Posted 11/11/97
Archived 11/18/97
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Ascend vs. S&P, Nov. '96
- Nov. '97
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Price History
Overview
Earnings Estimates
Recommendations
Growth Rates
Don't Shoot in the Dark
Visibility -- that is, a clear sense of a company's revenue and earnings going forward -- should be a
top priority for anyone eyeing growth stocks. Consider the contrast between Ascend and Level One,
for instance.
By Jim Jubak
"What did you think of Ascend's presentation yesterday?" I asked the analyst sitting next to
me. We had another 10 minutes to kill before the next company pitch. Just halfway through
day two of the American Electronics Assocation fall financial conference, I was already
starting to feel overwhelmed with data. So far I'd heard the chief executive officers and the
chief financial officers of 12 companies take 45 minutes each to tell me how wonderful
everything was with their businesses. With another 30 or so presentations looming ahead of
me, I was looking for every bit of help I could get to sort out the evasions from the half-truths.
"Not good," he said. We both nodded sagely. Here was a company that had missed Wall Street
earnings estimates by a mile just a few weeks ago. I walked into the session hoping to find out
if rumors of plunging sales were true. Were customers rejecting the company's new product?
When would Ascend (ASND) start showing 50% sales growth again instead of the anemic 9% of
the recently completed quarter? Would a stock that had dived from $80 to less than $30 as the
San Diego conference began fall still lower?
But I'd left the room with none of my questions answered. The company hadn't even addressed
them. "They just have no visibility on sales or earnings," my newfound analyst acquaintance
added.
"Visibility" is one of those bits of jargon that Wall Street loves, but the concept behind it is
extremely useful. It is really all about predictability, and it can help clarify the risk in a stock
such as Ascend. It can help an investor understand that how a company collects and
recognizes its revenues helps to determine the risk in any stock. Finally, "visibility" can
actually point you to growth stocks that are less risky than they seem. Let me use Ascend to
talk about the idea of visibility and how to use it. And then I'll use a couple of other companies
from the AEA conference to illustrate how "good visibility" can mean lower risk.
Here's the sequential pattern to Ascend's sales over the last four quarters before the recent
downturn: $249 million in the quarter that ended on Sept. 30, 1996, then $288 million, $293
million, and $312 million. Now you understand why the $270 million the company reported in the
recently concluded September 1997 quarter was such a shock to investors.
What will the next quarter bring? After listening to the company's presentation, I'd have to
conclude that management just doesn't know. They still don't know what led to the shortfall in
sales growth in the last quarter. Was it a slowing of growth across the industry or something
specific to Ascend? Europe was a big culprit -- which, since other networking companies such
as Cisco Systems (CSCO) also experienced slowdowns in Europe, suggests an industry-wide
problem. But the damage at Ascend was far greater than that experienced by most of its
competitors. So the company has taken steps to "fix" its European sales program just in case
the problem was Ascend-specific. But the truth is that the company can't announce that the
problem is fixed because it doesn't know precisely what the problem was.
That lack of visibility
translates into more
risk for investors.
This is about as bad as visibility gets for management and investors. Management can't offer
meaningful guidance to Wall Street about what to expect next quarter because it can't see a
quarter into the future with any clarity. Absent a reliable pattern of past growth or any
information from the company that would allow a confident projection of future growth, Wall
Street analysts wind up estimating in the dark. Estimates for Ascend's earnings in the current
quarter range from a high of 41 cents a share to a low of 14 cents -- 27 cents, almost twice
the low estimate, separates the high and low end. Visibility doesn't improve in the first
quarter of 1998. Estimates for that period range from a high of 40 cents a share to a low of 12
cents, a difference of 28 cents, or 233% of the low estimate.
That lack of visibility translates into more risk for investors. And the market has behaved
rationally under the circumstances by sending the price of Ascend down further. The stock fell
another $2 a share to $25 during the conference. Ascend's not likely to head back up until
earnings visibility improves. At this point, it's actually more important that investors start to
feel that they know what the future might bring-- even if it's bad news -- so that they can
estimate where the bottom might be on the stock. Visibility could improve as early as
December, I suppose, but the March quarter seems more likely. Right now, any investor
bottom-fishing in Ascend -- and I still like this stock, which I recommended as a turnaround
play at $41 ("Bargains or Blunders") -- is betting that a company with a leading position in one
segment of the networking industry and with quality technology will be able to find and fix its
problems. To me, that seems a reasonable bet for sometime in 1998, but with visibility so low, I
certainly don't know that the stock won't go lower.
Let me contrast Ascend's visibility to that of some other companies presenting at the AEA
conference.
Snapshot
Price History
Overview
Earnings Estimates
Recommendations
Growth Rates
Like Ascend, Level One Communications (LEVL) operates in a fast-moving industry where
standards and technology change overnight. But unlike Ascend, Level One management was
able to lay out the company's growth path into late 1998 at the conference. Level One is in the
business of building pumps that can push more information over the existing pipeline. The
company's chips are designed to get more bandwidth out of the existing telephone
infrastructure of copper wire. In part of the market right now, that means working with a
standard called fast ethernet. Level One has just introduced a new product into that market
and recorded 30 design wins in the third quarter of 1997 with the big original-equipment
manufacturers, such as Compaq (CPQ) and 3Com (COMS), that are its customers. All of those
will turn into revenue in 1998.
That fast-ethernet standard is giving way to one called gigabit ethernet. Level One expects to
produce the first sample chips for a gigabit-ethernet product in late 1998 -- with sampling,
design wins, and revenue to follow over the next 12 to 18 months. The company laid out a
similarly clear progression in its high-speed internet connection market, where T1 is giving
way to MDSL and HDSL2, and in its new wireless business, where the company has just
produced a test chip.
