More stuff from barron's year 2000 stocks should be avoided.
Monday, November 10, 1997
Time to Buy - Part 2
By Eric J. Savitz
Time to Buy - Part 1
Q: Let's pick some stocks. Chip?
Morris: We're not focused on any single sector right now -- we're doing more bottom-up stockpicking. I'll give you one or two stocks in a couple of categories.
Q: Fire away.
Morris: In the software arena, one company we like is Synopsys, which makes electronic design-automation software, for planning new semiconductors. The stock trades around 38. They should earn $2-plus for their September 1998 fiscal year. The company has shifted its business model, from 30% revenue growth and 20% operating margins, to a better balance at 20%-25% growth, and 20%-25% operating margins. We think the company is about to embark on an aggressive new product and technology cycle that will take it through 1998.
Q: Didn't Synopsys just do a big acquisition?
Morris: They're about to acquire ViewLogic, a company with strong products and high growth. It's a nice fit. Synopsys will probably streamline the operation somewhat, and there are some potential efficiencies that should be accretive to that $2 number. So here's a company that has really been profitable for I don't know how many consecutive quarters, growing year-over-year in excess of 20%, with high visibility, doing an accretive deal. And it has a fine balance sheet.
Q: So you like them. Morris: We're pretty excited about the stock, which carries a mid-20s multiple of projected calendar 1999 earnings of $2.40$2.50 a share. We think it can hit $60.
Q: What else do you like?
Morris: Parametric Technology, one of the dominant suppliers of computer-aided design and manufacturing software, CAD/CAM software. The stock trades around 44. The estimates for calendar 1998 are running about $2.20 a share. It's a company that's been in the box on two fronts. One, they had an issue in Japan, related to macroeconomic issues there. And they've been losing some market share to Dassault Systems, which has been on quite a tear. Dassault is a French company, which has benefited from the plunge of the franc against the dollar and other currencies. The dollar has strengthened against the yen and the mark.
But when you look at local currency results for each company, it looks like Dassault is outgrowing Parametric fairly rapidly. If you unwind everything and put it all on a constant-dollar basis, you find that Parametric is growing much faster than Dassault. In any case, we believe the issues involving Japan and Dassault will be resolved as we move through 1998 and that the company will actually be in a position to accelerate revenue growth as we move through the back half of 1998. So here's a stock that's in the mid-40s, which we think can earn $2.70-$2.80 a share in calendar '99.
Q: How fast are they growing?
Morris: Maybe 30% in 1999. Lower than that in the first half of 1998. This management has executed extremely well over time. And the company's technical position in the industry has not eroded at all. In a year, you could see the stock hit 60.
Q: Let's move on.
Morris: In the semiconductor arena, two companies we like are Analog Devices and ASM Lithography.
Q: Let's start with Analog.
Morris: Analog makes linear and mixed-signal chips, competing with companies like Linear Technology and Maxim Integrated Products. They also do a lot of business in DSP, digital-signal processing, a technology used in many communications devices. Those two high-growth areas account for about 80% of their revenues.
Q: Sounds good.
Morris: The thing about Analog is that their operating margins are about 10 percentage points or more behind those of the front-line competition in linear and mixed signal.
Q: Why?
Morris: For one thing, not all of their business is linear, and linear is their best business. Even within linear, though, they're way behind the competition in profitability. Part of that is because Analog is a lot larger than Maxim or Linear. They can't cream-skim as much. Also, the DSP business is a lower-margin business, though they and Texas Instruments really dominate the market. TI seems unlikely to be overly aggressive on pricing, since they are on a margin expansion program of their own. So we see the potential for Analog Devices to add 500 basis points to its operating margins over the next several years, and possibly more than that. The company has a big internal initiative to increase margins. In short, we see both a favorable mix shift, and better operating margins. And they benefit from having diverse end markets, communications, telecom, industrial automation. And unlike Texas Instruments, they don't have a lot of exposure to the disk-drive business in DSPs.
