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Let's hope this is what Cymer is doing with all that cash ....
investor.msn.com
Backing the Bullies
Earnings? Price? Fuggetaboutit. Buy those ruthless companies who
gladly kick their rivals when they're down.
By Jim Jubak
It's not crazy. Just downright mean.
While the market chokes on a glut of steel, Nucor (NUE)
announces that it will build a new plant to produce 1 million tons of
flat plate a year.
In the midst of a horrible slowdown in the sales of equipment used
to make computer chips, Applied Materials (AMAT) ups its
research and development budget by 18% and announces that it
will build a new factory in Japan.
Rather than using the weakness in prices for memory chips and
disk drives to pad their profits by a penny or two, Dell (DELL),
Compaq (CPQ), and Hewlett-Packard (HWP) accelerate their price
wars, slashing the price on their cheapest models from $1,000 to
$800.
What is it with these companies? Don't they know that every CEO
is scrambling to make earnings this quarter? Don't they know that
their industries are in the down leg of a boom-and-bust cycle?
What are they trying to do? Make it worse?
Exactly, said Richard Hoey, director of equity research at Dreyfus
Corp, when I raised these questions with him. If his or her
company is a low-cost producer with a strong balance sheet, a
good CEO will try to make the bottom of the cycle as tough as
possible for competitors: Add capacity. Spend more on R&D. Cut
prices to the bone. Anything to drive the weak sisters to the wall.
Then, rake in the profits when the industry cycle turns. With fewer
competitors, more profits flow to the survivors. Play the game long
enough and well enough, and a company can build an almost
unassailable market position.
Do I need to come right out and say it, or is the implication clear
enough? At a time like this, when industry after industry is awash
in extra capacity, forget about earnings per share. In fact, throw out
many of the measures that you use at other points in the business
cycle. Look for companies increasing capital spending, throwing
money at research and development, and breaking ground on
money-losing plants. Look for companies that are aggressively
using this time of troubles to wipe out as many competitors as
they can. Buy the ruthless and the mean. These are the
companies that will make you money when the cycle turns up.
Intel (INTC), for example, knows by now how to play this game in
its sleep. Look at the details in the company's latest financial
report, released last Tuesday. With revenue basically flat for the
fourth quarter compared with the year-earlier period, income
actually lower ($1.7 billion versus $1.9 billion), and margins
projected to shrink to 55% from 59%, the company announced an
increase in capital spending to $5.3 billion for 1998 from 1997's
$4.5 billion. R&D will rise to $2.8 billion in 1998 from $2.3 billion.
All this while the company is cutting prices to keep competitors
from gaining market share. Don't you think the execs at AMD
sweat knowing that they have to execute perfectly in order to pick
up ground?
You don't have to be in a high-technology industry to play the
game, either.
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Nucor, for example, can tell you precisely what plants --
Bethlehem Steel's (BS) Sparrows Point mill, for one -- its capital
spending will put out of business. Faced with stagnant demand for
plate steel and an aging plant that can't possibly produce steel at a
competitive price, Bethlehem faces an impossible dilemma. Close
the plant and lose market share to Nucor, or keep the plant open
and bleed dollars as excess capacity in the industry forces down
steel prices, hurting a high-cost producer like Bethlehem more
than an efficient steel maker such as Nucor.
Of course, Nucor will make less money. Lowering prices and
increasing capital spending to build a new mill will take a bite out
of earnings that ran at an annual rate of about $300 million in the
12 months that ended in the third quarter of 1997. But Bethlehem
will show not just falling profits, but actual red ink. The company
recorded a $110 million loss in the last 12 months.
And a company doesn't need to be the biggest or most established
player in a market to play Genghis Khan either. Last week
WorldCom (WCOM) announced a major push into the Japanese
phone market. The company will spend about $80 million to lay
fiber-optic cable for phone and data networks in Tokyo and several
other big cities. That's hardly a threat to Japan's giant NTT, which
owns 75% of the national telecom market. But WorldCom can
probably force to the wall some of the newer Japanese companies
that have targeted the corporate-data business. If WorldCom can
turn the game into one between itself and a slow NTT that's still
dragging the culture and capital structure of its days as a
monopoly, then it can grab the most profitable accounts for itself
with very little difficulty. (WorldCom will certainly face competition
from other U.S. and international telecom companies in Japan
once the country deregulates its market sometime after March.)
What kind of a payoff can a company reap by making the pain
deeper on the downward leg of an industry cycle? Look at the
numbers that Applied Materials posted before and after the big
downturn that began with the 1990 recession. In 1990, Applied
Material's earnings per share fell from 19 cents to 13. The downturn
got deeper in 1991 -- earnings fell to 10 cents a share -- before
turning up in 1992 and hitting a full recovery in 1993, when the
company recorded 30 cents a share in earnings.
