Fourth Quarter Ending on a Strong Note

Weekly Earnings & Sector Update
February 21^st 2005 through February 25^th 2005

Written By: Nick Raich, CFA
Director of Research

Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .I

Earnings & Sector Scorecard. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .II

S&P Companies That Reported Earnings Last Week. . . . . . . . . . . . . . . . . . . . .III

This Week In Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .IV

Key Companies Reporting This Week. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .V

Zacks Rank By Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .VI

Earnings and Sales Growth - Actual and Estimated. . . . . . . . . . . . . . . . . . . . . .VII

OVERVIEW
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Fourth quarter 2004 earnings season is almost over. The results definitely have exceeded our expectations. We feel very confident the final fourth quarter 2004 results will mark the fifth consecutive quarter of earnings growth exceeding 20%. As we factor in Zacks estimates for the companies yet to report with the companies that have already released results, we believe the final fourth quarter earnings results for the S&P 500 will easily exceed the current consensus estimate of 15% growth. Our best estimate is for final earnings growth of 28%. Strong year-over-year earnings gains in the Materials, Energy and Technology and Energy sectors have been driving the results.

Thus far, 438 S&P 500 companies have released fourth quarter 2004 earnings results. Of those that reported, 81% have met or exceeded their estimates. Average earnings growth has been 32% from last year with sales growth up 13%. Despite sounding like fantastic numbers, we believe the market has shifted its attention to next quarter where the current first quarter 2005 consensus earnings growth figures are only for 9% growth. In our view, this figure is too low and we expect final first quarter 2005 growth figures to be in the mid-teens. We do note that despite the slowdown in growth, the rates of growth will still be well above historical averages.

Zacks industry rankings are provided toward the back of this report. The rankings are based on a quantitative model developed by Zacks that focuses on past earnings trends and forward earnings revisions from Wall Street analysts. The model has an excellent track record of outperforming the market. Therefore, the Zacks industry rankings should provide a great starting point for your equity research.

Companies in the spotlight
In this section, we focus on two stocks that our independent equity analysts feel you should be buying or selling. Our analysts start with the quantitative Zacks model and build their final buy/sell decision by performing additional fundamental analysis on the company. To view the entire report on each of these spotlight companies or to gain access to our detailed analysis on over 1,300 companies, log on to:http://www.zacks.com/.

Buy – Kellogg Company (Ticker: K)

Kellogg Company manufactures and markets ready-to-eat cereal and convenience foods, including cookies, crackers, toaster pastries, cereal bars, and frozen waffles. The company is the world's leading producer and distributor of cereal, holding a dominant 40% market share in global volumes. Cereals (Kellogg's Corn Flakes, Rice Krispies, Special K, Frosted Flakes, All-Bran, Corn Pops, Raisin Bran, Frosted Mini-Wheats, among others) are marketed in more than 180 countries and account for 55% of the company’s sales. The company is a leading producer of convenience foods, including the brands of Keebler, Pop-Tarts, Eggo, Cheez-It, Nutri-Grain, Murray, Austin, Morningstar Farms, Famous Amos, Carr's, Plantation, Ready Crust, and Kashi. Geographically, North America accounted for approximately 66% of total 2004 sales, Europe 21%, Latin America 8%, and the Asia Pacific 5%.

In 1999, management began to execute a turnaround strategy to transition Kellogg from a commodity cereal producer to a value-added cereal and convenience food growth company. Through two strategy mantras (Volume to Value and Manage for Cash), the company’s earnings turned around from a six-year stall and began to gain upside momentum. In addition, the 2001 acquisition of Keebler provided Kellogg with not only the number two domestic cookie and cracker company, but also with a direct store door (DSD) delivery system. Kellogg’s is now reporting sustained consistent growth with quarterly earnings meeting or exceeding analyst expectations.

The Volume to Value strategy concentrates on profits (value) rather than market share (volume). Kellogg has focused on brand building through new product innovation and improving the product mix by concentrating on optimal price/mix combinations. Marketing efforts are aimed towards the more profitable cereals and snacks. The result is that sales have grown, and margins have expanded.

In the Manage for Cash financial model, working capital is reduced by effective inventory management and cost cutting, especially in integrating infrastructure. Capital spending projects have been prioritized, and capital expenditures are vigilantly controlled resulting in an improved ROIC (return on invested capital), which was 14% in 2004, up from 12.8% in 2002. The ensuant profits are utilized to improve financial flexibility by reducing debt and repurchasing shares, along with funding additional brand-building initiatives. Kellogg’s cash flows (cash from operating activities less capital expenditures) have risen substantially over the last seven years. In 2004, cash flow was $950 million, driven by higher earnings and working capital improvements. Debt has been consistently reduced from $6.8 billion in 2000 to $4.9 billion at year-end 2004. The long-term target is to pay down debt by approximately $300 million per year. During 2004 the company repurchased $298 million of Kellogg’s stock; the target for 2005 is to buy back shares up to $400 million.

Kellogg continues to market brands that generate higher margins, part of the Volume to Value strategy. Management is intensifying the brand-building program with increased advertising and promotional expenditures, in line with the goal of increasing brand-building spending at twice the rate of sales growth. New products like Fruit Harvest, Cinnamon Krunchers, low carb Special K, Eggo French Toaster sticks, Cheez-It Parmesan are adding to the sales momentum. Kellogg is absorbing higher operating expenses, including commodity and energy costs, as well as upfront spending on cost-savings initiatives. (The latter category includes plant closings and relocations, as well as a SAP software implementation). Kellogg increased U.S. cereal prices 4.5% in order to offset the higher commodity input costs.

