Timidly into Tech:- Is It Safe Yet?
After a horrendous slide, some tech shares look cheap. But be
careful
By ERIC J. SAVITZ
It's time to think about buying tech stocks.
We write these words with trepidation. After all, there are no visible signs of
improving tech demand. In the past few weeks, companies such as Nvidia, Adobe
Systems, National Semiconductor and Taiwan Semiconductor have scaled back
their growth expectations. Cisco Systems Chief Executive Officer John Chambers
last week said he feels more cautious about the tech spending environment now
than he did three months ago. And no wonder: Telecom remains in disarray.
Enterprise-software vendors are reeling. There's no growth in cellphones. PC
demand seems to be deteriorating. And we're still suffering from post-bubble
indigestion: Need a Sun server or a Cisco router? You can snap up barely used
gear on eBay for a fraction of what the new stuff costs.
As for a recovery in corporate tech spending -- well, it may take longer than we
all hoped. In particular, we are skeptical about the notion that fourth-quarter
results will benefit from an information technology "budget flush." Rather, chief
information officers this year will be rewarded for bringing in tech spending as far
under budget as possible. Ergo, profit estimates for both this year and next year
seem too high.
All that said, there are good reasons to start making a tech-stock wish list. While
we don't know just when corporate spending will rebound, we do expect a
gradual recovery to get going in 2003. When it does, shares of well-positioned
companies will rise. And some will move decisively: For some stocks, valuations
finally have fallen to reasonable levels. Others look downright cheap.
"We're in horseshoes and hand
grenades territory," says a long-time
tech investor, Roger McNamee, a
partner with Integral Capital Partners in Menlo Park, Calif. "I have no idea if this is
the bottom -- and no interest in trying to pick it. But the risk-reward trade-off,
which was awful, is now interesting. I can't tell you if this is an attractive time to
buy tech stocks -- but I can tell you they are a lot cheaper today than they were.
And if you want to own tech stocks, you could do a lot worse than buy them
right here."
Technology shares, of course, have endured a bear market of historic proportions.
The tech-dominated Nasdaq Composite, which peaked in March 2000 just above
the 5,000 level, now stands at about 1,300, off nearly 75% in 2.5 years. Tech
stocks, which in the bubble reached 36% of the S&P 500, now make up just 14%
of the index, according to UBS Warburg.
In short, over the past 30 months, the technology business has been thoroughly
humbled. The sector has endured the popping of the Internet bubble, a
still-unfolding financial disaster in telecom and an unprecedented collapse of
corporate tech spending. Those problems have been compounded by last
September's terror attacks, a U.S. recession and a crisis of confidence in financial
accounting. Profits have swooned, and so has investor faith in the tech sector.
Maybe this is as bad as it gets, suggests Arnie Berman, technology strategist at
Soundview Technology Group. "It has been absolutely sickening to look at the
screen every day, but I still think there's very compelling reason to be involved,"
Berman says, noting that growth in the third-quarter should turn positive on a
year-over-year basis. "Right now, it's viewed as a lunatic statement to suggest that
tech stocks and tech spending will stop going down, or that the recovery will be
anything but shallow and not very compelling. Given that conventional wisdom,
right now I'm kind of a lunatic."
The bull case boils down to this: Look out two or three years and tech companies
should see improving demand. Berman, for instance, believes the vicious cuts in
IT budgets of recent months have resulted in growing corporate to-do lists --
while some technology projects were cancelled, others have simply been
postponed. There is pent-up demand, he says, for a wide range of technology
goods.
Guessing just when -- and how quickly -- that potential can be converted to
orders is hard to say, though. Laura Conigliaro, hardware analyst with Goldman
Sachs, notes that First Call revenue estimates for enterprise computing businesses
suggest 10% top-line growth in 2003. But as Conigliaro notes, "Nobody expects
10% growth in IT spending next year, with the best case looking like 6% to 7%
growth."