Q: What about ASM Lithography?
Morris: We're taking the view that there's going to be a big cycle in semiconductor-equipment spending over the next few years. ASM, as the name implies, makes lithography machines, which play an integral role in the process for making chips.
Q: They made an impressive presentation at the American Electronics Association conference last week -- apparently, the company is sold out through the year 1998. Place an order today, and you won't get it before 1999. Well, anyway, Chip, here's your chance to be a hero. What would you avoid?
Morris: This always gets me in trouble.
Q: Be brave.
Morris: I think the ERP vendors could be headed for trouble.
Q: What's an ERP?
Morris: It's short for enterprise resource planning. Companies like SAP, Baan and Peoplesoft, which sell large software programs that play an integral role in helping companies run their businesses. These companies have benefited from the Year 2000 problem -- and from poor accounting rules. If you fix an existing system, that counts as a current expense. Which is bad. If you buy a new system, that's a capital-budget item, and you get to amortize it over time. So you have the choice of fixing something for $10 million and expensing it, or buying something for $10 million, and writing off $1 million a year over 10 years.
Q: Some choice.
Morris: If you're the chief investment officer, would you rather go to the CFO and say you need $10 million right now, or would you rather tell him you need a small bump in the budget for some years to come because you have to fix the Y2K problem? That issue has been helping the ERP companies. But as John pointed out, no one should be surprised if a year from now, we hear companies warning about near-term earnings shortfalls as companies stop trying to implement new systems, and focus on the short-term consequences of the year 2000 problem.
Q: So would you dump them now?
Morris: Well, these stocks can be viable at 30-35 times earnings. But most of them are selling at 50-60 times earnings, which is a whole different story. There will be plenty of growth for these companies beyond the year 2000. They've had plenty of business lately, which should continue through mid-1998. But then it's going to start to reverse. If you want to focus on a single company, look at SAP, whose software takes the longest to implement. They'd see the slowdown first. Peoplesoft would probably see it last. In short, while we like these companies for the long haul, the high valuations make the Year 2000-related slowdown a real issue.
Q: See, that wasn't so bad. John, you're up.
Force: Let me do a sort of sector thing. An area I talked about last year, which I still really like, are companies in IT services.
Q: Information technologies. Consulting, stuff like that, right?
Force: Yes. I've focused on some of the smaller names in the group. They can stay more nimble, hire and retain employees better. It really plays on some of the macro trends in technology. Information systems are increasingly complex. The costs of supporting them are escalating. Companies don't have core competencies in this stuff, and the product cycles are increasingly short. The IT consulting and staffing companies themselves are consolidating. A lot of the companies are regional, and most have good management. With a little vision, you can go in and buy out groups of offices in major metro areas.
Q: Consolidation is the name of the game.
Force: The companies I'd like to talk about have focused on the middle market, and on international markets. The overseas markets are well behind where the U.S. companies have been, so they have plenty of opportunity. Their balance sheets are impeccable; typically, they don't have any debt. They have positive free cash flow, and recurring revenues. The only real negative is difficulty in finding and retaining good personnel.
I put these companies into several groups. There are the composite-solutions providers, the big guys, the big accounting firms, EDS, Computer Sciences, IBM. These guys provide everything from professional services to platform management. They provide total outsourcing services. I aim a level below that, at companies with faster growth and expanding operating margins.
Q: The little guys.
Force: The area I like best would be the systems integration and applications development companies. The name I've owned there -- it was one I recommended last year, which I still like; it's one of my five largest holdings -- is Cambridge Technology Partners. Because of the nature of their business, visibility of earnings is excellent. I was buying them in March and April, when the small-caps were getting hammered. I own Technology Solutions, Whitman-Hart. I also own some of the IT staffing companies, which have lower margins. They're big beneficiaries of the Y2K problem. I own Keane, The Registry, and Computer Horizons. But I'd like to focus on two companies which are kind of baby Cambridges. The first is ECsoft.
