<RIMM? again.. maybe its time>
BARRON'S: Tech In 3D: Sector's Recovery Is Near, Says Fund Manager
An Interview With George Paoletti
With the Nasdaq at a two-year low and in the aftermath of three
major technology conferences in the past month, it seemed a great time
to check the outlook -- not to mention the pulse -- of a dedicated
follower of the sector. From his midtown Manhattan office, Paoletti
views technology in 3D: digitize, deregulate and deploy is the mantra
that helps his Digerati Partners and his $55 million long-short
Digerati hedge fund (ING Alternative Asset Management is the general
partner) stay focused on the drivers of the information-technology
revolution. For the three months the fund was up and running in the
last quarter of 1999, Paoletti produced returns of 61.1%, followed by
a net gain of close to 10% last year despite the bear market in
technology. Paoletti's career has been as focused on technology as his
portfolio. He steered the Morgan Stanley Dean Witter Information Fund
for two years, spent two years at Fred Alger Management as a senior
technology analyst and three years before that at Off Wall Street
Consulting, also as an analyst. More important, he's been on the
inside looking out, first as a systems engineer for Helix Technology
and then at General Electric's Aircraft Engines unit, where he
designed, purchased and managed information-technology systems. For
his perspective on technology investing right now, please read on.
-- Sandra Ward
Barron's: There's strong sentiment we'll have a magical recovery in
the second quarter. Do you see any support for a recovery?
Paoletti: I definitely see support for a recovery.
Q: Why?
A: Underlying demand for digital-related products and services is
still very strong. It is still the No. 1 wealth-creating trend in the
economy. Last year too many people and corporations invested too much
in that area, and underlying growth was not as strong as reported
numbers made it seem. This year underlying growth is stronger than
reported numbers suggest. Year-over-year comparisons will make it
easier to show decent earnings growth, but not until the fourth
quarter. Even if the economy is flat for a while, this sector will
start to be showing nice sales and earnings growth again.
Q: You started to focus more on smaller-cap companies just about a
year ago, didn't you?
A: Yes. From talking to sales people at all kinds of tech companies
I learned they were having a much easier time making sales. It was
part of the dot.com and venture-capital bubble: All kinds of money was
being thrown around. In trying to defend themselves, the Fortune 500
ended up doing the same. That changed a four- or five-year trend, in
which small companies had a hard time getting traction. I had backed
away from small-caps probably around 1997. But in the last year and a
half, I spent more time on small-caps.
Q: Has that proven to be the right strategy?
A: It was the right strategy until last summer. Since then it has
been mixed. I've been rethinking that approach for the last quarter or
so.
Q: Why's that?
A: It has do with the theory of the chasm and tornado in
technology-adoption life cycles.
Q: Come again?
A: It's a framework popularized by Geoffrey Moore. He's written a
couple of books: Crossing the Chasm, is one. The other is Inside the
Tornado. They're bibles in Silicon Valley, and I use the models they
put forth quite a bit to understand how these companies are
positioned, what they need to do next and where they are headed.
Q: What's the upshot?
A: Basically, niche strategies are used to appeal to different
customers, bridging the chasm that tends to exist between them. As the
technology is adopted by more and more customers, you reach the point
of a tornado where demand accelerates greatly. The vast majority of
the money is made in the tornado. The problem is VCs have been pushing
their companies to get to the tornado as fast as possible. So you have
a lot of small-cap companies that have gone public in the last year or
two whose whole strategy is to create their own tornado. Wall Street
doesn't like niche strategies, so the companies don't like to follow
the recommended route to the tornado. There is more luck than skill
involved with the tornado. A lot of small-caps have been spending too
much money, even though they are nowhere near profitability, trying to
create their own tornado. Instead of a tornado, they are creating
little dust devils. They never really develop the right foundation, a
part of which is having a strong niche to catapult from. The other
problem with this hyperspending by young tech companies is it's
justified as a cost of acquiring customers. Customer acquisition costs
hinge on the lifetime value of a customer. In technology, the average
life of a customer is very short because there is always some new, new
thing coming out that puts all the customers up for grabs again. These
young companies are spending a lot of money to acquire customers in a
business where the customer lifetime is just not long enough to pay
off.
Q: Where are you focusing your energies these days?