That clarity gives credibility to the company's business model, which calls for a gross margin of
58%. (It didn't hurt the presentation any that the margin in the first nine months of 1997 came
in at 58.1%). And it gives investors confidence that, going forward, the company will be able to
grow revenues at something like the 80% annual rate that Level One has produced since 1989.
For the December 1997 quarter, the high and low analyst estimates vary by only a penny (high
of 29 cents a share, low of 28 cents) and the same is true for the first quarter of 1998. And
that lack of variance is in spite of the company's extremely high rate of projected earnings
growth -- 71% in the fourth quarter of 1997 and 76% in the first quarter of 1998. Analysts
believe that these earnings will come through -- that's visibility. The stock, which currently
trades at a price-to-earnings ratio of 66, is selling at a P/E of around 36 on projected 1998
earnings. Not cheap, but cheaper than it seems without taking visibility into account.
Visibility plays an even more important role with other stocks, either because the nature of
the company's revenue stream makes future revenues and earnings more visible, or because
the company has consciously adopted financial policies that increase visibility.
Snapshot
Price History
Overview
Earnings Estimates
Recommendations
Growth Rates
Geoworks (GWRX), a stock that has more than doubled since I recommended it in my June 6
column ("Follow That Trend"), falls into the first category. Now this seems like a very risky
stock -- the company's future depends on smart-phone products from Toshiba (TOSBF) and
Nokia (NOK/A) that have just started to ship, and others from Ericsson (ERICY) and NEC
(NIPNY) that won't ship until the end of 1997. The company is moving toward break-even in
1998, exactly the point at which speculative companies tend to stumble.
But Geoworks' revenues have very high visibility. Going forward, most of the company's
revenue will come from a $12 a unit royalty that the company collects on every cellular phone
that uses its operating system. The company doesn't collect that revenue until they get a
report from Nokia, for example, on the number of phones sold -- typically a month after the
unit has shipped. A check for the royalty arrives with the report. Only then does Geoworks
recognize that royalty revenue. The nature of the revenue stream means that Geoworks has a
very good idea on what revenue will be -- from talking to Nokia about sales -- about a quarter
before the revenue actually goes on its books. With that kind of predictability within its
revenue stream, this company isn't likely to get surprised. When the management team told
analysts at the AEA that they were confident that the company would meet estimates of
break-even in the quarter ending March 1998, the statement carried weight. (The stock
climbed $3 per share to $15 3/4 during the week of the conference.) Despite an infinite
price-to-earnings ratio and the newness of the products using its operating system, Geoworks
isn't nearly as speculative as it seems at this point in its history, because revenue and
earnings are so visible.
Snapshot
Price History
Overview
Earnings Estimates
One company at the conference made a point of its policy of managing for visibility. Wind
River (WIND) manages sales and bookings for future sales in such a way as to create four or
five months of visibility. It sets internal quarter-to-quarter goals for sales growth, and after
sales have hit that level, it starts to build up an internal 90-day sales backlog. That means the
company never has to scramble to meet sales figures at the end of a quarter, and it has a
great deal of flexibility to respond to any sudden order cancellation by a customer.
A company can't manage this way without tremendous rates of revenue growth, and here
Wind River has a certain advantage. It's selling its operating system for embedded
microprocessors -- the chips that add intelligence to an automobile or to an Internet router --
into the market for 32-bit chips. The 32-bit market is growing at somewhere north of 50% a
year. And Wind River is likely to strike gold with the next-generation architecture that
handles peripheral devices -- printers, for example -- in a personal computer. Intel's i960 chip,
which is designed to handle the increasing number of peripherals that hang off every
computer, will incorporate Wind River's operating system. In addition, Intel (INTC) will ship
Wind River's development tools -- tools that let a peripheral maker write an application for the
chip to use in running its product -- with the i960 chip. Peripheral makers -- many of whom now
use their own tool set -- will have 30 days to pay Wind River a license fee if they want to use
Wind River's tools. Intel expects to ship 10 million of these chips in the next two years.
You wouldn't expect the stock of a company with these growth prospects to be cheap -- and
Wind River isn't. It trades at a price-to-earnings ratio of 73. But the visibility of the
company's revenues takes some of the risk that normally comes with a high-priced,
high-growth stock out of this equity.
High visibility means an investor is less likely to get blindsided -- not an insignificant advantage
when you're paying up for growth.
New Developments on Past Columns:
Cloning Dell
I recommended Aspect Telecom (ASPT) in my May 30 column. After listening to the company's
presentation -- and that of a competitor, Davox (DAVX) -- at the AEA conference, I don't think
this stock is going to get us where we want to go.
I picked the stock as the result of building a screen intended to find the next Dell. Aspect's
history showed all the right numbers, fantastic growth, efficient use of capital and assets,
solid margins. But since that recommendation, sales growth has slowed at the company. I've
watched for two quarters to see if this was a temporary problem -- even great companies hit
potholes -- and I've now reluctantly concluded that the problems aren't temporary.
The whole industry is undergoing major changes. Aspect is planning a tough transition from a
company that sells a proprietary telephone-call-center product consisting of hardware and
software, to a company that will predominantly sell software. Davox's presentation showed
that company moving in a similar direction (although it may be further along). At this point I
don't know if Aspect's transition plan will work. The market has no real standard, which makes
it difficult to write a truly open software product. But even if the company does succeed, I
don't see the growth potential or the competitive advantage to turn Aspect from a decent
stock into an investment success along the lines of Dell.
I'm going to stop following the stock -- and I'm moving it to the dropped section of Jubak's
Picks. In the next week or so, I'll be doing another column that builds a new -- and, hopefully,
improved -- growth stock screen that incorporates the lessons I've learned from Aspect.
Fortunately, readers who bought at my original recommendation price will be able to get out of
the stock without a loss.
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