HEDGING BETS
BUSINESS NORTH CAROLINA
By Arthur O. Murray
Illustration by George Breisacher

With the economy still dicey, most of our stock pickers make safe companies their odds-on favorites this year.

That the market tumbled over the past 12 months came as no surprise to veteran stock pickers. Even before the Sept. 11 attacks on New York and Washington, a stagnant economy teetering on the edge of recession worried consumers and investors alike, pushing many stock buyers and sellers into defensive crouches.

So it was with last year’s Business North Carolina panel of professional stock pickers. Each selected three Tar Heel stocks he thought would rise over 12 months, and most hunkered down, taking stocks trading near their 52-week lows. It was good strategy, considering that when BNC’s stock-picking year ended Oct. 19, the Dow Jones industrial average was down 10% — and the S&P 500, 23.2% — from the previous year.

And though it’s a cliché, good defense turned out to be the best offense. Five of the eight pickers finished in the black, and 10 of the 15 stocks selected by the panel gained in value. The pickers averaged a 1.6% gain, compared with a 13.5% loss in 2000. Big gainers were a trucking company that was sold, hardware — hammers and nails, not keyboards and monitors — and discount retail. Meanwhile, some of the panel’s high-tech and drug selections crashed.

North Wilkesboro-based home-improvement retailer Lowe’s Companies Inc., which ended the year up 67.3%, was the cornerstone of the portfolio of George Shipp of Scott & Stringfellow Inc., a subsidiary of Winston-Salem-based BB&T Corp. Shipp, director of private-client research, led 2001 pickers with an average return of 36.6%.

His other picks were Raleigh-based Highwoods Properties Inc. and Charlotte-based Bank of America Corp. “Bank of America had just taken giant loan-loss reserves, so Wall Street had puked out the institution with more deposits than anyone else,” Shipp says. “Tech was down a lot, but by no means was it cheap, so we consciously avoided what was then the most popular sector. Conversely, investors were shunning real-estate investment trusts such as Highwoods Properties, even though it carried a very attractive 10% yield at the time. I didn’t see how Highwoods was going to lose money for us.” It didn’t, finishing the year up 12%, while Bank of America was up 30.4%.

Two other pickers also went three for three. John Lynch, director of investment strategy for Charlotte-based Wachovia Securities Inc., was one of two panelists to zero in on Matthews-based Family Dollar Stores Inc., which closed the year up 62.2%, the third-largest gainer on our list. He also picked Bank of America and would have won the contest but for the meager 1% gain of his third pick, CommScope Inc.

The other picker with three winners, Jim Green, executive vice president at Ellington Smith LLC of Charlotte, had the most consistent selections. Bank of America, Nucor Corp. and Embrex Inc. increased between 20.2% and 30.4%.

At the other end of the standings were Alan Mann, first vice president of investments in the Raleigh office of Marion Bass Securities Inc., and Wes Sutton, vice president in the Winston-Salem office of Deutsche Banc Alex. Brown Inc. They gambled — and lost — with drug and high-tech companies.

Mann went with Durham-based Cree Inc., which makes light-emitting diodes and semiconductors, and Durham-based Red Hat Inc., which sells and offers technical support for the Linux computer-operating system. The stocks lost 64.1% and 71.6%, respectively. Cree’s net income for the year ending June 30 dropped nearly 9%, to $27.8 million, and its first-quarter net income for the 2002 fiscal year was down nearly 49% from the year before. Red Hat’s losses for the year ending Feb. 28 totaled $86.7 million, more than double the previous year. And it had lost nearly that much in the first six months of the current fiscal year. Triangle Pharmaceuticals Inc., also based in Durham, lost ground as well. More delays in getting FDA approval for its anti-HIV drug, Coviracil, hurt the stock, which lost 55% of its value.

Sutton did pick one winner, Greensboro-based RF Micro Devices Inc. The company, which makes integrated circuits for cellphones, showed a 23.7% gain. But his drug-company selection, Durham-based Inspire Pharmaceuticals Inc., saw its stock drop 44.9%. Inspire is developing drugs to treat respiratory and eye diseases, but none has been approved by the FDA. Sutton’s other pick was Cary-based SpectraSite Holdings Inc., which builds and manages cellphone towers. SpectraSite posted the largest decline of the 2001 selections, losing 84.2% of its value as analysts fretted over its debt and continued losses.