And that's a problem. The bears have some valid
arguments. Tech execs continue to say they have
little visibility, and that a pick-up in IT spending
has yet to materialize. We could be in for another
round of estimate cuts -- which suggests stocks
are more expensive than they now appear.
Integral's McNamee notes that the accounting
crisis could lead to understated profit reports in
the September quarter. Says McNamee: "They'll
be squeaky clean, but terrible."
Not the least of the problems, the bears argue
that the recovery in many key tech sectors will be anemic. The beleaguered
telecom sector is still deteriorating, hurting the prospects for suppliers of
communications gear and related components. Demand for both personal
computers and cell phones remains sluggish. The expected boost to storage and
security companies in the wake of last year's terrorist attacks has not offset
shrinking IT budgets. And weak PC and cell phone sales will mean more rough
days for many chip and semiconductor equipment stocks.
Yet, despite the caveats, we think there's a case for patient investors to start
nibbling.
Pip Coburn, technology strategist at UBS Warburg, nicely sums up the situation.
"The challenge is discriminating between companies with broken fundamentals
and stocks that have been crushed, but where you can look out and have a sense
of where the company will be several years out," he says. "I wish there were
more of those."
To help you pick through the rubble, we took a close look at the 20 largest tech
companies by market value. You'll find our comments -- and recommendations --
sorted into five categories: hardware, software, semiconductors, services and
wireless communications. Our assessment of these stocks started with the
premise that an investor is willing to hold the stocks for at least two years -- these
are no short-term calls. There's more information on the companies in the table
below.
Hardware
First to Rebound?
Soundview's Arnie Berman argues that when the IT spending logjam breaks, the
first checks will be written to hardware companies. His theory is that IT
departments have postponed buying even the most basic items, and that these
items -- PCs, servers, printers and switches -- can often be purchased at the
departmental level without executive approval. (The same isn't true of other tech
products, such as servers and enterprise software.) While Berman may be right,
we fear many hardware companies will be hampered by sluggish PC demand --
and we doubt corporate IT spending will recover even modestly before 2003.
Even so, we're bullish on several companies in this category -- and the one we're
most enthusiastic about is Dell Computer. None of Dell's rivals have figured out
how to effectively compete with Dell's direct-sales model. Indeed, the company's
success was the obvious driver behind Hewlett-Packard's merger with Compaq.
Dell continues to gain market share in the U.S. and abroad, it has a solid balance
sheet with about $8 billion in cash, and it's zeroing in on potentially large new
product areas.
The one catch? Valuation. The stock trades for 30 times expected earnings for the
January 2003 fiscal year. And PC demand is hardly robust. Microsoft recently
said it expects PC unit growth of 5% or less for its own fiscal year ending June
2003. That suggests Dell's growth -- the Street expects 13% higher revenue in the
January 2004 fiscal year -- must be driven by market share gains and expansion
into new markets.
Still, we tend to side with the bulls, who expect Dell to grow by applying its
direct-sales model to additional technology products. Steve Milunovich, tech
strategist at Merrill Lynch, says he's bullish on Dell "not so much for its PC
business, but rather for its ability to move up into routers and storage and
servers." The company also seems to be making plans to attack the printer
market, where it currently has no products of its own. Bob Rezaee, a portfolio
manager at Montgomery Asset Management, sums it up: "Dell benefits from the
commoditization of technology."
On Hewlett-Packard, our gut instinct was that the Compaq merger was a bad idea,
destined to create the next Unisys, a big, sleepy, low-growth tech company.
Nonetheless, the stock is statistically cheap -- far cheaper than the other large- cap
tech companies we looked at for this story. At a recent 12.92, H-P now trades for
about 0.5 times expected revenues for the October 2003 fiscal year, and under 10
times projected fiscal 2003 earnings. Goldman's Conigliaro calls it "dirt cheap, the
cheapest computer company by far."
There are reasons for the low valuation, of course. Integration problems have
slowed some H-P segments; the company still must prove it can wring the
expected savings out of the merger. And the stock has been hurt by speculation
about Dell entering the printer business.