A: I'm optimistic about the handheld market. My favorite stock is
Research In Motion. It is a very expensive stock, but it is one of the
few expensive small- or mid-caps that is really in a tornado.
Q: Talk about your enthusiasm for handhelds and get into the
fundamentals of Research In Motion.
A: The world has gone through the PC proliferation and the
cell-phone proliferation and I think handhelds will be next to
proliferate. I also own some Palm but I prefer RIMM, the maker of the
BlackBerry. They are both system plays. They both sell a piece of
hardware, but they both also provide their own operating systems.
Neither one runs off Windows. RIMM has its own applications and it
also provides services.
Q: Services such as what?
A: The basis for the RIMM product line is wireless services. The
main reason I prefer RIMM to Palm is the wireless advantage it has and
because I think it has a better -- a more profitable -- customer base
selling primarily to corporations. Its killer app is allowing
employees to access their corporate e-mail remotely. Palm sells to
consumers mostly.
Q: Although they seem busy trying to change that.
A: They are, and if RIMM wants to grow to be a really big company,
it needs to sell to consumers. They both need to cross over. RIMM has
had its tornado in the profitable corporate market and it needs to try
to extend that to the consumer market by lowering the price of the
product.
Q: But that will bring down their margins, won't it?
A: It will, unless they come up with a leap in technology that
lowers the costs. GPRS is a technology leap.
Q: Is this 3G?
A: Depends on who you talk to but it's more 2.5G. As the underlying
wireless technology moves to 2.5 and then 3G, starting with GPRS this
summer, RIMM unit costs will fall significantly. As the unit costs
fall, they can lower the unit price and they can try to expand into
the consumer market. RIMM has big opportunities to expand in the
consumer market.
Q: How about some numbers?
A: Though it seems like a very expensive stock, I think the
consensus numbers are far too low. From a big-picture standpoint, RIMM
is like AOL some years ago. AOL at the time looked very expensive, and
the bear story on it was that gross margins would fall. Here's the
analogy: The main part of RIMM's business is selling hardware. Margins
will hold up because as the technology moves to 2.5 and 3G, it will
cause RIMM's costs to fall at least as fast as prices fall. Like AOL,
too, RIMM has a second minority business which is highly profitable:
the wireless service. In the most recent quarter, wireless was about
16% of revenues and its gross margin was 60%.
Q: You see that becoming a bigger piece of revenues?
A: In about two years that should be more than one-third of the
business.
Q: And margins?
A: I think margins on that business will stay the same. Again, a 60%
margin is not strange for that kind of business. You could call it a
mission-critical business primarily for corporate road warriors. Where
I differ from consensus is on the core business selling devices. I
think they can lower the price of their product down to the consumer
price point and maintain the gross margin.
Q: Give me some sense of what you expect them to earn as opposed to
the consensus.
A: The earnings surprises have started. Last quarter, they beat the
earnings estimates by three cents. I don't think anyone expects RIMM
to get to 20% operating margins. But RIMM was at 20% operating margins
a year and a half ago. Between then and now, it invested a lot of
money to accelerate the business and help along some partners, hurting
operating margins. For the most recent quarter the operating margin
was 3.5%.
Q: Whoa!
A: It went from 20 to 19 to 14 to minus 3, to minus 5, and back to 3
1/2. It has seen the bottom. The operating margin is solidly back in
the black and I think it is going to move back up to the mid-teens.
Someday maybe it will return to 20, but it clearly can move back to
the mid-teens. Fiscal '01 ends at the end of February. For fiscal '02
the consensus expects about $430 million in revenues and so do I. But
consensus expects 33-34 cents a share and I expect 48 cents. The
difference is consensus has probably a 3% operating margin and I have
an 8% operating margin.
Q: How did you end up last year?
A: The net was 9.45%.
Q: Seems you gave a lot back toward the end of the year.
A: I didn't get bearish enough.
Q: What did you miss?
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BARRON'S: Tech In 3D: Sector's Recovery Is -2-
A: The dot.com bubble had overstated underlying demand drastically
and so many parts of the technology ecosystem held so much inventory.
Those were the two biggest things.
Q: How is your portfolio structured now?
A: We are about 40% long, 20% short and 40% cash.
Q: How long have you been at 40% cash?