Q: What's an ECsoft?
Force: ECsoft is a U.K.-based company, much like Cambridge in that they do systems integration and applications development. They've developed their own methodology, which reminds me of Cambridge's. Most of what they do is ERP implementation. In Europe, this stuff is accelerating. The companies over there are three, four, five years behind the U.S., and there isn't as much competition. They focus on client/server software, shifting away from legacy systems on older hardware, which has helped boost their margins. They've made acquisitions in Sweden, Norway and Denmark, all of which are big users of IT services. Their acquisitions have been accretive; they bought companies with higher margins than their own. So what you have is a company with top-line growth of 30%, and exploding operating margins. The stock isn't expensive in the world I live in.
Q: You live in Pilgrim Baxter -- land, I'll remind everyone.
Force: The earnings estimates on this thing are running 53 cents for this year, up from 40 cents last year. Next year, they should earn 71 cents. Those are the Street estimates, actually, and they are too low -- they don't include enough operating margin expansion or any acquisitions. Also, their employee turnover ratio is about 15%, which is lower than their U.S. counterparts'. The company has a market cap of about $150 million; ADR is trading for about 18. It's kind of neglected. But it's going to get bigger.
Q: What's next?
Force: IntelliGroup, a pure play on SAP implementation. It's a U.S. company, with about 12 million shares outstanding, trading for about 20, which gives it a market cap of about $250 million. Earnings were 14 cents last year. This year, they'll do about 43 cents, and next year, 61 cents. Both this year's and next year's estimates have gone up a dime over the last three quarters. And again, I think Wall Street has it mismodeled. They are only putting in $32 million in incremental revenue growth for next year; that's what they're going to do this year. Why is this one cool? Well, one unusual thing is that they're sourcing their people in India. There are two good reasons for that: You find highly trained people there, and the turnover rate is lower, only about 10%.
Q: So they are hiring in India -- the people who run the company are both Indian -- and bringing people over here.
Force: Exactly. They've literally set up living arrangements for these people in their offices.
Q: So they stick them in dormitories and lock the doors at night.
Force: These guys are well-paid. The only issue is getting them work permits. Since the U.S. has an extraordinary lack of qualified people, it seems reasonable that those guidelines will loosen up. That's really the only negative on this. Revenues in the most recent quarter were up 75%; operating income was up 134%. It's another company where you're getting margin expansion. Hirings are above plan this quarter. Sales, general and administrative costs have gone from 6% to 15%. It's worth noting that these guys are what's called an SAP logo partner, which means SAP sort of gives them free rein in bidding for jobs in the middle market. Contracts typically are $1 million-$2 million. They essentially take over management of the project, rather than just providing staffing.
Q: So those are baby Cambridges?
Force: Right. It's worth noting that Cambridge itself has started to re-accelerate revenues and earnings. It has the best management in the group and absolutely no Y2K exposure. They look at that as sort of a temporary phenomenon.
Q: What else have you got, John?
Force: Teledata. That's a wild one. It's an Israeli company that provides equipment for local telephone carriers. I started looking at this company after the IPO 18 months ago for a better-known company called Advanced Fiber. The company attacks the problem we talked about: lack of bandwidth in the local loop. This stuff is even more of an issue in developing countries and in Europe. They sell boxes that let you expand the capacity of the infrastructure already in place, to build out basic telephone service. They also have some sexier boxes that allow you to add on other services, like video-on-demand. They provide both wireline and wireless systems. My thesis was that it was growing as fast as Advanced Fiber and selling for a lower multiple. There's some political risk, though, since the company is in Israel.
Q: Is their business in the U.S.?
Force: Not yet.
Q: So, where do they sell this stuff?