While H-P faces big challenges in PCs and other computing segments, it remains
the premier manufacturer of printers. Dell is more likely to partner with Lexmark
or Canon than it is to make its own printers; H-P bulls see little chance of
significant near-term impact on H-P's printer business. H-P's imaging segment
reported just shy of $5 billion in revenue for the latest quarter; given a $20 billion
run rate, we think the current market value of $37 billion would almost be
reasonable for the printer business alone. By contrast, rival Lexmark trades for
about 1.2 times expected 2003 revenues.
"Everyone hates [H-P Chief Executive] Carly [Fiorina], but she's not evil
incarnate," says Soundview's Arnie Berman. If this company can ultimately
generate revenues equal to the combined results of H-P and Compaq for 2000, he
notes, and can realize the expense synergies management has promised, the
company could eventually earn $2.20 a share. "Now, the market does not believe
that," Berman adds, "but the stock clearly trades for a low multiple [based on its]
earnings potential. It can certainly move higher."
Sun Microsystems, once the dot in dot-com, is now the dot in dot-bomb. Trading
today for under $4 a share, the stock is down more than 70% this year, and over
90% from its 2000 peak. Having dominated the server market for Internet
startups, telecom companies and financial-services firms, Sun has been hammered
by the swoon in tech spending in those sectors and by increased competition.
Kevin Landis, portfolio manager with the San Jose, Calif.-based FirstHand Funds,
says the server business has become a "food fight," with IBM and H-P trying to
under-cut Sun's prices. "And it's working," he says. "I'm worried about them."
He's not the only one. Montgomery Asset Management's Rezaee thinks Sun has
been too slow to cut costs. "In the latest quarter, Sun had roughly $3 billion in
revenue," he says. "I don't understand how you can have $3 billion in revenue and
not be profitable. They're trying to fight too many battles -- proprietary chips,
their own operating system, the software -- you can't be everything to everyone.
Their business model was not designed for standards-based pricing and gross
margins. The environment just doesn't favor Sun."
We admire Sun CEO Scott McNeally's shoot-from-the-hip style. But given the
troubled backdrop -- and shares trading for 30 times expected June 2003 fiscal
year earnings -- we would avoid Sun for now.
Cisco Systems was the poster child for the late-'Nineties bubble. As a producer
of routers and switches for corporate networks, the company provided the
plumbing for the broad expansion of the 'Net. The company's market value at one
point reached half a trillion dollars.
Now it's down to less than $100 billion, badly bruised by slowing corporate
spending. John Chambers, Cisco's courtly CEO, remained resolutely bullish on
Cisco's growth prospects long after fundamentals had begun to deteriorate -- for
the July fiscal year, the dream of regular 30% to 50% revenue growth was
replaced by a nearly 15% decline. Even so, the stock carries a respectable
multiple, trading at 25 times expected earnings for the fiscal year ending July
2003, and nearly four times estimated sales.
Last week, Cisco reported profits for its fiscal fourth quarter, ended July, that
slightly beat Street expectations. Revenues rose 12% from the year-ago quarter,
and gross margins grew to a higher-than-expected 67.7%. Even in the current
moribund environment, Cisco produced sequential gross-margin improvement in
each of the past four quarters. While Chambers indicated continued weakness in
the telecom sector, he reported that demand from corporate customers was higher
than expected in the quarter. And he noted that the company has steadily been
gaining market share from rivals.
"It's the last man standing" in networking equipment, notes Paul Wick, portfolio
manager of the Seligman Communciations & Information fund. The once
formidable roster of Cisco competitors, he notes, now looks like a list of the
walking wounded: Juniper Networks, Alcatel, Nortel Networks, Lucent
Technologies and Ericsson. Cisco, in contrast, has about $20 billion in cash and
investments, a bigger stash than any tech company other than Microsoft.
