Smart Money Magazine - Posted 09/01/1998
STOCK UPDATE
NETWORK BARGAINS?
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DAILY SCREEN
Guilt by Association
STOCKS
Network Bargains?
PUNDIT NEWS
The Word From Abby: Buy
FUNDS TODAY
Who's Buying Now?
ASK SMI
Those Pesky Margin Calls
FUND SCREEN
Keep It Short
MARKET TODAY
Commentary: Are We Headed for a Recession?
Sectors That Bounce
Market Digest
SmartMoney Gainers and Losers
ARCHIVE
Complete 5-Day View
NETWORKING STOCKS
IT IS emblematic of this manic-depressive market that shares of Cisco Systems (CSCO), one of the premier companies of our time, were tossed around like some obsolete circuit board. On Monday, Cisco's stock plunged 12 5/8 to 81 7/8 only to rebound 8 1/8 on Tuesday to end the day at 90. That's around what Cisco was trading at in late June -- which is fitting, because not much has changed for Cisco in the last two months or so though the gyrations of the market would lead you to believe otherwise.
The question now facing investors, as columnist Jersey Gilbert points out, isn't Russia or even Japan, but whether the recent market selloff and a raft of economic statistics indicate a coming recession in the U.S. What you think is likely to happen will influence your investment decisions over the course of the next few months. A recession would obviously trigger a slowdown in spending by corporate America on the networking equipment that has been flying out of Cisco's warehouses over the past several quarters. But a market correction in the midst of a continuing economic expansion would be, as pundit Abby Cohen believes, a buying opportunity.
Cisco and the other stocks in the communications universe, such as Lucent Technologies (LU), have been some of the worst offenders in terms of unreasonably high premiums this year, and Monday's bloodbath was perhaps just punishment for trailing price-to-earnings ratios of 60 and 93, respectively, for two companies with 30% secular growth rates. But according to analysts, the premium prices these companies have enjoyed all year are a result of the especially strong spending lately by businesses, and by telephone companies such as Sprint (FON), which are upgrading their networks with asynchronous transfer mode and Ethernet gear.
Chris Stix, networking analyst with SG Cowen & Co., agrees the fundamental health of the networking industry and of information technology (or IT) spending are still sound. "The fundamentals are strong this fall, not for every player, but in general they're good." Stix points to the fast Ethernet cycle as a very strong area of IT spending -- especially with the move from 10 megabits per second Ethernet switching to flexible 10 and 100mbps switching -- as well as new layer 3 switches, which he expects will be popular with customers.
Musing on the concern over slowing spending, he notes that the Chicago purchasing managers index was down Monday, but he says that measure has little to do with networking. "That's a typical rust-belt spending indicator; it has nothing to do with networking."
Analysts were quick to talk up their favorites amid the gloom. Eric Buck with Donaldson, Lufkin & Jenrette likes the two cable box suppliers who are selling digital Internet receivers for televisions to TCI (TCOMA), namely General Instrument (GIC) and Scientific Atlanta (SFA). Buck also likes ADC Telecommunications (ADCT) and Tellabs (TLAB).
George Kelley with Morgan Stanley is looking for companies with good earnings visibility that will bounce back when the market reaches a bottom. "We say, let's pick the good companies and wait for some sentiment that says we're at a bottom, and then we're going to have a field day," says Kelley.
Paul Weinstein, an analyst at CS First Boston, calls 3Com (COMS) "the best turnaround" story, based on the fact that the company seems to have fixed problems that had prevented it from turning out product in a timely fashion. 3Com has dropped 23% in the past week and it is almost 60% off its 52-week high of 56. "Now we've got a modem standard," Weinstein says of the truce brokered between Rockwell (ROK) and 3Com's U.S. Robotics unit, both of which produce 56 kilobit per second modems.
"That's going to help stabilize [modem] pricing, which is going to help operating margins," Weinstein says. "And expectations are so low at this point [for 3Com], if you improve operating margins, it's going to drive the stock higher." Reason to look forward to the third quarter, perhaps.