Force: Less than 30% is in Israel itself. They've had big wins in Brazil and Europe -- Norway, for instance. And a potentially huge win with Deutsche Telekom could add 15-20 cents a share over the next two or three years. The numbers are amazing. In 1995, revenues were $32 million, and they lost four cents a share. Last year, they had $57 million in revenues, and made 70 cents. This year, $91 million and $1.20.
Let me point out that at the start of the year the estimates for 1997 were running at $70 million. They've gone up more than $20 million, and the earnings estimates have gone from 80 cents to $1.20. You get expanding operating margins, a huge market opportunity and an undiscovered company. For next year, the estimates are running $122 million and $1.60 a share. They've got great technology, and a new product coming on, which will compete with Advanced Fiber's. It may not be quite as good, but there are people who will use it as a second source. The other thing is that they have a huge backlog. They have visibility through 1998. The only drawback is that there's lots of competition. ADC, Tellabs. A whole list.
Q: But you're not that worried?
Force: They're in their first U.S. trial, and they're going to announce a partner here.
Q: How about some shorts?
Force: I'd short Applied Magnetics, which makes disk-drive heads. They compete with Read-Rite. In fact, they tried to buy Read-Rite. The company has fallen behind in the state-of-the-art technology, called MR. The bid for Read-Rite was a defensive move, because of their weak position in MR. They missed their last quarter, earning 60 cents a share, versus estimates in the 70s. Read-Rite and the Japanese suppliers are ahead of them. I think the stock can go back to where it was before the most recent rally, and that's hat size. I believe their earnings next year could be zero.
Morris: Where is the stock?
Force: About 27. Everything is going to be MR by the second quarter of '98, and I just think they aren't going to be there.
I'd also short Hutchinson Technologies, which also supplies parts to the disk-drive industry. There's some new technology that could displace what they do.
Q: Paul, it's up to you.
Wick: First, I want to talk about a networking outfit: Cabletron Systems. There's a new CEO, Don Reed, who should act as an agent of change. Reed used to be president of Nynex and chief operating officer of New England Telephone. We're excited that his pay package is a function of obtaining 30% earnings-growth targets. He's been on the job for only six weeks, and few people have met him. We have, and we think he's very credible. He's got a strategy to reignite the company's sales growth, which has been problematic over the last year.
Q: Is that why there was a change?
Wick: The company had been run by its founders, Craig Benson and Bob Levine. Benson became chairman; Levine departed voluntarily.
Force: They lost credibility on the Street.
Wick: The perception is that they lost interest in running the company. We think Reed has the right strategy. Cabletron has the best network-management software in the industry with their Spectrum product. They have very limited international sales, almost no business in Southeast Asia, which we currently see as a positive; the company is planning to turn that around. They are going after global accounts by expanding their direct sales force. Going forward, they'll also be partnering with more re-sellers and systems integrators.
Most importantly, they've cured the supply constraints on an important new switching product. A few months back, the lead time on their Smart Switch 6000 line was 10-12 weeks; they're down to roughly four weeks. We think the stock is cheap. At 30, the company has about a $4.8 billion market cap, roughly three times sales. It's trading at about 16 times calendar 1998 estimates of $1.80-$1.85 a share. The company has a strong balance sheet and high profit margins, which right now actually are a little bit sub-par for them, in the 22% area. We think they can move that higher soon. And it has always generated substantial cash from operations.
Q: What else do you like?
Wick: Creative Technology.
Q: The Soundblaster company.
Wick: Creative reported an outstanding September quarter.
Q: Do they still make sound cards for PCs?
Wick: Sound cards are still the key product. Creative essentially invented PC audio. About 80% of the company's revenues still come from the Soundblaster product line. The standard, surprisingly, has not eroded over time, despite repeated predictions that Intel or Microsoft would eventually figure out a way to kill it off. The problem is that virtually all PC games have been written to the Soundblaster standard. No one has been able to come up with an emulation of Soundblaster that works 100% of the time. And the PC companies are quite nervous about coming out with a PC that has the potential for incompatibility.
