 2.2 4.6 3.3 3.5 5.4 3.1 1.2 3.8 3.4 3.4 3.5 3.4 3.6 3.5 4.2 3.8 3.3 3.4 2.9 3.0 3.5 2.7 3.9 5.3 6.1 7.0 5.8 6.1 4.6 6.1 5.7 5.8 5.9 6.6 6.8 6.5 6.1 6.0 5.6 5.4 5.4 5.5 5.9 4.8 7.0 1.5 2.7 3.1 2.4 2.5 2.1 2.5 2.2 2.2 2.3 2.0 2.6 2.7 3.4 3.0 2.9 3.6 3.6 3.3 2.7 2.1 1.9 2.3 2.7 3.5 4.6 4.7 3.9 5.0 3.8 3.1 2.8 1.8 1.4 3.2 3.6 1.75 2.25 2.75 3.25 3.75 4.25 4.50 4.50 NA NA 1.00 2.25 4.30 4.17 4.30 4.20 4.20 4.35 NA NA NA NA 4.31 4.27 4.6 4.2 3.8 3.1 3.5 3.0 2.8 3.2 2.9 3.1 0.0 4.1 5.4 5.4 5.3 5.1 5.1 5.2 5.3 5.4 5.4 5.4 6.0 5.5 43.9 48.3 49.7 53.0 62.5 64.9 66.3 66.5 67.1 66.7 31.1 41.4 (374) (413) (3.5) (3.6) 16.59 17.83 17.95 19.03 19.00 19.77 19.70 20.05 20.00 20.75 55.52 67.03 15.0 16.8 13.1 13.7 14.5 10.9 9.7 5.4 5.3 5.0 15.8 20.7 14.18 13.94 16.95 18.30 48.74 58.55 12.9 5.9 11.7 20.0 76.7 20.1 4.89 5.33 5.35 5.36 17.39 19.43 13.5 5.5 17.6 15.0 8.2 11.7 29.5 29.9 29.8 28.2 31.3 29.0 Forecast 2005 2006 3.5 3.4 6.5 11.2 3.3 3.2 4.9 8.6 6.3 (0.1) 32.7 47.7 (0.2) 0.1 (628.4) (642.9) (0.3) (0.2) 7.2 6.7 6.3 5.2 1.5 1.9 3.7 3.2 6.2 5.7 2.5 2.2 3.3 2.5 4.3 2.2 4.25 NA 4.30 NA 3.3 3.0 5.2 5.3 55.2 66.6 (315) (300) (2.6) (2.3) 75.75 80.50 13.0 6.3 67.50 69.50 15.3 3.0 22.00 23.25 13.2 5.7 29.0 28.9 * On October 5, 2005, we raised our forecast for the peak of the Fed Funds rate to 4.50% fro m4.00%. The timing of tightenings and long rates are to be determined. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Office of Management and Budget, Federal Reserve Board, First Call, and Citigroup Week-Ahead U.S. Economic Data Releases Date/Time Oct 17, 8:30 Oct 18, 8:30 1:00 Oct 19, 8:30 Oct 20, 8:30 12:00 Report Empire State Manufacturing Survey (Oct) Producer Price Index (Sep) Excluding Food & Energy Housing Market Index Housing Starts Building Permits Leading Indicators Philadelphia Business Outlook Survey (Oct) Citigroup 21 1.0% 0.1% 66 1.995M 2.105M NA NA Street 20 1.1% 0.2% 64 1.950M 2.050M -0.5% 10 Prior 17 0.6% 0.0% 65 2.009M 2.138M -0.2% 2.2 Note: For detailed estimates, see the note “U.S.: A Look at the Week Ahead,” by Brian Jones. CITIGROUP PORTFOLIO STRATEGIST 17 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary U.S. Economic Charts of the Week 25 % 20 15 10 5 0 86 88 90 92 94 96 98 00 02 04 Plans to Increase Em ploym ent (Left) Payrolls (Right) 500K 400 300 200 100 0 -100 -200 -300 -400 Economics This Week Percentage of Small Businesses Planning to Increase Employment and Change in Non-Farm Payrolls Source: National Federation of Independent Business and Bureau of Labor Statistics Non-farm payrolls fell 35K in September, while net upward revisions to the two previous months were 77K. This result was significantly stronger than consensus, which most likely misjudged the way displaced workers were counted, as workers still held on payrolls were not counted as job losers, even if they were evacuated from hurricane-affected regions. Meanwhile, small businesses’ hiring intentions held steady at the upper range for this cycle, even though general sentiment softened. 250 200 150 100 50 0 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 250 200 150 100 50 0 Individuals Unable to Work Due to Bad Weather The September Household Survey of employment showed a job loss of 17,000 with 214K (not seasonally adjusted) unable to work due to weather conditions. This is similar to the 225K weather related displacements caused by the hurricanes in September 2004. The unemployment rate rose to 5.1% from 4.9%, but this jump is most likely temporary. In job categories such as leisure and hospitality, key industries in New Orleans, employment fell 80K. The effects of the hurricanes on employment appear to be moderately negative, but not overwhelming. 106 104 102 100 98 96 94 92 90 86 88 90 92 94 96 98 00 02 04 Optim ism (Left) R eal GD P (R ight) 6% 5 4 3 2 1 0 -1 -2 Source: Bureau of Labor Statistics Small Business Optimism (Three-Month Moving Average) and Real GDP (Year-over-Year Percentage Change) While the September survey of small firms revealed some additional softening in optimism, the decline still places overall optimism at a level consistent with near trend growth. Current indications signal that real GDP growth finished above 3½% in the third quarter and will likely cool to a 2½% pace in the fourth quarter. Source: National Federation of Independent Business and the Bureau of Economic Analysis Citigroup Financial Conditions Index and Domestic Final Demand Relative to Trend 3σ 2 1 0 -1 -2 -3 -4 -5 86 88 90 92 94 96 98 00 02 04 06 FCI, Lagged 7-Mo. (Left) Relative Aggregate Demand (Right) 3% 2 1 0 -1 -2 -3 -4 -5 Financial conditions remain supportive of above-trend growth in demand, but are now softening. Any improvement in financial conditions that further boosts aggregate demand is out of line with the Fed’s current goals due to the possibility of increased inflationary pressures. Fed officials have made it clear that the recent rise in consumer inflation expectations will not be endorsed or accommodated by policy. Source: Bureau of Economic Analysis, Congressional Budget Office, and Citigroup CITIGROUP PORTFOLIO STRATEGIST 18 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Fixed Income Strategy Fixed Income Strategy George Friedlander / Michael Brandes Taking a Stand in a Very Different Rate Cycle I For a variety of reasons, including the effects of Hurricane Katrina on energy costs, inflation concerns proved to be more worrisome than anticipated. As a consequence, our economists recently raised the base case projection for peak fed funds to 4.50% from 4.0%. Once again, this presents challenges in fixed income strategy for at least two reasons. First, it generates the prospect of even more flattening of taxable and muni yield curves. Second, it creates the perception, yet again, that long-term rates “must” head higher as well. As we have said for the past two years, we disagree with this outlook. Our economists are saying that 10-year treasury yields in the 4.40%–4.60% range would be “very attractive.” We concur, and note that rates are essentially there. The reasons for our views haven’t changed. The Fed will prevail in cooling long-term inflation expectations. Then there are the same old supply/demand factors keeping “real” rates anchored: a surplus of global savings, lower rates elsewhere around the world, and negligible demand for credit from corporations. Two additional circumstances support this view: the cyclical backdrop for long-term rates as the Fed finishes tightening, and the likelihood of a somewhat weaker economy as the Fed endeavors to lower inflation expectations. I Base Case for Fed Funds Peak Raised to 4.5% The reasons are varied, but are at least partially related to Katrina. Higher energy costs and related supply bottlenecks have put significant pressure on near-term inflation expectations, which are now threatening to seep into a structural change in long-term inflation expectations — the kind that matters most to the Fed and the bond markets. The Fed has to push harder to keep higher long-term expectations from becoming structural — its non-negotiable goal. In speech after speech, Fed governors have indicated their commitment to achieving that goal. I As short-term rates move higher under the above scenario, the willingness of investors to move out of their cash/near-cash “foxholes” may once again be diminished — and our challenge in coaxing them out will once again become greater, we suspect. …But We Still Don’t Think Long-Term Rates Will Follow Several publications have thus begun to refer to higher long-term rates — and we continue to disagree. Below we list our ongoing reasons, briefly, and add a few new ones. The existing reasons are: 1) the massive global demand for dollar-denominated fixed income investments, 2) the U.S. current account deficit and the vast surplus of global savings that are fueling that demand; 3) the surprisingly limited supply of net new debt, with nonfinancial corporate borrowings still running around zero and the deficit at a manageable 2 1/2% of GDP; and 4) the fact that long-term rates are considerably lower elsewhere in the world, and 5) the bond market’s belief that the Fed will prevail in the fight against higher long-term inflation expectations. I I Our view that long-term rates are unlikely to move significantly higher has been well articulated in a variety of comments, including prior articles in this publication. Yet, we feel it necessary to return to the subject once again. The reason: while our long-term rate view hasn’t changed, our economists’ and the markets’ base case for peak fed funds has moved up yet again, from the 4% to the 4.50% range. Importantly, investors should note the comparison of U.S. Treasury yields and a basket of 12 yields on longterm rates elsewhere around the world (see Figure 1). It is important to recognize that the excess yield over that basket has actual expanded as 10-year Treasury yields have moved about 40 basis points higher since the beginning of September. CITIGROUP PORTFOLIO STRATEGIST 19 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Figure 1. U.S. and Global — 10-Year Interest Rates (Percent) The excess U.S. yield over the global basket has expanded, as 10-year Treasuries have risen since the beginning of September. 7.0 7.0% 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 1999 7.0 7.0% 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2000 2001 United States 2002 2003 2004 12-Country Average 2005 Fixed Income Strategy Municipals: Still Some Slope but Also Some Risk In this environment, there are both challenges and opportunities in the municipal market. The challenges come from the important role of the individual investor, who is concerned and/or confused about rate trends, and will see higher short-term rates as a reason to stay very short. The opportunity is that, as usual, the slope of the municipal yield curve is steeper than elsewhere (see Figure 3), and that we expect a significant decline in new issue supply as refunding volume subsides. Refundings have been fully one-third of issuance year to date, and as they are completed, the amount of costeffective refundings yet to be done declines (unless yields head sharply lower again, an unlikely outcome). Source: Federal Reserve Board To the above, we add two more thoughts: First, we expect the Fed to end its tightening cycle early in 2006 under our economists’ base case — and during the first half even if the Fed decides it needs to push a little harder. Historically, once the Fed ends a tightening cycle, longterm rates tend to pause, and then head lower, not higher. This is shown in Figure 2. In other words, we would continue to move out of cash and into the 5–15 year range in the municipal market. If rates bump up along the way as the Fed tightens, that should be viewed as a buying opportunity — a reason to accelerate the move into munis and out of cash for that component of one’s portfolio. Figure 3. The Slope in the Muni Market Remains Extremely Steep Relative to Treasuries 5.00 4.50 4.00 3.50 After-tax yield on Treasuries Muni yield curve The reason relates to our second point: a Fed committed to controlling inflation expectations will only stop tightening once it prevails — i.e., once the concerns that led to tightening have been overcome. Indeed, this time, Fed officials have indicated their willingness to risk an “overshoot” (higher short-term rates than ultimately prove necessary), if that -is what is needed to tame inflation expectations. In any event, pressures on long-term rates are likely to subside, not increase, once the Fed ends its tightening cycle. Indeed, we would not be surprised to see the Fed back off from peak shortterm rates some time in the not-too-distant future, taking market short-term rates down a bit as well. Figure 2. Cumulative Change in 10-Year Yields After Curve Flattened to 25 Basis Points 1 1 3.00 2.50 2.00 1.50 Money 3-mth 6-mth market 1-yr 2-yr 3-yr 5-yr 7-yr 10-yr 15-yr 20-yr 30-yr Note: The 1-year yield reflects levels available in the secondary market. Source: Muni Market Data-Line 0 0 -1 -1 -2 FCM10.D-4.26 FCM10[T-282]-14.43 -2 -3 FCM10[T-201]-8.96 FCM10[T-128]-7.81 -3 -4 FCM10[T-69]-6.03 -4 -5 Q1 Q2 2005 -5 Q3 Q4 Q1 Q2 2006 Q3 Q4 Source: Federal Reserve Board CITIGROUP PORTFOLIO STRATEGIST 20 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Small & Mid-Cap Strategy Small & Mid-Cap Strategy Dr. Albert D. Richards, CFA Insurance Focus — Replacing HCC with UNM I In our “what works” analysis, we found trailing P/E to be the best predictor of future share price performance, with FY1 P/E, ROE, and P/B also appearing as useful factors. We screen both small & mid-cap markets with a simple model incorporating all four of these factors. In Mid-Caps, Buy-rated Unum Provident (UNM) comes out particularly well, and we add it to our Focus List in place of HCC Holdings (HCC). In Small-Caps our current Focus List idea, Max Re (MXRE) screened quite well, and hence we are keeping this name on the list. Small-Cap investors looking for additional ideas may also be interested in PartnerRe (PRE), although we are not adding this idea to our Focus List at this time. Figure 1. Russell 2000 Performance: Financial Industries Dec 2002 – Present 220 200 Russell 2000 Financials Performance Banks, Insurance, REITS Insurance 180 160 140 120 100 80 Aug-03 Aug-04 Aug-05 Jun-03 Jun-04 Dec-02 Dec-03 Dec-04 Jun-05 Oct-03 Oct-04 Apr-03 Apr-04 Feb-03 Feb-04 Feb-05 Apr-05 Oct-05 REITs I I Banks I Banks Insurance Real Estate I Source: Frank Russell Co. and Citigroup Investment Research Figure 2. Russell 2000 P/E Ratios: Financial Industries 40 Russell 2000 Financials Price/Earnings Banks, Insurance, REITS REITs 30 Price/Earnings Insurance, like the rest of the Financials sector, has been one of the better-performing areas of the market over the past few years. This performance, combined with a heavy weighting of this sector in our Focus List (2 out of 16 stocks, this after the recent removal of Allmerica Financial), causes us to revisit this sector. Recent Insurance Performance Shown in Figure 1 is performance since December 2002 for three of the four main Industry Groups in Russell 2000 Financials: Banks, Insurance, and Real Estate (we leave out Diversified Financials, as it is a relatively small sector in the Russell 2000). Note that we are using the Global Industry Classification Standard (GICS) sector definitions. Insurance has been a fairly strong performer over this time frame, although it lags other Industry Groups over longer periods. Insurance Valuations In Figures 2 and 3 we show historical trends in Russell 2000 P/E (Price/Earnings) ratios and P/B (Price/Book) ratios for the same three categories — Banks, Insurance, and Real Estate. In simple P/E terms, Insurance looks cheap, Banks look a bit expensive, and Real Estate is potentially very stretched after being bid up by yieldhungry investors. 35 25 Banks 20 15 10 Insurance 5 Dec-94 Apr-95 Aug-95 Dec-95 Apr-96 Aug-96 Dec-96 Apr-97 Aug-97 Dec-97 Apr-98 Aug-98 Dec-98 Apr-99 Aug-99 Dec-99 Apr-00 Aug-00 Dec-00 Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Banks Insurance Real Estate Source: Frank Russell Co. and Citigroup Investment Research The results of a simple P/B analysis look somewhat different. Here Insurance looks to be near the upper end of the historical range (raising concerns about a cyclical peak). Banks also look expensive, and Real Estate appears to be at the upper end of its historical range. CITIGROUP PORTFOLIO STRATEGIST 21 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Figure 3. Russell 2000 P/B Ratios: Financial Industries 3.0 Russell 2000 Financials Price/Book Banks, Insurance, REITS 2.5 Banks 2.0 Small & Mid-Cap Strategy rule investors seem to underpay somewhat for companies with strong profitability. Finally, price-to-book (P/B) also appears to add return, — companies with the lowest P/B ratios outperformed those with the highest. Outside of the valuation and profitability factors shown in Figure 4, we found a fairly strong result using “last month’s return” as a factor (Quintile 5 outperforming), but this is such a highturnover strategy we left it out of the analysis. Figure 4. Stock Picking in Insurance: What Works and What Doesn’t LTM Earnings' Yield (E/P) LTM ROE Earnings' Yield FY1 Earnings' Yield FY2 First 11 of Last 12 Month Return Forecast 5YR EPS Growth EV / EBITDA PEG-1 (FY1 PE / 5-yr Forecasted Growth) Market Cap PEG-2 (FY2 PE / 5-yr Forecasted Growth) Price-to-Book Quintile 1 24.0% 16.6% 21.6% 19.4% 16.0% 9.1% 6.4% 14.3% 14.4% 14.8% 5.8% Quintile 5 -2.6% 2.4% 8.4% 16.4% 16.5% 10.7% 8.3% 19.3% 19.7% 21.3% 14.8% Q1 - Q5 Delta 26.6% 14.2% 13.2% 3.0% -0.6% -1.6% -1.9% -5.1% -5.3% -6.6% -9.0% Price/Book 1.5 Insurance 1.0 REITs 0.5 Dec-94 Apr-95 Aug-95 Dec-95 Apr-96 Aug-96 Dec-96 Apr-97 Aug-97 Dec-97 Apr-98 Aug-98 Dec-98 Apr-99 Aug-99 Dec-99 Apr-00 Aug-00 Dec-00 Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Banks Insurance Real Estate Source: Frank Russell Co. and Citigroup Investment Research Stock Picking in Insurance Given the relatively strong performance of Insurance (and Financials in general), we thought it appropriate to re-visit our Focus List recommendations in this sector. This is particularly appropriate given our disproportionate weighting in Insurance (2 of 16 stocks after recently removing Allmerica Financial). Source: FactSet and Citigroup Investment Research We start with our usual analysis of stock-picking factors specific to this Industry Group. Unfortunately, we could only perform a portion of our normal analysis due to database access restrictions. Nonetheless, we find the results to be quite interesting and potentially very helpful when reviewing the Insurance stocks. In this “what works” analysis, we divided the Russell 2800 Insurance Industry Group into quintiles based on a number of valuation factors. (The Russell 2800 is our own invention — the combination of the Russell 2000 Small-Cap index and the Russell 800 Mid-Cap index.) For each factor, we then track the quintiles over time and on an equal-weighted basis with a monthly rebalance. We thus can determine the relative “stockpicking” effectiveness of each factor. Figure 4 shows the results of this analysis (a specific example appears below for those more interested in our process). As can be seen, a simple trailing P/E ratio (screened as E/P, or earnings' yield) was the best stockpicking factor in this sector. As in other sectors we have reviewed, trailing P/E did a much better job than forward P/E ratios, although P/Es based on FY1 earnings did provide at least a little return spread. In addition to trailing and FY1 P/E, profitability ratios delivered some differentiated returns, with higher ROE companies outperforming. Once again, we have seen a similar result in other sectors — indeed, as a general CITIGROUP PORTFOLIO STRATEGIST A Brief Example: FY1 Earnings’ Yield In Figure 5, we plot the rolling 12-month return spread between the highest and lowest quintiles for FY1 earnings’ yield (FY1 E/P). While this factor works much of the time, it clearly did not work during the bubble years. Knowing when each factor has and hasn’t worked is an important part of this analysis. Figure 5. Insurance: Rolling Spread Between Quintiles 1 and 5 Based on E/P 100% Low P/E outperforms 80% 60% 40% 20% 0% -20% -40% -60% 35095 High P/E outperforms 35277 35461 35642 35825 36007 36189 36371 36556 36738 36922 37103 37287 37468 37652 37833 38016 38198 38383 38564 Earnings Yield FY1 Screen - Top vs Bottom Quintile Russell 2800 Insurance Historical Index Constituents Source: FactSet and Citigroup Investment Research Stock Screens in Small- and Mid-Cap Insurance As a result of our factor analysis, we created a simple four-factor screening model for small- and mid-cap insurance stocks. In this model, we ranked each company within its respective universe (small- or midcaps) based on the four factors that delivered the best Rolling 12-Month Total Return (%) 22 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary differentiated returns, namely last twelve month’s (LTM) earnings’ yield, FY1 earnings’ yield, LTM return on equity, and price-to-book. We then take a simple average of the rankings as a gauge of the relative attractiveness of each stock. We see that Buy-rated UnumProvident (UNM–$19.55; 1H) shows up relatively well on this list. We particularly like this company’s strong ranking on the price-to-book screen. If, as Figure 3 suggests, we are nearing the upper end of an Insurance cycle, we believe that a company with a relatively low P/B ratio will provide some downside protection. UNM nicely “out-screened” our current Focus List name, HCC Figure 6. Screening Results for Mid-Cap Insurance Stocks GICS Industry Group Ticker Insurance AFG CGI ORI MBI FNF FAF NFS BER CNA UNM CNO SAFC LNC TMK AMH AFC AIZ SFG MCY PL GNW TRH UTR JP CINF PHLY ERIE HCC RGA MKL BRO AOC AJG CIR Rating Price 10/10/05 $33.10 $56.92 $25.71 $56.10 $42.30 $43.07 $39.02 $37.92 $29.35 $19.55 $20.68 $52.44 $49.19 $52.42 $56.31 $38.20 $37.42 $83.41 $60.24 $42.20 $30.95 $56.50 $45.64 $53.81 $40.75 $84.52 $52.75 $28.14 $44.64 $325.99 $50.49 $31.26 $29.02 Mkt Value (mil) $2,556 $1,913 $4,703 $7,519 $7,316 $4,091 $5,970 $4,815 $7,512 $5,824 $3,124 $6,702 $8,478 $5,492 $2,201 $2,044 $5,106 $2,308 $3,287 $2,938 $14,568 $3,721 $3,158 $7,252 $7,131 $1,948 $3,298 $2,961 $2,796 $3,208 $3,491 $9,957 $2,745 LTM E/P 14.9% 12.9% 10.6% 10.4% 13.7% 9.7% 9.8% 9.7% 9.9% 10.7% 10.4% 8.7% 9.0% 8.9% 9.4% 9.8% 7.9% 8.7% 8.3% 7.9% 8.4% 6.6% 8.7% 8.0% 8.2% 6.3% 7.7% 6.4% 7.4% 6.2% 4.0% 6.0% 2.7% FY1 E/P 11.1% 11.3% 9.8% 9.9% 8.8% 10.6% 9.5% 10.1% 9.7% 8.6% 8.5% 10.2% 8.8% 8.8% 8.0% 8.5% 8.8% 8.2% 8.2% 8.5% 8.0% 9.6% 6.1% 7.7% 7.4% 8.3% 6.4% 7.7% 7.3% 7.5% 4.2% 7.0% 6.3% Small & Mid-Cap Strategy Insurance Holdings (HCC-$28.14; 1M). As a result, we are replacing HCC with UNM on our List. In small-caps, our current Focus List idea MaxRE (MXRE-$24.07; 1H) continued to screen well, and hence we are leaving it on the list. Investors looking for additional insurance ideas may also want to look at PartnerRe (PRE-$62.60; 1M), another name that screened well. Citigroup Global Markets Inc. is a joint bookrunner on the proposed common stock offering for Max Re. Company Name American Financial Group Inc. Commerce Group Inc. Old Republic International Corp. MBIA Inc. Fidelity National Financial Inc. First American Corp. Nationwide Financial Services Inc. W.R. Berkley Corp. CNA Financial Corp. UnumProvident Corp. Conseco Inc. SAFECO Corp. Lincoln National Corp. Torchmark Corp. AmerUs Group Co. Allmerica Financial Corp. Assurant Inc. StanCorp Financial Group Inc. Mercury General Corp. Protective Life Corp. Genworth Financial Inc. TransAtlantic Holdings Inc. Unitrin Inc. Jefferson-Pilot Corp. Cincinnati Financial Corp. Philadelphia Consolidated Holding Co. Erie Indemnity Co. HCC Insurance Holdings Inc. Reinsurance Group of America Inc. Markel Corp. Brown & Brown Inc. AON Corp. Arthur J. Gallagher & Co. LTM ROE 16.4% 22.6% 12.8% 12.1% 25.4% 15.6% 11.4% 22.4% 8.1% 8.9% 9.5% 12.6% 12.9% 14.8% 13.2% 8.5% 11.2% 14.7% 19.0% 11.1% 10.0% 9.5% 13.6% 15.2% 9.6% 18.1% 20.3% 14.5% 9.3% 12.6% 22.3% 11.9% 10.3% Price to Book 1.1x 1.8x 1.2x 1.2x 1.9x 1.6x 1.2x 2.3x 0.8x 0.8x 0.8x 1.4x 1.4x 1.7x 1.4x 0.9x 1.4x 1.7x 2.3x 1.4x 1.2x 1.4x 1.6x 1.9x 1.2x 2.9x 2.6x 2.3x 1.3x 2.0x 5.5x 2.0x 3.8x LTM E/P 1 3 5 7 2 12 9 11 8 4 6 17 14 15 13 10 24 18 20 23 19 27 16 22 21 29 25 28 26 30 32 31 33 Rank FY1 LTM E/P ROE 2 1 7 6 14 3 10 5 8 15 16 4 11 13 22 18 12 21 20 17 23 9 32 25 27 19 30 24 28 26 33 29 31 8 2 17 20 1 9 22 3 33 31 29 18 16 11 15 32 23 12 6 24 26 28 14 10 27 7 5 13 30 19 4 21 25 Avg P/B Rank 5 22 10 8 23 19 6 29 2 1 3 16 15 20 12 4 14 21 28 13 9 17 18 24 7 31 30 27 11 26 33 25 32 4 7 10 10 10 11 12 12 13 13 14 14 14 15 16 16 18 18 19 19 19 20 20 20 21 22 23 23 24 25 26 27 30 2M 2M 1H 3M 2M 2L 1M 2H 2M 1L 2M 2L 1M 3L 2M 1M 2H Source: Frank Russell Co. and Citigroup Investment Research CITIGROUP PORTFOLIO STRATEGIST 23 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Figure 7. Screening Results for Small-Cap Insurance Stocks GICS Industry Group Ticker Insurance ACAP MXRE AFFM DRCT IPCC AEL SAFT PRE LFG BRW TGIC MLAN UCI STC STFC HMN AGII ZNT SIGI UFCS CERG EMCI OCAS RLI DFG FFG ORH DGICA NAVG BWINB FPIC PNX HGIC ALFA PRA TWGP HRH CLK TW UHCO PMACA CRD.B SUR USIH FAC NFP CIR Rating Price 10/10/05 $46.41 $24.09 $13.92 $18.99 $34.70 $11.43 $37.22 $62.60 $63.00 $17.90 $38.13 $32.88 $36.01 $50.10 $31.53 $18.76 $27.47 $63.38 $49.03 $44.93 $5.75 $17.64 $26.30 $45.50 $44.63 $29.53 $24.82 $20.82 $37.59 $24.63 $36.18 $12.05 $23.30 $16.19 $45.92 $15.18 $37.82 $16.12 $15.84 $22.44 $8.64 $7.22 $13.67 $12.64 $9.95 $43.75 Mkt Value (mil) $394 $1,111 $207 $407 $718 $439 $585 $3,421 $1,138 $557 $565 $622 $1,661 $909 $1,274 $805 $773 $1,453 $1,392 $1,060 $199 $240 $1,695 $1,159 $1,432 $854 $1,610 $374 $480 $363 $374 $1,146 $707 $1,296 $1,350 $300 $1,349 $295 $1,358 $1,299 $275 $353 $591 $727 $472 $1,552 LTM E/P 16.8% 12.4% 12.4% 11.8% 14.2% 11.2% 11.3% 14.6% 10.7% 10.9% 10.4% 11.0% 11.0% 9.8% 9.6% 9.4% 11.0% 10.6% 10.1% 9.4% 8.8% 7.1% 9.2% 8.8% 8.9% 8.8% 9.2% 8.1% 7.9% 7.8% 8.0% 7.6% 6.7% 7.2% 6.7% 4.7% 5.9% 5.4% 6.4% 5.5% -11.2% 6.3% 4.3% 1.7% 5.5% 2.7% FY1 E/P 17.0% 11.8% 11.6% 11.6% 9.7% 12.1% 11.5% 7.7% 11.1% 10.1% 10.8% 9.2% 10.3% 10.6% 11.0% 10.5% 7.3% 8.5% 8.2% 9.4% 8.5% 12.2% 8.4% 8.2% 8.2% 7.6% 5.7% 8.3% 8.9% 7.8% 8.0% 7.5% 7.6% 7.5% 6.7% 6.7% 6.0% 4.8% 6.0% 5.1% -7.6% 4.2% 5.0% 8.4% 5.3% 5.5% Small & Mid-Cap Strategy Company Name American Physicians Capital Inc. Max Re Capital Ltd Affirmative Insurance Holdings Inc. Direct General Corp. Infinity Property & Casualty Corp. American Equity Investment Life Holding Co. Safety Insurance Group Inc. PartnerRe Ltd LandAmerica Financial Group Inc. Bristol West Holdings Inc. Triad Guaranty Inc. Midland Co. UICI Stewart Information Services Corp. State Auto Financial Corp. Horace Mann Educators Corp. Argonaut Group Inc. Zenith National Insurance Corp. Selective Insurance Group Inc. United Fire & Casualty Co. Ceres Group Inc. EMC Insurance Group Inc. Ohio Casualty Corp. RLI Corp. Delphi Financial Group Inc. FBL Financial Group Inc. Odyssey Re Holdings Corp. Donegal Group Inc. Navigators Group Inc. Baldwin & Lyons Inc. FPIC Insurance Group Inc. Phoenix Cos. Inc. Harleysville Group Inc. Alfa Corp. ProAssurance Corp. Tower Group Inc. Hilb Rogal & Hobbs Co. Clark Inc. 21st Century Insurance Group Universal American Financial Corp. PMA Capital Corp. Crawford & Co. CNA Surety Corp. USI Holdings Corp. First Acceptance Corp. National Financial Partners Corp. LTM ROE 29.5% 14.8% 16.2% 20.5% 19.3% 15.7% 21.6% 15.2% 10.7% 19.5% 13.6% 15.9% 25.3% 12.7% 18.5% 13.3% 13.7% 29.2% 16.3% 19.4% 8.7% 8.0% 12.1% 16.3% 13.9% 9.3% 9.5% 12.5% 11.6% 8.6% 13.8% 4.4% 8.1% 13.5% 14.9% 18.7% 15.9% 5.9% 11.5% 16.5% -7.1% 12.0% 5.9% 3.5% 12.4% 7.4% Price to Book 1.8x 1.2x 1.3x 1.7x 1.4x 1.4x 1.9x 1.1x 1.0x 1.8x 1.3x 1.4x 2.3x 1.3x 1.9x 1.4x 1.3x 2.8x 1.6x 2.1x 1.0x 1.1x 1.3x 1.9x 1.6x 1.0x 1.0x 1.5x 1.5x 1.1x 1.7x 0.6x 1.2x 1.9x 2.2x 3.9x 2.7x 1.1x 1.8x 3.0x 0.6x 1.9x 1.4x 2.1x 2.2x 2.8x LTM E/P 1 5 4 6 3 8 7 2 13 12 15 10 11 17 18 19 9 14 16 20 24 33 21 26 23 25 22 27 29 30 28 31 35 32 34 42 38 41 36 40 46 37 43 45 39 44 Rank FY1 LTM E/P ROE 1 4 6 5 15 3 7 29 8 14 10 17 13 11 9 12 34 20 26 16 19 2 21 24 25 31 39 23 18 28 27 33 30 32 35 36 37 44 38 42 46 45 43 22 41 40 1 20 14 5 8 17 4 18 34 6 24 15 3 27 10 26 23 2 13 7 37 40 30 12 21 36 35 28 32 38 22 44 39 25 19 9 16 42 33 11 46 31 43 45 29 41 Avg P/B Rank 29 11 16 27 18 20 35 9 4 30 15 22 41 14 36 21 13 43 26 38 3 10 17 32 25 6 5 24 23 8 28 1 12 33 39 46 42 7 31 45 2 34 19 37 40 44 8 10 10 11 11 12 13 15 15 16 16 16 17 17 18 20 20 20 20 20 21 21 22 24 24 25 25 26 26 26 26 27 29 31 32 33 33 34 35 35 35 37 37 37 37 42 1H 1M 2H Source: Frank Russell Co. and Citigroup Investment Research CITIGROUP PORTFOLIO STRATEGIST 24 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Citigroup Investment Research Small & Mid-Cap Strategy Citigroup Investment Research SmMid Portfolio for 2005 Dr. Albert D. Richards, CFA GICS Sector Consumer Discretionary Ticker AAP AD CHS GME GTK OEH PLCE TPX BJ CPO UNFI ETP FST GRP NBL ARE ENN HCC MXRE TCB TSFG UNM CHE CONR COO CYH DOVP DVA OCR PDLI SNMX WC CPS CTAS DRS PLUG ROP SRCL TEX APH CSGS DST EEFT IDTI MANH NTGR RSAS XRTX LZ SSCC AMT CMS Company Name Advance Auto Parts, Inc. ADVO, Inc. Chico's FAS, Inc. Game Stop Corp. GTECH Holdings Corp. Orient Express Hotels Ltd The Children's Place Retail Stores, Inc. Tempur-Pedic International Inc. BJ's Wholesale Club Corn Products International United Natural Foods, Inc. Energy Transfer Partners, L.P. Forest Oil Corporation Grant Prideco, Inc. Noble Energy Alexandria Real Estate Equities Equity Inns Inc. HCC Insurance Holdings Max Re Ltd. TCF Financial Corp. The South Financial Group, Inc. UnumProvident Corp. Chemed Corporation Conor Medsystems Cooper Companies Community Health Systems DOV Pharmaceuticals DaVita Inc. Omnicare, Inc. Protein Design Labs Senomyx Wellchoice Inc. ChoicePoint Cintas Corporation DRS Technologies, Inc. Plug Power Inc. Roper Industries Stericycle, Inc. Terex Corporation Amphenol CSG Systems International Incorporated DST Systems Euronet Worldwide Integrated Device Technology Manhattan Associates, Inc. Netgear, Inc. RSA Security Xyratex Ltd Lubrizol Corporation Smurfit-Stone Container Corp. American Tower CMS Energy Analyst Bill Sims William Bird Kimberly Greenberger, CFA Elizabeth Osur, CFA Michael Rietbrock Michael Rietbrock Kimberly Greenberger, CFA Stephen Kim Deborah Weinswig David Driscoll, CFA Gregory Badishkanian John Tysseland Gil Yang Geoff Kieburtz Gil Yang Jonathan Litt Michael Rietbrock Ronald Frank Joshua Shanker Keith Horowitz, CFA Michael Diana Colin Devine Matthew Ripperger Matthew Dodds Peter Bye Oksanna Butler Yaron Werber, M.D. Matthew Ripperger Matthew Ripperger Elise Wang Elise Wang Charles Boorady Patrick Burton, CFA Leone Young Ferat Ongoren David Smith David Smith Leone Young David Raso David Pescherine, CFA Ashwin Shirvaikar, CFA Patrick Burton, CFA Tony Wible, CFA Glen Yeung Mark Verbeck Alex Henderson Chris Debiase Paul Mansky P.J. Juvekar Chip Dillon, CFA Michael Rollins, CFA Greg Gordon, CFA CIR Rating 2H 1M 1M 1H 1M 1H 1S 2S 1H 1M 1H 1M 1H 1H 1H 1H 1M 1M 1H 2M 2M 1H 1H 1S 1L 1H 1S 1H 1H 1S 1S 1L 1H 1L 1M 1S 1H 1M 1H 1H 1H 1H 1S 1S 1H 1S 1H 1S 1H 1H 1H 1M Mkt Cap Price (mil.) 10/11/2005 $2,828 $38.75 $920 $29.30 $6,640 $37.26 $678 $30.90 $3,611 $31.18 $1,073 $27.31 $1,054 $36.84 $971 $9.85 $1,781 $26.03 $1,498 $19.66 $1,381 $32.89 $2,436 $34.18 $2,958 $47.70 $4,607 $36.26 $7,472 $42.50 $1,535 $78.72 $707 $12.76 $2,881 $27.52 $1,088 $23.61 $3,417 $25.47 $1,956 $26.32 $5,899 $19.52 $1,073 $40.95 $742 $22.75 $3,108 $70.35 $3,345 $37.29 $360 $15.66 $5,012 $48.71 $5,528 $52.80 $2,647 $27.34 $357 $14.13 $6,323 $75.18 $3,893 $43.25 $6,736 $39.23 $1,426 $51.12 $458 $6.32 $1,562 $36.51 $2,515 $56.01 $2,561 $50.11 $3,551 $39.33 $1,099 $22.66 $4,439 $53.16 $991 $29.24 $1,042 $9.72 $636 $21.48 $672 $20.58 $909 $12.50 $411 $14.58 $2,826 $41.56 $2,472 $9.67 $9,355 $23.35 $3,500 $15.29 Optimized Weights S&P 400 R2000 1.38% 0.50% 1.58% 4.38% 2.27% 1.86% 0.58% 1.74% 0.64% 0.50% 1.27% 2.21% 0.50% 0.50% 0.50% 0.50% 2.32% 2.55% 2.17% 2.04% 2.36% 3.47% 1.37% 0.50% 4.00% 5.00% 0.90% 0.50% 2.91% 0.50% 4.01% 5.00% 4.70% 5.00% 5.00% 2.60% 1.00% 0.50% 3.79% 4.96% 3.46% 0.50% 0.50% 0.50% 0.50% 4.17% 0.68% 0.50% 0.50% 0.50% 1.77% 0.50% 0.54% 2.01% 1.28% 1.83% 2.27% 1.41% 0.59% 0.55% 0.50% 0.50% 3.59% 2.22% 3.62% 2.22% 4.31% 1.31% 2.07% 1.79% 0.50% 2.16% 0.50% 0.50% 2.55% 0.50% 1.78% 5.00% 3.66% 0.50% 1.22% 5.00% 3.78% 1.31% 0.87% 1.26% 2.85% 3.98% 0.84% 3.79% 0.50% 1.44% 0.50% 0.50% 0.50% 0.56% 5.00% 4.47% 1.45% 2.19% 1.70% 0.50% 1.65% 0.50% Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Svcs Utilities Source: Citigroup Investment Research and FactSet CITIGROUP PORTFOLIO STRATEGIST 25 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Figure 1. Last-Twelve-Month Performance SmMid Portfolio vs. Russell 2000 135.00 130.00 125.00 120.00 115.00 110.00 105.00 100.00 95.00 Aug-04 Nov-04 Feb-05 Small-Cap SmMid Portfolio May-05 Aug-05 Russell 2000 Nov-05 Russell 2000 Small-Cap SmMid Portfolio Quantitative Research Figure 2. Last-Twelve-Month Performance SmMid Portfolio vs. S&P 400 135.00 130.00 125.00 120.00 115.00 110.00 105.00 100.00 95.00 Aug-04 Nov-04 Feb-05 May-05 Aug-05 S&P 400 Nov-05 Mid-Cap SmMid Portfolio S&P 400 Mid-Cap SmMid Portfolio Source: Citigroup Investment Research, Bloomberg, and FactSet Figure 3. Citigroup Investment Research SmMid Portfolio Performance Summary Trailing 12Months Last 30 Days Year-ToDate Tracking Error(1) Turnover (Annualized)(2) Small-Cap SmMid Russell 2000 Small-Cap SmMid Excess Return Mid-Cap SmMid S&P 400 Mid-Cap SmMid Excess Return 12.7% 9.1% 3.6% 21.0% 15.1% 6.0% -6.0% -7.5% 1.5% -5.1% -5.2% 0.1% 2.2% -1.6% 3.9% 9.5% 4.9% 4.6% 6.2% 28.9% 6.9% 14.9% (1) Tracking error defined as the standard deviation of the difference between portfolio returns and its benchmark (2) Portfolio turnover calculated as the total market value of the sales executed in each security as a percentage of the market value of the portfolio Source: Citigroup Investment Research and FactSet Citigroup Investment Research SmMid Focus List Company Name Activision, Inc. Avaya Inc. BJ's Wholesale Club CSG Systems Intl DRS Technologies, Inc. GTECH Holdings Corp. Kindred Healthcare Lam Research Max Re Ltd. PETCO Animal Supplies Plug Power Inc. Sybase Terex Corp. UnumProvident Corp. Waste Connections Inc. Wellchoice Inc. Analyst Elizabeth Osur, CFA Alex Henderson Deborah Weinswig CIR Sector (Russell Sector) Leisure Products (Technology) Telecom Equipment (Technology) Retailing--Broadlines (Consumer Discretionary) CIR Ticker Rating ATVI 1H AV BJ CSGS DRS GTK KND LRCX MXRE PETC PLUG SY TEX UNM WCN WC 1S 1H 1H 1M 1M 1H 1H 1H 1H 1S 1H 1H 1H 1H 1L Stock Price 10/11/05 $19.23 $11.16 $26.03 $22.66 $51.12 $31.18 $29.73 $30.06 $23.61 $19.78 $6.32 $23.09 $50.11 $19.52 $33.20 $75.18 Market Cap (mil) 10/11/05 $3,650 $5,318 $1,781 $1,099 $1,426 $3,611 $1,379 $4,202 $1,088 $1,145 $458 $2,194 $2,561 $5,899 $1,584 $6,323 Addition Price Date 1/11/05 $14.96 4/25/05 11/3/03 4/18/05 3/29/05 4/5/05 10/4/05 4/18/05 12/12/04 5/24/04 11/24/03 8/9/05 12/16/03 10/10/05 7/18/05 2/24/04 $8.61 $26.55 $15.96 $41.77 $23.75 $31.53 $26.37 $19.28 $30.74 $5.15 $21.32 $26.87 $19.55 $36.18 $34.77 Investment Considerations Tier-one player in its sector; strong secular growth ahead VoIP exposure / attractive valuation counterbalance legacy erosion Good turn-around story, around 6x EBITDA and good growth Double-digit free cash flow yield with a stable near-term outlook Strong free cash flows expected to drive continued growth Past its problems and supported by strong FCF Compelling investment at current valuation levels Playing in the semiconductor cycle with high free cash flow yield Expect strong '05 after tough '04 but stock still at 1x book Capturing value from "pet parents" Moving from development to commercialization of fuel cells Well-geared to benefit from improved data mgmt / integration svcs growth Discount to CAT still larger than we think warranted Cheap on our 4-factor insurance model with remaining restructuring upside Late-cycle business with attractive FCF yield Empire BCBS, great NY franchise, attractive acquisition if price slips Ashwin Shirvaikar, CFA IT Services (Technology) Ferat Ongoren Michael Rietbrock Matthew Ripperger Timothy Arcuri Joshua Shanker Bill Sims David Smith, CFA Chris DeBiase David Raso Colin Devine Leone Young Charles Boorady Aerospace & Defense (Technology) Leisure & Recreation (Consumer Discretionary) Health Care Svcs (Health Care) Semiconductors (Technology) Insurance--Property & Casualty (Financials) Retailing--Hardlines (Consumer Discretionary) Power Technology (Other Energy) Software (Technology) Machinery (Materials) Insurance (Financials) Environmental Svcs (Consumer Discretionary) Managed Care (Health Care) Source: Citigroup Investment Research and FactSet CITIGROUP PORTFOLIO STRATEGIST 26 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary Quantitative Research Quantitative Research Keith L. Miller / Daniel E. Cox In Style: 2005 Style Strategy Performance Update I In September, for the second straight month, we had the combination of large-cap value outperforming growth, small-cap growth besting value, and large-caps outperforming small-caps. Last month, price and earnings estimate momentum strategies performed best among the companies in the four major Frank Russell Indices. Year to date (through September 30), price and earnings estimate momentum strategies continued to perform best among the four indices. Low priceto-cash flow also added value to mid-caps, and low price-to-earnings growth (PEG) also added value to small-caps. I third column of Figure 1). The widest value-growth outperformance margin has been among large- and midcaps as the Russell 1000 Value Index outperformed the growth index by 3.5 percentage points. The narrowest differential has been among small-caps, as the Russell 2000 Value Index outperformed the growth index by 1.5 percentage points. The Relative Performance of the Size Segments This Year Remained Similar to Last Year I In this article, we summarize the year-to-date (through September) performance of the growth, value, and size segments of the equity market and compare it with last year’s performance. We also compare the performance of various style strategies (e.g., low beta and low P/E) this year and in 2004 to determine if style performance trends have changed. Market Performance Summary In 2004, the broad market, as measured by the Russell 3000 Index, rose 12.0% and advanced for the second straight year. Furthermore, as shown in the second column of Figure 1, growth-value segmentation was moderate, as value stocks in all four of the size segments outperformed their growth stock counterparts. Moderate performance differences also occurred among the size segments, as mid-caps and small-caps outperformed large-caps (the Russell Top 200 Index) by 11.9 percentage points and 10.0 percentage points, respectively. Last Month: Value Outperformed Growth Except Among Small-Caps As the third column of Figure 1 shows, mid-caps continued to moderately outperform large-caps year to date. However, small-caps have outperformed largecaps by a much smaller margin than last year, and midcaps have outperformed small-caps by a much larger margin. Figure 1. Total Return Spreads Between Russell Indices: 2004, 2005 (Through September), and September 2005 Indices 2004 2005 Growth and Value Performance Top 200: Growth - Value -9.61% -3.24% R-1000: Growth - Value -10.19% -3.48% Midcap: Growth - Value -8.23% -2.81% R-2000: Growth - Value -7.94% -1.50% Size (Market Cap) Performance Top 200 - Midcap -11.91% -8.34% Top 200 - R-2000 -10.00% -1.68% R-1000 - Midcap -8.82% -6.00% R-1000 - R-2000 -6.93% 0.67% Midcap - R-2000 1.89% 6.67% Sep 2005 -1.29% -0.94% -0.07% 0.96% -0.56% 0.46% -0.40% 0.62% 1.02% Source: Russell Investment Group and Citigroup Investment Research In September, for the second straight month, we had the combination of large-cap value outperforming growth, small-cap growth besting value, and large-caps outperforming small-caps (see the fourth column of Figure 1). Prior to August, that combination had not occurred since January 2003. Year-to-date through the end of September, value stocks in all four of the major Russell indices continued to outperform growth stocks by narrow margins (see the CITIGROUP PORTFOLIO STRATEGIST Style Strategy Performance by Market Cap Mega-Cap Russell Top 200 — As the first row of Figure 2 shows, the best-performing style strategies among mega-cap Russell Top 200 companies in 2004 were a unique mixture of low market capitalization, low sales momentum, high 20-quarter earnings trend, high one-year sales growth, and low price-to-sales. The best performing strategies among mega-caps through September of this year remained price and earnings estimate momentum. Price and earnings estimate momentum strategies also added the most value to mega-caps last month. Russell Midcap — As the third row of Figure 2 shows, the best-performing style strategies among Russell mid-cap companies last year were low P/E, low beta, high ROE, and low forecasted FY2 EPS growth. The 27 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Macro / Commentary best-performing strategies among mid-caps through September of this year were also price and earnings estimate momentum, as well as low price-to-cash flow. The success of these strategies apparently reflects continued investor preference for attractively valued mid-caps with strong one-year price performance and higher earnings estimates. Last month, price and earnings momentum and high equity market value strategies added the most value to mid-caps. Small-Cap Russell 2000 —As the fourth row of Figure 2 shows, the best-performing style strategies among Russell 2000 companies in 2004 were low FY1 P/E (current year P/E), low price-to-sales, low price-tocash-flow, low forecasted FY2 EPS growth (next year EPS), and low price-to-book. Our research indicates that the success of these low-price-multiple and lowgrowth strategies last year reflects the strong performance by defensive small-cap value stocks, which climbed 22.3% in 2004. The best-performing strategies among small-caps through September of this year were price and earnings momentum as well as low price-to-earnings growth (PEG). Price and earnings momentum strategies also added the most value to small-caps last month. Description of the Style Strategies Quantitative Research set of 35 style attributes or style selection parameters that many investors use to define the individual strategies within a category. We construct portfolios whose constituents have very large and very small values of the style attributes and then measure their monthly performance. Specifically, at the end of the first month, we rank the stocks in each of the four major Russell Indices in ascending order by the values of each style attribute (for example, P/E, ROE, beta). Then, the stocks are grouped into deciles by the value of the attribute so that the lowest decile (“decile one”) contains the stocks with the smallest values, and the highest decile (“decile ten”) contains the stocks with the largest values. The stocks are equally weighted within each decile, and the total returns of each decile portfolio are measured at the end of the second month. We then re-rank the stocks by the latest values of the style attributes, construct new decile portfolios, measure their returns at the end of the third month, and so forth. (All stocks with prices under $5.00 are excluded.) We use the difference between the top and bottom decile returns as our performance measure because it is a better indicator of excess returns and of the style attribute’s power to add value. The strategies listed in Figure 2 for a given index had the largest difference between the cumulative returns of the top and bottom deciles during the indicated periods. From the style categories of value, growth, size, momentum, profitability, and risk, we have identified a Figure 2. Summary of Last Month, 2005 (Through September), and 2004 Style Strategy Performance Among Large-Cap, Mid-Cap, and Small-Cap Stocks September 2005 High First 11 of the Last 12 Months Return High Prior 1-Month Return Russell Top 200 High 12-Wk Change in FY2 EPS Estimate High 4-Wk Change in FY2 EPS Estimate High 6-Month Change in Earnings-to-Sales High Prior 1-Month Return High First 11 of the Last 12 Months Return High 12-Wk Change in FY2 EPS Estimate High 4-Wk Change in FY2 EPS Estimate High 12-Wk Change in FY1 EPS Estimate Stock Universe Best Performing Style Strategies 2005 (Through September) High First 11 of the Last 12 Months Return High 12-Wk Change in FY2 EPS Estimate High 12-Wk Change in FY1 EPS Estimate High 4-Wk Change in FY2 EPS Estimate High Citigroup Growth-Momentum Score High First 11 of the Last 12 Months Return High 12-Wk Change in FY2 EPS Estimate High 4-Wk Change in FY2 EPS Estimate High 12-Wk Change in FY1 EPS Estimate High Citigroup Growth-Momentum Score High 12-Wk Change in FY2 EPS Estimate High First 11 of the Last 12 Months Return High 4-Wk Change in FY2 EPS Estimate High 12-Wk Change in FY1 EPS Estimate Low Price-to-Cash Flow High First 11 of the Last 12 Months Return High 4-Wk Change in FY2 EPS Estimate Low PEG High 12-Wk Change in FY2 EPS Estimate High 4-Wk Change in FY1 EPS Estimate 2004 Low Equity Market Value Low 6-Month Sales Momentum High 20-Quarter Earnings Trend High 1-Year Sales Growth Low Price-to-Sales Low Beta Low 1-Year Trailing P/E Low FY1 P/E Low Forecasted FY2 EPS Growth High Dividend Yield Low 1-Year Trailing P/E Low Beta Low FY1 P/E High ROE Low Forecasted FY2 EPS Growth Low FY1 P/E Low Price-to-Sales Low Price-to-Cash Flow Low Forecasted FY2 EPS Growth Low Price-to-Book Russell 1000 High Prior 1-Month Return High First 11 of the Last 12 Months Return Russell Midcap High 4-Wk Change in FY2 EPS Estimate High Equity Market Value High 12-Wk Change in FY2 EPS Estimate High Prior 1-Month Return High First 11 of the Last 12 Months Return High 4-Wk Change in FY1 EPS Estimate High 12-Wk Change in FY2 EPS Estimate High 12-Wk Change in FY1 EPS Estimate Russell 2000 Source: Citigroup Investment Research CITIGROUP PORTFOLIO STRATEGIST 28 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Proprietary / Proactive Industry Banks Ruchi Madan / Keith Horowitz, CFA Why We Are Bullish on Trust and Processing Banks I We are bullish on trust banks since revenue growth is good, there is upside to net interest revenues at State Street and Bank of New York, expense headwinds should subside, managements have never been more focused on expense and operating leverage, and we see consolidation potential. Bank of New York upside is driven by management execution with respect to potentially targeting higher operating leverage than in the past and by some upside from net interest revenues. State Street upside is driven mostly by net interest revenue and continued positive operating leverage. Mellon upside is driven by stronger money market flows and potential for consolidation. We show why the key to higher P/Es is higher operating leverage and that consolidation economics work. even more evident in 2006, which means we are likely to reach inflection points in the stocks as well. Securities-servicing revenue growth has been pretty good... After I I I I very strong EPS growth in the late-1990s, the three-year compound annual growth for the four major firms has ranged from 2% to 11%. This has caused investors to question the attractiveness of these businesses. However, for the most part revenue performance has been fairly good considering that these companies grew revenues in the securities servicing business by an average of 10%– 15% over the past two years. ...but other factors that should now be behind us have been weighing on earnings performance, and profitability should improve... While revenue performance in the core Summary of Why We Are Bullish and Findings of Our Custody-Related Profitability Analysis We currently have Buy ratings on Bank of New York, Mellon, and State Street, and we are generally bullish on the trust and processing banks. In this article, we discuss why we are bullish and what we believe the major issues are. We also provide a new analysis of the levels and drivers of profitability of the custody-related businesses. Our key points follow. Investor sentiment about long-term growth and returns seems too pessimistic, and we are reaching an inflection point. We servicing business has been quite strong, earnings growth has been weak, driven by poor expense management, net interest revenue headwinds, and factors such as higher option/pension expenses and the costs associated with building new remote data centers post-9/11. We believe these headwinds are now largely…behind. For Bank of New York and State Street, we think the net interest revenue headwind can become a tailwind, and the special expenses of data centers and higher option and pension expenses should be just about fully absorbed this year. We also believe there has been a major shift in how managements are thinking about expense growth. I Headwinds have meaningfully weighed on EPS... We believe these are inherently very attractive businesses, with relatively high revenue growth rates and low capital requirements, as well as the potential to improve profit margins and incremental profit margins. Over the past few years, these stocks have been underperformers, at first because of revenue weakness as the market environment became more difficult (and the companies were totally unprepared from an expense management point of view). Even as the market strengthened, they