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NET SENSE
The risk of betting on cash piles
Commentary: Is zero in their destination?
By Bambi Francisco, CBS.MarketWatch.com
Last Update: 12:05 AM ET Nov. 5, 2002
SAN FRANCISCO (CBS.MW) - In the past several weeks, investors have been placing bets on tiny cash-rich tech companies with low prices on the notion that they're unlikely to go the way of the dodo bird.
Hey, they got themselves this far, right?
But if history is any guide, there is a high extinction rate among companies whose shares have fallen significantly, even if they have a lot of cash in the bank.
Taking a look at stock performances since 1962, for stocks (broadly speaking) that declined by more than 60 percent, survival rates during the following two years are less than 70 percent according to research from Sanford Bernstein. "Technology, which was the center of excess, should closely track historical patterns of extinction," warned Vadim Zlotnikov, tech strategist at Sanford Bernstein.
Zlotnikov, who issued this caveat to his clients, sought to temper any inclination they might have to plunge into the market after he unveiled his findings that a number of tech companies were trading close to their cash values.
That list includes I2 Technologies (ITWO: news, chart, profile), Vignette (VIGN: news, chart, profile), Openwave (OPWV: news, chart, profile), ProBusiness Services (PRBZ: news, chart, profile), Sycamore Networks (SCMR: news, chart, profile), Comverse Technology (CMVT: news, chart, profile), Eclipsys (ECLP: news, chart, profile), Gateway (GTW: news, chart, profile), Applied micro circuits (AMCC: news, chart, profile), Lucent (LU: news, chart, profile), Ciena (CIEN: news, chart, profile), Vitesse (VTSS: news, chart, profile), Adaptec (ADPT: news, chart, profile) and GlobespanVirata (GSPN: news, chart, profile).
He was right. Investors jumped in.
I2 Technologies has enjoyed some of the biggest percentage gains. The stock has soared nearly 200 percent since the start of October, and it was up as much as 29 percent, to $1.21, percent on Monday ahead of a company presentation at a Goldman Sachs Software retreat in Laguna Niguel, Calif.
Apparently, Zlotnikov's words of wisdom were not heeded.
But they're worth recalling. He's particularly wary about shares of software and services companies, as opposed to semiconductor and storage stocks.
Given that the software and services industries have low barriers to entry and new entrants flood those businesses during boom years, the median life of such companies -- which has been historically 3 to 4 years -- will be shorter, Zlotnikov wrote.
Beyond the cash pile
"Companies don't trade below or close to cash for just any reason," echoed Greg Jones, director of research at Briefing.com. "For most of these companies whose problems are permanent rather than just cyclical, they may have little rallies on their way to zero, but their destination is still zero."
No doubt, having cash is better than not having it. But Jones would caution that a stock is worth its cash only if it has high chances of reaching profitability, or if it finds a suitor willing to pay a premium to the cash, or if the company decides to give shareholders back that cash. "If you're banking on the last two, it's a long shot," he said, adding, "Hell, even getting to profitability is a long shot" especially in an environment where profits aren't growing fast enough.
That is, of course, if companies are generating profits.
For instance, I2 Technologies may have $527 million in cash, but it's burning through a lot of it, according to a UBS Warburg note issued after I2 reported its third-quarter results. I2 spent $92 million in the third quarter, wrote analyst Ken Carey, who has a "sell" rating on the shares. In addition, I2 also has $350 million in convertible debt due 2006. This means that I2 will have to come up with that amount of cash to pay it off, a doubtful prospect in light of the slow-growing IT spending environment, forecast to grow just 3 to 5 percent next year, according to Sanford Bernstein.
Now, I2 could do what many other companies, like Comverse, Lucent and Nextel (NXTL: news, chart, profile) are doing these days, which is to use the cash or stock to lower its outstanding debt. In fact, the amount of convertible bonds repurchased this year is nearly double the amount from last year and 3.5 times the amount in 2000, according to Converbond.com. But using that cash could put I2 at a disadvantage in the fast-moving tech sector where innovation requires spending on research and development. What's more, even though the debt security trades at a discount of 60 cents to the $1, that price would likely go up if I2 began buying back its debt. And, other ways to raise capital to reduce debt in the future, such as a secondary offering, would dilute shares.
If I2 were to be valued for its cash and debt, it would have a net-cash value of 24 cents, as calculated by Carey.
Even if a company manages to take care of its debt, or has little debt exposure, in the case of Vignette, it's the business that matters. Consider Critical Path (CPTH: news, chart, profile). Last year, General Atlantic Partners purchased $65 million in face value of debt, leaving Critical Path with $30 million in cash. The stock shot up to more than $3 a share during the fall of 2001, but now it trades at less than 70 cents.
Cutting to the bone
Bernstein's Zlotnikov says that the positive performance in the software industry in the third quarter has more to do with cost cutting and less to do with improving demand or pricing power.
More than half of the software companies exceeded third-quarter sales projections, but forward revenue estimates were reduced, he said.
While three out of four business application software vendors, such as SAP (SAP: news, chart, profile) and PeopleSoft (PSFT: news, chart, profile), exceeded earnings targets in the third quarter, 70 percent of them fell short of sales projections.
To this end, sustainability of positive revisions into next year seems "questionable as demand remains weak and operating leverage that is built into consensus estimates is somewhat aggressive," he said.
Translation: If sales remain weak, companies may have to continue to cut expenses in order to achieve those earnings goals.
Already, software companies are anticipating this. In the third quarter, while 80 percent of software companies met or exceeded consensus earnings estimates, many, depending on the sector, largely lowered forward earnings projections, he said.
All this said, quantitative analysis does suggest that the ratio of a company's market cap and cash is a "surprisingly effective predictor of performance," said Zlotnikov.
For instance, when ProBusiness Services and Comverse Technology traded at $6.90 and $7.92, respectively, their cash positions were 85 percent of their total market cap. Vignette, at 96 cents, had a cash position that was 124 percent of its market cap. This compares to the average cash position of 5 percent for all tech companies in 1965.
Cash positions as a percent of market cap rose to 10 percent in the mid-70s, but dropped back down to between 5 and 10 percent in the 80s. Now, they're nearing 20 percent.
It is no wonder these tiny tech companies have raged higher.
It may even be the case that buyers will hold onto gains and short-sellers will stay away until after the Tuesday elections and Wednesday's Federal Reserve meeting.
But no doubt short-sellers are scouring for targets. Who wouldn't be after this run-up?
And, when investors pull out their fingers from their ears, after singing "La, La, La, La, La" to drown out the negative news that consumers are unconfident, over-leveraged and unemployed, then they'd better be ready to watch some quick gains turn into quick losses.
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Bambi Francisco is Internet editor of CBS.MarketWatch.com, based in San Francisco |
