The Three New Rules for Tech-Stock Investing
By Jim Jubak
MSN Money Markets Editor
5/16/2007 10:56 AM EDT
URL: thestreet.com
Tech stocks are dead. Long live technology investing.
The three great rules for finding a highly profitable technology stock still work as well as they did back in the days when Microsoft (MSFT) , Intel (INTC) , Dell (DELL) and Cisco Systems (CSCO) were the kind of stocks that set an investor's blood racing and produced lip-smacking profits for portfolios.
I just don't think the rules work very well for mainstream technology stocks anymore.
That's because, first, the technology sector has changed so radically since the good ol' days before the bear market that began in March 2000. And second, because changes in the energy sector -- yes, the energy sector -- have created stocks in that part of the market that show all the traits of technology stocks in the 1990s.
Sales, Apps and Margins
What are the three great rules of technology investing?
1. Look for the hockey stick. This has nothing to do with sports. Instead, the "hockey stick" describes a highly desirable pattern in a company's sales growth. Initially, sales start off at a low level and grow slowly over time, sketching in the blade of the hockey stick.
Then, if all goes well, at some point sales start to increase more rapidly, creating the upward curve that is the stick's neck. And then, if this technology company is really on to something, sales take off and growth becomes almost vertical. That's the handle of the stick.
Do I need to say that you'd like to own a stock when the company's sales -- and earnings -- growth goes vertical?
2. Look for the killer app. The killer application -- the software program, piece of hardware, product improvement or whatever -- that everyone has to have is what powers hockey-stick growth. It took everyone a while to figure out what an Internet browser was and what it was good for, but once that period of slowly growing use was past, everybody had to have one, because being browserless was just inconceivable. Same with digital cameras and wireless phones and, before that, with routers and personal computers themselves.
3. Look for a company with sustainable high margins. In the technology markets of the 1990s, a company could ride a sustainable proprietary edge -- and a willingness to use that temporary advantage over the competition as if the devil were at its heels -- to years and years of outsized profit margins.
As the company's sales climbed up that hockey stick, fixed costs would be spread over a larger and larger volume of sales, and profit margins would grow. As advantages of scale kicked in, successful technology companies would wipe out competitors that were unable to spread costs over a big enough sales volume, and that would allow the victor to increase profit margins again.
But these rules just don't fit the technology titans very well right now. How they'll fit the sector in five or 10 years is anyone's guess.
New Times, New Rules
So here are three new rules that are a better fit for the sector as it now exists.
1. Instead of hockey-stick growth, think mature blue-chip growth. Cisco Systems is a great company, but it now has more in common with a company like PepsiCo (PEP) than with the technology competitors of the 1980s and 1990s or today's technology-driven competitors, such as Juniper Networks (JNPR) .
Cisco is now all about line extensions, about building on its strength in hardware to sell more software in much the same way that PepsiCo uses clout in cola and potato chips to grab shelf space for bottled water and "healthy" Doritos. It's all about motivating an already-hard-running sales force into running harder and harder each day. Investors who are disappointed that Cisco Systems is growing revenue by only 15% a year need to have their heads examined.
PepsiCo and Procter & Gamble (PG) would kill for that kind of predictable growth. But if you're still comparing today's Cisco Systems with the technology model of the 1990s, I can understand the source of the reaction.
2. Instead of killer apps, think killer fashion sense. Why has Nokia (NOK) taken over from Motorola (MOT) at the top of the wireless-phone market? Because Nokia does a much better job, year in and year out, at matching its phones to the fast-changing trends in the consumer market. (Well, Nokia's ability to actually manufacture phones efficiently so that it can supply a fashion-driven market at a healthy profit does have something to do with it.)
Even when Motorola delivered a hit such as the Razr, the company managed to quickly turn a hot phone cold because it didn't understand it was managing a fashion phenomenon. That's a fundamental mistake in this new market for technology goods that Apple (AAPL) , a technology company that has become adept at selling the sizzle, would never commit.
3. Instead of growing profit margins, think shrinking margins. There's so much capital in the world now that a high profit margin becomes a red flag that draws a horde of well-funded competitors from around the world -- and at least a few of those are willing to run at a loss for years because the government that has arranged the financing has goals besides profitability.
So many technology products are now produced by contract manufacturers that new competitors don't face a steep learning curve before they can efficiently manufacture a new product.
The use of contract manufacturers means that only those few technology companies, such as Intel, that run their own factories can reap higher profits from increased manufacturing volumes. And finally, because many new technology products are extensions of newly developed technologies, being first to market now yields months, not years, of outsized profits until competitors catch up.