continued to be relatively weak performers, primarily because of various expense and net interest income pressures. From a fundamental point of view, we believe we have already passed the inflection point of some of the headwinds. We believe this will become CITIGROUP PORTFOLIO STRATEGIST estimate that these factors have weighed on EPS growth by 5%–20%. Lower net interest revenue, for example, have cost State Street 15% of EPS (since 2001), and higher expenses for options, pension, and data centers have lowered Bank of New York’s 2005 EPS by 4%, by our estimation. I ...and we believe there is a lot of upside to net interest income over the next couple of years at State Street and Bank of New York. We estimate State Street is underearning on net interest income by about 15% of EPS and Bank of New York has about 5% EPS upside from net interest revenue, implying this will become an important tailwind. I Managements are more focused on profitability than ever. Bank of New York, JPMorgan Chase, and even 29 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Proprietary / Proactive State Street are very focused on expenses and improving margins. Their frame of mind and determination are very different from how they came into this year, implying we will get a better result on this front in 2006. ...which implies better earnings momentum, which in turn implies potential P/E improvements. This all implies improved Industry whether the companies become more profitable by getting headwinds behind them and/or through pricing or reengineering their cost structures, or the industry consolidates, this could be a win/win situation for investors over the next year or two. Key Findings of Our Profitability Analysis earnings performance going forward, which has the potential to improve P/Es in the sector. The stocks are trading at the low end of historical absolute and relative (versus banks) P/Es. Figure 1. Absolute P/E: MEL, STT, NTRS, and BK 40 30 20 10 0 Mar-00 May-99 May-04 Mar-05 Nov-96 Sep-97 Nov-01 Jan-96 Jul-98 Jan-01 Sep-02 Jul-03 M EL STT NTRS BK We constructed income statements for just the custodyrelated businesses for each company and compared each company’s performance relative to assets under custody and other factors. Our major findings follow. Custodians are losing money on basic services. Most investors that follow these companies closely understand that custodians give away the basic services to earn revenues in the very high-margin businesses such as securities lending, foreign exchange, and deposits. However, our analysis shows that the large custodians are actually losing money in their basic business and that what should be 75%-plus margins in the value-add services are actually closer to 50%. This suggests they should feel greater urgency to improve their cost structures. JPMorgan Chase (JPM–$33.90, 1M; Target Price $46.00) needs to improve revenues, not just costs. While we believe Source: FactSet and Citigroup Investment Research JPMorgan has, by far, the lowest margins among the large competitors, we found that low revenue per assets under custody at JPMorgan Chase may be as big of an issue as expenses. Bank of New York’s (BK–$28.86, 1M; Target Price $37.00) margins are lower than we thought. We were surprised to see that We believe the key to improving P/Es over the long term is higher targeted operating leverage, which we believe some managements will be implementing. In our view, the reason these stocks have been out of favor over the past few years is that they became viewed as “bull market stocks.” We believe that if their financial models assumed less market lift and higher operating leverage (than the 50–100 bps they seem to be targeting), this would reduce earnings uncertainty and volatility, since it would give managements more flexibility to invest in good times and not disappoint investors in weaker ones. We believe Bank of New York will target higher operating leverage in 2006 than its target for 2005 (100 bps), which would be an important catalyst for the stock. If the trust banks do not improve profitability, pressure to consolidate will build. Because we believe investors are Bank of New York’s margin in the business is only about 23% (versus its business segment margin of 30%), which also highlights that its diversified business model is an advantage. Our estimated 23% margin is similar to those of State Street and Mellon. State Street (STT–$49.92, 1M; Target Price $57.00) and Mellon (MEL–$31.36, 1M; Target Price $37.00) have above-average revenue yields, but they give it up with above-average expense bases. beginning to understand that there are very large efficiencies in merging these operations, we believe pressure will grow to produce higher operating leverage and margins and that the companies that cannot improve margins (and earnings growth) may have lagging stock prices, and may, therefore, be pressured to consolidate. We also believe that if one company consolidates, this could set off a domino effect within the sector. So, CITIGROUP PORTFOLIO STRATEGIST State Street and Mellon have the highest revenue yields on basic servicing fees, implying they are selling more value-add services like accounting and performance analytics. They are also doing a decent job penetrating their customers with securities lending and foreign exchange (although State Street appears to have upside here). Still, both have higher expense structures than the other firms. Although net net versus Bank of New York and JPMorgan Chase their margins are fine, relative to Northern Trust (Not Rated) they are quite weak. This implies the business can be managed for better margins. — October 7, 2005 30 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Proprietary / Proactive Industry Multi-Industry Jeffrey T. Sprague Third Quarter Survey: Contrary to Fears, Industrial Markets Strong I Our proprietary distributor survey indicates that the broader industrial markets grew units 5% in the third quarter, with prices up 2%–7% depending on the end market. This direct field research contradicts investor speculation that high energy costs and rising interest rates are already slowing down the industrial economy. In fact, the industrial economy accelerated modestly, with 5% year-overyear volume growth and 70 bps of sequential improvement (second quarter 2005 growth of 4.3%). Distributors predict 6.6% revenue growth for the fourth quarter based on backlogs that generally extend into mid-November. This has allowed distributors to predict the median core revenue growth rate one quarter in advance within 110 bps in three of the past four quarters. Some investors who are bearish on industrial markets have been selling GE to hedge macro risks. Based on the survey, these macro risks appear to be less of an issue. The strong results of this survey support an opportunity to buy undervalued shares of General Electric. Also, the survey results point to possible short-term trading opportunities in shares of Hubbell and Rockwell Automation ahead of the quarterly results. against difficult comparisons (Rockwell was up 16% last year). I I Margins expanded last year despite the price spike in steel and other metals. This year, the spike in energyrelated costs is not as severe as what was digested in metals last year; for most companies, metals are a more significant cost than energy/transportation. Pricing power is intertwined with the current level of strong demand. Broad-based demand is robust, and prices are strong in the distribution channel. Original equipment manufacturer (OEM) prices are weaker. The magnitude of this price differential between channels to market will likely be the key determinant of the accuracy of this survey’s estimates of core revenue growth for the quarter. For the fifth consecutive quarter, all end markets are up year over year, with power transmission and distribution (T&D), defense, water, institutional construction, and aerospace showing the greatest strength sequentially. Markets with slower sequential growth included institutional maintenance, repair, and overhaul (MRO) and commercial construction. The strongest share gains within our coverage list appear to be by Rockwell and General Electric in automation/control, Hubbell in wiring devices, Cooper Industries in power and fuses, and Danaher in tools/testing. Dealer inventories among power distributors are depleted due to strong pre-hurricane demand and increased demand in the wake of the hurricanes. Excluding the power market, dealer inventories remain near ideal levels, indicating a strong pullthrough of demand. Hazardous duty equipment displayed the strongest year-over-year and sequential growth within the electrical/construction markets, fueled by strong capital expenditures and MRO activity in the raw material and infrastructure markets. I I I I I Key Takeaways from the Survey I Our survey suggests third quarter industry unit volume growth of 5%. Pricing power should add 2%–7% to volume gains, which confirms our formally modeled estimate of 5%–7% core growth and is above last quarter’s actual median core sales growth of 5.5%. More importantly, this sequential acceleration further supports our thesis that we have not yet reached the midpoint of a multiyear industrial upcycle, despite investor fears to the contrary. Differential industry growth rates continued as power grew volumes at about 9%, electrical/construction equipment at approximately 5%, and automation at about 3%. Automation is up 31 I I I I CITIGROUP PORTFOLIO STRATEGIST October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Proprietary / Proactive Actionable Trading Insights Guide to Aligning Your Portfolio Ahead of Earnings Based Solely on the Results of this Distributor Survey Industry forecast of 5% year-over-year growth down to slightly negative unit volume growth for 2005 nonresidential construction. However, Dodge reports that the first half of 2005 experienced a material decline in nonresidential construction. This means its calendar year-end forecast of slightly lowered volumes implies a material pickup in nonresidential construction in the fourth quarter to bring volumes closer to par with 2004. Survey Trading Insight: Buy General Electric (GE-$33.99; 1L) Before the Quarter The short-term trading insights below are based solely on the results of the distributor survey and are not necessarily consistent with our official investment ratings, target prices, and risk ratings on the stocks, which take a longer-term view. The trading calls below are for short-term trades only and do not meet Citigroup Investment Research’s long-term target price standards or detailed valuation derivations. Due to the short-term nature of these trading strategies and the fact that their thesis is drawn from anecdotes from a small number of distributors, trading strategies would all carry speculative designations at best. Survey Trading Insight: Buy Hubbell (HUBB-$45.96; 2M) Ahead of the Quarter Based on the results of this survey, more than 60% of Hubbell’s revenues could beat consensus expectations. That is, 40% of Hubbell’s revenues (Lighting) could surpass very muted market expectations, while 21% of Hubbell’s revenues (Power) could eclipse already-lofty expectations. Hubbell has had two subpar quarters in a row due to poor margin conversion on volume losses in Lighting (about 40% of sales and about 37% of EBIT). Hubbell’s volume losses were due to noncompetitive pricing, as peer Cooper Industries has been deploying an aggressive pricing strategy in its Lighting segment to pull through other products. Our distributor survey revealed that Cooper Industries is having trouble meeting delivery schedules in project light fixtures due to the implementation of an enterprise resource planning system. Furthermore, our distributors reported that Acuity Brands was also having trouble making on-time deliveries due to restructuring/plant relocations. Acuity Brands confirmed these reports on its fiscal fourth quarter (ended August) conference call on October 5. We believe this creates an excellent opportunity for Hubbell to gain back some of the share it has lost the past two quarters, as Cooper Industries, Acuity Brands, and Hubbell are the three major national manufacturers of light fixtures into these markets. (Although the survey’s Market Share Diffusion Index does not explicitly indicate that Hubbell is gaining share, it does indicate that Cooper Industries is losing significant share in lighting.) See our original note for more on power T&D and anecdotal comments. Viable risks to Hubbell’s earnings upside include continued operational problems in lighting, an inability to pass through increased input and logistics costs, and weaker-than-expected growth in nonresidential markets, as the Dodge Forecast recently revised its previous CITIGROUP PORTFOLIO STRATEGIST Some investors who are bearish on industrial markets have been selling GE to hedge macro risk. These survey results further support our thesis that we have not yet reached the midpoint of a multiyear industrial upcycle. The results of this survey create an opportunity to buy undervalued shares of General Electric, which are trading near a 52-week low based on fears of a slowdown. Risks to even a short-term long position in GE reflect its exposure to the troubled airline industry through its engine and leasing businesses. We believe it has managed its airline risks well, but the potential for further industry deterioration remains a risk. We do not believe increases in interest rates are a major risk. Survey Trading Insight: Buy Rockwell Automation (ROK-$50.72; 2M) Before the Quarter We expect Rockwell to grow EPS to $0.71, or 29%, in fiscal fourth quarter 2005 (ended September), $0.02 above consensus. We forecast it will achieve these earnings on approximate 7% core revenue growth and about an 18% segment operating margin. Our distributor survey predicts further upside, indicating that Rockwell’s end markets grew 10.7% in the September quarter. Currently, Rockwell’s solid EPS profile is being driven by the “sweet spot” dichotomy of high commodity prices (but not high enough to derail the economy) and a strong consumer, which in turn drive industrial capex and production. Rockwell’s customers that either directly serve the consumer or directly extract/refine commodities constitute about 85% (or possibly more) of Rockwell’s current revenue mix, which should overcome higher input and logistics costs to result in another solid quarter. — October 11, 2005 Related Note: “Third Quarter Preview: Costs Pose Risks, But Strong Demand Should Trump” Electrical equipment/multi-industry companies appear to be winning a battle among price, cost, and volumes, but risks are elevated. On balance, earnings look solid and the stocks are inexpensive, having already discounted pervasive economic pessimism. — October 11, 2005 32 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Large-Cap, Growth Electronic Arts Inc. (ERTS) Elizabeth Osur, CFA Buy/Medium Risk (1M) Leisure Time Upgrading to Buy as Cycle Transition Nears I We are upgrading ERTS shares to 1M from 2M and maintaining our $62 target price. Shares have fallen 9% since the end of fiscal first quarter 2006 (ended June), and while risk of negative guidance revision remains, we think long-term investors would benefit from building positions ahead of the Xbox 360 launch (in November) and PS3 (in October/November 2006 in North America and Europe). Recent stock declines should sufficiently price-in risk for the fiscal second quarter 2006 (ended September) release (where we assign a 50% probability management will lower full year guidance or include the fiscal fourth quarter weighting, both of which would be perceived as negative). Downside risk on this may be limited because: 1) many investors are expressing interest below $50 and 2) fiscal 2007 numbers have cushion (our forecasts are sales up 15%, operating margin up 200 bps, and EPS up 22%, above consensus EPS growth of less than 20%). Further upside from accretive M&A is also possible. Our $62 12- to 18-month target reflects adjusted P/E of 22x fiscal 2008 (29x fiscal 2007) and absolute P/E of 25x fiscal 2008; this seems appropriate based on shares trading at up to 25x fiscal 2003 EPS in calendar 2001. Company Metrics Price (10/10/05) 52-Week Range Div (E) (Cur/Prev) Est. 5-Yr Growth Target Price Expected Share Price Return Expected Dividend Yield Expected Total Return I $51.35 $69-$44 Nil 18% $62.00 20.7% Nil 20.7% Market Cap. (bil.) P/E (3/06E) P/E (3/07E) 3/05A EPS 3/06E Cur EPS 3/06E Prev EPS 3/07E Cur EPS 3/07E Prev EPS $15.8 32.8x 27.0x $1.71 $1.56 NC $1.90 NC For additional metrics, please consult Global Equities Online. • ELECTRONIC ARTS INCORPORATED (ERTS) PRICE 51.3 DATE 10-10-2005 118 91 70 54 41 32 24 19 14 11 9 7 5 4 3 StockVal® 54 41 32 24 19 14 11 9 7 5 4 3 1995 3.8 2.6 1.8 1.2 0.8 0.6 0.4 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 I HI LO ME CU 3.80 0.44 1.10 2.90 10-06-1995 10-10-2005 Source: StockVal ERTS shares remain risky ahead of the fiscal second quarter 2006 earnings conference call likely to occur in late-October or the first week in November, but we believe recent declines create an attractive entry point for shareholders with a longer-term perspective. Specifically, we think owning ERTS is one favorable way for investors to gain exposure to the growing video game sector just ahead of the console transition, and at a time when margins are depressed and the true strength of operating leverage is still unknown but likely above current expectations given the tendency for forecasts to swing too far up and down as the cycle progresses. We forecast video game industry software sales in North America to be about flat in 2005 but then rise at a doubledigit rate in 2006 and 2007, with high single-digit growth in 2008 and 2009. Electronic Arts is likely to grow faster than the overall industry based on our belief that its strong cash position and appetite for growth could lead to acquisition activity. Catalysts for the shares could CITIGROUP PORTFOLIO STRATEGIST include the Xbox 360 launch next month, full year guidance reaffirmation on the fiscal second quarter call, successful unit sales volumes of new releases, increased hype around certain media-licensed games (e.g., Harry Potter), and gross margin improvement. ERTS is one of four Buy-rated stocks in our video game universe. We think ERTS represents a solid long-term choice for investors interested in participating in the cycle, but other stocks may meet different investor needs. I Our top pick in video games and throughout our leisure universe is GameStop for its stronger earnings growth potential (medium-term EPS compound annual growth rate near 30% versus mid-teens for the publisher group). We continue to favor Activision for investors with a more near-term focus (given Activision’s relatively stronger holiday lineup). October 13, 2005 I 33 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary I Large-Cap, Growth margin expected in fiscal 2006 versus 12% for the groups as a whole) and returns (20% return on capital expected in fiscal 2006 versus 17% for the group), and a more consistent revenue growth profile. Risks We rate Electronic Arts Medium Risk. The earnings and price volatility could merit a higher risk rating; we would argue this is primarily due to the company’s leverage to the cyclical video game console cycle. However, we believe Electronic Arts has managed to insulate itself to a certain extent from this by developing and annually publishing such strong franchise titles as Madden NFL, FIFA, and The Sims. In addition, we believe the company will be better positioned going into the final year leading up to the new generation, with more releases for the current PlayStation 2 console than the company had released for PS1 in 2000. We also believe its strong cash-generating capabilities and nonexistent leverage also indicate just moderate risk. We also recommend that investors with very high risk tolerance consider an investment in Take-Two Interactive. Take-Two has a fairly soft holiday 2005 lineup, but because of its highly concentrated revenue and income base, it could benefit disproportionately in the first half of 2006 as investors focus on the release of the next Grand Theft Auto game, expected for holiday 2006. Notably, our Buy rating reflects 21% expected total return to our unchanged $62 target price. We believe that our target is appropriate based on ERTS’s trading history in the last cycle transition. Additionally, our upgrade is consistent with the context that we provided to investors at the time of our July downgrade, when we cited near-term concerns that affected our view despite a more favorable longerterm outlook and cited the low- to mid-$50s as where we would be more constructive. We continue to believe shares could be pressured ahead of and around fiscal second quarter 2006 earnings results, but we also think that downside is relatively limited (but potentially down to the high $40s) at current levels and that long-term investors should use weakness for opportunistic buying. Valuation We derive our $62 12–18-month target based on adjusted P/E and P/E, using enterprise value to operating income before depreciation and amortization (EV/OIBDA) and discounted cash flow (DCF) analyses as crosschecks. From a macroeconomic perspective, video game industry sales are subject to many of the same risks as other consumer discretionary spending industries. These include sensitivity to changes in consumer sentiment, GDP, and disposable income. Industry risks include: 1) Video games are a hit-driven business and are thus difficult to predict; 2) short product life cycles mean that product delays can negatively affect sales and significantly impact earnings results for a given period; 3) video games have a seasonal sales profile, creating a short selling window for product concentrated around the holiday season or specific movie releases; 4) the industry is cyclical based on the product release schedule of new hardware platforms; and 5) piracy may make intellectual property rights difficult to defend. Company risks include: 1) A small number of key licenses and media company partners with which it operates under finite contracts, and failure to renew any of these contracts (or expensive renewal rates) could result in declining sales and/or write-offs of R&D investments; 2) it is subject to competitive pricing by other publishers of titles in the same categories; 3) distribution of third-party titles is at risk of delays that are out of the company’s control; 4) foreign exchange risk; 5) accounts receivable reserves have been falling as a percentage of sales, potentially indicating management is more aggressively accounting for estimated future price reductions. If the impact on the company from any of these factors proves to be greater than we anticipate, it may prevent the stock from reaching our target price. — October 10, 2005 34 October 13, 2005 We look to adjusted (for cash) P/E, backing out interest income, but giving credit for more than $9 per share in cash on the balance sheet. On this basis, we target shares to trade at roughly 22x–23x on fiscal 2008 adjusted EPS estimates (from 29x fiscal 2007 adjusted EPS estimates), resulting in our $62 target price. We are rolling forward our multiple base year because we are past the midpoint of fiscal 2006 and think that investors will begin to look forward to the following year’s earnings potential to determine valuation. We are also lowering our multiple to account for the higher risk associated with earnings farther out, and this multiple is below the stock’s 27.5x ten-year median as tracked by StockVal. In our P/E analysis, we target the shares to trade at around 25x fiscal 2008 EPS estimates (from 32x–33x fiscal 2007 EPS estimates) based on a slight premium to the peer group “normalized” target of 24x (which was based off of just one-year forward numbers). Our lower multiple (versus our prior target) is again due to the higher risk associated with these earnings. Our target for Electronic Arts is a premium to our normalized target for the video game group overall based on the company’s leading market share position, strong margins (greater than 18% operating CITIGROUP PORTFOLIO STRATEGIST See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Large-Cap, Growth Harley-Davidson, Inc. (HDI) Gregory