A: It's moved around, but I would say we have been more than 30%
cash for three months. This is an unusual time. It leads back to the
weak macros combined with what I was saying about a lot of companies
running their businesses poorly. A lot of the companies I would like
to invest in because I think they own a good spot in the digital
economy are just not being run correctly at the moment. The cupboard
is a bit bare of good companies with good fundamentals and good
opportunities, and most of all good management.
Q: What's throwing everyone for a loop?
A: Volatility, for one thing. Another problem is trying to balance
really bad earnings results with really aggressive Fed rate cuts.
Q: Elaborate on that.
A: I am not an economist. I don't try to predict interest rates. But
when the Fed cuts rates multiple times, historically it causes a
rally. That's probably more true when the cuts are aggressive. The
other side of the coin is the Fed is doing this because the current
year-over-year numbers and sequential numbers look so weak. If you
want to invest based on fundamentals, you don't want to own stocks
right now, at least within technology. If you want to invest based on
the next 12 months, it is probably a very good place to be. Another
issue is more and more hedge funds are measured on monthly numbers and
that leads to more volatility. It is very difficult to buy low because
you are not quite sure how low you might go.
Q: Isn't that always the case?
A: If you wanted to look out a year, I think it is easy to believe
that we are closer to the bottom than the top. If you didn't have to
worry about next month's numbers, you could buy stock and not have to
pick the exact bottom. But if you are worried about your next month's
numbers, it is much harder to avoid trying to pick the bottom, and
that's one of the things that leads to more cash. It is dangerous to
invest ahead of the bottom because your next month or two might be
negative.
Q: Is there a particular sector of technology you are negative on?
A: Fiberoptic, or, more specifically, photonic components. The whole
sector is switching from being in a supply shortage to a supply glut.
Too much capital was thrown at it last year and most of the capital is
being used to raise capacity. Now as Nortel stated recently, demand is
falling. New capacity comes on just as demand falls. That whole sector
is in trouble. And vendor after vendor has the same strategy. Oplink
Communications plans to spend $60 million in 2001 to raise capacity.
It spent $35 million last year. New Focus plans to spend $100 million
in 2001; they spent $52 million last year. JDS Uniphase is the gorilla
and they're on track to spend $850 million in 2001; that's 50% more
than last year.
Q: What are you short?
A: The one I've been shorting aggressively most recently is Oplink.
It has been one of the most expensive in the group on a price-to-sales
basis. The management team basically was hired in time to do the IPO.
But management aside, what happened with Nortel a few Fridays ago is
the end of the road for Oplink. Oplink has customer-concentration
problems.
Q: Do tell.
A: Nortel was 29% of Oplink's revenues last quarter. In dollars,
Nortel was 100% of Oplink's growth from September to December. The
rest of the business was flat. The other customer issue is Corning.
Corning signed a deal to buy from Oplink just before Christmas. The
deal had a potential size of $40 million in the next 12 months. Well,
the division of Corning that was supposed to buy the components builds
them into subsystems and sells them to Nortel. Almost half the
business of that Corning division goes to Nortel. So 29% of Oplink's
direct business goes to Nortel and half of its supposed Corning
business goes to Nortel. After Nortel pre-announced, Corning
pre-announced. And Corning lowered its own photonic revenues for this
year by $300 million. So Oplink will be lucky if the $40 million deal
with Corning reaches $20 million.
Q: When did you start shorting?
A: I shorted it back in November in the low 20s and then in December
the whole group got really hurt. And I covered some and when the stock
got back above 20, I shorted some more. The stock trades at 11 or so
and has gone as low as 7.50, but I think it is going to 4.
Q: Has this been public very long?
A: Since October 2000.
Q: So we could see insiders starting to unload shares.
A: This isn't the main issue, but about 140 million shares are going
to unlock on April 1. So even if things were going well, the stock
will be under pressure. And things are not going well. Let me give you
the numbers. They did $43 million in sales last quarter, their fiscal
second quarter. Consensus sees sequential revenue growth of 10%-15%,
bringing sales for calendar '01 to $2l5 million and nearly $20 million
in operating profits in CY '01. I think they will be lucky to keep
sales at $43 million and they will probably decline. Instead of $2l5
million in sales, I think they'll report $170 million. Gross margins
will stop going up and operating margins will go back into the red
because of all of the expenses they've been piling on, especially in
China. I expect a $10 million loss from operations. But that will be
offset by $10 million of interest from the cash from the IPO.