The biggest gainer among the 2001 picks was Kenan Transport Co., a Chapel Hill-based trucking company, which was acquired in April by Canton, Ohio-based Advantage Management Group Inc. The purchase price was $35 a share, a 72.8% premium over Kenan’s price in October 2000. Unfortunately for the man who picked it, Bobby Edgerton of Capital Investment Counsel Inc. in Raleigh, that gain was almost wiped out by another of his picks: Red Hat.

For the coming year, panelists are again favoring safety over sex appeal. Three picked Duke Energy Corp., while two went for Bank of America. Green went for Bank of America and Duke. “A bank as large as Bank of America is a good place to have your money. They can take a credit hit of $300 million or more and still move forward. The California thing has hurt Duke a little, but it’s a really quality company, and we always need energy.”

Sutton, burned by high-tech stocks in 2001, is sticking with them. “Perhaps I’m a glutton for punishment,” he says. “But here’s a trivia question: What was the best performing stock in the S&P 500 for the year 2000? Philip Morris. At the beginning of 2000, pundits predicted the end of tobacco. Today it’s the end of technology and telecommunications. The market almost always overshoots, both directions.” That’s why he’s sticking with RF Micro and adding Burlington-based Laboratory Corporation of America Holdings and Durham-based Digital Recorders Inc.

Shipp, meanwhile, believes stock prices that sank after the Sept. 11 attacks have great potential for increase. “Therefore, we’re going to prudently play a little offense and hope that the economy can give us some breaks over the next 12 months.” He says there are lots of bargains. “Our difficulty was finding only three picks.”

The picks:

Bobby Edgerton
President, Capital Investment Counsel Inc.
Raleigh

First Citizens BancShares Inc.

I have always had an enormous amount of respect for the Holding family: Snow, Big Frank and Frank Jr. They are first-class. They don’t get caught up in the bank-acquisition game. They stick to what they do best and don’t dilute the stock. With any luck, this year’s earnings will surpass $100 million. And how many banks can claim a debt-free balance sheet?

Red Hat Inc.

The risk/reward on Red Hat is incredible. This company sits on a huge cash load of $300 million, which is roughly 40% of its market cap. The Linux operating system continues to grow, and Red Hat doubled its top line in 2000. Major corporate wins include GE, Nortel and Deutsche Telecom. Red Hat could reach consistent profitability this year.

RF Micro Devices Inc.

This company makes radio-frequency integrated circuits for wireless communications, primarily for the cellphone industry. A solid, debt-free balance sheet should enable it to prosper when business recovers. Bill Priddy, the CFO, strikes me as a man who knows exactly what he’s doing. RF Micro had a small loss in the quarter, but $34 million in cash helps me sleep at night. A great bet on the economy and the wireless business turning around.

Robert Gaskin
Vice president/investments, UBS PaineWebber Inc.
Charlotte

Laboratory Corp. of America Holdings Inc.

LabCorp is the United States’ largest independent clinical laboratory. The company’s laboratory services are used by hospitals, managed-care groups and independent physicians to test bodily fluids and human tissue. It has 24 major laboratories and approximately 1,200 service sites. Recently, LabCorp received FDA approval for a new plasma-donor-screening test that we believe gives it a competitive advantage in the marketplace. LabCorp is currently trading at 16 times our 2002 cash-earnings estimate, which is a 27% discount to the group average of 22 times. Due to LabCorp’s strong fundamentals, it should at least trade in line with the group.

BB&T Corp.

BB&T is one of the better-positioned regional banks to generate sustainable revenue and earnings growth over the next few years. The company’s acquisition strategy continues to bear fruit in terms of cost savings and revenue enhancements. Our earnings estimate for BB&T represents a 14% growth rate in 2002, which is well above our expectations for the average regional bank.

Lowe’s Companies Inc.

Lowe’s is the second-largest U.S. home-improvement retailer with more than 575 stores in 38 states. Lowe’s results have truly shone over the last 12 months — in many ways leading the industry. The surprising element of Lowe’s results continues to be escalating prices in spite of many other retail chains’ move to cheaper prices. Lowe’s average ticket rose by 2.3%, with areas like carpet seeing gains as high as 8%. Lowe’s push into metro markets may also provide a lift.

Jim Green
Executive vice president, Ellington Smith LLC
Charlotte

Bank of America Corp.