Badishkanian Buy/Medium Risk (1M) Emerging Growth — Recreation Still Plenty of Gas Left in the Tank; Upgrading to Buy I Sentiment is negative for Harley-Davidson, as seen in the high short interest (8% of the float), fall in stock price (14% since September 19), and negative First Call reports. The view is that the company has poor growth prospects and will capitulate on its long-term shipment/retail guidance of 7%–9% over the next quarter or two. We think dismal trends and downward forward guidance are priced into the stock. Yet, we think business trends may have improved based on our channel checks. We believe investors expect 3%–7% U.S. retail sales growth in the third quarter, and we see growth at the upper end of that range. More important, we think growth trends in the last two months of the quarter have accelerated, driven by the company’s new product introduction. We are upgrading HDI to Buy (1M) from Hold (2M) and raising our target price to $55. Company Metrics Price (10/10/05) $44.40 52-Week Range $62-$45 Div (E) (Cur/Prev) $0.68/$0.68 Est. 5-Yr Growth 15% Target Price $55.00 Expected Share Price Return 23.9% Expected Dividend Yield 1.5% Expected Total Return 25.4% Market Cap. (bil.) P/E (12/05E) P/E (12/06E) 12/04A EPS 12/05E Cur EPS 12/05E Prev EPS 12/06E Cur EPS 12/06E Prev EPS I $12.5 13.3x 11.7x $3.00 $3.34 NC $3.81 NC For additional metrics, please consult Global Equities Online. • HARLEY-DAVIDSON INCORPORATED (HDI) PRICE 44.4 DATE 10-10-2005 101 80 64 51 40 32 25 20 16 13 10 8 6 5 4 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 StockVal® 51 40 32 25 20 16 13 10 8 6 5 I Harley-Davidson Faces Various Issues Soft Retail Sales and Rising Dealer Inventory Levels 4 1995 5.6 4.0 2.8 2.0 1.6 1.2 0.8 We believe Harley-Davidson’s soft retail sales growth is due in part to lackluster product introductions and share erosion to custom manufacturers, which have been on the leading edge of motorcycle trends. We expect the company to regain or at least stabilize its market share given its innovative new products and favorable feedback from our dealer contacts. Rising Commodity Costs May Impact Margins HI LO ME CU 5.33 0.93 2.76 3.27 10-06-1995 10-10-2005 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) Source: StockVal Many investors may believe discretionary income spent on motorcycles has been affected by higher gas prices. Spending on gas, however, ranges from only $133 to $200 per year by our estimate. In addition, a $0.50 increase in the price of gas brings an incremental cost of just $22–$33. Therefore, given the annual cost of gas is only 2%–3% of the price of the lowest-priced HarleyDavidson-branded motorcycle, we do not view this as a significant deterrent to retail purchases. We believe the rise in aluminum, steel, and oil prices could affect margins over the next several quarters, particularly given reduced pricing by Harley and other motorcycle manufacturers. In addition, since some components are outsourced and raw materials are purchased on contract, commodity price increases from CITIGROUP PORTFOLIO STRATEGIST previous quarters may not fully affect margins until second half 2005. Increased commodity costs hurt fourth quarter 2004 gross profits by $6 million. If Harley were to incur a similar surcharge of $6–$8 million for each quarter in 2005, it would see additional costs of $12–$16 million (or $0.025–$0.035 per share). Low Expectations for Third and Fourth Quarters 2005 In light of four straight quarters of dismal U.S. retail sales (down 10%, up 7%, down 1%, and up 3.2% from third quarter 2004 to second quarter 2005, respectively), many investors believe Harley’s growth is characteristic of that of a mature company. Investors and sell-side analysts likely do not expect a reacceleration of shipments/retail sales to the company’s long-term guidance of 7%–9% (versus the still-decent 4%–7% motorcycle industry growth). Given First Call notes and our conversations with investors, we believe investors expect third quarter retail sales growth in the 3%–7% range. 35 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary However, we believe business trends may have improved, and we see retail sales in the upper end of the 3%–7% Street expectation, based on our dealer surveys. More important, we think growth trends in the last two months of the quarter have accelerated, driven by the company’s new product introductions. We expect at least mid- to high-single-digit retail sales growth for the next few quarters, which should be viewed favorably by investors even if management cuts its 7%–9% longerterm growth target. HDI Stock Is Priced for a Meaningful Production Cut and Downward EPS Revisions We believe a very negative outlook is priced into HDI stock. HDI is trading at 12.6x forward-year earnings, which is a ten-year low. In addition, the stock trades at an 18% discount to the S&P 500 (an all-time low) versus its historical average of a 14% premium. The stock also trades at a 1% discount to the leisure vehicle group, near its ten-year low of a 2% discount. This compares with the stock’s ten-year median of a 90% premium to the group. There is also high short interest in the stock: 20.6 million shares are being sold short (as of September 2005), equivalent to roughly 8% of the float (versus 12.5 million shares short in October 2004). New Products Are Being Well Received by Customers Based on our recent conversations with more than two dozen dealers, Harley’s innovative 2006 model year lineup appears to have been well received by customers. Given the overwhelmingly strong response from dealers in our initial survey in July and our recent surveys, we believe Harley’s 2006 product line is likely to be a more meaningful contributor to sales growth in the coming year than the 2005 line was for 2005 and could rejuvenate recently lackluster retail sales. Strong Initial Dealer Response to Harley’s Model Year 2006 Line Large-Cap, Growth Relative P/E Analysis: HDI trades at roughly a 1% discount to the leisure vehicle peer group on a forward four-quarter P/E basis versus a 90% premium over the last ten years. We attribute the reduced premium to the more-mature stage of the motorcycle industry and Harley’s expected more-moderate shipment growth. Given Harley’s superior brand, dominant market share, significantly larger market capitalization, and slightly higher EPS growth rate, we think a 10% premium to the group is reasonable. Applying our target multiple of 14.3x (previously 14.0x) to our calendar 2006 EPS estimate of $3.81 results in a target price of roughly $55 (previously $53). EV/EBITDA Analysis: Over the past two years, the EV/EBITDA ratio for Harley has ranged from 6.9x to 13.3x. The shares now trade at 6.9x (previously 8.3x), or at a 34% discount to their two-year historical median of 10.5x. Given that growth appears to be moderating, we believe a multiple of 9.0x (previously 8.3x, but increased given our view that business trends have improved) is justified. Applying this multiple to our 2006 EBITDA estimate of roughly $1.8 billion yields a $55 target price (previously $51). We prefer to use the relative P/E valuation, as it is the metric we use to value the stocks we cover in this industry. Risks We rate Harley Davidson Medium Risk. While the company has a market capitalization of about $13 billion, strong return on equity, relatively low debt-tocapital, and consistent earnings growth, we believe a Medium Risk rating is appropriate given the highly cyclical leisure vehicle industry and company-specific risks, including the following: 1) trends in foreign competitive pricing (e.g., if foreign manufacturers lower prices) may affect Harley’s competitive positioning on currency; 2) Harley may not be successful in attracting women riders and younger riders; 3) consumer attraction toward Harley’s key heavyweight motorcycle segment may wane; 4) Harley may not be able to achieve continued operating efficiencies; 5) Harley may not successfully match shipments with retail sales growth; and 6) interest rates may increase. An additional risk to note is the risk associated with the company making effective use of its strong free cash flow (e.g., if cash flow is not productively redeployed, the company’s return on invested capital would likely decline significantly). Dealers we spoke with in late July agreed unanimously that the 2006 lineup surpassed 2005’s. On a scale of 1 to 10, the dealers rated last year’s product launch between 6 and 7, on average, while they rated this year’s launch between 9 and 10. Dealers were particularly excited about the changes that Harley introduced to keep up with the custom competitors, such as West Coast Choppers, saying they were “right on time.” Valuation We are raising our target price to $55 from $53 to reflect our higher target multiple. Our $55 target price is primarily derived using a P/E relative to the leisure vehicle group. We also look at an enterprise value (EV)/EBITDA analysis, although we prefer the P/E relative valuation and, thus, believe $55 is the appropriate target price. CITIGROUP PORTFOLIO STRATEGIST If the impact on the company from any of these factors proves to be greater than we anticipate, the stock will likely have difficulty achieving our target price. — October 10, 2005 36 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Industry Homebuilding Stephen Kim Buy on the Hype, Not into It I The homebuilder stocks traded down approximately 3.4% on October 5, as investor fears mounted over myriad concerns about housing market strength. We believe these concerns are overblown and that the issues are not nearly as serious as they may seem. We remind investors that housing supply remains significantly constrained, that demand has not weakened to any material degree in the major markets, and that margins in backlog likely reside above recently reported levels. With the builders trading at roughly 6.2x forward earnings, we believe the current valuations in the space position the group well for a significant reversal in sentiment, and we expect to see a sustained rally from here, driven almost entirely by earnings growth. Current valuations in the group represent an attractive buying opportunity. I Historically, such dips have only occurred when a crest in earnings appeared inevitable, and we believe the current valuations represent an attractive buying opportunity. Insider Sales: Not as Troubling as Investors Think Among recent investor concerns about the homebuilders has been a perception that insider selling is unusually high this year, foreshadowing troubling times ahead. Indeed, the increase in insider selling this year was recently characterized in the New York Times as homebuilding executives “bailing out.” Upon closer analysis, however, insider-selling data are not nearly as troubling as they initially might seem. We make several observations: I I I The value of insider sales naturally rises each year as the homebuilder stock prices rise. For example, the I We Believe Investor Fears Are Overblown The homebuilder stocks traded down approximately 3.4% on October 5, as investor fears mounted over myriad concerns about the strength of the housing market. Insider selling, apparently weak order trends, rising inventory levels, and concerns about the Washington, D.C., market were the primary factors driving negative investor sentiment. We believe these concerns are overblown and that the issues are not nearly as serious as they may seem. As we discussed in our September 21 note entitled “The Fear Factor,” we believe that some of these concerns are entirely off the mark, and that none of them (in isolation or combined) should represent more than a modest headwind to already conservative earnings expectations. We remind investors that housing supply remains significantly constrained, housing demand has not weakened to any material degree in the major markets, and margins in backlog likely reside above recently reported levels. average stock price over the 13 builders we cover was more than 60% higher year over year during the first nine months of 2005. Thus, even if executives were to sell the same number of shares each year (e.g., based on options grants), their level of insider sales would automatically rise. I Much of the recent increase in insider selling has been driven by one company. In June and July 2005, Toll Brothers executives sold roughly $265 million of stock, which is more than one-third of the $741 million in insider sales reported by the entire industry so far this year. While insider selling of this magnitude certainly merits closer scrutiny, we do not think it provides any meaningful insight into how the broader industry is faring. I Insider sales over the years have been a poor predictor of future stock price performance. Homebuilding With the builders trading at roughly 6.2x forward earnings, we believe the current valuations in the space position the group well for a significant reversal in sentiment, and we expect to see a sustained rally from here, driven almost entirely by earnings growth. CITIGROUP PORTFOLIO STRATEGIST executives have sold shares periodically in the past five years as homebuilding shares have continued to rally. From this perspective, it appears that recent insider selling is nothing more than a continuation of a longer-term trend of homebuilding executives realizing a substantial portion of their compensation through equity incentives. 37 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Disappointing Orders from Brookfield and Hovnanian Brookfield Homes (Not Rated) reported disappointing new orders for the three months ended September 30, 2005, on October 4, which totaled 246 units, a decrease of 55 units compared with the same period in 2004. Brookfield attributed the 22% year-over-year decrease in orders to a lower community count in San Francisco and Los Angeles that resulted in fewer homes available for sale in California. We believe this is a result of the company operating in California, where demand is strong and supply is constrained. In the past few months, we have heard similar accounts from the builders we cover. It is not unusual for them to fall short on subdivision counts in areas of strong demand where permitting and construction delays are rampant. Indeed, we would expect builders with California operations to simply defer closings into subsequent quarters. Industry generated in the past five years. Approximately 78,400 jobs were generated during the 12 months ended June 2005, up 25% from the comparable prior-year period; in contrast, permits have been static (at 41,993 in 2005) for five consecutive years. As a result of this severe job/permit imbalance, the inventory of speculative homes for sale has been running at an astoundingly low level. Also, all the builders indicated that they were continuing to raise prices as they operated from waiting lists in Washington, D.C. This continued pricing strength in the D.C. market is a function of supply constraints, which is an essential part of our thesis. Rise in Speculative Inventory Levels On September 27, new home inventories were reported for August, reflecting a 19% year-over-year increase in the absolute level of speculative inventory of new homes. This seemed to raise concerns about the inventory levels in the market. We point out that the government includes in its data a category of inventory called Homes Not Yet Started, which contributed to 22% of the total speculative inventory. Homes Not Yet Started refers to situations where a builder has received a permit to build a house but has not yet begun construction. This type of activity is, quite simply, not speculative inventory, and has no place in a speculative inventory statistic; yet, we consistently find that analysts include it. Investors should understand that, in many cases, these permits are obtained by a builder who is marketing a home to be built and has no intention of starting the unit speculatively. Additionally, many builders pull permits in advance of selling a home so that, once it is sold, its construction will not be further affected by regulatory delays. The true, accurate measure of speculative inventory is the sum of the other two subcategories of New Homes For Sale: Completed and Under Construction. Excluding the Homes Not Yet Started category, speculative inventory was up only 10% year over year in August and represents a mere 3.6 months on a months’ supply basis, which is virtually an all-time low. Weakness in the High-End Market Recently, some investors have expressed concern about the health of the high-end housing market, fearing that anecdotal evidence of weakness there could be a precursor to broader housing market weakness. However, we note that weakness in the high-end market rarely trickles down to lower-end homes. The public builder’s focus is primarily on first-time and move-up home buyers, and we expect demand there to remain strong regardless of high-end market dynamics. Following our conversation with Brookfield, we believe demand remains strong in the California region, and the inventory shortfall this quarter will likely be made up in subsequent quarters. In its press release, the company also mentioned that it remains on track in 2005 to close around 1,750 homes and achieve its previously announced EPS guidance of $6.50–$7.00. In addition, Hovnanian reported strong unit volumes for September on October 5. Consolidated orders for the month increased 48% year over year versus our 26% estimate for the quarter. The average order price for the month was $334,000, well above our $320,000 expectation for the quarter. Like Brookfield Homes, Hovnanian also reported a decline in California order growth (down 12% year over year), attributable to a shortfall in subdivision count. Overall, we are pleased with the strong order growth reported by the company, as this continues to reflect the strength in the housing market. Washington, D.C., Market Weakness As homebuilding stocks have weakened in recent weeks, among the primary concerns of investors has been the health of the Washington, D.C., housing market. To explore this issue in detail, we hosted a dinner on Thursday, September 22, in New York City. Local Washington, D.C., managers from Hovnanian, M.D.C. Holdings, and Toll Brothers discussed what they are seeing in their market with respect to traffic patterns, pricing trends, investor activity, credit standards, and inventory levels. All three builders stressed that D.C. remains an extremely strong market. Specifically, M.D.C. stated that the Washington, D.C., metropolitan area has remained the top market for jobs CITIGROUP PORTFOLIO STRATEGIST — October 5, 2005 38 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Industry Integrated Oils Doug Leggate Opportunity or Risk: Catching the Falling Knife — Upgrading MRO I Uncertainty about the hurricane impact on third quarter 2005 earnings and other factors have sparked a sell-off in the energy sector. Seasonal weakness and demand slowdown concerns are factors, but the severity of the sell-off has taken valuations below levels implied by the earnings outlook for the sector. A short-term trading view may dictate that it is too early to “buy the sector.” However, looking through third quarter 2005, we note that valuations have returned to levels that offer exposure to the operational catalysts that should drive performance of specific names beyond simply an oil price call. We are taking advantage of current weakness to upgrade Marathon to Buy. Amerada Hess remains our top pick on value. We recommend ExxonMobil on the basis of both growth in 2006 and defensive merits. Looking through the seasonal trade, we continue to buy the refiners for upside we think will be near 30% through 2006. I Looking beyond the uncertainty of third quarter 2005 earnings, we note that all indicators point to sustained earnings momentum for the sector. Against this backdrop, we are inclined to view near-term weakness as more of an opportunity than a risk. Refining Sector I I Recent share performance reminds us that the “seasonal trade” is never far away. However, we still believe the earnings capacity of the U.S. independent refiners — and of the industry as a whole — remains materially underestimated by the market. Historical metrics suggest “seasonal” downside risk from here; we would buy on weakness to gain exposure to upside potential that we expect could lift the sector 30% from here. Major Oils Three Factors Behind Recent Weakness As we see it, three factors have sparked indiscriminate selling of the energy sector: fears of demand weakness, technical breaches across the commodity index of critical support levels, and the prospect of the first negative earnings revisions across the sector in two years, in the wake of hurricanes in the Gulf of Mexico (GOM). All of this is during what has traditionally been the weakest month for energy stocks. Earnings momentum remains key. Although the third quarter holds considerable uncertainty given the hurricanes’ impact, key negatives from weaker marketing margins and shut-in GOM production look transitory. We do not believe oil prices or refining margins can be sustained anywhere near current levels, but valuations still imply long-term oil prices of $35– $40/bbl. Given the increasingly technical nature of the oil market, leveraged plays should be avoided. Rather, we look to current weakness as an opportunity to revisit those names with the operational catalysts to move the needle beyond simply a macro call. Oil Majors: Stay Selective While we believe sector valuations are attractive, oil price uncertainty and a third quarter earnings season fraught with risks present the obvious pitfalls of a blanket positive view on the sector. All the metaphors come to mind — catching a falling knife, standing in front of a moving train, etc. Near-term trading moves may indeed reflect further downside risk, but looking beyond the near term, we believe current sector weakness will ultimately provide an opportunity to reenter the sector. This is surely not the time to “catch the falling knife,” and we should not fool ourselves that we can call the next short-term move in commodity prices. However, the earnings outlook remains robust, while valuations remain substantially below levels implied by current oil prices. Short-term/seasonal trades will undoubtedly dictate near-term share performance; this spells bad news for the “pure” momentum plays. However, a meaningful and perhaps welcome pullback in valuations also provides an opportunity to revisit those names with the catalysts to “move the needle” at the operating level as well as a recurring theme in our research over the past year. In other words, stay selective. CITIGROUP PORTFOLIO STRATEGIST Given the uncertainty about where oil prices will move next, our focus remains on names with operational catalysts to “move the needle” beyond a simple macro call. After the recent move in share prices, valuations on several stocks appear attractive to us. We believe material operational catalysts remain to support their shares beyond the distortion of third quarter earnings. 