Q: At one point, this company had been knocked firmly on its behind.
Wick: The stock was absolutely decimated a few years back. The company made the mistake of getting into the CD-ROM business and becoming vertically integrated. They got into that business because they sell CD-ROM upgrade kits with their Soundblaster audio cards. They realized they made a big mistake when the CD-ROM market went through a bloodbath over the past couple of years. Creative exited that business, took a big writeoff. They've since had a significant increase in gross margins, which have risen from a low of around 10% at the trough to 33% in the most recent quarter.
Q: So, they're making money again.
Wick: The company, in the space of a little under two years, has generated almost a half-billion dollars of cash. They now have $5 a share in cash on their balance sheet. They have lots of new products that have been meeting with some success, including a 64-bit version of the Soundblaster audio card. They've also got a graphics card, which has met with a good response in the market, called the Graphics Blaster. And, maybe most importantly, they have a product that came out October 31 -- a $379 DVD multimedia upgrade kit. At $379, it's far and away the cheapest in the market and it could be a hot product for Christmas. Moreover, the stock is cheap, selling at not much more than one times revenues and roughly 10 times June '98 earnings.
Q: Uh, Paul, pardon me, but what is the point of a DVD upgrade kit at this point? There's very little software out there.
Wick: The software is coming. The greater storage capacity of the DVD compared to a CD-ROM will be attractive to some people. It's likely to be a niche market to some degree. But on the other hand, there probably will be some people who want it -- maybe they'll install it on their laptops, and use it to watch movies on airplanes. Their first foray into this area, which came out earlier this year, was priced at $500 and it sold very well. So there seems to be some enthusiasm.
Q: The stock is trading ..
Wick: .. in the mid-20s.
Q: And this year, the company should earn ..
Wick: ...about $2.60 a share.
Q: Cheap! Why do people hate this stock?
Wick: It's a combination of things. The company is based in Singapore, although almost all of its revenues come from the U.S. and Europe. The CEO doesn't speak English very well. For some reason, it just isn't on people's radar screens.
Q: What else do you like?
Wick: Some semiconductor-equipment stocks. Bargains abound in the sphere right now. We think 1998 is going to be somewhat of a recovery year. We're not looking for a huge upswing in capital-equipment spending in '98. We do think that 1999 has the potential to be an outstanding year. We're seeing improved profitability and more stable business in all of the leading companies. If you bought these stocks over the years whenever people have thrown in the towel on them, usually they recover over the ensuing 12-24 months. What perplexes me is that these stocks are getting shellacked very early in the start of an upcycle in the industry. I don't buy the argument that we are about to roll over into a major-league recession in the industry. It would be unprecedented.
Q: What are your equipment picks?
Wick: I like both Teradyne and Credence. I'll start with Teradyne. It's a close No. 2 in the world in semiconductor test equipment -- about two-thirds of its revenues come from semiconductor test equipment. The balance are in telecom, printed circuit-board tests, and high-density printed circuit boards, or backplanes. All of those businesses have better than 20% long-term growth potential. Maybe with the exception of the board test area, which is probably high single-digit growth. Teradyne is unique in the test industry in that it's either No. 1 or No. 2 in all three main areas of semiconductor testing -- No. 1 in mixed signal/analog, No. 2 in logic, and No. 2 in memory. The company has done well from the standpoint of new products. And it's gaining share in virtually all three of the major test areas. In logic, they've been gaining share from Schlumberger and Advantest. On the DRAM side, there's big growth opportunity from the move to 64 megabit chips and synchronous DRAMs. They essentially require a forklift upgrade cycle.
Q: What's a forklift have to do with it?
Wick: You install new equipment, and pull the old stuff out, with a forklift.
Q: Ah.
