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Six money managers examine portfolio management strategies in the latest issue of The Wall Street Transcript, available at (212/952-7433) or http://www.twst.com/info/info550.htm

TWST: What about Computer Associates?

Mr. Ganucheau: Computer Associates (NYSE:CA) has done quite poorly since I talked about it in April of last year. Several issues have recently hurt CA, including a slowdown in corporate spending and the use of pro forma accounting, which the Street has viewed with extreme skepticism. The stock is down 51% from its 52-week high and 76% from its all-time high. On average, our list from last year performed well, beating the S&P 500 by 13.25% over the past 12 months. The average dividend yield on our list was 1.1%, marginally lower than the S&P 500’s 1.2% at the time of investment. We feel a much longer period is needed to judge performance in a meaningful way, but it was fun to see our names do well as a group.

TWST: What are the risks involved with Computer Associates?

Mr. Ganucheau: One risk is that corporate information technology spending is low due to economic pressures, leading to reduced demand for their products. This is a cyclical business and demand will likely increase as the economy gradually improves. Another is that while they’re in transition from the large, long-term license sales to a shorter-term subscription-based contract, you have a mismatch of revenues and expenses. This mismatch has led to GAAP earnings that are not very useful, in our opinion, in gauging the earnings power of the business. That’s why we also analyze the pro forma number, which represents results had the subscription-based model been in place for several years. In this case, revenue from past deals would be recognized in each year of the contract, including current periods. Under the new subscription-based method today, the company is realizing the revenue over several years, rather than all upfront. So your revenue recognition has just declined significantly. Also, you have the fact that, under the new model, expenses related to the sale of the shorter-term contract or the subscription model are still realized upfront. That’s why they have presented pro forma accounting, which says, “Look guys, we’re going to give you something you can use to see what the earnings power of the business is.” Pro forma results assume that the subscription-based contract method was used in the past. Had this been the case, past deals would still be producing revenue, which would allow a closer match of revenues and expenses. This is reasonable. Otherwise, you’ve got an artificial gap in the reported EPS due to a mismatch of revenues and expenses, while the transition to the new model takes place. They also provide security and storage software. One thing that can give you comfort in Computer Associates is the fact that they have leading market shares, which is kind of the proof in the pudding — companies buy their products. They do add value, proven by high renewal rates on these products. They also serve 99% of the Fortune 500, which are the largest corporations in America, representing a large and valuable embedded customer base. These products have high switching costs, meaning that if customers did want to switch from CA, they would incur a significant cost to do so. CA doesn’t rely on that. They continue to innovate and bring on more functionality to their enterprise management software, as well as their security and storage software. This barrier to entry can provide added comfort in the sustainable, annuity-like nature of the cash flow stream. They should be able to grow sales longer term at around 10%. That sales growth reflects a combination of their exposure to slower growing mainframe products, which should grow in line with the economy, and faster growing distributed systems networks, where you have individual machines networked to servers. So we believe that, longer term, earnings can grow at 13%, given a 10% sales growth rate. Several items have hurt them recently: the slowdown in IT spending, the accounting controversy, their debt being downgraded recently by Moody’s and the pending investigations. These, in addition to investor scrutiny over a large block of options that was granted to management several years ago, have driven the company, in our opinion, to a discount to intrinsic value. CA produces strong free cash flow of approximately 1.5 billion and the company is currently trading at only 7 times earnings. And again, we’re looking at a discounted cash flow framework, applying reasonable growth rates to arrive at the implied discount rate in the company’s current price. Today’s price of Computer Associates implies over a 20% discount rate, which is very attractive, given your 5.65% long-term T-bond. Of course, the long-term bond is risk-free. But again, you’re getting paid to take the risk to be in this equity, first of all. Second of all, you’re doing it in a real annuity-like business that generates free cash flow, which helps businesses survive spending downturns. It also helps them continue to have strong balance sheets.

This special Investing Strategies Report includes:

1) Peter F. Ganucheau IV, Principal, Portfolio Manager/Analyst with GSB Investment Management, Inc., examines portfolio management strategies in this timely and deeply informative 11,400-word interview from The Wall Street Transcript.

2) William J. DeRosa Jr., Portfolio Manager with Badgley, Phelps and Bell, Inc., examines portfolio management strategies in this timely and deeply informative 4,500-word interview from The Wall Street Transcript.

3)Jonathan W. White, Senior Vice President and Chief Investment Strategist for Banknorth Investment Management Group, examines portfolio management strategies in this timely and deeply informative 3,100-word interview from The Wall Street Transcript.

4) Geoffrey R.B. Carey and Jane W. Korhonen, both Partner and Senior Portfolio Managers at Brown Investment Advisory & Trust Company, examine portfolio management strategies in this timely and deeply informative 3,500-word interview from The Wall Street Transcript.

5) Richard H. Earnest, Director for HighMark Capital Management, examines portfolio management strategies in this timely and deeply informative 4,900-word interview from The Wall Street Transcript.