Q: So they break even.
A: Roughly break even, yes. And the way that I get a $4 stock is
that Oplink starts to look like a mid-quality semiconductor company
that has its own fabrication plant. Atmel is a good comparison. Atmel
trades at 3.4 times nicely growing sales. If Oplink trades at three
times sales, and it's sales won't be growing, and you add a dollar for
the cash on the balance sheet, you get a $4 stock.
Q: Any other sectors in general you're negative on?
A: Energy-technology stocks, or alternative-energy plays. All of the
stocks had a big run. A lot of them have come back already. A few
haven't. And I think there has been a confluence of events that made
it a hot tech sector. There is the higher price of oil and natural gas
in general. There was the crazy IPO market of last year, which brought
out a lot of supply of these stocks and then got the underwriters
pounding out the buy recommendations. Furthermore, there was a thirst
for the next hot tech sector. The dot.com bubble had burst. The
biotechs had a good run. People jumped on these energy-technology
stocks. There is a fundamental problem with these stocks. There is no
technology revolution causing a whole new group of companies to
displace the old. There is just no technology leap that justifies the
valuation. The physics behind these products is pretty much as it has
been for most of a century. And they have used engineering hours to
tweak the application and raised the efficiencies slightly. But the
physics is the same. And today's energy industry uses the current
architecture because it is the most efficient and effective way to
convert the natural resources into electricity.
Q: Are you shorting a basket of these?
A: I am short a few of them, depending on which ones go crazy. One
is FuelCell Energy. They have small sales. They have negative gross
margins. The products they sell cannot create electricity cost
efficiently compared to the current approaches. These products simply
cannot take big market share. Let me give you one more.
Q: Shoot.
A: I just started shorting Transmeta again.
Q: The one that would rival Intel.
A: This is a big-story stock. There is a huge market. They only need
to get a small market share to build a big company. That's the story.
What they have been able to accomplish is basically misunderstood. The
problem is the company they need to take 10% market share from is
Intel. And Intel doesn't need to compete product-by-product against
these guys. They don't need to duplicate what Transmeta has. All they
need to do is use their power in the industry and segment these guys
off into a little niche and keep them from ever becoming very big. And
that's what they will do. That's what they have done. Transmeta hasn't
taken market share from Intel. They haven't been designed into any
mainstream notebooks. The only design wins they have are in what's
called ultra-light notebooks, generally those notebooks with screens
less than 12 inches. IBM went pretty far down the road to design them
into a mainstream ThinkPad. At the last minute, IBM pulled away. Two
reasons: One, Intel pressured them. Two, what they provide is a
low-power CPU. The CPU in a notebook is not the only thing absorbing
or consuming power. In a mainstream notebook with a big screen, and a
big hard drive, and lots of RAM, the CPU consumes only 20% of the
total power. These guys are only solving one-fifth of the problem. But
in one of these little ultra-lights, the CPU consumes a higher
percent. So they do provide a better value proposition in the ultra
light.
Q: Has all this been reflected in its stock?
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BARRON'S: Tech In 3D: Sector's Recovery Is -3-
A: It was, and then a couple of things happened. They were promoted
by Gilder's technology newsletter. Plus, Merrill Lynch put a new Buy
recommendation on it. I think Merrill Lynch was jockeying for position
in the secondary -- which will probably occur. The third reason the
stock got moving was they talked about new markets because they were
already failing to meet estimates in the core PC market. The revenue
for the most recent quarter missed the underwriters' numbers.
Q: So have you put a target on this one?
A: It can probably go to about one-third of the current value
because I think it is likely to get only about one-third of the market
share people are projecting in the PC world. I think you can see a $10
stock. Actually, with the lockup expiring and if they try to do a
secondary without having won any big design wins, people are going to
be very concerned. They have been promising a big design win since the
IPO.
Q: How about something you're positive on?
A: LTX is something I owned for a while, and got out of because the
industry was so fundamentally depressed. But the stocks have been
acting well and I have been getting back in.
Q: What do they do?