39 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Amerada Hess (AHC, 1H; Target Price $160) Industry from exploration and transfer of best practices. In light of its organic portfolio promising growth in production with higher margins than its legacy assets, we continue to believe Chevron is a core re-rating story for the longer term. Near term, the weight of uncertainty may cause the shares to underperform the sector. Looking beyond this and considering recent share price weakness, we continue to rate the shares Buy/Low Risk. We believe CVX remains a core holding longer term. Marathon Oil (MRO, Upgrading to 1M; Target Price $74) We continue to rate Amerada Hess as the sector’s most compelling deep-value stock. Amerada’s third quarter earnings will be hurt more than those of most other oil majors, given that any loss of production in the GOM leaves earnings with even greater exposure to underlying hedged production (with oil realizations pegged at just $32). However, from 2006, hedges are largely removed, leaving the full portfolio exposed to higher oil prices for the first time in nearly four years. In addition, a strong suite of new projects with good visibility and lower costs than the legacy asset base supports earnings even against our expectations of falling oil prices over the medium term. Finally, we believe management’s revamped exploration offers material leverage for a company of its size. We rate AHC shares Buy/High Risk and maintain our target price of $160. ExxonMobil (XOM, 1L; Target Price $72) Limited disclosure on its exposure to the effects of the GOM hurricanes leaves a cloud of uncertainty over ExxonMobil’s earnings for third quarter 2005. However, the company is one of the most defensive of the oil majors, its balance sheet currently supports a share buyback program of $5 billion per quarter, and it has significant leverage to the resilience we expect from refining margins. Thus, ExxonMobil should be a net beneficiary of current sector uncertainty. We have argued in the past that, given the company’s size, identifying operational catalysts remains difficult. However, we also believe this is about to change. The year 2006 promises material growth in oil and gas production for a company that for five years has failed to deliver. Project visibility and the timing of new project start-ups are in stark contrast to those of super-major peers. In our view, this will accelerate the shares’ recovery to a market multiple of mid-cycle earnings. This is the basis of our current $72 target price on XOM shares, which we rate Buy/Low Risk. Chevron (CVX, 1L; Target Price $74) We are upgrading MRO shares to Buy/Medium Risk after their recent pullback, in order to access once again what we believe will be an enduring operational story for the long term. Recent share price performance has, in our view, been dominated by the completion of the Marathon Ashland Petroleum (MAP) transaction. While leaving the shares trading largely with the refining sector, it also leaves earnings exposed fully to resilient margins for the longer term (which we expect). Furthermore, long-standing operational factors continue to support the upside potential. Unrealized exploration success in Angola and the prospect of reentry to Libya offer meaningful differential catalysts for performance versus the sector. In addition, we view the shares as moderately defensive. The MAP transaction rebalances earnings across Marathon’s businesses, and large relative exposure to U.S. natural gas prices points to positive earnings revisions beyond the distortions of hurricane-related downtime in third quarter 2005. Our target price is unchanged, at $74, but we forecast 23.4% upside from here and a current dividend yield of 2.3%. The prospect of a 25.7% total return leads us to upgrade the shares to Buy/Medium Risk. Figure 1 sets forth our preferences in the U.S. oil sector. Figure 1. Recommendation Summary Recommendation Old New 1H 1H 1L 1L 2M 1M 1L 1L 2M 2M 2M 2M Target Price New 160 72 74 74 85 76 Expected Returns Price Div ETR 36.2% 1.0% 37.2% 22.9% 2.0% 25.0% 23.4% 2.3% 25.7% 23.3% 3.2% 26.5% 10.9% 1.7% 12.6% 22.5% 2.1% 24.6% Chevron will be among the hardest hit of the U.S. oil majors from the impacts of hurricane Katrina and Rita. With some 350,000 barrels per day of oil and gas production exposed to the hurricanes, visible facilities damage, and one of its largest refineries down for several months, Chevron will see its third quarter earnings and, very likely, fourth quarter earnings significantly affected by the lingering impact. In addition, at our recent meeting with the company, management suggested its initial estimate of $350 million of lost opportunity costs was only a start. We fully expect the impact to get worse. On a positive note, the Unocal acquisition offers material upside from portfolio high-grading, synergies, and intangible value CITIGROUP PORTFOLIO STRATEGIST Company Amerada Hess ExxonMobil Marathon Oil Chevron Occidental Petroleum ConocoPhillips Source: Citigroup Investment Research Also in energy comments this week: "Exploration and Production: Higher Prices Create Opportunity for Minimally Hedged Companies in 2006," by Gil Yang (October 10, 2005) and "Energen Corp (EGN): Initiating Coverage with a Buy Rating and $45 Target Price," by Faisel Khan (October 10, 2005). — October 6, 2005 40 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary Mid-Cap Meredith Corp. (MDP) William G. Bird, CFA Buy/Medium Risk (1M) Publishing Good Growth and Attractive Valuation; Up to Buy I We are upgrading MDP to Buy/Medium Risk (1M) from Hold (2M) based on lagged performance despite solid EVA creation, attractive relative growth and valuation, and improving fundamentals. We are raising our target price to $60 from $55. Meredith’s earnings have compounded at 18.3% over the past two years, yet the stock has compounded at 5.5%. Year to date, the stock is down 9.7% (9.3% underperformance versus the S&P 500), yet first half EPS were up 15%. See also our related note from October 5 in which we downgraded Washington Post to Hold (2M) from Buy (1M). ® Company Metrics Price (10/5/05) $48.81 52-Week Range $54-$45 Div (E) (Cur/Prev) $0.40/$0.40 Est. 5-Yr Growth 12% Target Price $60.00 Expected Share Price Return 22.9% Expected Dividend Yield 0.8% Expected Total Return 23.7% Market Cap. (bil.) P/E (6/06E) P/E (6/07E) 6/05A EPS 6/06E Cur EPS 6/06E Prev EPS 6/07E Cur EPS 6/07E Prev EPS I $2.5 17.4x 14.8x $2.50 $2.80 NC $3.30 NC For additional metrics, please consult Global Equities Online. • MEREDITH CORPORATION (MDP) PRICE 50.9 DATE 10-06-2005 74 64 58 50 44 38 34 30 26 22 20 18 16 14 12 I StockVal® 50 44 38 34 30 We believe MDP offers attractive growth at a reasonable price. 26 22 20 18 16 14 12 1995 1.6 1.3 1.0 0.8 0.6 0.5 0.4 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) 09-29-1995 10-06-2005 HI LO ME CU Key potential stock drivers include 1) widening growth profile versus media; 2) the potential for successful integration of recently acquired G+J, a reasonably priced “fixer-upper” with strong margin potential; 3) increasing visibility of Meredith’s integrated marketing initiatives, a line extension that underscores its ability to grow new businesses and adapt to changing client needs; and 4) increased speculation on a possible Meredith TV sale resulting from potential media crossownership relief on the horizon in second half 2006. We believe MDP offers the potential to get paid twice on above-average growth and an improving multiple as capital flows to scarce growth in media. We believe the market is a “voting machine” in the short term and a “weighing machine” in the long term and that Meredith’s rising profits and lagging stock performance are unlikely to persist. Meredith will report earnings on October 24, and we forecast 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1.58 0.47 1.01 1.26 Source: StockVal circulation strategy, and robust relational database, a key asset that allows for new launches and product extensions. Meredith continues to enjoy strong competitive positioning in publishing, with an opportunity for improved growth by successfully integrating the acquisition of Gruner + Jahr, further leveraging its relational database, scaling its mid-sized publications, and continuing to extend its brands. At this stage, Meredith seems to have climbed the steepest part of the curve in its TV turnaround, but potential improvement at WGCL-Atlanta (about 12% of TV revenues) could still be meaningful to the turnaround story (a 1-point ratings improvement in Atlanta represents about $8 million in net revenues). October ad page trends are strong at Meredith titles. Magazine ad page trends at Meredith titles appear to be improving in October, with ad page bookings up 7.3% (at nine titles tracked), compared with a decline of 2.4% in September and a rise of 1.4% in August. earnings of $0.51 versus $0.46, in line with consensus. We believe Hurricane Katrina had an immaterial impact on results, as Louisiana and Mississippi account for less than 2% of Meredith’s circulation. Background. Meredith is arguably one of the top operators in the magazine industry, with consistently higher ad growth, upper-end circulation growth and quality, upper-end operating margins, and a history of success in new launches. Key differentiators include its focus on the women’s service field, professional management, editorial focus, financially disciplined CITIGROUP PORTFOLIO STRATEGIST 41 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. On the Contrary The integration of the G+J acquisition could contribute to aboveaverage growth. Meredith has a strong track record of Mid-Cap Indicative of Meredith’s adaptability to emerging growth prospects, the company now reaches one in every three adult Hispanic women. Meredith’s auto ad exposure is “less bad.” At 8.7% of total company revenues (about 2.4% for magazines and 27% for TV), the company’s exposure to auto advertising, which seems likely to deteriorate, is below the 17% average for other media companies. Meredith is continuing to mine the value of its database. Is TV a keeper? Whether Meredith will be an operator or Risks We rate Meredith Medium Risk as its above-average financial leverage and relatively smaller market cap is offset by low stock-price volatility (beta of 0.86). choose to exit TV remains an open issue, in our opinion. It is our impression that a sale is unlikely until efforts to increase the profitability of the broadcasting group are complete. With a TV group tax basis of approximately $700 million, we believe tax efficiency would be an important consideration in any potential TV transaction. Meredith appears to be undervalued relative to its free cash flow conversion. Relative to the newspaper group, Meredith appears to be trading cheaper on most metrics. We believe the company is a more attractive investment in terms of growth, profitability, capital intensity, cyclicality, and secular issues. CITIGROUP PORTFOLIO STRATEGIST In the near term, we believe the primary risk to Meredith’s investment story is the absence of a suitor. This is primarily a valuation risk, as we believe that MDP’s current valuation is discounting the possibility of a sale. Voting control is also a risk factor, as the Meredith family owns Class B stock with voting control totaling 65%. Other key risks include potential variability in ad commitments, continued economic uncertainty, and concerns over the strength of consumer confidence. If the impact on the company from any of these factors proves greater than we anticipate, the stock will likely have difficulty achieving our target price. — October 5, 2005 42 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. ® Meredith’s 75-million-name relational database is among the largest in the industry and contains 300 data points on three-quarters of American homeowners. The size, depth, and functionality enable it to develop more effective direct marketing, driving higher response rates. There appear to be untapped opportunities to monetize this database and provide more marketing tools to the company’s marketing partners. Our EVA model is currently calculating a target price of $61 based on regression analysis and two marketimplied momentum measures. For a detailed explanation of EVA valuation, please refer to our 52page report titled “Economic Profit Valuation” (published November 30, 2004; order no. US11M133). The average of the two-stage growth target of $59 combined with our EVA target of $61 results in our $60 target price. (Economic Value Added [EVA ] is a registered trademark of Stern Stewart & Co. in the United States of America and throughout the world.) ® Industrywide, secular issues remain an overarching concern to media investors. With that said, particularly in publishing, Meredith’s goals appear to be less challenging: 1) continuing to effectively use the Internet for customer acquisitions; 2) continuing to develop innovative solutions that enable clients to address the three biggest trends shaping media — fragmentation, targeting, and measurability; and 3) its core magazine audience (mature women) and core ad group are “under-indexed” online. Our two-stage growth model assumes EPS grow 12% over the next five years and 3% thereafter. We assume that free cash flow will be 110% of net income over the next five years and 110% thereafter. Through a discounted cash flow model that incorporates a conservative 6% equity risk premium, we are in effect deriving a stock price and implied P/E multiple. These assumptions suggest that the appropriate earnings multiplier for the stock is 21x, yielding a target price of $59. ® integrating underperforming publishing assets. Arguably, Meredith’s best integration was its last acquisition (American Baby, completed in December 2002). We believe Meredith should be able to significantly improve the performance of the Gruner + Jahr titles. It is worth noting that MDP began discussions with G+J in February 2004 and was therefore well aware of the task at hand. The titles included are Parents, Child, Fitness, and Family Circle. The G+J titles appear to be a good fit with Meredith’s lifestyle, female, and Hispanic market focus. Although Hispanic revenues are proportionately small, Meredith now reaches one in every three adult Hispanic women through such titles as Ser Padres, Siempre Mujer, and American Baby’s Espera. The major challenge with Hispanic magazines is that the targeted demographic does not traditionally subscribe to magazines. Valuation Our new $60 target price (previously $55) reflects a change in methodology to a two-stage growth model and intrinsic value measure (EVA versus MVA regression) from sum-of-the-parts analysis. Insights Large-Cap, Value ConAgra Foods, Inc. (CAG) David Driscoll, CFA Buy/Medium Risk (1M) Food Manufacturers Risk/Reward Balance Tips to Reward: Initiating with a Buy I We are initiating coverage of ConAgra Foods with a Buy/Medium Risk (1M) rating and $27 target price, at 16x our calendar 2007 estimate of $1.68. We expect restructuring savings and a recovery in ConAgra’s packaged meat business to fuel 8% EPS growth in the next three years. We recognize that the company’s portfolio and many of the company’s metrics are below average — but believe that only modest earnings gains are needed to see material gains in the shares. Industry-best dividend yield and strong free cash flow yield are attractive. We see ample cash flow to protect the dividend and lift marketing support 30% in fiscal 2006. Our projections include only 25% of the estimated benefit from restructuring efforts, which could add $0.16 to EPS in fiscal 2006 and $0.40 by fiscal 2008. We also expect recovery in packaged meats to add $0.05 to EPS in fiscal 2006. Company Metrics Price (10/6/05) 52-Week Range Div (E) (Cur/Prev) Est. 5-Yr Growth Target Price Expected Share Price Return Expected Dividend Yield Expected Total Return I $24.01 $30-$22 $1.09/NA NA $27.00 12.5% 4.5% 17.0% Market Cap. (bil.) P/E (5/06E) P/E (5/07E) 5/05A EPS 5/06E Cur EPS 5/06E Prev EPS 5/07E Cur EPS 5/07E Prev EPS $12.5 16.2x 15.0x $1.38 $1.48 NA $1.60 NA For additional metrics, please consult Global Equities Online. • CONAGRA FOODS INCORPORATED (CAG) PRICE 24.0 DATE 10-06-2005 47 42 37 33 29 26 23 20 18 16 14 12 11 I StockVal® 33 29 26 23 20 18 16 14 12 11 1995 1.2 1.0 0.8 HI LO ME CU I 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 New CEO and Big Restructuring Savings in View Means Investors Will Get Paid to Wait We believe that recent problems in packaged meats and SAP integration have only temporarily depressed earnings at ConAgra. Furthermore, through our proprietary analysis, we see very significant cost savings coming from multiple, parallel restructuring programs, whose potential, we believe, is not well understood by investors, as ConAgra has not quantified their expected benefits. Lastly, we believe that the current $1.09 per share dividend, which yields 4.5% and is well above the peer group average rate of 2.7%, is safe and should act as a powerful incentive for investors who will get paid to wait for improvements in the underlying business. Consequently, we are initiating coverage of ConAgra Foods with a 1M rating and 12month target price of $27 per share. Clearly, ConAgra does not posses the strength we see at the premier packaged food companies; however, we assert that 0.6 0.5 0.4 0.3 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) 1.15 0.32 0.70 0.59 09-29-1995 10-06-2005 Source: StockVal structure. Indeed, in an odd sort of way, ConAgra may have more potential for improvement than just about any other food company we have analyzed. It becomes even more interesting given that ConAgra has not provided any guidance on the expected savings of their various programs, meaning that investors do not likely have a good idea what these efforts could be worth. Our proprietary analysis has revealed enormous restructuring savings potential amounting to cumulative annual savings for ConAgra to be a good stock, it does not have to. We believe that ConAgra’s weaker portfolio position is well known to investors, but that the driving force behind the stock price has been, and will continue to be, the direction of improvement of its portfolio and its cost CITIGROUP PORTFOLIO STRATEGIST of more than $325 million (pre-tax), or $0.40 per share, by fiscal 2008. These savings will come from programs that have been under way for more than a year and include SKU rationalizations, headcount reductions, plant closures, and SAP (enterprise application software) implementation. Importantly, we factor in only 25% of the expected savings. Even with the reduction, we expect important annual savings of $81 million (pre-tax), or $0.10 per share by fiscal 2008, with initial savings of $32 million, or $0.04 per share, in fiscal 2006. 43 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights In the second half of fiscal 2005, ConAgra had significant problems in its large package meat business (Armour, Healthy Choice, Butterball, Eckrich, etc.). The division stumbled during the SAP integration, with sales hurt by an inability to fill customer orders. Costs for raw materials soared, but management reacted too late and failed to adequately price its products to recover the higher costs. Management estimates that the troubles cost $150 million, or $0.18 per share, in lost earnings. With the SAP integration now complete, the systems are once again working properly and the company is adjusting prices to recover the cost of higher input costs. This suggests that the large decline in meat profitability is reversing and should positively affect earnings in the current quarter (fiscal second quarter 2006), becoming more significant as the company laps the third and fourth quarters of fiscal 2005, which is when the problems peaked. In sum, we are estimating only a partial profit recovery of $40 million, or $0.05 per share, in fiscal 2006 from packaged meats. Many of these points rely on management execution, and we see the recent hiring of Mr. Gary Rodkin as CEO as positive for ConAgra. Mr. Rodkin is a highly regarded, seasoned Large-Cap, Value estimates as a victory and a step in the right direction. Our fiscal 2007 estimate of $1.60 is $0.08 above consensus given our expectations of significant cost savings. Therefore, we believe the current price reflects past difficulties more than it reflects future potential. Longer term, we estimate sales will grow at a compounded rate of 2.1% over the next five years, generating earnings growth at a rate of 8%. This growth, coupled with fundamental improvements in ConAgra’s cost structure, is estimated to generate an improvement in returns on invested capital of 400 bps, from 10% in 2005 to 14% by 2010. Valuation We Believe the Shares Are Undervalued At the current share price, CAG is attractive to us, and we have established a target price of $27 using a P/E multiple of 16x and an EBITDA multiple of 10.5x our calendar 2007 estimates. Our choice of multiples reflects modest premiums to historical median valuations on ConAgra and reflects our belief that improvements will drive multiples closer to the historical median of the peer group — P/E of 18.5x and EBITDA of 10.7x. Risks We apply a Medium Risk rating to ConAgra based on its recent restructuring and corresponding earnings volatility. Significant risks for ConAgra that could make it difficult for the stock to reach our target price include the following: I I I veteran of the food business. Most recently, he was President and CEO of PepsiCo Beverages and Food North America and is credited with building winning teams at PepsiCo, Tropicana, and General Mills. He began his tenure at ConAgra on October 1, 2005, and will likely add a much-needed sense of urgency to its senior management team. We see the dividend as safe. Importantly, even factoring a Management decides to reduce the dividend. Private label continues to take market share from ConAgra. Packaged meat sales continue to decline. Low levels of order fulfillment, high input costs, and uncompetitive levels of innovation hurt the company’s packaged meat business in 2005. Direct and indirect costs from energy remain high. The company’s restructuring is unsuccessful. ConAgra could significantly alter its portfolio composition. The company’s new CEO could “re-base” earnings. He could invest heavily in marketing and other spending upfront, resetting the base for earnings going forward, which could materially affect our estimates. — October 6, 2005 significant increase in marketing spending, we still conclude that the dividend is quite safe. Our estimates indicate that ConAgra should have $1.1 billion to cover an estimated dividend payment of $565 million (with no increase), which we believe provides an ample margin of safety. Critically, we believe that this is a significant point for investors, as they will get paid the dividend to wait for business improvements. The current sentiment on ConAgra is quite bearish, and ratings on I I I I the Street are almost exclusively holds or sells, with multiple earnings warnings from the company in fiscal 2005. We believe that the stock reflects these concerns and does not incorporate the potential opportunities in the near term. Consequently, we see the situation as opportunistic and expect investor sentiment to improve as our expectations for cost improvement play out. In fiscal 2006, our $1.48 EPS estimate is just $0.01 above consensus, but given ConAgra’s recent history of earnings disappointments and the negative sentiment on the Street, we believe investors will view simply achieving earnings CITIGROUP PORTFOLIO STRATEGIST 44 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights Large-Cap, Growth International Business Machines Corp. (IBM) Buy/Medium Risk (1M) Richard Gardner PC & Enterprise Hardware RVA=ÉÅáêm=íÉÖê~q==WÉê~ïÇê~e=é~`JÉÖê~i=åá=âÅám=éçq=êìl=ïçk I We are upgrading IBM to Buy/Medium Risk (1M) from Hold/Medium Risk (2M), with a new 12-month target price of $95. Services bookings are on track to rise 10%–15% in 2005, following a 22% decline in 2004. Services margins should also benefit from European restructuring, which appears to be slightly ahead of schedule. Company Metrics Price (10/7/05) $80.50 52-Week Range $99-$72 Div (E) (Cur/Prev) $0.80/$0.80 Est. 5-Yr Growth 8% Target Price $95.00 Expected Share Price Return 18.0% Expected Dividend Yield 1.0% Expected Total Return 19.0% Market Cap. (bil.) P/E (12/05E) P/E (12/06E) 12/04A EPS 12/05E Cur EPS 12/05E Prev EPS 12/06E Cur EPS 12/06E Prev EPS I $133.7 16.2x 14.6x $4.51 $4.98 $4.94 $5.52 $5.41 I IBM continues to gain share in mid-range and highend servers thanks to a superior microprocessor architecture relative to Hewlett-Packard or Sun Microsystems. Future quarters should benefit from a new mainframe cycle. The shares look attractive at just 15x our forward 12-month EPS estimate, which already includes options expenses. For additional metrics, please consult Global Equities Online. • INTERNATIONAL BUSINESS MACHINES (IBM) PRICE 80.5 DATE 10-07-2005 196 166 142 120 102 86 74 62 54 46 38 32 28 24 20 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 StockVal® 120 102 86 74 62 54 46 38 32 28 I Services: We See 10%–15% Growth We believe IBM is on track to report services bookings of $11–$12 billion for third quarter 2005. While this is below last quarter’s impressive $14.6 billion, full year services bookings appear on track to grow 10%–15% after declining 22% in 2004. Most of the recovery is attributable to the Infrastructure Outsourcing and Business Transformation Outsourcing unit, in which bookings will likely grow more than 20% this year; in contrast, consulting bookings may be flat. 