KM,
Thanks for pointing to that Barron's piece.
IMO, the entire Barron's article is well worth reading - and rereading - and absorbing.
Chaudhri is one very smart guy and his view of the IT revolution is quite prescient, I believe.
bg
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interactive.wsj.com
May 10, 1999
Info-Tech's Winners
If Buffett bought stocks like these, here's how he'd do it, says a fund boss
An Interview With Rajiv J. Chaudhri -- Digital Century.
The name of this young hedge fund has a nice ring to it and a performance to match. It was up 89% net of fees and expenses last year and another 46% in the first four months of 1999. Chaudhri and his partner invest in information technology, by which they mean silicon-based companies, including semiconductors, hardware, software, networking, telecom equipment, wireless communications and the Internet. He also seeks long-term winners, in the belief that "as markets become larger, the number of successful participants declines," and is a firm believer in scale and horizontal consolidations.
Will eBay's auctions on the Internet hurt Christie's and Sotheby's? Why is America Online's business model so successful? Can Intel boost its market share to 90% from 75%? Read on.
-- Peter C. Du Bois
Barron's: How big is the information-technology sector?
Chaudhri: It has a market cap of approximately $2.5 trillion right now.
Q: In the United States?
A: The U.S. is the bulk of the tech sector worldwide. But actually, this includes some of the more prominent non-U.S. companies as well.
Q: What do you look for?
A: I like to think that the way I invest is the way Warren Buffett would invest, were he to choose to invest in technology. You look for the biggest and the best ideas that are available out there. You plan to hold them forever and you concentrate your holdings into those few good names.
Rajiv Chaudhri
Q: What's the current size of your fund?
A: Approximately $200 million.
Q: How many stocks are you focused on?
A: We would have between 25 and 30 names. And that includes the longs and the shorts.
Q: How many long and how many short?
A: Fifteen to 20 longs and eight to 10 shorts.
Q: And you use borrowed money?
A: We do use leverage, and typically the leverage is 1.5- to 2-to-1. However, we are never net long more than 100%. So we use leverage to basically build our short positions. And our net long positions typically are in a range of 50%-100%. I don't believe in being leveraged in the technology sector because the sector is so volatile.
Q: You take a Buffett approach, you say, but how you can hold any technology stock forever? Technology itself moves so fast.
A: I would disagree with the idea that technology changes so rapidly that you cannot own stocks for the long term. Clearly, if you looked back at the last 10 years, Intel and Microsoft have been outstanding companies -- businesses as well as stocks. And you could have owned them consistently over that period and made a lot of money.
Q: Do you still hold Intel and Microsoft?
A: Yes.
Q: What are you looking for in these big gorillas?
A: The most important thing in making money in investments is getting the big ideas right. To get the big ideas right, you have got to do three things. The first is identify the right markets, the markets where the revenues are going to be the greatest. And by the way, when I look at revenues, I'm looking for them to be in the tens of billions of dollars for these markets, potentially even hundreds of billions of dollars. The second step is identifying the sectors within those markets where managements are implementing the right business models. Does the company have a position within this large marketplace that allows it to generate a sustainable unfair advantage over the other players in that same industry? That is, do they have a market position that allows them to earn much more than the others in this industry?
Q: I realize you are very proud of the fact that for calendar '98 you had an 89% net gain and you didn't book any capital gains. So it was tax-free to the investors. Won't there come a time when you will harvest the huge profits you have in some of these stocks?
A: We would sell our winners only in very exceptional circumstances. And there would have to be a combination of the winner companies facing a different market environment that might make it difficult for them to grow as rapidly as they have grown before. Or it might be a valuation that is not just an overvaluation, but an inordinately high overvaluation that it would take the stock a long time to grow into.
Q: Do you have any rule of thumb as to how far ahead of itself a stock can get?
A: If I believe the earnings can catch up in the next two to three quarters to the valuation the stock might have right now, I wouldn't bother about it. If the stock is at a valuation that will take it four or five years to justify, we would get out of it.
Q: If you think a stock has a good long-term potential of three to four years and yet it is overpriced, would you take a separate short position instead of selling?
A: I wouldn't do that because in many circumstances that is not tax-efficient. However, what we would do is short stocks in the same or a similar industry that represent companies that are not as well positioned and are typically second- or third-tier names and have run up along with the sector, but are probably a lot more vulnerable.
Q: Speaking of tiers, you have devised a law about technology markets.