A: They are the No. 4 semiconductor test-equipment vendor. I think
this is one group that has seen its bottoms. LTX competes against
Teradyne, Credence Systems and Agilent Technologies in back-end test
equipment. LTX is a proven turnaround of a firm which was in serious
trouble in the early 'Nineties. They spent a few years regrouping, and
totally redesigning the product from scratch. And they have the best
product cycle of any test vendor right now. Its mixed analog-digital
tester -- Fusion HF -- has a deep technical edge. It is the best
tester for testing "systems-on-a-chip" devices. These are mixed-signal
chips that have some analog and some digital. These are very
complicated chips. LTX's customer base is much better than Credence's
and as good as Teradyne and Agilent's. It has been gaining market
share, which really showed recently. In the most recent quarter they
grew revenue 74% year-over-year and 12% quarter-over-quarter, better
than any of the competitors. They are taking market share. Another
indication is its book-to-bill [orders relative to sales] is higher
than any of the other companies' test-equipment divisions. Teradyne's
overall book-to-bill is higher, but that's because they have some
non-test-equipment business, which isn't as cyclical. At least not
yet. When LTX comes out of the downturn, it will come out faster than
the others. LTX has more new customers with leading-edge products as a
percentage of its business, yet LTX is the cheapest of the bunch.
Q: What is it trading at?
A: It's a $14 stock, trading at 28 times calendar '01. Credence
trades at 100 times. Teradyne is a little complicated because it has
the non-test business, and a new accounting rule, SAB 101, will give
Teradyne a 25-cent, one-time gain this quarter. If you back out the
25-cent one-time gain, Teradyne trades at 27 times calendar '01
earnings. LTX trades at 8.5 times calendar '02 earnings, estimated at
$1.65 a share. Teradyne trades at 13 times. And Credence trades at 12
times.
Q: When did you start buying this one?
A: I actually bought it a year ago. I bought it as high as 30 and it
ran all the way to 45. I pared my position because the semiconductors
were having issues. But I have been buying back recently in the low
teens to as high as 15 1/2.
Q: How about one more?
A: Brocade Communications Systems is a recent investment and so far
it has not been a profitable investment. Well, it has been mixed.
Originally we shorted McData and bought Brocade.
Q: What's the story here?
A: There has been a new architecture for storage-area networks.
Brocade dominates the mid-range of the market. And McData is the No. 1
player in the high end of the market. It had been owned by EMC until
recently. A few weeks ago they finished the spinoff. McData comes from
the high-reliability mainframe world. Brocade comes from the good-
price-performance world. We think Brocade can add the reliability that
McData has more easily than McData can come up with new products to
meet the price performance of Brocade. McData has a common
architecture for their high- mid- and low-end products. But the
architecture originates from the high-end product and the result is
the mid- and the low-end products are too expensive.
Q: Brocade held up well until recently.
A: We originally bought it as part of a hedge because to me, for a
long time, it was just too expensive. Now it is at a reasonable,
though not cheap, valuation. At 42, it is trading at 60 times
consensus calendar '01 earnings.
Q: And what do you think its growth rate is going to be?
A: Last quarter they grew 25% sequentially. I think that will
clearly decline going forward, but I think it will decline slowly and
they will still be growing at just under 20% sequentially. Let me give
you a number. A year from now, I think they will still be growing
revenues at 80%. For fiscal '01, which is an October number, I think
they will do $750 million in revenues, which is 130% revenue growth. A
year from now they will still be growing at more than 80%
year-over-year. They have a 60% gross margin. They have a 28%
operating margin. It is a very profitable company. It is just as
profitable on a percentage basis as Oracle was until about 11/2 years
ago. It is more profitable on a percentage basis than Cisco. There is
less upside than people would have liked for the next few quarters,
but there is still a lot of room to grow.
Q: Do you have a target price?
A: I think it can get back to 77.
Q: In the next year?
A: In about a year. For calendar '02 they could earn $1.10. That's
not even being very aggressive.
Q: Okay. Thanks very much, George.
---
Paoletti's Picks . . .
Company Symbol Price
Research In Motion RIMM $42.13
LTX LTXX 14.00
Brocade Communications
Systems BRCD 41.81
And Pans . . .
Oplink Communications OPLK 10.88
FuelCell Energy FCEL 48.31
Transmeta TMTA 30.50
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