24 20 1995 2.8 2.2 1.8 1.4 1.2 1.0 0.8 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) 10-06-1995 10-07-2005 HI LO ME CU 2.67 0.89 1.89 1.67 Source: StockVal While we concede that flat consulting bookings are not overly inspiring, consulting margins should receive a boost from recently announced restructuring actions. Recall that in second quarter 2005, IBM announced plans to reduce headcount by 10,000–13,000, primarily within European services. Our checks suggest that one-half of these employees left the company during the first two weeks of the third quarter, indicating the program is proceeding on or slightly ahead of schedule. The impact of growing offshore labor content is often highlighted as a significant risk to IBM’s billing rates, margin, or market share within services. First, we view IBM’s decision to proactively shift services headcount to lower-cost locations at the margin as a sign that the company is determined to maintain a competitive cost structure. Second, we believe the primary near-term impact CITIGROUP PORTFOLIO STRATEGIST on billing rates will be in application development and maintenance and supporting roles, which, combined, constitute less than 10% of IBM’s total services revenues. Finally, while offshore companies continue to build their geographic coverage and domain expertise, we do not expect them to become viable competition for IBM’s highend business consulting or infrastructure consulting for several more years. Given this year’s rebound in outsourcing bookings (with minimal leakage from backlog) and solid execution on restructuring initiatives, we consider our previous 2006 services revenue and gross margin estimates conservative. Therefore, we are raising our services revenue and gross margin estimates from $50.9 billion and 26.1%, respectively, to $51.3 billion and 26.4%. Hardware: New Mainframe Product Cycle Recent checks suggest that IBM server sales remain very solid. IBM has been gaining RISC-UNIX revenue share 45 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights for five solid years thanks to superior microprocessor architecture and price/performance. We expect continued share gains in the mid-range and high-end RISC-UNIX markets in 2006 as IBM upgrades the entire pSeries product line to the Power 5+ microprocessor. Power 5+ should also come to iSeries, providing a strong incentive for existing users to remain with the platform and limiting revenue declines within this line. More important, IBM should benefit from a new mainframe product cycle in fourth quarter 2005 through 2006. Mainframe was the second-fastest growing server platform (second only to Linux in revenue terms) from fourth quarter 2003 through second quarter 2004, achieving revenue growth of 30%–40%. In the past four quarters, mainframe revenues have declined 4%–24% year over year as customers completed a significant round of upgrades and consolidation and waited for the new Z9 to arrive. Given mid-September volume shipments of the new Z9, we believe IBM will enjoy a significant rebound in mainframe revenue and MIPS (millions of instructions per second) growth in the coming year. Relative to other widely owned large-cap hardware names, we prefer IBM due to its lack of PC or printer exposure. In light of slowing industry growth, product commoditization, and intense competition, we believe pricing will be challenging in the PC and printer markets. Given the prospect of further estimate reductions at Dell (DELL-$32.08; 1M) and limited estimate upside at fairly valued HP (HPQ-$27.10; 2H), we expect IBM to outperform within large-cap hardware in 2005. Microelectronics: Upside from Next-Gen Game Consoles Microelectronics sales to external customers represent less than 5% of IBM’s total revenues. However, because of the capital intensity of this business, microelectronics can have a much larger impact on operating income during periods of improvement or deterioration in utilization and yields. Large-Cap, Growth services, microelectronics, and server fundamentals, these above-market growth rates should support modest expansion in the company’s P/E multiple in 2006. IBM is now our top pick within large-cap hardware. Our target price suggests 18% price appreciation in the coming year. Valuation We derive our IBM target price using P/E and discounted cash flow (DCF) analyses. Given historical metrics and our medium- to long-term growth outlook, we consider a 16x multiple to our forward 12-month EPS appropriate for IBM shares (16x is the 15-year mean forward 12-month multiple for the S&P 500 based on operating earnings). Sixteen times our revised EPS estimate of $5.94 for the four quarters beginning in fourth quarter 2006 suggests a 12month target price of $95. Our DCF analysis assuming 3%–5% revenue growth during the coming decade, 37% gross margin, 3.0% terminal free cash flow growth, a 1.10 beta, an 8.7% average market return, and a risk-free rate of 4.2% yields a 12-month target price of $94–$95. Risks The ongoing migration of some services labor offshore could pressure consulting and systems integration bill rates and, thus, gross profit dollars. Within Microelectronics, IBM’s strategy of maintaining leading-edge process technology and working with a limited number of strategic customers could cause operating results to fluctuate considerably. Within Enterprise Systems, IBM derives most revenues from proprietary platforms, such as iSeries, mainframe, mainframe storage, and tape, areas that have not grown consistently in recent years. While the pSeries server line has grown significantly in recent quarters, we view it as a declining market in which IBM’s growth is due mainly to market share gains. Within software, the company continues to lose market share in collaboration software to Microsoft. The company is also defending itself in a high-profile pension-benefit discrimination case (Cooper et al. vs. IBM). In 2006, we expect the positive utilization and margin impact of deliveries to Microsoft, Sony, and Nintendo for next-generation game consoles to more than offset the ramp-down of G5 microprocessor shipments to Apple. We expect sales of console microprocessors to earn better margins than sales of G5 processors to Apple due to more favorable contract terms. Our Top Pick in Large-Cap Hardware We view the current valuation of IBM shares, at just 15x our forward 12-month EPS estimates, as attractive. Our estimates suggest low- to mid-single-digit revenue growth and high single- to low double-digit diluted EPS growth in 2006 and 2007 (excluding the impact of the PC divestiture). Combined with growing confidence in CITIGROUP PORTFOLIO STRATEGIST We rate IBM Medium Risk because more than one-half of the company’s pretax income is derived from annuity sources, such as IT outsourcing, maintenance, software, and financing, contributing to a high degree of EPS predictability. Market cap, liquidity, and a solid balance sheet also suggest a Medium Risk rating. If the impact on the company from any of these factors proves to be greater than we anticipate, the stock will likely have difficulty achieving our target price. Likewise, if any of these factors proves to have less of an effect than we anticipate, the stock could materially outperform our target. — October 9, 2005 46 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights Industry Semiconductors — Specialty Craig A. Ellis NAND Flash: Lowering Ratings on Share Appreciation I NAND fundamentals appear bullish. We are increasing our 2006 EPS estimates and target prices for M-Systems and SanDisk. M-Systems should benefit, near term, from USBdrive market share gains. We are increasing our third and fourth quarter 2005 revenue estimates. SanDisk should benefit, near term, from a benign pricing and manufacturing transition and, long term, from handset card wins and higher royalties. Lower bit growth should be offset by benign pricing and higher gross margin in the third and fourth quarters of 2005. The shares are, however, largely discounting solid fundamentals. Since June 30, FLSH and SNDK are up 54% and 120%, respectively. Our expected total returns (ETRs) of 14% for FLSH and 9.6% for SNDK are insufficient to warrant Buy ratings. We are downgrading M-Systems and SanDisk to Hold from Buy. Their risk/reward ratios, which appeared compelling just a month ago, are now more balanced. supported our positive industry and company theses in the past three months. Auguring Well for 2006: Increasing Our 2006 EPS Estimates I I Incorporating conclusions from our late-September Asia and U.S. Cellular Telecommunications and Internet Association (CTIA) field checks and analysis of U.S. retail sell-through data for August, we are increasing our estimates for M-Systems and SanDisk. I M-Systems We have raised our second half 2005 I revenue estimates, reflecting universal serial bus (USB) share gain, with second half earnings now more third-quarter weighted. Our third and fourth quarter 2005 EPS estimates are $0.24 and $0.45, respectively. We have raised our 2006 EPS estimate to $1.38 from $1.37 on better USB-drive revenues and scale-driven margin efficiencies, and our target price is now $34, up from $33. I I SanDisk Our unchanged 2005 EPS estimate of $1.64 Increasing Estimates, but Lowering Ratings We have been bullish on NAND flash fundamentals and FLSH and SNDK shares since mid-July. Company and sector developments (see Figure 1) have broadly reflects lower bit growth (better handset card revenues, but surprising USB share loss), offset by benign pricing and higher gross margin. Our above-consensus third and fourth quarter 2005 EPS estimates are also unchanged, at $0.39 and $0.50, respectively. We have raised our 2006 EPS estimate to $2.57 from $2.15 on higher royalties as well as increased revenues for handset memory M-Systems Customer USB drive US market share gain Toshiba/SanDisk 70nm and 300mm transitions U3 launch Figure 1. Review of Third Quarter 2005 NAND Flash Sector and Company-Specific Developments Macro SanDisk Positive Tight supply/demand 3Q retail price/MB - tracking to down 5% qq Apple nano 2GB and 4GB launch SNE Walkman handset momentum in Europe Flattish Q4 contract pricing expectations Strong Play Station Portable European launch Visible signs of handset demand growth Motorola ROKR US launch and SNDK bundle Seasonally normal US card and drive bit growth Trusted Flash, iNAND product launch at CTIA Supply chain component and product inventories Positive buzz at CTIA on vendor/carrier momentum MU expects balanced memory mkt in 2006 U3 product launch microSD momentum with Nokia design-ins micro Memory Stick product announcement Samsung 2005 bit growth outlook from 195% to 220% Toshiba/SanDisk 70nm and 300mm transitions Negative Katrina, Rita 4Q05, 1Q06 demand implications Pricing's lT application growth implications DRAM pricing less robust than expected Component double ordering in 2H05 Increased risk of oversupply in 1H06 New suppliers such as SMIC in 2006 3Q US retail unit market share loss of 5% to 7% qq 3Q US retail bit growth tracking flattish qq Decelerating avg unit card/drive density migration in 3Q Samsung one month behind on MLC ramp Samsung 2005 bit growth outlook from 195% to 220% Absence of CTIA product announcement Lack of buzz with carriers/vendors at CTIA Longer-term competitive implications of iNAND Lack of noticeable 3Q Tier-one handset design ins Source: Citigroup Investment Research CITIGROUP PORTFOLIO STRATEGIST 47 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights cards and traditional cards, and our target price is now $57, up from $50. Our estimates are approaching a “best-case” view. Recent Share Price Performance Limits Upside Potential Industry NAND supply agreements, and the potential for positive product mix shift. Therefore, while seasonal dynamics could help FLSH share performance near term, upside potential appears limited for investors with a nine- to 12-month view. SanDisk IP-driven royalty positives and an industry- M-Systems and SanDisk shares have appreciated 54% and 120%, respectively, since June 30 against a backdrop of healthy and mostly better-than-expected fundamentals, as well as increasing Street EPS estimates. Mindful of the risk/reward ratio, we note: I With about 14% ETR, to our new $34 target price, FLSH shares appear close to discounting the incremental USB drive positives we now observe. With about 10% ETR, to our new $57 target price, SanDisk appears well ahead of the 2006 Street EPS consensus, which in the past three months has increased just 14%; it seems to be discounting the higher end of the $2.40–$2.57 Street range instead. I leading position in numerous flash-based products appear increasingly reflected in SNDK shares. Also, while potential catalysts such as a first quarter 2006 royalty revenue inflection, gross margin expansion into mid-2006 on a 300 mm 70 nm start-up, and a steady mid-2006 ramp up in SanDisk’s bundled handset memory card business are positives, they now seem well recognized by the Street. So, while seasonality remains a tailwind for the shares near term, upside potential for investors with a nine- to 12-month view now seems limited. — October 5, 2005 Fairchild Semiconductor: Upgrading to Buy on Valuation; No Change to Our EPS Estimates Shares Again Interesting for Longer-Term Investors Figure 2. FLSH and SNDK: New and Old Target Prices, ETRs, and Target Multiples New Target Price FLSH SNDK $34 57 Old Target Price $33 50 Target Multiples ETR 14% 9.6% EV/S 3.10 3.80 P/B 2.80 3.06 P/E 24.30 23.40 *ETR Based on Prices as of 10/5/2005 Source: Citigroup Investment Research Sector Thesis Still Bullish; Company Theses Recognize Recent Share Appreciation Our sector thesis is unchanged. Bullish on the longerterm outlook for NAND flash fundamentals, we see our confidence in steady long-term application growth and a relatively balanced market confirmed in fieldwork and validated by spot and contract pricing that suggests industry concerns are tipped more toward supply than demand. That said, fuel-related demand risks bear watching in the months ahead. In summary, our industry thesis holds that growing breadth in NAND applications, deriving from handsets, next-generation gaming, and software-enabled USB drives, among other sources, argues for an even tighter near-term supply/demand balance than our outlook for just 1%, 1%, and 3% oversupply in 2005, 2006, and 2007, respectively. Our company views follow. M-Systems Numerous 2005 and first half 2006 positive catalysts now appear significantly discounted in FLSH shares. Favorable product catalysts include the second half 2005 mobile DiskOnChip (MDoC) density upgrade and the first quarter 2006 Mega-SIM launch. Gross margin expansion is meanwhile expected in 2006 and 2007 given competitive inventory turns, preferential CITIGROUP PORTFOLIO STRATEGIST We believe Fairchild’s valuation suggests that investors with a 12- to 18-month time horizon should begin taking a position in FCS shares. Core story elements are unchanged: New CEO Dr. Mark Thompson is attempting to engineer an inflection in gross margin to around 30% by fourth quarter 2006 and 35% longer term, from 19.9% presently, by pulling product mix, capex, and cost control levers. Gross margin catalysts include lower depreciation expense in second half 2005 and utilization and product mix–driven margin improvement in 2006. Share price performance elsewhere in the group augurs well if Fairchild can achieve its financial goals. For example, margin improvement stories Intersil and National Semiconductor currently trade 53% and 73%, respectively, above their 52-week lows, while Fairchild is just 10% higher. Fairchild’s channel inventory excesses are a known risk for second half 2005, but they should soon abate, removing a margin expansion headwind. Further, because capex and cost savings variables are within the company’s control, it is not unreasonable to expect significant gross margin expansion over the next five quarters. Our gross margin estimate for fourth quarter 2006 has increased to 28.0%, up from 22.0% in fourth quarter 2005. Indeed, if the company can hit its 30% target in fourth quarter 2006, competitor share price performance suggests the stock should reach or exceed our $19 target price. — October 9, 2005 48 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights Mid-Cap, GARP StanCorp Financial Group, Inc. (SFG) Keith F. Walsh / Colin W. Devine Buy/Low Risk (1L) Insurance — Life Initiation of Coverage with 1L Rating and $92 Target Price I We are initiating coverage of StanCorp Financial Group with a Buy/Low Risk (1L) rating and a $92 target price. StanCorp has never had a significant reserve strengthening. Strong underwriting is driven by a pricing discipline and risk selection process that is second to none. StanCorp has consistently priced its group longterm disability product at a 7%–10% premium over the peer group median. Over the next several years, we project industry premium growth of 6%– 8% and annual premium increases for StanCorp of 10%–12%. StanCorp should continue to command a premium valuation, driven by its 14%–15% ROE. Company Metrics Price (10/5/05) 52-Week Range Div (E) (Cur/Prev) Est. 5-Yr Growth Target Price Expected Share Price Return Expected Dividend Yield Expected Total Return I I $82.34 $89-$65 $1.10/NA NA $92.00 11.7% 1.3% 13.0% Market Cap. (bil.) P/E (12/05E) P/E (12/06E) 12/04A EPS 12/05E Cur EPS 12/05E Prev EPS 12/06E Cur EPS 12/06E Prev EPS $2.3 12.1x 11.2x $6.64 $6.80 NA $7.35 NA For additional metrics, please consult Global Equities Online. STANCORP FINANCIAL GROUP INC (SFG) PRICE 82.5 DATE 10-06-2005 118 104 92 80 72 62 56 48 42 38 34 30 26 22 20 StockVal® 80 72 62 56 48 42 38 34 30 I Company Overview StanCorp is a leading provider of employee benefit products, serving the life and disability insurance needs of employers and individuals. The Portland, Oregon– based company undertook a full demutualization in 1999. Based on 2004 industry data, StanCorp is the No. 4 provider of group long-term disability (LTD), No. 4 provider of group short-term disability (STD), No. 8 provider of individual disability insurance (DI), and the ninth-largest provider of group life insurance. Key Drivers Behind Our 1L Rating Above-Average Premium, Sales, and Earnings Growth 26 22 20 1995 4.2 3.2 2.4 1.8 1.4 1.0 0.8 PRICE RELATIVE TO S&P 500 INDEX WITH OPERATING EPS (SPX) 04-16-1999 10-06-2005 HI LO ME CU 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 4.03 • 0.90 2.95 3.77 Source: StockVal StanCorp has been able to take a business that has modest growth characteristics and expand at a much faster rate than the rest of the industry. In aggregate, StanCorp has been able to increase sales and in-force premiums at a compound rate that is 3.4x and 2.5x faster than that of the entire industry. This growth shows no signs of slowing down. Over the next several years, we project industry premium growth of 6%–8% and annual premium increases for StanCorp of 10%–12%. Underwriting and Pricing Track Record Are Second to None StanCorp stands out relative to many other industry players in that it has never had a significant reserve strengthening. (The company did have a $9 million reserve charge in first quarter 2004, owing to a pricing CITIGROUP PORTFOLIO STRATEGIST miscalculation on one large contract.) Strong underwriting is driven by a pricing discipline and risk selection process that is second to none. A falling or steady loss ratio is the surest indicator that a company has priced correctly for the level of risk it is undertaking. The rapid decline in StanCorp’s loss ratio may indicate its underwriting discipline is achieving better profitability than was initially priced for. Looking out over the next few years, we would expect the loss ratio to uptick toward 77% compared with the 75% reported in second quarter 2005. This is well below the peer group average for second quarter 2005 of 82.9%, utilizing a composite of the top industry players that account for more than 70% of total market premiums. StanCorp has consistently priced its group LTD product at a 7%–10% premium over the peer group median. At December 31, 2004, StanCorp had a premium per life of $234 compared with $218 for the industry. 49 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Insights Diversified Book of Business Provides Consistent Results Mid-Cap, GARP Valuation Our primary valuation methodology derives a target multiple of 1.92x our estimated 2005 book value of $47.81 and 1.75x our projected year-end 2006 book value (excluding FAS 115) of $51.01. This multiple is based on our industry regression model and compares to the peer group target multiple of 1.85x estimated 2005 book value. This is consistent with the valuation under our regression model, which factors in a projected ROE for StanCorp of 14.9% for 2006. StanCorp has carefully enhanced its employee benefits business by targeting the most profitable employer segments. It does this by selective underwriting while maintaining a broad, diversified book of business. Its diversification spans industry type, region, and customer size. Interest Rate Management Despite the sharp reduction in interest rates over the past few years, StanCorp has consistently maintained pricing margins. As a point of reference, a 25-bp change in the discount rate equates to $2 million pretax, or $0.05 per share after-tax, per quarter. Macro Indicators Are Headed in the Right Direction; Wage and Employment Growth Are Key Drivers Employment growth is an important indicator for premium growth. As companies expand and hire more workers, many of those new employees will become premiumpaying customers of StanCorp or some other group provider. According to the Bureau of Labor Statistics, nonfarm total employment is projected to improve by 21.6 million jobs, or 16.5%, over 2002–12. The Citigroup economic research team projects a baseline 1.5% annual employment increase going forward. Conservative Accounting Is a Plus We also use a target P/E multiple of 12.5x our 2006 EPS estimate of $7.35 and 11.3x our 2007 EPS estimate of $8.20 — a modest 2% premium to peer group target multiples. Historically, SFG has traded in line with the group, but we believe a slight premium is justified based on its above-average EPS and ROE gains despite interest rate headwinds. Our premium valuation is driven by its 14%– 15% ROE range, 200 bps above the industry average. Risks We rate StanCorp Low Risk. Management has successfully managed the risks of the business through its disciplined underwriting and pricing track record. We consider the following as risks to our 1L rating: I Statutory accounting is essentially “cash” accounting and is a good proxy for operating cash flow. StanCorp employs some of the most conservative accounting treatments to its GAAP financials in the entire industry. StanCorp reports a statutory book value that is consistently in the 75%–80% range of its GAAP level, demonstrating its conservative accounting and high quality of earnings. In other words, it runs expenses through the income statement faster than peers do. Solid Level of Excess Capital Low interest rates can strain earnings. A 25-bp change in the discount rate equates to $2 million pretax per quarter ($0.05 per share after-tax). StanCorp is overweight commercial mortgage loans. Commercial mortgage constituted 40% of total investments as of June 30, 2005. A full 33% of these loans are located in California. Sales and premium slowdowns can affect valuation. StanCorp’s forward premium growth rate is a strong indicator of P/E multiple direction. There is bid-rigging headline risk. Contingent commissions accounted for about 7% of total broker commissions on an annual basis. Also, no single broker represented more than 4% of sales in 2003. I I StanCorp currently has about $125 million of free capital on hand. Management’s priorities to utilize excess capital are, in order: 1) reinvest in the business; 2) acquisitions; and 3) share repurchases and dividends. We would regard StanCorp as having top-quartile capital flexibility, as it has a debt-to-capital ratio that is well below the typical 25% level for its peers, and the company will avoid the pending reserve increases expected for term life and universal life writers. Strong Management Team I If the impact on the company from any of these factors proves to be greater than we anticipate, the stock will likely have difficulty achieving our target price. Please note related comments published today on: FBL Financial Group “Initiating Coverage with a 2H Rating and $30 Price Target,” Protective Life “Reiterate 2L Rating — Multiple Expansion a Challenge,” and AmerUs Group “AMH: Reiterate Our 1M Rating and $60 Price Target.” — October 5, 2005 50 October 13, 2005 We regard StanCorp’s management team as top quartile. We have a high degree of confidence that Chairman and CEO Eric Parsons will deliver on his long-term ROE and EPS growth targets. CITIGROUP PORTFOLIO STRATEGIST See Appendix A-1 for Analyst Certification and Important Disclosures. Global Focus The Globaliser The Globaliser Bruce Rolph Views and Insights from Citigroup’s Analysts Around the World for October 3–10, 2005 On…a bounce in U.K. housing, India’s love of gold, our bull in global equities, the change in Asian markets, a cut for Argentina, the Spaniards are coming, a positive on European equities, Europe’s M&A targets, stretched in U.K. oils, downgrading BP, upside risk in iron ore, a good year for European steel, very bullish on sugar, awash in European paper, we like the U.S. building cycle, up go U.S. cement prices, Singapore 1/Northwest Airlines 0, Japan’s U.S. auto putsch, U.S. beer 1/U.S. spirits 0, the big vaccine conundrum for U.S. parents, the squeeze on Indian generics, plus the upside in Europe’s investment banks. Economics and Currencies the past two weeks, suggesting inflation fears are overdone…meanwhile, leading inflation indicators, despite having risen, are still not a threat…so, too much Fed tightening remains a threat, but leading indicators are still pointing to growth, the corporate bond spread is flat, and the yield curve is still positively sloped… what’s more, recent weakness appears to be the embodiment of distressed sentiment…consistent with our models saying, ‘be bold, be bullish’…with a preference for U.S. and European equities, followed by Japan and emerging markets.” Pullback Opportunity: Be Bold, Be Bullish — October 7 — Ajay Kapur “One of the first principles investors are taught is the importance of diversifying assets within a portfolio, and preferably into assets that are not closely correlated (having all your eggs in one basket is not a good idea unless you want to make an omelette)…it is noteworthy, therefore, that with correlations between Asian (excluding Japan) markets and developed markets having risen in recent years, Asia has become very simply a beta trade, not a diversification story…a trend driven by money flows and the internationalization of the stock indices…with the biggest changes coming from India and Korea…markets that used to walk to the beat of their own drum, but now they are part of an ensemble.” The Asia Investigator — Markets More Correlated than You Think — October 3 — Markus Rösgen “We view the recent three-day, 7.8% drop in Latin America as just another pullback in the three-year rally…a sell-off that has damaged sentiment and leads us to believe that the region has now seen its high for the year, but investors should not be overly pessimistic…especially since Latin America markets have not been in bubble territory…so what to do?