The RTW Weekly for April 21 - April 27, 2002
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In This Issue:
1. MARKET COMMENTARY
2. THE RACKET LOSES MORE POLITICAL SUPPORT
3. SECOND HALF SLUMP
4. QUALCOMM REPORTS
5. VERISIGN REPORTS
6. JUNIPER: ALL DRESSED UP WITH NO PLACE TO GO
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1. MARKET COMMENTARY
We consider the events of the past week critical in that the equity markets and the Nasdaq in particular, began to reflect the, at best, modest recovery in technology spending and economic growth during 2002. Something noted numerous times since the start of 2002 by RTW publications. About six weeks ago, the markets were rallying, bond yields on the long end were skyrocketing, and many of the pundits and experts were gleefully cheering on the robust economic recovery and stock market rise that would inevitably continue for many months ahead. At the time, we stressed yet again that investor expectations for 2002 were still too high, and the market is beginning to reflect just that. Now, the Nasdaq sits below the approximate low 1700's level that represented the previous 2002 lows and the yield on the ten-year note sits almost 40 basis points below the highs of late March to yield just over 5.00%. We strongly encourage investors to consider what the bond market is saying unless an investor thinks he or she is smarter than the second largest and most liquid market in the world.
The first look at first quarter GDP growth, the employment cost index, the four- week average of jobless claims, and a potential cooling in the housing market all reinforce our thesis that prospects for robust economic growth this year are muted while the potential for a "double dip" is not by any means out of the question. The GDP data suggests that unless consumer and corporate consumption leaps substantially the inventory benefit realized in the first quarter will likely not persist throughout the year. The drop in durable goods orders of 0.6% in March (a 1.2% drop when excluding defense) reinforces the premise that outside of the obviously strong defense industry spending on durable goods remains tepid. The employment cost index and rising four-week average for unemployment claims together provide more evidence of the lack of inflation outside of certain sectors such as health care, housing, and education. With little pricing power and stagnant revenues firms could likely look to cut costs and employees further in the months ahead.
While it may sound as though we are maintaining our relatively pessimistic stance on the markets and economic growth for the near and intermediate term (and we are doing just that), the action in the market this week actually presents an excellent opportunity to take a solid look at the valuations of some wonderful technology firms. We are still looking for a substantial capitulation led decline (on top of the action in the last couple of weeks) in the Nasdaq to rid the market of some excesses that still remain, but nonetheless, we intend to use such an event, if it should occur, to apply some conservative yet realistic assumptions to valuation analyses of RTW firms. It is imperative for investors to understand that the corporate customers of many RTW firms must witness a significant improvement in their cash flows before ramping IT spending. In the late 90's, firms purchased IT equipment and services in part out of fear for Y2K and the potential edge gained by their competitors, and in 2002 and perhaps even throughout 2003 we expect firms to become even more prudent and cost conscious. If investors in aggregate follow last week's action in the next few months by incrementally or rapidly throwing in the towel we will incrementally, or perhaps rapidly, become more optimistic about the prospects for technology stocks as we avoid missing the forest for the trees two feet in front of our faces.
2. THE RACKET LOSES POLITICAL SUPPORT
Sell side analysts continue to receive a beating from the media and, in many cases, for good reason. We feel as though there are undoubtedly literally hundreds of absolutely brilliant individuals working in this space but the intelligence of these people sits behind the steel wall of the Wall Street Racket. One simply can't deny that there is an enormous conflict of interest issue that makes the research presented to the average investor of little use or value, and corporate leaders don't always play an effective "honest broker" role either. After all, have many CEOs or CFOs ever asked themselves if their stock could reasonably always be considered a STRONG BUY? As investment banks face the heat applied by the National Association of Securities Dealers, the SEC, the New York State Justice Department, and soon the United States Justice Department, we would like to stress yet again to our readers the importance of unbiased and honest research and analysis. We will not promise that we will always be correct since that is unrealistic and inappropriate, but we can promise that we will continue to present our honest opinions based on a foundation of sound, quality research. Investors deserve a direct connection between themselves and the fundamental valuation of a business that considers only economically relevant current pieces of information while steadfastly focusing on the developing long-term picture if corporate leaders and professionals can't provide such a service.
3. SECOND HALF SLUMP
Wednesday, as the Durable Goods Report was announced, it felt like time stopped. You could hear the analysts saying the second half recovery was at hand. John Joseph of Smith Barney declared semiconductor prices had bottomed, due to the fact that prices are so low, they could not go any lower. But yet, it was 2002, and the same ruminations of last year continue to abound, although we found prices could go lower.