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But look at the profit margins before and
after the downturn in the sweet part of the
cycle. In 1989, Applied Material's operating
margin was 19%. In 1994, it hit 24% and
kept climbing to 25% in 1995 and 26% in
1996. Net profit margin, which peaked at
11% at the top of the earlier cycle, ran at
almost 15% for both 1995 and 1996. Why
the difference in profitability? At the top of
the earlier cycle, Applied Materials was a
good company among a handful of industry
leaders. By the mid-'90s, it had become
the 800-pound gorilla of the
semiconductor-equipment industry. The
company has been able to use its size, its
financial resources, and the breadth of its
product line -- fairly or unfairly -- to push around the competition.
There's no easy way to find these ruthless companies. You can
get some hints by looking at my list of "The 50 Best Stocks in the
World." All the companies on this list got there because they have
a sustainable competitive advantage. Some of them got that edge
by knowing exactly how to kick a competitor when it's down.
(Some dominant companies don't have the killer instinct, though.
Federal Express (FDX), for example, was content to raise its
prices when UPS did. That will help earnings, for sure, but it's no
way to gain market share.)
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News on mergers is another hint. What company is buying smaller
competitors or adding new products by acquisition while its
competitors struggle? Notice how Cisco Systems (CSCO), for
example, continues to buy small technology companies, while
3Com (COMS) and Ascend Communications (ASND) struggle. The
company's December announcement of the acquisition of
LightSpeed International, an Internet telephony firm, is just the
most recent example.
Scan earnings reports by companies in currently hard-pressed
industries to see who is spending on capital equipment and
increasing their research and development dollars during the bad
times.
Besides the companies I've mentioned in passing, let me suggest
two other potentially profitable industries that you might scan in
search of this kind of ruthless competitor. First, the credit-card
industry: We're seeing rapid consolidation. Citicorp (CCI), for
example, just bought AT & T's (T) credit-card portfolio. A handful of
big players are coming to dominate the industry -- their size gives
them the advantages of scale that result in lower processing and
marketing costs. I'd be watching companies like Citicorp and
MBNA (KRB) in this sector.
Second, the auto-parts industry. Thanks to increased outsourcing
of manufacturing by the big auto makers, this has been a growing
business. But now a few companies -- through a combination of
mergers, international growth and acquisitions -- are starting to
stand out from the pack. They have attained a size that enables
them to offer one-stop shopping for an auto maker interested in an
entire system. For example, with its recent acquisitions of T&N
and Fel-Pro, Federal-Mogul (FMO) now has the ability to sell a
complete drive-train system to such companies as Ford (F) and
General Motors (GM). And the company is only an acquisition or
two away from being able to build an entire engine.
With auto makers looking to outsource as a way to cut costs, but
interested in working with fewer suppliers as a way to ensure
quality, that kind of systems capability is a major competitive
edge. Magna International (MGA), which recently acquired a
controlling interest in Steyr-Daimler-Puch, an Austrian drive-train
developer, is another company that seems to understand this logic
and is moving aggressively to gain the edge that comes with
systems capability.
It takes a rather unusual mindset to invest in this type of company.
Many of your instincts and strategies as an investor are, in fact,
useless or even counterproductive here. For example, all that you
know about price-to-earnings ratios and how they help to guide the
timing of buy-and-sell decisions will tell you to avoid these
companies at exactly the moment when you want to buy them.
After all, I'm arguing that you should buy these companies when
earnings are low, and -- since you're buying good companies that
hold much of their stock price when sales go sour -- when P/E
ratios are high.
To pursue this strategy, you have to start thinking about these
investments as companies and not as stocks. You're putting your
money into a business and backing a manager. The traditional
numbers that investors use to make buy-and-sell decisions matter
far less in this situation than do your feelings about the quality of
the company and your conclusions about its competitive position.
It's not the only way to invest, certainly. But for the patient,
long-term investor, it can be a very profitable one. And it is a
strategy that's especially well suited to a global economy and
market like the one we're in now.
New Developments on Past Columns:
The Blue-Chip Safety Premium
With earnings season hard upon me, it's hard to keep you up to
date on what I think of the announcements from companies I follow
for Jubak's Picks unless I'm very brief. Here goes: Intel reported
earnings pretty much in line with what I expected. Revenue was flat
and earnings down from the year-earlier quarter, and the company
reiterated its view that margins would continue to shrink in 1998
toward 50% from the current 59%.
Finally, Fannie Mae reported record revenue and earnings that led
to analyst upgrades and new, higher projections for 1998 earnings.
Lower interest rates will keep the mortgage-lending business
humming. In addition, the lower rates make fixed-rate mortgages
more attractive than adjustable mortgages, as borrowers try to lock
in today's low rates. The savings and loans that originate those
fixed-rate mortgages sell the loans to Fannie Mae (FNM), so the
lender should see continued revenue growth from that trend as
well.
Chip Investors, Roll Up Your Sleeves
Vitesse rose by better than $5 a share -- not so much because it
beat estimates by a penny, but because the next few quarters look
so great. Vitesse (VTSS) hasn't had enough manufacturing space
to make all the chips that customers want. That's led to a gradual
build-up in orders until the company has a six-month backlog of
almost $71 million. But in its earnings announcement, Vitesse
reported that its new factory in Colorado Springs would come on
line on schedule. First sales from that plant should hit the bottom
line in the quarter ending in June.
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