…we cut Argentina to underweight, raise industrials in Brazil to overweight, and add to Mexican consumer names.” Latin America Strategy Notebook: Where’s the Bottom? — October 7 — Geoffrey Dennis “Spain has become the world’s fourth-largest foreign investor after ten years of strong investment… of which our universe coverage collectively accounts for €121 billion of investments abroad, or 25% of the Spanish market capitalization…with around 80% of that having so far been channeled into Latin America… although the U.S. and Europe are also fast becoming 51 October 13, 2005 “There are now signs that the [U.K.] housing market is past its worst, with gains in mortgage commitments, housing turnover, and (by some measures) prices…high population growth is also a positive for housing… nevertheless, a big house price surge seems unlikely because housing affordability is poor across all regions of the U.K. as a result of the last housing boom… leaving us to expect house prices to rise 4%–5% per year in 2006–07…a modest housing pickup that should not stop the MPC from cutting rates.” Sterling Weekly: Housing — Some Light, No Boom — October 7 — Michael Saunders “India’s love of gold and its expertise in diamond cutting and polishing have lent a remarkable sheen to the country’s gems and jewelry industry…with India accounting for 30% of the world’s demand for gold, and 11 out of every 12 diamonds used in jewelry worldwide being polished in India…a result of rising incomes, changing demographics, and the advent of the mall culture…a dazzling diamond and glittering gold industry that are providing India’s next leg up.” India Macroscope — India’s Dazzling Diamond and Glittering Gold Industry — The Next Leg Up — October 6 — Rohini Malkani Top-Down Analysis Strategy “There is no Newtonian law of gravity at work, which would suggest that markets that have gone up must come back down…and, just because they have gone up, we should not lose sight of fundamentals…of note, the Treasury Inflation Protection Securities (TIPS)/government bond markets spread has fallen in CITIGROUP PORTFOLIO STRATEGIST See Appendix A-1 for Analyst Certification and Important Disclosures. Global Focus growing key markets for Spanish companies…resulting in those companies emerging as international champions in their respective sectors…yet, in spite of this, Spanish companies remain historically underleveraged and undervalued…highlighting not only that the market has yet to fully value these profitable investments, but that continued expansion by Spanish corporations looks to be well supported, both organically and via future acquisitions.” Country Research — Spain: International Expansion — October 7 — Dario Vila and Jaime Gortazar Quantitative The Globaliser short-term, momentum-driven plays, such as Sell-rated Cairn Energy.” U.K. E&P Sector — Time to Focus on Stock Specifics — October 5 — Mark Bloomfield “The party is over (for now)…for BP’s third quarter trading statement has highlighted considerably larger hurricane effects than we expected in a number of areas…effects limited not just to the third quarter, but also likely to linger into the fourth quarter and beyond…also featured were higher costs and severely squeezed U.S. marketing margins, especially in September, as the sharp rise in refined product prices could not be passed on at the pump…still importantly, this represents the first earnings downgrade in the sector for some time…raising the prospect that earnings expectations may have gone too far…so in addition to slashing third quarter earnings by 21% and full year 2005 by 4%, we are downgrading BP to Hold from Buy.” BP — The Party Is Over (for Now) — October 5 — Jonathan Wright Materials “We are optimistic on the outlook for the corporate sector as we move into the third quarter reporting season…consistent with the outlook of our earnings surprise model…where, of the 204 companies in the S&P/Citigroup European Broad Market Index that are expected to report, 139 are expected to beat expectations versus only 33 that are expected to fall short…with Energy, Banks, Pharma, and Technology likely to come out stronger…while, by stock, large-cap positive surprise candidates include: ASML, Akzo Nobel, Nokia, GlaxoSmithKline, and Telenor.” Earnings Surprise Forecast Monitor — Positive on Tech and Energy — October 5 — The European Quantitative Research Team “Riding the M&A wave has been the most important theme this year…a year in which European equities have delivered a staggering 21.5% year-to-date return, including another 4.5% in September…moreover, the year-to-date market relative return of our basket of takeover candidates is 5.1%, with alpha in the third quarter reaching 3.2%…leading us to update our list of stocks with the highest takeover likelihood as determined by our multifactor quantitative model…a list that includes Brambles, International Power, Lonmin, Pilkington, Stanley Leisure, and HMV.” What Works in Equity Markets — Ride the M&A Wave — October 4 — The European Quant Team Global Sector “Risks to our iron ore price forecast appear to be on the upside based on our recent trip to Brazil…where, versus current Citigroup forecasts for flat prices in 2006, some Brazilian steel producers are guiding toward iron ore price increases of 10%–20%…boding well for CVRD’s share price momentum…positive noise that we expect will overshadow our near-term concerns surrounding currency and higher input costs… accordingly, we are lifting our target price for Buy-rated CVRD by 32%, to US$50.” Companhia Vale do Rio Doce — Raising Target Price: Stay with Shares Through Price Negotiations — October 4 — Jennifer Corrou “We expect 2006 to be a good year for European steel prices, driven by strengthening U.S. and European demand and supportive supply-side dynamics… conditions that even China should not threaten…rather, not only should China maintain its position as a net importer of finished steels, due to unattractive price differentials between that country and the U.S., but we believe any steel produced in China will stay there… against which, we see hot rolled coil European export prices lifting from current US$385 per tonne levels to an average of US$465 per tonne next year, well above the long-term average steel price of US$312 per tonne (in 1997–2004), but lower than 2005…yet, while this implies a fall from peak earnings due to better earnings clarity (underpinned by strong macros, continued price discipline in Europe, corporate restructuring, and cost reductions), we are initiating coverage of the European steel sector with a bullish outlook…and Buy ratings for Arcelor, Corus, and ThyssenKrupp.” Value on a Steel 52 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Energy “Against spot oil prices climbing from US$38 per barrel to more than US$60 per barrel, the sector has risen by 80% year to date, with little discrimination among the stocks…another ‘dot com bubble’?…we wouldn’t go that far yet…although a mixed message is starting to emerge when comparing near- and longerterm valuation metrics…still, we continue to see upside in the sector…albeit preferring strong stock-specific stories that offer support on the downside…or Buyinitiated Tullow Oil and Paladin Resources…rather than CITIGROUP PORTFOLIO STRATEGIST Global Focus Platter — Initiating on Arcelor, ThyssenKrupp, and Corus — October 4 — Thomas Wrigglesworth “Four factors are set to drive up the sugar price long term: 1) rising production costs in Brazil; 2) demand for alternative fuel, such as ethanol, leading increasing volumes of cane to be diverted away from sugar; 3) changes to the European Union (EU) Common Agricultural Policy possibly resulting in 25% of EU sugar exiting the market; and 4) India and China shifting from net exporters to net importers…as a result of these structural factors, sugar stockpiles as a percentage of consumption are likely to be permanently diminished (taking trading prices up)…our top picks in Asia are India’s Bajaj Hindusthan and Balrampur Chini…while, in the U.S., our top picks are Archer Daniels and Corn Products.” Global Sugar — Structural Changes Offer a Sweet Deal — October 6 — The Global Agricultural Commodities Team “There’s an explosion of new capacity on the news that Myllykoski has placed an order for a new, supercalendered (SC) paper machine (to be built in the Czech Republic)…this machine would correspond to 135% of the current annual Western European SC paper exports to Eastern Europe…added to the new machines scheduled for start up by Stora Enso and UPM…for net additions amounting to a staggering 15%…alarming, disappointing…European paper continues to demonstrate a complete lack of discipline.” European Capacity Update — SC Paper — An Explosion of New Capacity — October 5 — Thomas Brodin Industrials “Apart from minor concerns about possible housing cyclicality, our U.S. road trip, covering companies with activities in distribution, cement, homebuilding, plasterboard, aggregates, and concrete, confirmed that the U.S. market appears to be in fine shape…of note, pricing in heavy construction products not only continues to look strong, but it appears set for further healthy increases…of around 10% (from January) for cement, 4%–6% for aggregates, and 4%–6% for concrete products…interestingly, even plasterboard prices, which are seen as nearing a top by some commentators, look robust, with further strong rises expected in the next year…elsewhere, the market for renovation is expected to grow sharply in the next five to ten years, due partly to the larger housing pool, more expensive new houses, and an aging housing stock, which are all positive for distribution and plasterboard suppliers…nonetheless, we are not changing any forecasts…but we do feel more positively about the stocks with high U.S. exposure: Wolseley, Hanson, CRH, Titan, Taylor Woodrow, Wimpey, BPB, and CITIGROUP PORTFOLIO STRATEGIST The Globaliser Lafarge.” Building & Construction — U.S. Road Trip — Activity Looks Good in the Land of the Free — October 10 — The European Building & Construction Team “U.S. cement prices have continued their climb, rising 0.7% month over month in August, and marking the fifth consecutive month in which wholesale U.S. cement prices have increased…with the mid-August price action occurring even before the U.S. government breaks ground on any Katrina-related reconstruction… so U.S. cement prices should continue to rise as the U.S. cement shortage worsens.” Cement Pricing Survey — Prices Remain Strong Across All Regions — October 4 — Stephen Trent “Since the recent Chapter 11 filings by Northwest and Delta, Singapore Technologies (ST) Engineering’s aerospace division has seen outsourcing jobs from Northwest increase…a trend we expect to continue throughout the U.S. airline industry…in its bid to cut costs against intensifying competition from emerging and/or expanding low-cost carriers…supported by this, a strong balance sheet, attractive dividends, high ROEs, and prudent management, ST Engineering is rated Buy and is a constituent of our Singapore model portfolio.” ST Engineering — Third Quarter 2005 in Line; Watch for More Outsourcing — October 7 — Kevin Chong Consumer Discretionary “There was no Indian summer for U.S. auto sales in September, as they slipped 7.6%…reflecting the ill effects of Hurricane Katrina, lessening incentive activity, and a July/August hangover…meanwhile, surging pump prices (peaking above US$3 per gallon), took their toll on light truck sales, which were down 17.8% as customers switched to more fuel-efficient passenger cars (with those sales up 6.3%)…Ford and General Motors, the main victims of this trend, both suffered 20% sales declines at the hands of approximate 30% falls in light truck registrations…which were exacerbated by a sharp pullback from the summer’s heavy incentive activity…to the benefit of the Asian makers, with aggregate Asian brand sales increasing 10.4%, led by Japan’s Toyota, Honda, and Nissan (all posting double-digit increases)…and Korea’s Hyundai trailing not far behind.” Auto Manufacturers — September U.S. Auto Sales Down 7.6% — October 4 — John Lawson Consumer Staples “The discount-led sales drive by the U.S. beer industry appears have skewed consumer demand away from spirits, based on the latest AC Nielsen data for U.S. spirits for the four weeks ended September 24, 53 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Global Focus 2005…highlighting a slowdown in industry sales growth on much-reduced volume growth of 2.1%, which is not only the lowest spirits industry growth in 2005, but also coincides with a sharp rise in beer industry volumes…nevertheless, given that the beer industry’s discount-driven volume growth is likely unsustainable and that the spirits industry has improved its competitive positioning through more than a decade of increased investment in media spending, this is unlikely to unwind quickly…hence, we believe the medium-term competitive outlook for U.S. spirits remains positive.” U.S. Spirits: Competition from Beer Slows Volume Growth — October 10 — Philip Morrisey Health Care “With Merck’s human papilloma virus (HPV) vaccine scoring 100% efficacy in preventing cervical cancer, the game is on…the vaccine will now be submitted to the U.S. Food and Drug Administration (FDA) for an expected fiscal 2007 (ending September) launch…however, there is conjecture about Middle America’s reaction to vaccinating its teenage daughters against a sexually transmitted disease (the vaccine’s key market is girls starting at age 10, and one study showed that 24% of parents surveyed believed the vaccination would spur children onto sexual activity faster)…and reaching the target market could also be hindered by the Bush administration’s preference for teaching abstinence…as a result, the HPV royalties from Merck that we have already incorporated into our estimates for Australia’s Buy-rated CSL are, in our view, conservative and sensible.” CSL Ltd. — HPV Vaccine Scores 100% for Prevention — Game On! — October 7 — Andrew Goodsall Financials The Globaliser “With U.S. firms reporting their best-ever earnings and European investment bank share prices closing much of the gap between current prices and our targets, investment banks have done well globally in the past few weeks…which, combined with recent market share wobbles, is causing investors to ask whether to sell the European investment banks…but there is more to go given still-cheap valuations (P/Es of 9x–12x versus historical norms of 12x–15x), M&A being on a multiyear uptrend, equity volumes increasing, and fixed income being resilient…so we raise our target prices on Buy-rated UBS (to Sfr133 from SFr120) and Deutsche Bank (to €90 from €80), and Hold-rated Credit Suisse (to SFr60 from SFr54).” Investment Banking Update — October 7 — Jeremy Sigee Companies mentioned in this article: Akzo Nobel N.V. (AKZO.AS€36.84; 1M), Arcelor S.A. (CELR.PA-€19.57; 1M), Archer Daniels Midland Co. (ADM-US$23.88; 1H), ASML Holding N.V. (ASML.AS€13.72; 2H), Bajaj Hindusthan Ltd. (BJHN.BO-Rs215.20; 1M), Balrampur Chini Mills Ltd. (BACH.BO-Rs87.90; 1H), BP p.l.c. (BP.L-£6.22; 2L), BPB plc (BPB.L-£7.37; 2M), Brambles Industries DLC Group (BIL.AX-A$8.57; 1M), Cairn Energy plc (CNE.L£18.46; 3H), Cipla Ltd. (CIPL.BP-Rs393.40; 3L), Companhia Vale do Rio Doce (RIO_p.N-US$36.32; 1M), Corn Products International, Inc. (CPO-US$19.93; 1M), Corus Group Plc (CS.L£0.50; 1H), Credit Suisse Group (CSGN.VX-SFr57.15; 2H), CRH plc (CRH.L-€22.51; 1L), CSL Ltd. (CSL.AX-A$39.40; 1M), Deutsche Bank AG (DBKGn.DE-€77.98; 1M), Dr. Reddy's Laboratories Ltd. (REDY.BO-Rs968.10; 1L), Ford Motor Co. (FUS$8.93; 2H), General Motors Corp. (GM-US$25.48; 3H), GlaxoSmithKline plc (GSK.L-£14.65; 1L), Hanson PLC (HNS.L£5.77; 2M), HMV Group plc (HMV.L-£1.91; 2M), Honda Motor Co., Ltd. (7267-¥6,520; 1M), Hyundai Motor Co. (005380.KSKRW78,900; 1M), International Power plc (IPR.L-£2.39; 1M), Lafarge S.A. (LAFP.PA-€72.30; 1M), Lonmin Plc (LMI.L-£12.60; 1M), Matrix Laboratories Ltd. (MAXL.BO-Rs183.95; 1M), Merck & Co., Inc. (MRK-US$26.90; 2M), Nissan Motor Co., Ltd. (7201¥1,275; 2H), Nokia Corp. (NOK1V.HE-€13.86; 1H), Paladin Resources plc (PLR.L-£2.87; 1M), Pilkington plc (PILK.L-£1.30; 3M), Ranbaxy Laboratories Ltd. (RANB.BO-Rs510.10; 3M), Singapore Technologies (ST) Engineering Ltd. (STEG.SI-S$2.53; 1L), Stanley Leisure PLC (SLY.L-£6.57; 2M), Stora Enso Oyj (STERV.HE-€11.21; 1M), Taylor Woodrow plc (TWOD.L-£3.15; 2M), Telenor ASA (TEL.OL-NKr56.75; 1M), ThyssenKrupp AG (TKAG.DE-€17.66; 1M), Titan Cement Co. S.A. (TTNr.AT-€28.32; 1M), Toyota Motor Corp. (7203-¥5,100; 1M), Tullow Oil plc (TLW.L-£2.32; 1H), UBS AG (UBSN. VX-SFr111.70; 1M), UPMKymmene Corp. (UPM1V.HE-€16.55; 2M), Wimpey Plc (George) (WMPY.L-£4.21; 1M), Wockardt Ltd. (WCKH.BO-Rs492.00; 1L), Wolseley plc (WOS.L-£11.74; 1L) “Generics are continuing to be squeezed from all sides, resulting in severe pricing pressure that has significantly eroded generic industry profitability… global challenges that not only are likely to get worse, but do not augur well for Indian pharma…for sure, the recent unfolding of cross-border acquisitions should help…however, this is occurring at a time when lowprice ‘warriors’ are just about starting to scale up their businesses…accordingly, we believe the key to surviving the downturn and delivering sustained growth remains differentiated business models built around niche opportunities…as reflected in our key contrary Sell ratings on Ranbaxy and Cipla…and our key Buy ratings on Dr. Reddy’s Laboratories, Wockhardt, and Matrix.” Indian Pharmaceuticals — Searching for Relief as Headaches Persist — October 10 — Madhusudan Bagree and Prashant Nair CITIGROUP PORTFOLIO STRATEGIST 54 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Index of Companies Index of Companies Activision, Inc. ........................................34 Acuity Brands, Inc. .................................33 Akzo Nobel N.V.......................................53 Amerada Hess Corp................................40 Apple Computer, Inc................................47 Arcelor S.A. ............................................53 Archer Daniels Midland Co. ....................54 ASML Holding N.V. .................................53 Bajaj Hindusthan Ltd. .............................54 Balrampur Chini Mills Ltd. ......................54 Bank of New York Co., Inc. (The) ............30 BP p.l.c. .................................................53 BPB plc ..................................................54 Brambles Industries DLC Group ..............53 Bristol-Myers Squibb Co...........................6 Brookfield Homes Corp...........................39 Cairn Energy plc.....................................53 Chevron Corp. ........................................41 CIGNA Corp. .............................................5 Cipla Ltd.................................................55 Companhia Vale do Rio Doce..................53 ConAgra Foods, Inc. ...............................44 Cooper Industries, Ltd. ...........................32 Corn Products Int’l, Inc. ..........................54 Corus Group Plc .....................................53 Coventry Health Care, Inc. ........................5 Credit Suisse Group................................55 CRH plc..................................................54 CSL Ltd. .................................................55 Danaher Corp.........................................32 Dell Inc. ..................................................47 Delta Air Lines, Inc. ................................54 Deutsche Bank AG..................................55 Dr. Reddy’s Laboratories Ltd. .................55 Electronic Arts Inc. .................................34 Exxon Mobil Corp. ..................................40 Fairchild Semiconductor Int’l Inc.............49 Ford Motor Co. .......................................54 GameStop Corp. .....................................34 General Electric Co. ............................... 32 General Mills, Inc. .................................. 45 General Motors Corp. ............................. 54 GlaxoSmithKline plc ............................... 53 Gruner + Jahr AG & Co. ......................... 42 Hanson PLC ........................................... 54 Harley-Davidson, Inc............................... 36 HCC Insurance Holdings, Inc. ................. 22 Health Net, Inc. ........................................ 5 Hewlett-Packard Co................................ 46 HMV Group plc....................................... 53 Honda Motor Co., Ltd. ............................ 54 Hovnanian Enterprises, Inc..................... 39 Hubbell Inc. ........................................... 32 Hyundai Motor Co. ................................. 54 International Business Machines Corp.... 46 International Power plc .......................... 53 Intersil Corp. .......................................... 49 JPMorgan Chase & Co. .......................... 30 Lafarge S.A............................................ 54 Lexmark Int’l Inc. ..................................... 7 Lonmin Plc............................................. 53 M.D.C. Holdings, Inc. ............................. 39 Marathon Oil Corp.................................. 40 Matrix Laboratories Ltd. ......................... 