Critical to our analysis of the market, is the thesis that inventory rebuilding was the major force driving the economic numbers higher in the First Quarter 2002. Understanding replenishment is only a short-term cure; the key to long term growth resuming is capital spending by the business sector. 2000 was the year the bubble burst, but economic gurus continue to underestimate the impact and number of how many capital assets were created by the bubble, and it's effects on the long term. The excesses in terms of factories, office buildings, equipment, and software are a continuous force driving capacity utilization rates at or below 1990 recession levels. Until the excesses are worked off or used, healthy business investment will not return. Looking at the capital goods component, non-defense orders are down almost 20% from a year ago, and continue to deteriorate. First quarter GDP numbers showed final sales growth at 2.6%, at first glance respectable, yet it was primarily a consumer/government driven number. Projections for the future need to be scrutinized, looking at them through this hypothesis, but analysts continue to assess the second half of 2002 using the sell side mentality.
First call consensus numbers call for a 120% increase in earnings per share in Q3 2002 compared to Q3 2001(**). It is hard to make comparisons when companies are losing money, and of course this number covers the market as a whole. Regardless, let's look at RTW companies making money, and one losing, and roughly compare. Last year, Q3 VRTS reported eps of $.12. In Q3 2002, the consensus eps is $.16. MERQ made $.11 eps in Q3 2001. In Q3 2002; consensus eps is $.19 eps. Last, JDSU in Q3 2001 made $-.20, and in Q3, 2002 they will lose money. As a side note, AMCC says it will be six quarters before profits return, representing communication ICs and providing insight into telecom vendors. Comparison shows few trends indicating large increases in eps. Q3 last year was the best quarter for comparison due to diminished eps overall, resulting from the terrorist attacks. MERQ, the best consensus comparison, will post a 72% gain, which is incredible. Overall though, these numbers reflect ongoing weakness in the technology market, so we theorize if eps goes up at all in technology, it will be the few companies who maintain competitive advantages, pricing power, and provide mission critical products. Earnings in Q1, 2002 suggest software companies with these characteristics will continue to perform well relative to their competition.
In summary, until the excesses of the bull market of the 90's are worked off, healthy capital spending in IT by business will not return. The SOX (semiconductor index) is trading at around 150-200 trailing P/E. We have seen a modest up tick in semi-equipment orders, but once again, this may be inventory replenishment, plus need to upgrade to .13 micron. Regardless, this still signifies that the market has already priced in these large consensus gains. In the following weeks, and months, if they fail to materialize, losses will increase. The NASDAQ is battered and bruised, but don't let someone tell you to buy because "the prices are so low, they cannot go any lower".
**Due to different fiscal years, Q3 is July-September to provide comparison.
4. QUALCOMM REPORTS
Qualcomm caused some excitement this week by moving their earnings announcement and conference call from the evening to the morning. However, all the speculation turned out to be much ado about nothing and the company delivered a slightly disappointing second quarter. Considering the raft of bad news coming out of other wireless equipment providers and the telecommunications industry as a whole, Qualcomm must be considered the shining star of telecommunications right now. With its impeccable balance sheet, Qualcomm is well positioned to thrive when the economy recovers and growth returns to the wireless industry.
On a pro-forma basis, revenue for Q2 were $696 million, down from $717 million in the same quarter last year. Pro-forma earnings for Q2 were $161 million down 23% from $210 million last year. GAAP earnings were $44 million, down from $110 million for the same quarter last year. The difference between pro-forma and GAAP earnings reflect continuing investment losses in the strategic initiatives division. The pro-forma earnings were in-line with the guidance given last quarter.
Qualcomm is an innovative company with the best technology in wireless and the management team remains impressive. The largest concern right now is the question of when will growth return to the wireless industry? The wireless cellular market is saturated. The primary hope for growth in the industry comes from the so-called 3G wireless data market. In this vision of the market, customer will have always-on high-speed access to the Internet via their 3G mobile devices. However, to make this vision a reality, the wireless service providers will need to increase the amount of money they charge on a monthly basis. The compelling applications, which will compel more than just the mobile elite customer to pay this extra monthly stipend, seem far off. Until these 3G applications develop and gain customers, Qualcomm remains an excellent company reinforcing their leadership in a troubled industry. Eventually growth will return to wireless but the important question is when?
5. VERISIGN REPORTS
On Thursday, Verisign reported results for Q1 2002. Even before the announcement, the market had serious concerns regarding how the company would perform. On Wednesday, data out of SnapNames revealed that the domain name business was weaker than expected. To our dismay, the company's results were even worse than feared. Reported revenues were $327.8 million, versus previously stated guidance in the neighbourhood of $345 million. Gross margins also tumbled from 63% in Q4 to only 55%. Operating cash flow was also hit extremely hard, dropping from $60 million in the previous quarter to only $20 million. It was only last quarter that management had guided down forward estimates to a level that it viewed as very conservative and implied that there might be some room for upward revisions to the second numbers. Obviously, this will no longer occur as the domain name business continues to deteriorate. The registrar ended the quarter with 12 million managed domain names, down considerably from 13.6 million at the end of the year.