As a result of the successful implementation of the Volume to Value and Manage for Cash strategies, Kellogg’s EPS have accelerated above the former $1.74 peak in 1995. Earnings not only continue to grow, but also are being reported at or above expectations. We expect Kellogg’s stock to outperform and the buy recommendation is maintained with a target price of $49.25.

Sell – TC PipeLines, L.P. (Ticker: TCLP)

TC PipeLines, L.P is a master limited partnership (MLP) whose principal assets are its interests in two U.S.-based pipeline systems, the Northern Border Pipeline Company and the Tuscarora Gas Transmission Company. The partnership owns a 30% general partner interest in the 1,249-mile Northern Border Pipeline, which stretches from the Montana-Saskatchewan border to the U.S. Midwest and carries more than 20% of the natural gas shipped from Canada to the U.S. In addition, TCLP has a 49% interest in the Tuscarora Gas Transmission Company, which transports gas from Oregon to Nevada. Equity income from Northern Border and Tuscarora accounted for 87% and 13%, respectively, of the partnership’s 2004 earnings. The partnership was formed by TransCanada Corporation ( TCP - Analyst Report ) to manage its U.S. pipeline assets. TransCanada Corporation retains the partnership’s general partner interest and also maintains a roughly 16% interest in the limited partner units.

TC PipeLines’ equity stakes in the two key pipeline systems enables it to generate stable, recurring, and low-risk earnings and cash flows. However, the prospects from its principle asset, the Northern Border Pipeline system have stalled. At the beginning of 2004 approximately one third of its capacity was due to expire by the end of the year, by the third quarter NBPL was able to successfully re-contract at maximum tariff rates but under shorter-term transactions. In 2005 the situation is similar, approximately 800 MMcf/d, one third of its capacity, will expire at the end of May. It is questionable whether the demand is strong enough to continue to contract at maximum tariff rates. In fact management has estimated that the unfavorable effects could range between $5-$10 million, depending on market conditions. Looking ahead, the pipeline’s organic growth prospects are limited in the near term and portions of its system are likely to be retired. The Black Mesa pipeline, will likely be retired at the end of 2005. A large gas fired powerplant is likely to retire at the end of the year due to environmental constraints; the impact to Northern Borders is a 3% reduction in EBITDA. Organic growth opportunities in the near future are not evident for Northern Border Pipelines. There are approximately $50 million of projects named, but none will be complete until mid 2006.

On a positive note, the outlook for Tuscarora remains positive following late last year’s expansion of its facilities. The weighted average life of its contracts exceed 10-years, providing limited risk in its revenues. Additionally, TCPL’s coverage ratio is well above the average; approximately 1.3 for 2004 compared to an average of 1.1 for the pipeline industry. This increases the likelihood of either future increases or provides an added measure of security for its current distributions. We believe TCPL will continue to conservatively monitor its distribution philosophy, principally due to the uncertainties of its primary asset, the Northern Border Pipeline system.

In 2004 the partnership increased its distributions by approximately 4.5%. Given its limited prospects in 2005 we believe the distributions will increase in the range of 2% to a high of 4%. Management does have incentives to increase its distributions in order to reach the higher GP allocations. Distributions need to increase by 20% before the partnership reaches the high splits (50% GP share of cash flows above an annual distribution run rate of $2.76).

TCLP has historically traded close to or below the average MLP pipeline distribution yield, approximately 200 basis points above the 10-year Treasury rates. Currently, TCLP is trading at approximately 180 basis above, consistent with the MLP pipeline group. Positive demand for MLP securities, and limited prospects for the overall market, are holding up MLP valuations. We believe MLP securities should generate stronger interest, however, we are more inclined to own growing partnerships, those with more significant organic growth opportunities. TCLP’s short-term prospects are limited, and its GP has not provided an outlook, which incorporates acquisition growth.

A key area of concern for MLP investors is the up-cycle in interest rates. Being yield-oriented securities, MLP unit prices will remain under pressure in a rising interest rate environment. TCLP in the prior year, like its peer group, saw its unit prices dip and then recover as interest rates ran up and then recovered as it turned out that the economic recovery was moving at a slower pace than originally anticipated. Looking ahead, the speed of rate increases by the Fed is uncertain, but the direction is not. We expect the 10- Year Treasury rate to end the year at 5.00%, 100 basis points higher than today.

On a positive MLP note Congress recently passed legislation, which makes MLP a qualifying income source for mutual funds. We believe the result of this bill would be to enable significant amounts of capital, potentially in the hundreds of millions, to flow into MLP assets. Given a total industry market cap of approximately $50 billion, a few hundred million is enough to increase unit prices. We do not believe a significant amount of funds will flow into TCLP, however, given its low float it will not take much demand to increase its unit price.

4Q 2004 Earnings Scorecard – S&P 500

438 companies in the S&P 500 have released 4Q 2004 earnings results as of 2/18/05.
65% (of the companies) exceeded estimates
16% matched estimates
19% missed estimates

4Q 2004 SECTOR SCORECARD - S&P 500
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Note: EPS and sales growth compare current quarterly results vs. prior year ago quarter

S&P 500 COMPANIES THAT REPORT EARNINGS LAST WEEK
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THIS WEEK IN EARNINGS
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Below is a list of key companies that should report this week. To view the entire list of companies reporting on a given day,remember to check out the Zacks earnings calendar.

KEY COMPANIES REPORTING THIS WEEK
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INDUSTRIES RANKED BY ZACKS (1= STRONG BUY, 5 = STRONG SELL)
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EARNINGS AND SALES GROWTH - ACTUAL AND ESTIMATED FOR THE S&P 500
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