Don't Shoot in the Dark
That lack of visibility translates into more risk for investors.
investor.msn.com
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.
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.
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.
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.
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. |