Chipmaker Broadcom (BRCM) gets two votes from the analyst community as the company with perhaps the most exciting story to tell in networking -- after Cisco, of course. The company went public this past April at 62, a 158% jump from its offer price of 24. At Tuesday's price of 54, it's still double that IPO price, of course, and 83 times this year's projected earnings of 65 cents a share. Broadcom is developing chips not only for cable modems, but also for high-speed digital phone technology, dubbed digital subscriber line, while it currently cleans up in the Ethernet networking market.
"Broadcom has the best fundamentals, in terms of multiple markets that are all going in the right direction. It's such an electric company," says Kelley. He notes that Morgan Stanley considered Broadcom too expensive at its offering price, but that he started a recommendation three weeks ago at 58 and thinks it's a steal any lower than that. "If you believe in the Internet and in cable modems, this is the company for you," he says.
According to networking analysts, smaller stocks such as MRV Communications (MRVC) and Xylan (XYLN) are somewhat more of a wild card.
"Smaller stocks are more of a challenge," says Stix, "because they tend to have more retail holdings." Unlike Cisco, Xylan and MRV are falling despite having dropped at points throughout the year. Nonetheless, Kelley is one of those who is bullish on the specific fundamentals of Xylan. "They've got a nice business, good visibility, good partners. It's just really cheap," at Tuesday's price of 15 1/4, or just under 15 times next year's projected earnings per share of $1.12. "And, it's got a 10 million share short position," says Kelley. "I think when this stock rebounds, the shorts in it are going to say 'Look, it doesn't get much better than 15,' and they'll rush to cover their positions, says Kelley.
Though it's not a networking equipment stock, Kelley recommends Aspect Telecom (ASPT), a maker of computer telephony software that allows corporations to set up call centers. "Earnings visibility is excellent with this company. Management knows most of what's going to happen in the next couple of quarters," says Kelley, meaning capital spending surprises should be minimal for Aspect.
Of course there's another factor to keep in mind and that's the dividend discount. The dividend discount principle says that in a market with record low inflation and robust growth, still true of the U.S. economy at this moment, the payoff from the bond market is going to be relatively low relative to the risks of investing in that market. This means there's going to be a natural premium attached to individual equities that can be expected to offer a much greater payoff. It's another way of saying that if there are no visible signs of drastic economic slowdown, the market will ultimately return to prizing companies for their strong fundamentals.
We'd expect companies like Cisco to have that kind of invulnerable premium, at some level, while companies such as Intel (INTC), under a cloud right now regarding its long-term profitability, ought to enjoy less of a premium P/E.
Cowen's Stix agrees the premiums are still very high, but he thinks the fundamentals at Cisco are so strong that the company deserves it. He also thinks the selloff of Ascend Communications (ASND), down 57% in the past week and trading Monday at 29 times this year's projected earnings of $1.20 per share, is excessive. "With Ascend, the correction's way too large at this point. I certainly think it's got 50% [to grow] from here." Ascend was up 2% Tuesday at 36.
Morgan Stanley's Kelley still thinks many of the hottest stocks are cheap. He says MMC Networks (MMCN) has the momentum in silicon switches, being a young company with a stronger focus than larger, more established chipmakers. "They're working 16 hours a day," Kelley says of MMC. "While some of their competitors are working far less. They've got those stock options to incentivize them."
Perhaps there was less of an incentive Monday. MMC was trading down 16% Monday, to 16.75, still 60 times this year's expected earnings of 28 cents per share, and 418 times last year's earnings of 4 cents per share.
Kelley thinks the upside on Broadcom means its premium is also reasonable. "The market will assign this company a very high P/E" because investors know it's impossible to calibrate the real future earnings potential, Kelley says of Broadcom. Given that the growth is expected to be so high going forward, he says, "the P/E that looks like it's 60 really is probably only 40 times" future earnings.
Even for companies with the strongest fundamentals, there's enough cushion left in the stocks' valuations that it's difficult to call a bottom just yet and easy to be worried about a further drop should signs of recession materialize. "There isn't anything in terms of core asset value that you could point to," with respect to many networking stocks, says DLJ's Buck. "In order to say, 'Hey, these guys can't sell below that [price].' At least not until these stocks go much lower down than they are today."
-- By Tiernan Ray
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