A: Most people tend to think a rising tide lifts all boats, and if a market is growing, a lot of companies can benefit from it and become more successful. Chaudhri's Law says the exact opposite -- that as markets become larger, the number of really successful companies becomes fewer and fewer, and at the end of the day there are one or two companies at most that really dominate and walk away with the bulk of the profits. We have seen that in microprocessors. We have seen that in operating systems. We have seen that in PCs. We have seen that in all kinds of product markets. In the Internet sector, the same thing is going to happen. You have a half-dozen companies running around trying to become portals right now. You have probably 15 or 20 companies that think they are going to make money selling advertising. And so on. And the reality is that when the dust settles five years from now, there will probably be one company that will have 60% or 70% market share that will have the bulk of the profits in that particular segment. There will be a No. 2 guy with 20% market share. And he will be doing okay. And then there will be another three or four or five companies that will have tiny market shares and they will either be losing money or just getting along. This is going to be repeated in market segment after market segment. So it is very important to identify the winners.
Q: Are you willing to forget about the current P/Es and what some might deem excess valuations?
A: Absolutely. Because these companies that benefit from Chaudhri's Law and become the winners in their markets will have higher revenue growth than people think. Their market share will grow, not decline, despite their size. As their market share builds up, they have higher margins. So not only do they have upside surprises on revenue growth, they also have upside surprises on earnings. These companies end up walking away with a disproportionate market share. You can already see that. Yahoo has a disproportionate market capitalization of the entire portal sector. Microsoft has a disproportionate market share of the entire software sector. Intel has a disproportionate share in semiconductors. Dell Computer has a disproportionate share in PCs.
Q: And if the government should succeed in breaking up Microsoft, would this have very bad implications for other dominant companies in technology?
A: I don't think so. Typically, as an investor, when I am looking at the companies that are going to dominate, I am looking out three to five years. I don't see any government action in the Internet market that is likely to curb the prospects of the companies I think are going to be winners.
Q: Let's run through your strategy.
A: There are two distinct elements to the strategy. One is a portfolio strategy, which is sort of top-down, how I look at the world. And then there is a stock-selection strategy. In the portfolio strategy, what I try to do is capitalize on three aspects of the technology industry sector that I think are fundamental to technology that you don't necessarily find in other sectors. The most important thing is the secular growth of the sector. This sector has got much more secular growth ahead of it than any other sector of the economy. What that means is because the secular growth is very strong, we are always net long.
That brings me to my second point. Technology is also a very volatile sector. And the way we capture that in the portfolio strategy is by never using leverage on the long side.
The third thing is that technology, because of the dynamism and the change this industry experiences, creates not just a lot of new winners, but also a bunch of companies that lose out in the process. And that is where we get our short ideas.
Q: Which ideas are you focusing on?
A: One of the big ideas is e-commerce. It's going to represent hundreds of billions of dollars, maybe even trillions of dollars, of revenues.
Q: Will anybody make a profit?
A: It will be very profitable for a few select companies. And you can buy into companies that are physically owning the product and selling it over the World Wide Web. You can buy into companies that may not own products, but participate in the selling process. You can buy into companies that supply software to these industries. You can buy into companies that are providing infrastructure to e-commerce vendors. To me it is clear that the biggest e-commerce markets are going to be the markets where the companies are in direct contact with the customers.
Q: So one big idea is e-commerce.
A: Another big idea is that the X-86 microprocessor architecture is going to remain the dominant platform for hardware. And X-86 is the microprocessor architecture that's owned by Intel.
Q: Is this the Pentium?
A: Yes.
Q: Is there anything in development that could knock X-86 out of the box?
A: Companies have been trying to knock Intel off its perch, by increasing products that are clones of Intel or products that are different from Intel but are targeted at specific niches. And they really haven't been able to do it for the last 10 years. I expect that will continue. Intel already has the installed base, both in terms of users and in terms of software written for the X-86 architecture. And Intel is advancing the X-86 technology as fast or faster than anybody else in this industry could take advantage of new developments in semiconductor technology.
Q: Let's hear your third big idea.
A: Subscriptions. I am talking about the Internet now. I believe e-commerce and subscriptions are going to be more important sources of revenues than advertising. A subscription, very simply, is a monthly or annual charge you pay to the vendor for services rendered. There is a general perception that the way to make money on the Internet is through advertising. You make everything free to the consumer.
Q: You don't believe paid advertising on the Internet is going to work?
A: I believe advertising on the 'Net is not going to be as big a market as people think it is right now. And I believe there will be very few companies that are truly able to benefit from it.
Q: What is another big theme?
A: It is going to be increasingly harder for companies in the hardware space to grow revenues and provide the historical returns they have provided.
Q: Hardware space?
A: Computer hardware. In technology, when we talk about space, we are talking about the market. It is going to be increasingly hard to sustain historical levels of profitability in the computer hardware markets because of growing commoditization. You have a segment of the PC market operating at the $500 and $600 price points. Those kinds of price points will make it very hard for hardware companies to make money.
Q: Will the people who make the low-price machines make money, though?