Wick: The synchronous DRAM and 64-meg DRAM cycle has really just started to unfold in a big way. Teradyne should see some significant growth for its DRAMs in 1998. And in the mixed signal/analog area, they have been relentlessly gaining share from LTX and a couple of other rivals. The company reported earnings just a couple of weeks ago. They reported record orders of over $400 million. They have tremendous visibility looking out to the middle of next year. And operating profit margins right now are only around 16%. Assuming that these orders hold up, the company could see operating profit margins hit the low 20s. Earnings estimates for calendar '98 have risen to the neighborhood of $3. The stock is around $40. It's cheap.
Q: What about Credence?
Wick: I recommended Credence a couple of years ago. At first they did great. But then they had some rocky times. This year revenues have begun to recover. Still the stock has been under a lot of pressure. Credence doesn't do memory testing; the bulk of its product line is mixed-signal and digital-testing gear. The advantage they have had historically is that their testers are smaller and cheaper and have a lower cost of ownership than anyone else's.
Q: That seems like a good thing.
Wick: Over the years, Credence has been the other company, besides Teradyne, that has gained share. It's had some tough times, though. It troughed at $40 million in revenues in the January 1997 quarter and moved up to $51 million in the July quarter. We think it will report roughly $65 million in the October quarter. They are sold out through February. They sell in dollars everywhere. They do have a lot of sales in Southeast Asia, which is one reason the stock has gone down from the mid-50s to about 30. But the fact is, these people sell to Taiwanese foundries, which sell their services to American chip companies and price in dollars.
Q: Anything else we should know?
Wick: This company has always had very high profit margins, and a reputation for being one of the best-managed operations in the industry. Its gross profit margins have traditionally been in the high 50s. Credence managed to maintain those high gross margins throughout the industry downturn, although their expenses climbed as a percentage of sales. As the company's revenues continue to expand, we expect expenses as a percent of sales to decline enabling operating profit margins to rebound back to the 24%-25% range.
SG&A and R&D as a percentage of sales are still relatively high. We think they can hit 20% operating margins in the current quarter. Also, the company has $4 a share of cash, no debt. There are 22 million shares outstanding. The price is 30. And the company is at a run rate of about $260 million in sales, and we see that going up substantially. The Street expects $2 a share in the October 1998 fiscal year, which we think is materially too low.
Q: What else do you like?
Wick: Lattice Semiconductor, the No. 3 maker of PLDs, or programmable logic devices. PLDs are chips used in relatively expensive products like telecom switches, networking hubs and routers and Ethernet switches, wide-area networking equipment and military radar.
Q: Tell us more.
Wick: Lattice has always been a very tightly run ship. And even though it's the No. 3 PLD company, it's been the fastest-growing high-density PLD company over the past year. Lattice has a low-density PLD operation, which is somewhat of a commodity business. And it has this high-density PLD business, a very high value-added line. Lattice has actually gotten very high profit margins on both parts. It historically had operating profit margins in the high 20% to low 30% area. The company a couple of years back had a business mix of 80% low-density and 20% high-end. That's shifted; the low-density business is now only about 30% of sales. The high-density business is approaching 70% and growing at almost 100% per year. The stock is really cheap.
Q: Paul, let's have one final pick.
Wick: I don't own much in the disk-drive industry. But I do like Read-Rite. Lately, it's been somewhat of a disappointment, but we think the worst is over. The stock is just too cheap. The company is the largest merchant supplier in the world for hard disk-drive heads. It was initially late in adopting MR technology, but they were 30% of revenues in the last quarter, going to 70% by the middle of next year. Their largest customer, Western Digital, is moving almost its entire product line to MR heads from thin-film inductive heads. The company should get some help from Western Digital's move to disk drives of higher density, from 1.2 gigabytes per platter to 2.1 gigabytes over the next year -- the higher-density drives require heads with higher selling prices. And the company is on the cusp of getting some significant sales volumes from Seagate, which we're hearing is going to give Read-Rite significant orders for MR heads, starting in the March quarter.
Q: As usual, gentlemen, lots of food for thought. Thanks.
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