55 Max Re Capital Ltd................................. 22 Medco Health Solutions, Inc..................... 4 Mellon Financial Corp. ........................... 30 Merck & Co., Inc. ............................... 6, 55 Meredith Corp........................................ 42 Microsoft Corp........................................ 47 M-Systems Flash Disk Pioneers Ltd. ...... 48 Myllykoski Oyj........................................ 54 National Semiconductor Corp................. 49 Nintendo Co. Ltd..................................... 47 Nissan Motor Co., Ltd. ........................... 54 Nokia Corp............................................. 53 Northern Trust Corp. .............................. 31 Northwest Airlines Corp. ........................ 54 PacifiCare Health Systems, Inc. ................4 Paladin Resources plc ............................53 PartnerRe Ltd. ........................................22 PepsiCo, Inc. ..........................................45 Pfizer Inc. .................................................6 Pilkington plc .........................................53 Procter & Gamble Co., (The) .....................7 Ranbaxy Laboratories Ltd. ......................55 Rockwell Automation, Inc. ......................32 SanDisk Corp. ........................................48 SAP AG...................................................44 Schering-Plough Corp. .............................6 Sony Corp...............................................47 ST Engineering Ltd. ................................54 StanCorp Financial Group, Inc.................50 Stanley Leisure PLC................................53 State Street Corp....................................30 Stora Enso Oyj........................................54 Sun Microsystems, Inc. ...........................46 Take-Two Interactive Software, Inc. .......35 Taylor Woodrow plc................................54 Telenor ASA ...........................................53 The Washington Post Company ..............42 ThyssenKrupp AG ...................................53 Titan Cement Co. S.A. ............................54 Toll Brothers, Inc. ...................................38 Toyota Motor Corp..................................54 Tropicana Products, Inc..........................45 Tullow Oil plc .........................................53 UBS AG ..................................................55 UnitedHealth Group Inc.............................4 Unum Provident Corp..............................22 UPM-Kymmene Corp. .............................54 WellPoint, Inc. ..........................................5 West Coast Choppers, Inc........................37 Wimpey Plc (George) ..............................54 Wockhardt Ltd........................................55 Wolseley plc ...........................................54 Wyeth.......................................................6 CITIGROUP PORTFOLIO STRATEGIST 55 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Appendix A-1 Analyst Certifications: For each company mentioned in this compendium report, the respective analyst (or analysts) who cover the company (companies) certifies that all of the views expressed in this research report accurately reflect the analyst's (or analysts') personal views about any and all of the subject issuer(s) or securities. The analyst (or analysts) also certify that no part of the analyst's compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. IMPORTANT DISCLOSURES Analysts' compensation is determined based upon activities and services intended to benefit the investor clients of Citigroup Global Markets Inc. and its affiliates ("the Firm"). Like all Firm employees, analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the Private Client Division, Institutional Equities, and Investment Banking. For important disclosures regarding the companies that are the subject of this research report, please contact Citigroup Investment Research, 388 Greenwich Street, 29th Floor, New York, NY, 10013, Attention: Production Administration. In addition, the same important disclosures, with the exception of the Valuation and Risk assessments, are contained on the Firm's disclosure website at www.citigroupgeo.com. Private Client Division clients should refer to www.smithbarney.com/research. Citigroup Investment Research Ratings Distribution Data current as of 30 September 2005 Buy Hold Sell Citigroup Investment Research Global Fundamental Coverage (2650) 41% 42% 18% % of companies in each rating category that are investment banking clients 48% 47% 32% Citigroup Investment Research Quantitative World Radar Screen Model Coverage (5582) 30% 40% 30% % of companies in each rating category that are investment banking clients 33% 27% 25% Citigroup Investment Research Quantitative Decision Tree Model Coverage (356) 45% 0% 55% % of companies in each rating category that are investment banking clients 43% 0% 36% Citigroup Investment Research Quantitative European Value & Momentum Screen (582) 30% 40% 30% % of companies in each rating category that are investment banking clients 42% 30% 35% Citigroup Investment Research Asia Quantitative Radar Screen Model Coverage (1102) 20% 60% 20% % of companies in each rating category that are investment banking clients 12% 19% 19% Citigroup Investment Research Quant Emerging Markets Radar Screen Model Coverage (1098) 20% 60% 20% % of companies in each rating category that are investment banking clients 14% 22% 21% Citigroup Investment Research Australia Quantitative Top 100 Model Coverage (96) 30% 40% 30% % of companies in each rating category that are investment banking clients 41% 34% 31% Citigroup Investment Research Australia Quantitative Bottom 200 Model Coverage (156) 30% 40% 30% % of companies in each rating category that are investment banking clients 4% 6% 2% Citigroup Investment Research Australia Quantitative Scoring Stocks Model Coverage (10) 50% 0% 50% % of companies in each rating category that are investment banking clients 0% 0% 40% Guide to Fundamental Research Investment Ratings: Citigroup Investment Research's stock recommendations include a risk rating and an investment rating. Risk ratings, which take into account both price volatility and fundamental criteria, are: Low (L), Medium (M), High (H), and Speculative (S). Investment ratings are a function of Citigroup Investment Research's expectation of total return (forecast price appreciation and dividend yield within the next 12 months) and risk rating. For securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), investment ratings are: Buy (1) (expected total return of 10% or more for Low-Risk stocks, 15% or more for Medium-Risk stocks, 20% or more for High-Risk stocks, and 35% or more for Speculative stocks); Hold (2) (0%-10% for Low-Risk stocks, 0%-15% for Medium-Risk stocks, 0%-20% for High-Risk stocks, and 0%-35% for Speculative stocks); and Sell (3) (negative total return). For securities in emerging markets (Asia Pacific, Emerging Europe/Middle East/Africa, and Latin America), investment ratings are: Buy (1) (expected total return of 15% or more for Low-Risk stocks, 20% or more for Medium-Risk stocks, 30% or more for High-Risk stocks, and 40% or more for Speculative stocks); Hold (2) (5%-15% for Low-Risk stocks, 10%-20% for Medium-Risk stocks, 15%-30% for High-Risk stocks, and 20%-40% for Speculative stocks); and Sell (3) (5% or less for Low-Risk stocks, 10% or less for Medium-Risk stocks, 15% or less for High-Risk stocks, and 20% or less for Speculative stocks). Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in risk rating, or a change in target price. At other times, the expected total returns may fall outside of these ranges because of price movement and/or volatility. Such interim deviations from specified ranges will be permitted but will become subject to review by Research Management. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock's expected performance and risk. CITIGROUP PORTFOLIO STRATEGIST 56 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Appendix A-1 Guide to Quantitative Research Investment Ratings: Citigroup Investment Research Quantitative Research World Radar Screen recommendations are based on a globally consistent framework to measure relative value and momentum for a large number of stocks across global developed and emerging markets. Relative value and momentum rankings are equally weighted to produce a global attractiveness score for each stock. The scores are then ranked and put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citigroup Investment Research Quantitative Decision Tree model recommendations are based on a predetermined set of factors to rate the relative attractiveness of stocks. These factors are detailed in the text of the report. Each month, the Decision Tree model forecasts whether stocks are attractive or unattractive relative to other stocks in the same sector (based on the Russell 1000 sector classifications). Citigroup Investment Research Quantitative European Value & Momentum Screen recommendations are based on a European consistent framework to measure relative value and momentum for a large number of stocks across the European Market. Relative value and momentum rankings are equally weighted to produce a European attractiveness score for each stock. The scores are then ranked and put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citigroup Investment Research Asia Quantitative Radar Screen and Emerging Markets Radar Screen model recommendations are based on a regionally consistent framework to measure relative value and momentum for a large number of stocks across regional developed and emerging markets. Relative value and momentum rankings are equally weighted to produce a global attractiveness score for each stock. The scores are then ranked and put into quintiles. A stock with a quintile rating of 1 denotes an attractiveness score in the top 20% of the universe (most attractive). A stock with a quintile rating of 5 denotes an attractiveness score in the bottom 20% of the universe (least attractive). Citigroup Investment Research Quantitative Australian Stock Selection Screen rankings are based on a consistent framework to measure relative value and earnings momentum for a large number of stocks across the Australian market. Relative value and earnings momentum rankings are weighted to produce a rank within a relevant universe for each stock. The rankings are then put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citigroup Investment Research Quantitative Research Australian Scoring Stocks model recommendations are based on a predetermined set of factors to rate the relative attractiveness of stocks. These factors are detailed in the text of the report. Each month, the Australian Scoring Stocks model calculates whether stocks are attractive or unattractive relative to other stocks in the same universe(the S&P/ASX 100) and records the 5 most attractive buys and 5 most attractive sells on the basis of the criteria described in the report. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citigroup Investment Research Quantitative World Radar Screen and European Value & Momentum Screen recommendation of (1), (2) or (3) most closely corresponds to a buy recommendation; a recommendation from this product group of (4), (5), (6) or (7) most closely corresponds to a hold recommendation; and a recommendation of (8), (9) or (10) most closely corresponds to a sell recommendation. For purposes of NASD/NYSE ratings distribution disclosure rules, a Citigroup Investment Research Asia Quantitative Radar Screen or Quantitative Emerging Markets Radar Screen recommendation of (1) most closely corresponds to a buy recommendation; a Citigroup Investment Research Asia Quantitative Radar Screen or Quantitative Emerging Markets Radar Screen recommendation of (2), (3), (4) most closely corresponds to a hold recommendation; and a recommendation of (5) most closely corresponds to a sell recommendation. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citigroup Investment Research Quantitative Research Decision Tree model recommendation of "attractive" most closely corresponds to a buy recommendation. All other stocks in the sector are considered to be "unattractive" which most closely corresponds to a sell recommendation. Recommendations are based on the relative attractiveness of a stock, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected relative performance. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citigroup Investment Research Quantitative Australian Stock Selection Screen model ranking in the top third of the universe most closely corresponds, subject to market conditions, to a buy recommendation. A ranking in the bottom third of the universe, subject to market conditions, most closely corresponds to a sell recommendation. All other stocks in the universe correspond to a hold recommendation. However, because Citigroup Investment Research Quantitative Australian Stock Selection Screen model rankings are based on the relative attractiveness of a stock as compared to other stocks in the same universe, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected absolute performance. For purposes of NASD/NYSE ratings-distribution-disclosure rules, membership of the Citigroup Investment Research Quantitative Australian Scoring Stocks Model buy portfolio most closely corresponds to a buy recommendation; membership of the Citigroup Investment Research Quantitative Australian Scoring Stocks Model sell portfolio most closely corresponds to a sell recommendation. However, because Citigroup Investment Research Quantitative Australian Scoring Stocks Model recommendations are based on the relative attractiveness of a stock, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected absolute performance. OTHER DISCLOSURES For securities recommended in this report in which the Firm is not a market maker, the Firm is a liquidity provider in the issuers' financial instruments and may act as principal in connection with such transactions. The Firm is a regular issuer of traded financial instruments linked to securities that may have been recommended in this report. The Firm regularly trades in the securities of the subject company(ies) discussed in this report. The Firm may engage in securities transactions in a manner inconsistent with this research report and, with respect to securities covered by this report, will buy or sell from customers on a principal basis. Securities recommended, offered, or sold by the Firm: (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. 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CITIGROUP PORTFOLIO STRATEGIST 58 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. Appendix A-1 © 2005 Citigroup Global Markets Inc. Citigroup Investment Research is a division and service mark of Citigroup Global Markets Inc. and its affiliates and is used and registered throughout the world. Citigroup and the Umbrella Device are trademarks and service marks of Citicorp or its affiliates and are used and registered throughout the world. Nikko is a registered trademark of Nikko Cordial Corporation. All rights reserved. Any unauthorized use, duplication, redistribution or disclosure is prohibited by law and will result in prosecution. The Firm accepts no liability whatsoever for the actions of third parties. 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CITIGROUP PORTFOLIO STRATEGIST 59 October 13, 2005 See Appendix A-1 for Analyst Certification and Important Disclosures. U.S. Equity Research Department Matthew Carpenter — Director of U.S. Equity Research matthew.carpenter@citigroup.com 212-816-2622 MACRO Chief Investment Officer Edward M. Kerschner, CFA .................212-816-3532 Chief U.S. Equity Strategist Tobias M. Levkovich...........................212-816-1623 Chief Global Equity Strategist Ajay Kapur, CFA..................................212-816-4813 Quantitative Research Keith L. Miller .....................................212-816-2285 Deep C. Kapur, PhD............................65-6432-1152 Jonathan Barden ................................212-816-6033 Daniel E. Cox ......................................212-816-5545 John G. Rowe.....................................212-816-6054 ADR Research Kathleen Boyle, CFA ...........................212-816-3702 Closed-End Funds—U.S. Dennis P. Emanuel .............................212-816-3356 Frank Sileo, CFA .................................212-816-5041 Kathy A. Jones ...................................212-816-6008 Economic & Market Analysis Steven Wieting ...................................212-816-7148 Valuation and Accounting Phillip H. Gainey IV, CFA .....................212-816-6485 U.S. EQUITY RESEARCH Basic Materials, Energy, Electrical Equipment, Health Care, Transportation, Multi-Industry, and REITs Peter Mangano — Deputy Director 212-816-1642 Aerospace & Defense George D. Shapiro ..........................212-816-3421 Ferat Ongoren ................................212-816-6551 Airfreight & Surface Transportation Scott Flower ..................................212-816-5667 Auto Parts & Equipment Jon V. Rogers ................................212-816-5274 Biotechnology Elise Wang .....................................212-816-8834 Yaron Werber, MD..........................212-816-8836 Building & Housing–Related Industries Stephen S. Kim ..............................212-816-1666 Business Services & Staffing Leone T. Young ..............................212-816-1627 Chemicals P. J. Juvekar ..................................212-816-3097 Drugs George Grofik, CFA, CPA.................212-816-1820 Electric Utilities Greg Gordon, CFA...........................212-816-2802 Brian Chin, CPA..............................212-816-2861 Health Care Policy Paul Heldman ................................202-879-6809 Health Care Services Oksanna Butler ..............................212-816-8309 Matthew J. Ripperger.....................212-816-0975 Integrated Natural Gas & Gas Utilities Faisel Khan, CFA ............................212-816-2825 Integrated Oils Doug Leggate.................................212-816-3258 Managed Care Charles Boorady ............................ 212-816-7539 Master Limited Partnerships John K. Tysseland ......................... 212-816-1442 Medical Supplies & Technology Peter J. Bye ................................... 212-816-5781 Matthew J. Dodds.......................... 212-816-6928 Mining & Precious Metals John H. Hill, CFA............................ 415-951-1714 Multi-Industry/Electrical Equipment Jeffrey T. Sprague, CFA ................. 203-975-5051 David B. Smith, CA, CFA ................ 212-816-2654 Oil—Exploration & Production Gil Yang......................................... 212-816-5803 Oilfield Equipment & Services Geoff Kieburtz................................ 212-816-3139 Paper & Forest Products/Containers & Pkg. Chip Dillon, CFA............................. 212-816-2793 Real Estate Investment Trusts Jonathan Litt ................................. 212-816-0231 Michael Bilerman........................... 212-816-1383 Jordan Sadler................................. 212-816-0438 John J. Stewart, CFA...................... 212-816-1685 Shipping John Kartsonas.............................. 212-816-6134 Specialty Pharmaceuticals Andrew Swanson........................... 212-816-1635 SMALL & MID-CAP RESEARCH Small & Mid-Cap Strategist Albert D. Richards, PhD ..................... 415-951-1809 Banks Michael Diana ......................................... 212-816-1720 Biotechnology Yaron Werber, MD ................................... 212-816-8836 Electronic Payments & Information Services Tony Wible, CFA ...................................... 212-816-3732 Food Distribution/Natural Products Gregory R. Badishkanian ......................... 212-816-2720 Health Care Services Matthew J. Ripperger .............................. 212-816-0975 Insurance—Non-Life Joshua D. Shanker .................................. 212-816-2973 Medical Supplies & Technology Peter J. Bye............................................. 212-816-5781 Multi-Industry/Electrical Equipment David B. Smith, CA, CFA .......................... 212-816-2654 Software Christopher R. DeBiase............................ 415-951-1869 Mark Verbeck.......................................... 415-951-1839 Consumer, Financials, Media, Technology, Telecommunications, and Industrials Jonathan Rosenzweig — Deputy Director 212-816-3284 Banks Ruchi Madan............................... 212-816-1946 Keith Horowitz, CFA..................... 212-816-3033 Beverages/Tobacco Bonnie Herzog............................. 212-816-3306 Michael Diana ............................. 212-816-1720 Broadcasting Eileen Furukawa ......................... 212-816-2276 Brokers & Asset Managers Ruchi Madan............................... 212-816-1946 Prashant A. Bhatia, CFA .............. 212-816-1815 Building & Housing–Related Industries Stephen S. Kim ........................... 212-816-1666 Cable Jason B. Bazinet ......................... 212-816-6395 Computer Services and IT Consulting Patrick M. Burton, CFA ................ 212-816-3469 Ashwin Shirvaikar, CFA ............... 212-816-0822 Cosmetics/Household Products Wendy C. Nicholson .................... 212-816-8216 Data Storage Infrastructure Paul Mansky ............................... 415-951-1668 Electronic Payments & Information Services Tony Wible, CFA.......................... 212-816-3732 Electronics Manufacturing Services David Pescherine, CFA ................ 415-951-1680 Entertainment/Leisure Time Elizabeth Osur, CFA..................... 212-816-2823 Environmental Svcs., Engineering/Construction Leone T. Young ........................... 212-816-1627 Food Distribution/Natural Products Gregory R. Badishkanian ............. 212-816-2720 Food Manufacturers David Driscoll, CFA...................... 212-816-0440 Gaming Michael J. Rietbrock ................... 212-816-7777 Geoffrey Davis, CFA .................... 212-816-4930 Insurance—Life Colin W. Devine, CFA, CMA 212-816-1682 Insurance—Non-Life Ronald W. Frank, CFA ...................... 212-816-1681 Joshua D. Shanker .......................... 212-816-2973 Imaging & Visual Media Matthew Troy .................................. 212-816-9051 Internet Mark S. Mahaney ............................ 415-951-1744 Lodging Michael J. Rietbrock ........................ 212-816-7777 PC Hardware/Server & Enterprise Hardware Richard Gardner .............................. 415-951-1669 Publishing & Advertising William G. Bird, CFA......................... 212-816-6698 Retailing—Broadlines Deborah L. Weinswig, CFA............... 212-816-1860 Retailing—Hardlines Bill Sims .......................................... 212-816-1513 Retailing—Softlines Kimberly Greenberger, CFA.............. 212-816-6409 Semiconductors Glen S.P. Yeung............................... 415-951-1885 Semiconductor Equipment Timothy M. Arcuri ............................ 415-951-1734 Semiconductors—Specialty Craig A. Ellis .................................... 415-951-1887 Software Tom Berquist................................... 415-951-1766 Mark Verbeck .................................. 415-951-1839 Christopher R. DeBiase .................... 415-951-1869 Specialty/Mortgage Finance Donald Fandetti, CFA ....................... 212-816-2971 Telecommunications—Wireless Services Michael I. Rollins, CFA ..................... 212-816-1116 Telecommunications—Wireline Services Michael I. Rollins, CFA ..................... 212-816-1116 Telecommunications—Equipment B. Alexander Henderson ................. 212-816-4651 Daryl Armstrong ............................. 212-816-1952 Editorial Staff, Portfolio Strategist Pamela Nelson, CFA, Managing Editor Editorial Team Kathryn Paulsen Gill, Editorial Manager Susan Basas Alexandra Braine Linda Good David Heires Ben Sagel Andrew Simpson Production Team Bob McKenna, Production Manager Sarah Kane Christopher Mascaro Felix Santiago ASSOCIATE DIRECTORS Michael Artura.....................................................................................................................415-951-1651 Kathleen Boyle ....................................................................................................................212-816-3702 Maura Byrne........................................................................................................................212-816-4954