The recent decline of almost 20% in the price of the bank’s common stock from its August high of $65 appears to provide another opportunity to acquire these shares. Under the leadership of new CEO Ken Lewis, the nation’s second-largest bank is phasing out some of its more risky businesses, such as auto leasing and subprime real-estate lending. While this year’s earnings per share are expected to be up only marginally from last year’s $4.72, the bank has set long-term goals of 7% to 9% revenue growth and 12% to 15% EPS growth. With our current soft economy and the effects of Sept. 11, achievement of these goals may be pushed out six to nine months. But the opportunity to purchase shares at less than 11 times current earnings could be rewarding for long-term investors.

Duke Energy Corp.

Duke has become an extremely diversified energy company with operations in pipelines, independent power plants and real estate, as well as in trading markets for power and energy. Revenues this year should approach $70 billion, almost four times 1998 revenues of $17.6 billion. With management’s emphasis on nonregulated businesses, traditional utilities account for less than 50% of profits. We expect increased individual- and institutional-investor interest in Duke as it continues to demonstrate strong earnings growth through acquisitions.

PharmaNetics Inc.

This biotech company develops, makes and markets tests that allow cardiologists to monitor the formation and dissolution of blood clots. The goal is to ensure the correct anti-coagulant drug is provided in the right dosage to the right patient. The company has more than $14 million in cash — and no long-term debt — to carry it through while it rolls out products in conjunction with several major pharmaceutical companies. Revenues are expected to be in the range of $6 million to $7 million this year and could grow eight- to tenfold over the next three years. Its collaborators include such industry leaders as Aventis, AstraZeneca, Eli Lilly, Knoll and Schering. Through a recent private placement at an above-market price, Bayer Diagnostics now owns 19.9% of PharmaNetics.

Frank Jolley
President and chief investment officer, Jolley Asset Management LLC
Rocky Mount

Coca-Cola Bottling Company Consolidated

Coca-Cola Bottling Company Consolidated is the second-largest bottler of Coca-Cola products in the United States. At the current price of $38, the stock appears to be a bargain, based on operating cash flow, as it is down about 50% from its all-time high of $75.75 in 1998. The soft-drink business typically proves to be recession-proof. And the company has been throwing off high levels of free cash flow, which should enable it to deleverage its balance sheet, driving earnings higher. The Coca-Cola Co. owns 22% of the voting shares of Coca-Cola Bottling Consolidated, and Coca-Cola Enterprises, the largest bottler in the country, also owns shares in the company. While the company has no research coverage on Wall Street, we think it is undervalued at current levels. The stock yields approximately 2.6%.

Jefferson-Pilot Corp.

Jefferson Pilot is a life-insurance company and also has communications/media properties. The Greensboro company has grown operating earnings at an annual rate of 16% over the five years ended Dec. 31, 2000. Cash dividends have risen by an annual rate of 12% over the same period and have been paid each year since 1913. While we would expect near-term earnings growth to slow, largely due to weak results in communications and media, the recent pullback in the stock represents an opportunity for the long-term investor. In addition, there has been considerable consolidation in the insurance industry over the past few years. Jefferson-Pilot and other mid-sized insurers could likely become the targets of larger domestic or foreign financial-services companies looking to expand their life-insurance operations.

Quintiles Transnational Corp.

Durham-based Quintiles Transnational is the world’s largest contract-research company. It also rents salespeople to drug and health-care companies. The stock is down considerably from its high of $56.88 in 1998. But the price should recover over the intermediate term, as annual earnings are projected to rebound sharply in 2002 to 66 cents per share. The stock appears to have little downside risk at its current price. Quintiles’ market capitalization is about $1.75 billion, and the company’s balance sheet has some $750 million in cash and equivalents.

George Shipp|
Director, private-client research, Scott & Stringfellow Inc.
Norfolk, Va.

Duke Energy Corp.

Let’s start with what should be our most conservative pick, Duke Energy. The company has become a true energy giant, with annual revenue exceeding $60 billion. The company should be able to deliver on its commitment for 10% to 15% annual earnings growth. Electricity can be cyclical, but it’s essential, and natural-gas consumption actually rose during the 1990-91 recession. Duke shares have pulled back a bit, to about 14 times estimated 2002 earnings, where they trade at a 25% to 30% discount to market averages and provide a dividend yield higher than the money market.

MedCath Corp.

