MARKET ACTIVITY/TRADING NOTES FOR DAY ENDING FRIDAY, NOVEMBER 19, 1997
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High-Tech Reality Check
Market hiccups and product shakeouts are separating the wheat from the chaff in technology stocks.
The Financial Post
Chicken Little appears to be the broker of choice for technology investors these days.
And while the sky is still intact over most of the technology world, more and more Canadian tech companies have felt some of it fall on their heads.
Consolidation, market volatility, confused customers and a stock meltdown in Asia have damaged the prospects of some technology companies - and reminded everyone that, after all, a company's fundamentals really do matter.
The stumbling Southeast Asian economy, to which stock markets reacted so poorly, hurts Canadian technology companies in particular, says Brendan Kyne, portfolio manager at Driehaus Capital Management Inc.
First, many of them sell products to Asia. Second, competing Asian products may now be cheaper. Third, investors may conclude the first two factors will slow growth at technology companies, which will in turn drive down the value of their shares.
Meanwhile, a string of high-profile bubbles bursting in technology companies - Newbridge Networks Corp., Fulcrum Technologies Inc., Gandalf Inc., AIT Corp., Corel Corp., and HookUp Communications Inc., to name a few - has some investors reassessing the allure of the entire sector.
"We're used to the market going up forever. When it doesn't, we say
'My God, it's the end of the world'," says Duncan Stewart, a partner at technology investment firm Tera Capital Corp.
"But for every [company] that's missed, there are several who have
reported perfectly fine numbers."
It is those companies, says Mark Pavan, an analyst at Yorkton Securities Inc., that will weather the storm. "If there is a market downturn, leading technology stocks may drop with the market, but they will recover along with the market."
Firms such as Hummingbird Communications Corp. have shown they can survive a shakeout. Hummingbird has steadily increased sales and profit, but trades below the price-earnings multiple enjoyed by some of its peers.
This may sound like obvious advice: buy quality companies when their price is low.
But it's particularly relevant in this sector because investors haven't always been able to discern where quality is to be found. Analysts say the technology sector is now paying the price for "concept stocks," or companies that hit the market full of vague
promises and heady growth plans.
"We've had people coming into technology who were lured by the bright shiny object of rapidly ascending numbers," Stewart notes. Witness the phenomenal stock price rise of two Ottawa-based Internet companies, Milkyway Networks Corp. and iStar Internet Inc. Both went public two years ago on a wave of Internet hype.
iStar's initial price of $12 a share (WWW/TSE) jumped to $22 on its first day of trading Nov. 27, 1995. Last week, U.S.-based PSINet Inc. bought the company for $1.20 a share.
Milkyway's IPO on July 2, 1996, was eagerly snapped up at $13 a share. Mounting losses and increased competition have pulled the stock (MKY/TSE) down to a recent close of $1.40.
David Wright, an analyst at Marleau Lemire Securities Inc., says investors feel less secure now about guessing which technology companies will dominate two years down the road.
Due to the fact that stocks are priced on forecast profit rather than actual profit, knowing who will ride the next wave can make lucky investors rich.
In fact, analysts say, some of the attention paid to the technology sector in recent years followed the dazzling early success of Netscape Communications Corp.
But the breakneck growth of some technology firms may have contributed to their downfall.
A booming stock market and easy access to venture capital have resulted in a lack of discipline among some firms. Stewart says those factors have also inflated expectations of success, prompting analysts to keep boosting earnings estimates so they can maintain "buy" recommendations.
But Yorkton's Pavan says institutional investors are becoming more discerning about what they buy.
"Unlike two years ago," he says, "startups with little revenue now find it difficult to find financing."
The pace of change in technology itself is proving to be a major issue too.
"The whole technology business is undergoing dramatic change," says Eric Goodwin, chairman and chief executive of Fulcrum. "[It is] in part driven by the acceptance of the Internet and the expectation that the value of the software should be commoditized because there are so many free products available."
Goodwin says large companies such as world-beating Microsoft Corp. can wipe out a whole sector simply by adding a product to their stable or integrating a new feature into existing software.
For example, Microsoft's decision to add search capabilities to its office software was part of the reason Fulcrum's sales fell earlier this year. That prompted the company to lay off 20% of its staff and search for a financial savior.
Its principal banker, Royal Bank of Canada, could force it into receivership as early as Dec. 1 if an equity partner isn't found.
Pavan adds that the technology is often secondary to a company's management.
"When Internet companies were extremely highly valued, with growth rates of 200%, people forgot that you can't grow at that rate without facing tremendous challenges."
There are any number of companies that have great technology, says Pavan, but fall short when it comes to executing a good business strategy.
Denzil Doyle, president of venture capital firm Doyletech Corp. and founder of Digital Equipment of Canada Ltd., says many technology firms lack a skilled and seasoned board of directors that can guide rookie executives.
"If you ask me, the real skill shortage in this country can be found in the boards of directors," Doyle says.
"The board has a heavy responsibility to ensure the founders of the company get the mentoring to grow with the company, or make sure they are replaced."
For example, a good board will ensure the company has a rational strategy for adapting its products to new operating platforms like the Internet, he says.
"It is the responsibility of the board to insist on an annually updated strategic plan, one that talks at length about migration strategies for each of the company's products," Doyle says.
That's not as easy as it once was, Stewart argues.