And Now for Energy
But in the energy sector, the three old rules of technology investing are still a great fit:
1. The hockey stick lives. In the energy sector, truly innovative -- and therefore extremely risky but potentially very profitable -- technologies are just now moving from proof of concept to the early stages of the hockey stick.
Take Color Kinetics (CLRK) , for example. Sales grew by 28% in the first quarter of 2007, but sales are still tiny: $65 million in 2006. The company has demonstrated its LED lighting technology, built up a portfolio of patents and increased manufacturing efficiency while attacking the market for digitally controlled solid-state color lighting.
In this market, the company has recently tested a system of digitally controlled color lights on the Empire State Building and signed a contract with Ford (F) for an LED instrument panel that would allow drivers to control the color of the display.
But the company has just started to penetrate the market for intelligent white LED lighting, which is much more energy-efficient than incandescent or fluorescent lighting. In 2007, the company estimates white lighting will make up about 5% of sales.
But this is where the future lies in a quintessential hockey-stick fashion: As white-light sales grow, the company (and it competitors) can bring down the prices so that this technology can pick up market share. As LED prices drop and energy prices (and carbon-offset costs) rise, white-light sales will grow -- and so on in a virtuous cycle.
2. The killer app lives. Here's a startling figure that should guide your investing strategies for the next decade: The giant multinational oil companies of the world together own or have access to less than 10% of world oil resources. The rest belongs to state-controlled national oil companies. Think that puts the multinational oil companies in a bind? They've got the cash flow to invest just about anywhere, but they can invest just about nowhere.
Sitting back and doing nothing isn't a viable strategy for any oil company CEO, since it amounts to presiding over the liquidation of the company. So any company selling a "product" -- and I'm using the term very loosely here -- that promises to solve this problem can charge just about anything.
In the case of the energy sector, that product is the deep-water oil deposits of the continental shelf. In many cases, these areas belong to countries such as the United States that are still willing to grant production rights to the multinationals, and drilling for this oil requires expensive technology that only the multinationals can afford, so they have more negotiating clout.
But drilling in deeper and deeper water is pushing the envelope for drilling technology. It requires the invention of new pipes and valves, the outfitting of new deeper-water drill ships and the exploration of even more challenging environments.
I can think of two energy companies that fit this profile. First, Transocean (RIG) is a leader in deep deep-sea drilling and the owner of the largest fleet of mobile offshore drilling units. The worry in the drilling sector has been that the extraordinary run of higher and higher lease rates for drill rigs can't go on. But, au contraire, mon ami, it can in the deep-sea business, because global politics is pushing multinationals to drill in ever-deeper water no matter the price.
And second, Statoil (STO) , one of the few national oil companies to trade publicly, owns a huge chunk of the continental shelf. (Well, actually Norway does, and Norway owns 70% of Statoil.) And it's about to own even more. The U.S. Geological Survey, the source of some of the more optimistic projections on global oil reserves, estimates that 25% of the world's undiscovered oil lies in the lands and seas around the Arctic Circle.
Believers in global warming might note that exploration in these areas is going to get easier, but even global-warming skeptics can be sure that as push comes to shove -- and Statoil is facing a big shove because it is pumping oil from existing reserves faster than it is finding new oil -- oil companies will drill in these areas. It will take a while for Norway and Russia to sort out who owns what part of the continental shelf in their region, but sort it out they will. And drill Statoil must.
3. Growing profit margins live. All the old-technology sector rules seem to apply. For a company such as Tenaris (TS) , for example, adding more and more technology to its steel pipes for oil and gas wells increases the profit margins on the pipe, which in turn gives Tenaris the cash to buy competitors such as Maverick and to acquire Hydril (HYDL) and its pressure-control technology, which will add even more value to Tenaris' pipes and increase margins even more.
Or for a company such as Johnson Controls (JCI) , where growing scale is leading to growing margins in its building-efficiency business. The company is combining its expertise in heating and cooling systems (acquired when it bought York) with its knowledge of systems control to move into the new business of providing outsourced energy management for other companies' buildings.
Deutsche Bank projects that margins in the business will grow by 2 percentage points from 2007 to 2009. Each time the company adds a client, of course, it is better able to cut its costs for providing energy to its customers, which increases the savings it can deliver, which increases its customer base. And all that with higher margins, too.
I realize these five stocks -- Color Kinetics, Transocean, Statoil, Tenaris and Johnson Controls -- aren't from the same family as the great technology stocks of the 1990s. But they fit the old rules well. And, after all, profits and technology are where you find them. |