"Cisco's competitive position has been enhanced by the downturn," says Integral's
McNamee. "It has never been as well-positioned relative to the competition as it is
today." Cisco has made aggressive use of its financial strength to add customers,
particularly in the difficult telecom market. "The carriers are really hurting,"
McNamee observes. "And the guys who sell to carriers are really hurting, with a
capital H. Cisco goes to the carriers and tells them, take our product, and pay me
in a year. The competitors can't do that. Cisco can afford to wait a year, and grab
the customer. Ballgame over. They are making the bet that the revenues at risk are
small compared to potentially owning those accounts at the end of this. It's smart
accounting, and smart business." And a good stock to own.
"With Cisco, my conviction is higher than on just about any other company," says
UBS Warburg's Pip Cobrun. "They have 85% of the router market and 65% of the
switching market. They are dominant in their distribution channel and they have
mediocre competition. As long as you think they can manage the business back to
25% operating margins" -- in the July quarter, Cisco's operating margin hit 21.5%,
up from the low single digits a year earlier -- "you can feel good about the story
even without much top-line growth."
Like Cisco, EMC was once a huge investor favorite, dominating the market for
high-end data-storage systems. But the company's once-fabled margins have been
eroded by the emergence of considerable competition, and the stock has taken a
beating: Now trading at about $7, it is down dramatically from more than $100 a
share in late 2000.
In response to the shifting competition, EMC has been beefing up its
storage-software offerings, including features allowing the integration of its
hardware with competitive gear. The company has also been an aggressive cost
cutter. "They're doing all the right things after an incredibly hard time," says
Soundview's Berman. "Last year the competition was finally competitive -- they
would have had problems in 2001 even if tech spending was good. And EMC is
far more advanced on the software front than their hardware rivals, like Hitachi
and IBM."
EMC is a corporate turnaround story, not a simple bet on improved corporate IT
spending. On a statistical basis, the stock is hardly bargain priced, trading at a
lofty 41 times expected 2003 earnings, but robust IT spending in 2004 would
boost profits considerably. A bet on EMC will require more patience than other
hardware stocks -- the company and its investors have to adjust to a storage
market that is a far more competitive place than when EMC dominated the playing
field. We think it will be a difficult adjustment. While we agonized on this one, we
can't recommend it.
Semiconductors
Groping for the Floor
Semiconductor stocks continue to ratchet lower, as chipmakers report a steady
stream of bad news -- the Philadelphia Semiconductor index has been cut in half
since April. And it may not be over quite yet. It's worth noting that Cisco's
surprisingly good gross margins in the latest quarter were partly the result of
lower component prices. While some chipmakers will benefit once IT spending
rebounds, we would tend to avoid those with high exposure to the personal
computer and cellphone sectors.
Ergo, we cannot recommend Intel. No question, the company still has firm
control of the microprocessor business, even though rival Advanced Micro
Devices has some new chips in the works that could challenge Intel's lead at the
high-end of the market ("The Next Big Thing," Aug. 5). Intel has a strong balance
sheet, smart management and cutting-edge factories. But its fate is inextricably
tied to the PC demand cycle -- there is little room to increase market share, the
way Dell can, and efforts to move into the communications sector have been
disappointing.
And there's another issue: At 32 times expected 2002 earnings, or 4.4 times
anticipated revenues, Intel is no cheap stock in an environment where PC demand
is growing in the low single digits.
"It's hard to imagine Intel not having a dominant position," says FirstHand's
Landis. "The issue is the saturation of the opportunity. This is the ultimate example
of a company that made the most of one of the greatest business opportunities
ever. But now what?" Sell it, we suggest.
Landis thinks STMicroelectronics offers a smart alternative. "I was looking at
Intel recently as a way to have more semi exposure, because that's what everyone
will run back to when demand turns," he says. "But it's hard for Intel to grow. I
wanted a big-cap, reasonably priced, well-known liquid stock. And STMicro fit
the description." Landis notes that, like Texas Instruments, the company has
broad product exposure serving multiple markets. One difference: Where TI has
more exposure to the communications sector, STMicro is more tied to consumer
electronics. The company has some exposure to the cellphone market -- Nokia in
particular is a big customer -- but it also does considerable business in industrial
and automotive applications.