"What you're attempting to do with a product migration strategy is predict the future. Unless you're Cisco Systems [Corp.] or Microsoft and can control the future, no one is very good at this," Stewart says.
"When you get to the smaller companies like Fulcrum, they really can't predict the future and they have no ability whatsoever to control it."
Moreover, even the best-laid migration strategy can fail in the face of a market that changes at hyper-speed.
"You might see a market shift coming," says Stewart, "and it takes six months to migrate your product. If, in five months, you suddenly see you have to change course, you can't do it."
The speed at which a company can shift direction often depends on the company's size, Goodwin adds.
Very small companies are nimble enough, or in a narrow enough customer niche, to dodge market blows. Very large ones have the deep pockets to withstand them. But the ones in the middle often have too much baggage, too many expenses and not enough cash to withstand a market change.
"Companies larger than 100 employees need to be on a very aggressive path of growth, which means high risk," says Goodwin. "Or they need to think about joining forces with another company to create more mass in the market."
Those that go it alone often face a doubtful market and several quarters of serious shortfalls while the shift is made.
When Corel decided to change its emphasis from home use to corporate and server-based software products, and modify its use of Java, chief executive Michael Cowpland suggested investors think of the new Corel as "a large new start-up company."
Chief financial officer Chuck Norris, facing mounting losses and furious shareholders, dourly added the new Corel was "a startup with a lot of baggage."
Analysts who have watched the high-tech scene for several years stress the importance of keeping the latest difficulties in perspective.
The Nasdaq technology index is still 50% above its 52-week low, despite the turbulence that sent it plunging two weeks ago.
There are other factors influencing some stock slides, not the least of which is the annual double-whammy from fund managers. When they clean up their portfolios, many poorly performing stocks are sold for tax purposes.
Kyne adds that when volatility hits the market, investors gravitate to the most liquid stocks, which often have the largest floats.
Nevertheless, he and other analysts still think there is value to be found. For example, Kyne likes Geac Computer Corp., which, relative to its anticipated profit, trades at a very low multiple.
Other favorites include Open Text Corp., which Yorkton's Pavan says is executing its promised business strategy well, and little MGI Software Corp., which is lauded for an excellent management team and good prospects.
"Stock picking in this type of environment has to be disciplined," Kyne says, starting with companies that are "premier names with strong growth and management you trust."
That way, any market pullback can be viewed positively. "Just use market declines to accumulate more of the stock."
What's Hot For 1998? Computers, Aerospace, Management
Vigorous demand for computers and other high-tech goods should keep the U.S. economy growing next year despite consumer fatigue and a deteriorating trade balance, the U.S. government predicted Friday.
In addition to computers, hot industries for 1998 also should include aerospace, dental equipment and management consulting, the Commerce Department said in a revival of an annual publication discontinued four years ago.
Businesses projected to shrink by the department's "U.S. Industry & Trade Outlook '98" include shipbuilding, printing services, footwear and jewelry.
The report evaluates 350 business sectors - manufacturing and services.
All major services and more than 80 per cent of manufacturing industries are projected to grow through next year and beyond.
Overall, the department projected an inflation-adjusted growth rate in manufacturers' shipments of 5.5 per cent annually this year and next, up from 3.9 per cent last year and 4.4 per cent in 1995. A comparable aggregate figure wasn't available for services.
Computer equipment is leading the way, with 29.6 per cent growth projected annually this year and next.
"The importance of this industry to the economy cannot be overstated," said Jonathan Menes, director of the department's Office of Trade and Economic Analysis.
"If computers are excluded, the total of all manufacturing output . . . would be about three per cent annually for 1997 and 1998 instead of the 5.5 per cent growth," he said.
With strong orders for commercial airliners, the aerospace industry is projected to increase shipments by 17.4 per cent a year in 1997 and 1998.
Dental equipment should increase 10.5 per cent, a result of the aging of the Baby Boom generation, and radio and television equipment, 10 per cent.
More traditional sectors of the economy are expected to show only modest growth compared with high-tech industries. Motor vehicles and parts shipments should increase 1.8 per cent in 1997 and 1998. The slower growth of the driving-age population is cutting into sales, but the average cost per vehicle is rising as older drivers opt for luxury vehicles, especially larger sport utility vehicles.
Canada Dollar Ends Firmer
Canada's dollar ended on a firmer note on Friday from Thursday's close after investors digested earlier moves and concentrated on more Asian turmoil.
"The Canadian dollar is kind of being caught in the crossfire here of the Asian situation," said Michael Gregory, vice president at Lehman Brothers. The dollar firmed after news that the Asian market turbulence could ease with more aid. But it lost ground on reports one of Japan's four biggest brokerage firms, Yamaichi, plans to ask the government for permission to stop operating. The dollar closed at C$1.4178 (US$0.7053), up from Thursday's finish of C$1.4202 (US$0.7041).
The Bank of Canada delayed a widely expected short-term interest rate to help prop up the currency, which is wavering around 2-1/2 year lows. Analysts have been debating the possibility and timing of a rise for nearly three weeks.
Gregory forecast the dollar would trade in a narrow range of C$1.4150 to C$1.4200 at the start of next week.
On the crosses, Canada's dollar rose to 89.05 yen from Thursday's close of 88.63 yen and slipped to 1.2249 marks from 1.2260 marks.
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