Are Tech Stocks Like Intel Still Overpriced? -->
By Jim Jubak
Senior Markets Editor, MSN MoneyCentral
09/07/2001 09:05 AM EDT
Are technology stocks still too expensive?
Sure, the Nasdaq Composite is down better than 60% since it hit 5049 in March 2000, and individual stocks such as Cisco (CSCO:Nasdaq - news - commentary - research) , Intel (INTC:Nasdaq - news - commentary - research) and JDS Uniphase (JDSU:Nasdaq - news - commentary - research) have been savaged even more fiercely.
You Can't Tell Me This Intel News Is Not Good
But even after all that punishment, Cisco is still trading at 76 times estimated earnings per share for the year that ends in July 2002, Intel sells for 53 times estimated calendar 2001 earnings and JDS Uniphase goes for a whopping 628 times estimated earnings for the fiscal year that ends in June 2002.
Don't technology stocks have to fall further to bring them back to historically average valuations? For example, Intel's average price-to-earnings ratio on trailing earnings for the past 10 years is just 19.5.
This is a powerful argument on Wall Street these days. And in the short run, the still-high valuations of many technology stocks will keep pressure on prices. It will be hard for many tech stocks to increase significantly until investors can see the earnings growth to support these multiples.
In the long run, however, the argument underestimates exactly how fast a cyclical technology stock -- and its earnings -- can bounce back once business conditions change. The same earnings-per-share leverage that has been so devastating to the sector on the way down also works to the sector's benefit once these stocks start to climb off the bottom.
Let me show you how this works using the example of Intel, a cyclical technology stock with an established history of riding these cycles. And then I'll tell you what I think this means for the technology sector as a whole.
Intel's Ups and Downs
Over the past five years, Intel has managed to grow earnings per share by an impressive 22% a year on average. But as with any cyclical stock, that smooth average hides some impressive peaks and valleys. For example, in 1998, earnings per share fell about 10%, while in 2000 they grew by 42%.
All companies see their earnings rise and fall with the ups and downs of demand in their markets. And Intel's earnings volatility is, in part, a function of doing business in the PC market, which is subject to sharp spikes in demand and steep plunges.
But the peaks and valleys in Intel's earnings are magnified by the nature of how Intel makes its money. Like many other technology manufacturers, Intel is a high fixed-cost business. In bad times, while it's possible to lay off some workers and maybe shutter an assembly line or two, Intel still owns expensive factories full of costly machinery. When slow demand makes it necessary for Intel to run its factories at less than full capacity, these fixed costs eat into the company's profit margins. To generalize, a high fixed-cost business like Intel's magnifies the profit downturn at the bottom of the industry cycle.
On the other hand, this same structure results in a huge increase in earnings when times improve. Equipment that was a drain on earnings now starts to contribute to profits. And production lines that were running inefficiently at half-capacity now churn out product at increasingly lower unit costs. That last addition to efficiency isn't a small factor, either, at a company like Intel that continues to invest -- good times or bad -- in state-of-the-art manufacturing equipment.
You can see the results in previous Intel slumps. In the early 1990s, Intel was facing a deep slump in sales of its 486 processors -- the precursor to the Pentium line. Earnings per share hit just 16 cents in 1992, up 23% from earnings of 13 cents a share in 1991 on a 22% jump in revenue. Toward the end of that year, Intel started to heavily discount the price on 486 chips in order to speed their penetration into the market. Thanks to those cuts and a pickup in the economy, the company saw a 50% jump in revenue in 1993 from the year earlier.
What about earnings? Well, that 50% jump in revenue produced a 106% leap in earnings per share to 33 cents in 1993.
More Upside Ahead
Now, I don't know when investors can expect to see this kind of explosion in Intel's earnings per share, but based on past history, we should see it. Analysts currently project that the company will earn 51 cents a share this year, significantly down from the $1.51 a share recorded in 2000. And 2002 doesn't look much better to Wall Street. The consensus calls for just 68 cents a share in calendar 2002. If Intel trades near the recent price of $27.50, the stock would trade at a price-to-earnings ratio of better than 40. That's way above the 19.5 average multiple of the past 10 years.
But I suspect that estimate for 2002 is far too low. And no matter when the recovery in Intel's business begins in 2002, I'd expect it to be in full swing by 2003. A reasonable projection for Intel's earnings that year would be something like $1.60 a share. And at that level, a multiple of 25 -- well below today's price-to-earnings ratio but still above the 10-year average -- produces a price of $40 a share for Intel. That's about 45% above recent prices.
But that's not the peak for Intel's earnings, either. As the telecommunications recovery gradually kicks in and Intel's communications business starts contributing to earnings in 2004 and 2005, earnings will climb toward $2.50 a share in 2005. A multiple of just 20 gives me a price for Intel of $50 a share, 25% above the 2003 level and better than 80% above today's prices by 2005.
Instead of arguing about the details of those earnings projections -- and I've seen estimates well short of that, as well as numbers above mine -- notice what has happened to the distressingly high price-to-earnings ratio of 2001. As Intel's earnings recover, the multiple goes down to something like the historical average and the price of the stock actually goes up.
Other Stocks With Similar Bounce
I don't expect all technology stocks to behave like this. The scenario I've built for Intel hinges on the established and extreme cycle in the company's earnings growth. It works only because Intel shows such a huge bounce in earnings off the bottom of the cycle. And I don't think it applies to technology companies that will experience less-leveraged recoveries.
You can count on seeing this pattern in stocks like Applied Materials (AMAT:Nasdaq - news - commentary - research) , LSI Logic (LSI:NYSE - news - commentary - research) and Atmel (ATML:Nasdaq - news - commentary - research) because these companies have the same kind of high fixed-cost structure that Intel does and they show historical track records of similar earnings volatility. Look at the 10-year pattern for LSI, for example, if you want to see earnings volatility that makes Intel's look placid. In 1992, LSI Logic lost 62 cents a share; the next year it reported a profit of 27 cents a share. In 1998, the loss came to 47 cents and the rebound in 1999 to a stunning 91 cents a share.
I feel uncomfortable, however, projecting this kind of behavior across the technology sector. Many tech companies in recent years have decided to contract out the manufacturing of their products in an effort to reduce their need for investment capital and to lower fixed costs. That was supposed to offer these companies some downside protection at the bottom of the demand cycle, although the track record on that is certainly mixed so far in this cycle, I'd say. It also will probably damp the upside surge in earnings off the bottom as well.
But I'm just guessing. Quite frankly, we really don't know how a company like Broadcom (BRCM:Nasdaq - news - commentary - research) , for example, will behave through a technology cycle because the company simply hasn't been around long enough to build up a meaningful record. In the case of Broadcom, investors can look at just four years of numbers. The penny-a-share loss in 1997 reflects not a bottom in the cycle, but a young company's growth to profitability. The collapse from 36 cents a share in 1999 to a loss of $3.13 in 2000 doesn't tell us anything, either, about how fast earnings will rebound.
Broadcom just hasn't been around the block often enough to build a record that investors can extrapolate into the future. And given the paucity of that record for stocks that resemble Broadcom and their still-high P/E and price-to-sale ratio, I feel much less confident about the direction of the prices of these stocks. They might still be too expensive.
The crossroads for cyclical technology stocks with historically meaningful earnings records will come in the next few months as the end of the 2001 calendar year starts to prod Wall Street analysts into making earnings projections for 2003. If, by that time, there are signs of a looming cyclical recovery for stocks such as Intel and Applied Materials, then one part of the technology sector, at least, will no longer seem too expensive. |