We’ve long been intrigued by MedCath, which re-entered the public markets in July. The company aligns with local cardiologists and surgeons and builds specialized heart hospitals. In Willie Sutton vernacular, heart disease is “where the money is,” the biggest category in health care. By specializing, the company hopes to drive down costs and improve clinical outcomes. And MedCath’s prospectus says that its patients have a shorter length of stay and lower mortality rate than competitors’, despite a greater proportion of complicated cases. Through nine months, revenue grew 22%, to $296 million, and operating cash flow, 17%, to $52 million. Because the company is in a build mode, it’s still reporting net losses. It’s really a three- to five-year story, but we’re giving it a shot for 12 months.

Capital Bank Corp.

Capital Bank, which was started in 1997, has shown better growth than most early-stage banks, and its proposed merger with First Community in Burlington builds assets to about $600 million. Our analysts believe Capital Bank has good upside potential relative to risk. Small banks tend to become larger banks, or they tend to be bought by larger banks. In any case, June 30 results showed loans up 25% and deposits up 16% versus a year ago.

Gerry Smith
First vice president-investments, Salomon Smith Barney Inc.
Charlotte

Family Dollar Stores Inc.

Recommending that investors choose a retail stock in an economy that is likely in recession may not seem like a logical move, but take a closer look. Discount retailers like Family Dollar hold up fairly well in tough times since they sell essential products. Family Dollar operates a chain of small stores that are self-service, cash-and-carry, serving mostly low- and middle-income customers. It offers a broad range of merchandise, including household products, health and beauty aids, toys, school supplies, candy and snacks, seasonal merchandise and apparel and shoes. With consumer confidence eroding, Family Dollar is likely to benefit from the Wal-Mart or Kmart customer who is willing to trade the broader selection of merchandise offered at those stores for the value and convenience of shopping at Family Dollar.

Bank of America Corp.

With interest rates at historically low levels and credit costs declining, Bank of America is in a position to enjoy interest revenue growth and higher earnings going forward. But there’s more going on at Bank of America. Ken Lewis, the bank’s new CEO, is making changes that should improve long-term growth and profitability. Management is focusing more on risk management, capital allocation and reinvestment for future growth. The bank generates significant free cash flow each year — much of which is used to repurchase shares. Even in a weak economy that will likely include less capital-market activity, Bank of America could be considered a defensive stock with a dividend yield of slightly more than 4%. In addition, its price-to-earnings ratio is low, 16.54, compared with its largest competitors, Citigroup and J.P. Morgan Chase, which average 19.73.

Duke Energy Corp.

Duke Energy is a globally diversified energy company that historically has focused on electric utilities and pipelines. With deregulation, Duke has changed its business to include the trading and marketing of energy as well as the control and construction of power plants. The energy-merchant business — wholesale energy marketing and power generation — has represented a growing portion of Duke’s business in recent years, and this is likely to continue. Duke has a leading franchise in the industry, the company is well-managed, and its valuation remains low relative to the S&P 500, all of which should lead to a higher stock price in coming months.

William Wesley Sutton II
Vice president, Deutsche Banc Alex. Brown Inc.
Winston-Salem

RF Micro Devices Inc.

RF Micro Devices continues to be an innovator in wireless communications, and despite an incredibly trying environment for this industry, the company is actually gaining market share with most of the major handset manufacturers. Management recently raised earnings guidance for the third quarter, indicating a 30% increase in quarter-to-quarter revenue and “better than break-even earnings.” This is a seismic shift from recent industry trends. It should also be noted that the wireless phones of tomorrow will be very different than what we use today, and RF Micro stands to be a significant beneficiary of what’s to come.

Laboratory Corporation of America Holdings Inc.

Burlington-based LabCorp is the second-largest clinical-testing laboratory in the U.S., administering more than 4,000 tests used by health-care professionals. Every time your doctor requests a blood or urine test, there is a good chance the cash register rings at LabCorp. But the exciting part of LabCorp is its genetic testing. That has higher margins and is the fastest growing segment of the business. LabCorp has excellent management and cost control and will continue to benefit from the aging of America.

Digital Recorders Inc.

Digital Recorders is exploiting several niches. Its transportation division specializes in what it calls a talking-bus system, which provides voice announcements about stops, transfer points, route and destination information and public-service messages. It also makes electronic signs for buses and trains. Its Digital Audio subsidiary sells audio surveillance and enhancement technology to law-enforcement and intelligence agencies and recently announced four new products. Digital Recorders is somewhat of a turnaround, having posted net income of $64,860 for the first six months of 2001 as opposed to a net loss of $603,250 for the same period in 2000.


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