We were disappointed but not overly concerned by the deterioration in the domain name business since we have never viewed the mass-market segment as a significant future growth driver. While this segment used to account for 60% of the company's revenues, it has now fallen to a 34% share as the Enterprise and Service Provider (ESP) segment continues to increase as a percentage of sales. Unfortunately, this migration of value towards the ESP division had historically been driven by strong growth in this segment rather than a significant deterioration in the mass-market division. Most disappointing to us was that the ESP business came in flat with the previous quarter in terms of organic growth.
We've always viewed security infrastructure as Verisign's future. Unfortunately, although still the dominant name in PKI, it would appear that this market has finally succumbed to the slowdown in IT spending. It is unlikely that this business will experience a significant return to growth for some time. However, over the longer term, we view the growing popularity of Web Services as an enormous opportunity for Verisign. The company has aligned itself with the biggest software players in the world to develop solutions for easily securing Web Services. Partners in this initiative include Microsoft, IBM, BEA and many others.
Even further down the road, we see considerable opportunity in the converged voice/data services vision evolving out of the Illuminet acquisition. Significant synergies from this combination are unlikely to materialize before the middle of the decade but it is, nonetheless, an exciting opportunity.
Our long-term view of Verisign has not changed but has definitely been pushed back by the disappointing results. We have become more cautious over the near term but continue to view the company as one of the new franchise names in technology.
6. JUNIPER: ALL DRESSED UP WITH NO PLACE TO GO
On Monday, Juniper finally announced its long awaited next generation core router. The T640 (until now known under the codename Gibson) is the company's new flagship product, which it hopes will help it gain back some of the market share that it has lost to arch rival Cisco in recent quarters. By all measures, the product is very impressive and once again leapfrogs Juniper over the competition into the leadership position in routing technology. The T640 offers four times the capacity of the company's previous offering, the M160 and includes support for 32 OC-192 interfaces for 640 Gbps of total throughput in a single unit. This compares to 16 for Cisco's current top of the line system. Perhaps most importantly, the product also offers an upgrade path to multi chassis configurations. This new scalable architecture will allow customers to link multiple T640s together using a switching matrix called TX to create a single virtual router and offer multi terabit capacity.
One area of concern surrounds the OC-192 10 Gbps line cards. Probably the biggest problem with the M160 was the fact that it had a small bug in its OC-192 cards that resulted in packet ordering problems. Fortunately, with the T640, Juniper developed an entirely new set of ASICs that it says has rectified this issue. While this is good news, it also means that old OC-192 line cards will not be supported in the new design. Therefore, although slower line cards are transferable, customers upgrading their existing system from the M160 design to the T640 will have to purchase all new OC-192 interface cards. Nevertheless, we expect there to be some immediate demand for the product, especially from those carriers who have not yet upgraded their networks to 10 Gbps speeds. Furthermore, we are hopeful that some of Juniper's recent warnings have been due, at least in part, to customers holding off on upgrades until the T640 was released. As a result, we believe the new product to help stabilize revenues but we don't expect it to act as a significant near term catalyst.
Juniper now has an entire suite of new products, along with the new core router, the company has also announced its first product for the wireless market, the J20, which it jointly developed with Ericsson. The company has also moved into the cable market with the G10, a Cable Modem Termination System (CMTS) that it gained through its acquisition of Pacific Broadband Communications. Finally, the company also released a host of new features for the edge routing market. Unfortunately, while Juniper's products are all technology leaders in their respective markets, customer demand is hard to come by. In just the past month or so, we've seen most major US carriers once again slash their 2002 CapEx estimates. Qwest, one of Juniper's largest customers, slashed another $500 million off its planned spending, which now stands at $3.2 billion. The financially strapped company indicated that, if necessary, that number could fall to as low as $2 billion. Furthermore, based on Nokia and Ericsson's disappointing quarterly results along with the latter's plans to lay off 17,000 workers, we believe that market for wireless networking equipment continues to deteriorate. The one area that has shown some signs of strength is at the edge. Unfortunately, this is also the most competitive segment in which Juniper currently competes.
These new products should place Juniper in a strong position when the market finally does begin to recover. However, the current weakness will likely limit the degree to which the company can leverage its technology lead to gain significant new customer traction as it did with the launch of the M160 several years ago. As always, we remain extremely impressed with the company's execution but still see no turnaround in sight for the telecom equipment market.
Have a Nice Week.
- The RTW Group
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The RTW Weekly is a weekly publication that provides commentary on markets and issues relating to technology investing. It is delivered to subscriber email boxes at the beginning of each week. The RTW Group also publishes a detailed monthly report that is delivered on or about the first of every month. Archived monthly reports are available at the RTW briefcase:
briefcase.yahoo.com |
