Stockscom Report for Sunday Feb 24, 2002

Publisher: Colin Alexander     Editor: Ken Wilson (450-691-4617)

Subscriptions and Administration: Pierre Fichaud (toll-free: 866-487-9711)

Market Synopsis

Despite the release of economic data showing signs of a recovery in the economy, investors continue to flee the stock markets and especially the tech sector. Nasdaq has now fallen over 6% since the latest rollover began on Feb 14. Ironically some of the big names alleged to have questionable accounting practices are not even traded on the Nasdaq; companies such as Enron, Qwest, J P Morgan, IBM and this week’s special, Computer Associates, which although it steadfastly denied any hint of impropriety with regards to accounting, did admit that the SEC began probing their company affairs for undisclosed reasons.

In the case of the Dow and S&P, the falls were much less dramatic with drops amounting to 0.3% for the former and 2.3% for the latter. This bifurcation of the markets is most likely due to the higher premium that’s been placed on tech issues and the slowdown, which has affected this part of the economy to a greater extent than any other sector.

While much of the evidence is anecdotal, including this week’s rise in the Leading Indicators, there are indications that the economy is recovering to a degree from the enormous drop it suffered in 2001. The latest figures from the ISM (purchasing managers) have shown growth for the first time in several months in the number of orders and we see confirmation of this from the likes of Agilent Technologies which reported this week that orders for its testing and measurement products (for semiconductor chips) were higher than expected in this latest quarter.

Even the Federal Reserve has been modestly upbeat with Greenspan recently saying that manufacturers can expect production rates to increase. At the very least, the production of goods for inventory will happen in the short term to counter the effects of the massive drawdown in inventory that we’ve seen in the past six months.

The question then changes from when will a recovery happen to how much of a recovery can we expect? The answer depends on which sector we’re talking about. For the overall economy, recovery will probably be weak as sectors such as telecom continue to wreak havoc not just on the tech sector but on the entire economy and corporate bankruptcies continue to rise.

Enron is an excellent example of how a corporate bankruptcy affects so many people. For starters, there is the obvious capital destruction – the amount of capital that so many individuals had invested in that company is completely wiped out. In the case of Enron, it is a doubly gruesome act since many of the employees had large parts of their retirement savings tied to the fortunes of Enron in the form of equities, which are now worthless. By destroying this capital, the Enron situation changes the market psychology by introducing greater levels of fear in investors’ minds, discouraging them from further investments and forces its investors to save at much higher rates than they previously needed to. And this psychological shift is not identical to that of investors who have seen the values of their equity investments take a nosedive. Many investors, who continue to hold onto losing shares, do so because they have hope in a recovery and hope is a powerful psychological force, but investors in Enron no longer have the benefit of hope.

As for telecom, huge industry-wide debt levels restrict their abilities to invest in the rapid technological change characteristic of this industry. Add to that falling prices for all products in this domain, excess network capacity, and high fixed costs and you have a recipe for disaster. Undoubtedly, more bankruptcies will occur in this sector as the weaker smaller firms collapse. The superior capital structure of the largest firms will support some of them through this period, but their share prices will suffer without the impetus of growth to support them. Some of the larger companies such as France Telecom, whose market capitalization of $28 billion is dwarfed by its debt of $55 billion, will probably only survive through government largesse. Conversely Sprint and Qwest, which are seriously indebted (Sprint has $16.5 billion in long-term debt, Qwest has $20.2 billion and both have over $4 billion each in short-term debt), are going to find 2002 particularly difficult for raising new capital to finance their activities. While interest rates are at their lowest levels in decades, available credit for high-risk companies such as these is drying up rapidly.

Our Stock Picks

The stop losses of $7.80 on AOF and $11.20 on MUO are maintained.

Gold bullion prices dropped a few points this week in the commodities markets but this only served to consolidate prices in the $290-300 per ounce range, which is an encouraging sign and strengthens our belief that a sustained price above $300 is becoming reality.

New Buy Recommendations:

None.

New Short Sales

Ciena – CIEN. We initiate a short sale on Ciena this week. Despite the low stock price, which might prove attractive to some buyers, we dismiss this consideration remembering the adage that no price is ever too low. On any list of bankruptcy candidates, Ciena must be placed near the top as the company continues to struggle to stay afloat. This week, it announced that it was merging with ONI Systems, a company on the cutting edge of building optical networks in metropolitan areas. Normally that would seem to be a good thing, but if we look at this deal closely, here’s what we find.

Strategically, the announcement as it stands seems to suggest that Ciena has all but given up on selling their technologically advanced optical equipment aimed at large network implementation and now are aiming at the metropolitan markets with equipment used to bring the optical network to the business door.

The merger is a share swap – no cash, which is good since neither side can afford to give up cash. Together they have about $2.2 billion in cash, however Ciena needs to pay out $178 million to convertible note holders at the end of April 2002 and ONI Systems must pay out $300 million to convertible debenture holders at the end of October 2002. Add to that an additional $690 million owed to other Ciena convertible note holders in the longer term.

In the short-term, they both will have exceptionally bad quarters. Ciena requires about $250-260 million revenue per quarter to breakeven. They will be lucky to get $100 million in this quarter. ONI Systems has a breakeven figure of over $100 million but most recent quarterly revenue fell short at $42 million. Thus we have a current burn rate directing the company quickly toward zero.

Regardless of this quarter, they both need customers to buy this equipment over a longer timeframe. Ciena currently derives 52% of their revenue from Sprint and Qwest – not good as we discovered before. These two firms have already told Ciena to expect a drop of 33% in quarterly revenue for the next quarter, but as we’ve seen already, their futures are hardly clear and it would not at all be surprising for them to continue this reduction in investment to further quarters. As for ONI Systems’, they have their work cut out for them in trying to encourage cash-strapped networks to invest in their equipment. Add to that the behemoths such as Lucent, Nortel and Cisco developing similar technology and having the leverage to sell it to these same networks and it spells disaster for either Ciena alone or with a partner.

Needless to say, the chart action only confirms this scenario. Price is diving, OBV is falling off a cliff, MACD the same. About the only thing that appears to be a final roadblock to further drops in price is the $0 dollar line.

Stock Positions to Sell/Exit:

None.

List of Current Stock Recommendations:

Action Ratings. The following is the legend for designating immediate action
for our stock recommendations. The first is B, meaning the stock is timely
to buy but the case for doing so right here is not overwhelming. Either the
stock may have gotten ahead of itself and may be vulnerable to a retracement or
else the stock has been performing disappointingly but may simply be
regrouping. B+ and B++ indicate stocks for which there is a technical case
to buy now, with plusses adding weight according to how many there are, up
to a maximum of two. Stocks rated H are ones to hold, awaiting confirmation
to buy more or to sell. SELL, of course, means what it says. It seldom pays
to override this designation. In the case of stocks held short, the rating is S where positions should be retained. S+ and S++ indicate stocks for which there is a technical case to add to the positions with plusses adding weight similar to long positions. The maximum number of plus signs is 2.

Stocks marked # are eligible as Canadian content in Canadian RSP funds. Otherwise there is a 30 percent restriction on foreign stocks held in these accounts.

Short sells