Headquartered in Geneva, Switzerland, STMicro trades for 20 times projected
2003 earnings, and 2.3 times projected revenues. That makes it cheaper than TI,
which changes hands for 26 times expected 2003 earnings and 3.5 times
revenues.
We have recently waxed bullish on Texas Instruments ("Ready to Rebound," July
1), which in recent years has reconfigured its business to focus on analog and
digital signal-processing chips. TI has been showing improving revenue and
profits, though it sees moderating growth ahead. While still impressed with the
turnaround story, we've lately become concerned that the Street has largely
discounted the rebound in TI's fortunes. We worry about the company's high
relative valuation and its significant exposure to the cellular-handset market. It
would be easy to be enthusiastic at lower levels. But for now, pass. For a
broad-based semiconductor bet, STMicro, with heavier exposure to
consumer-electronics gear, looks cheaper.
Of the stocks reviewed here, none seems more attractive than Taiwan
Semiconductor, the world's biggest maker of silicon chips for other companies
and a pioneer of the foundry model in which chips are made to order for a wide
range of semiconductor companies that don't have factories of their own. "The
semiconductor industry is so capital intensive now that the argument for using a
foundry to make your stuff has never been better," says Soundview's Berman. "In
the last cycle, foundries gained a lot of share at the lagging edge, where they were
able to make parts more cheaply." But now, he adds, they have leading-edge
capability, with technologies like 300-millimeter silicon wafers. And that means a
new set of customers.
"Texas Instruments, Motorola, STMicro and Advanced Micro Devices,
historically integrated vendors, have decided to outsource at least a portion of their
manufacturing -- they're all adopting asset-light strategies," says Integral's
McNamee. "TSMC and UMC [United Microelectronics] are disproportionately
advantaged by this. Both TSMC and UMC have always been great companies, but
they had been too expensive to own for a long time. Not anymore." The stock
trades for just under 17 times expected 2003 earnings. We'd buy it, though there
is one caution: TSMC can periodically get caught up in politics. When tensions
between Taiwan and China heat up, Taiwanese stocks tend to cool off.
Micron Technology, the dominant producer of the computer memory chips
known as DRAMs, has gained market share in recent years as the memory
business has endured difficult times. In recent years, the sector has suffered from
severe overcapacity, resulting in the recent financial distress at Korea's Hynix
Semiconductor and the exit of several other players.
The problem with Micron? It sells commodity parts with close ties to PC demand.
"The company loses money at least one out of every two quarters," says
Seligman's Wick. "It's a bad business, and capital intensive. The company has $11
a share in book value, so at at about 18, it's at a level without much more valuation
risk. But I wouldn't be long."
Neither would we. Micron might make sense if you believe in a big coming PC
cycle -- but we don't. Micron is a stock to trade, not to buy and hold.
Applied Materials and other equipment makers have been under intense pressure as
Wall Street rethinks its expectations for the semiconductor-equipment sector.
Applied maintains that three concurrent technology trends will continue to drive
sales of semiconductor manufacturing equipment: a shift to 300-millimeter silicon
wafers from 200 millimeter wafers, a reduction in circuit line widths, and a switch
to copper from aluminum for certain chip circuitry.
While that's true, the timetable on adoption of those technologies is stretching out.
Intel, AMD, UMC and TSMC all recently cut capital spending plans in the face of
slower component demand. Weak PC and cellphone sales will hamper the chip
recovery and push out a pick-up in the equipment business. And Applied remains
pricey: The stock trades for 20 times expected earnings for the October 2003
fiscal year and 75 times current-year estimates. Moreover, we suspect profit
projections may be too high. In other words, the stock may yet trade lower. We'd
avoid it for now. |