A: No, they won't. The point that is interesting, though, is that it is a killer application. Unlike past new applications -- like spread sheets and more complicated word processing, which increased hardware requirements and required you to buy more powerful boxes at higher prices -- the Internet does not require you to have the latest and greatest machines at the cutting edge of hardware technology to take advantage of it. In fact, you can use most Internet applications quite comfortably with hardware that is not state-of-the-art. And that is one of the reasons why these low-priced PCs are so popular.
One of the fundamental rules in technology is that you make a ton of money on the cutting edge. You make a modest amount of money in the middle. And you lose money on the low end.
Q: But if more people are buying something that provides less technology, aren't you making money on the volume?
A: You make some money. But it's not the same. At the low end the profits are just not high.
Q: What are some company stories?
A: The first long I would like to talk about is eBay. This is, I think, the most significant story in the e-commerce space. It is the leading vendor in person-to-person commerce. But you really have to look beyond the description of their business to understand the economic power of the business model they represent. As you mentioned, they help in facilitating auctions. And they charge a percentage of each transaction to create their own revenues. But the most fundamental thing about eBay is that they enable a price-formation process that is superior to the traditional processes.
Ravi Chaudhri
Q: How do they do that?
A: If you wanted to get the best price for any product, however valuable or invaluable the product might be, the best way to do that would be to auction it. Whether it was a $5 item or a $500,000 item, the best way to get the best price would be to auction that product while making the potential bidding audience as large as possible. So it is fundamentally superior to a fixed-price model. It is a model that applies to all kinds of products, a whole range of products -- everything from Beanie Baby dolls to vintage cars. They are addressing a market that is in the hundreds of billions of dollars. They have a business model that is superior; it scales directly with the revenues that are generated on eBay. That is, their revenues go up in direct proportion to the revenues of the products that are transacted on its Website.
Q: That is just another way of saying they are taking a commission on each lot sold.
A: Right. My point is that it is not as if there is a limit to the amount of revenues they generate. There is no cap. It basically scales up in a linear fashion with transactions on their Website. Also, they don't have to take the risk of figuring out which products will be sold on their Website. The buyers and the sellers decide what they are going to offer, what kinds of items are best sold on eBay and what kinds of items are not.
Q: So this makes eBay a toll booth. They collect a fee.
A: Right. And the contrast is with companies that get into the Web retailing business and they say to themselves, "I am going to sell groceries on the Web." Or "I am going to sell X or Y on the Web." And they build up an infrastructure to support that particular product. And it costs them up-front money to do that. And maybe the product doesn't sell on the Web. So you made all that investment, and it doesn't work. EBay doesn't have to make that decision. It takes a tremendous amount of risk away. And it also means that new product categories can be brought on eBay much faster than they can be brought on by a real-world retailer. For example, the number of product categories that are offered on eBay has basically doubled in the last six to nine months, from a few hundred categories to well over 1,500. And because they don't carry inventory, the model is very low in capital intensity. So it is high in margin and low in capital intensity. And that makes for a very high return on equity.
Q: Do you see eBay competing with Christie's and Sotheby's? Christie's and Sotheby's are going to start offering fine arts online. Or will eBay continue to offer low-end, relatively inexpensive items?
A: I think if they are not careful, the folks at Christie's and Sotheby's will be working for eBay in five years.
Q: Why?
A: There are several reasons. One is that eBay is a more efficient way of organizing auctions. Second, its combined fees to sellers and buyers are much less, about 6% versus at least 16%. Also, the number of bidders eBay can bring into the system is a lot higher. The Internet wins. The question then is whether Christie's and Sotheby's can succeed on their own in building an Internet presence or whether eBay will dominate that market. History shows us that new technologies end up being dominated by new companies because the incumbents failed to react quickly enough to the challenges of new technologies.
Q: What do you see for earnings?
A: I believe eBay's revenue- and earnings-growth rates are going to be much higher than Wall Street expects.
Q: What is Wall Street saying and what do you believe?
A: Wall Street is saying that in 1999 eBay will have revenues of $180 million and earn approximately 22 cents a share. We think revenues will be about $220 million and earnings will be nearly 40 cents. Long-term, we have a similar feeling that eBay's revenue growth rates will be much faster than what Wall Street sees and earnings probably will be double the consensus again in 2000.
Q: What is your target for the stock?
A: I think over the next 12 months the stock can get up to the $300 range.
Q: That's interesting. What's next?
A: The second stock we should talk about is America Online. AOL has been the trend-setter in bringing the Internet to millions of people, not just in the United States, but around the world. They have slightly under 50% of all consumer Internet in the U.S. But their incremental market share is actually greater than their average market share, meaning that of the new subscribers who are coming on the 'Net, they are getting more than 50%.
Q: Anyone can buy volume by offering a low price, or giving it away. That is the model you reject.
A: That model has not worked. In fact, AOL prices are slightly higher than what a lot of others charge. But what AOL offers is, first of all, a branded product that a lot of users are comfortable with. No. 2, they offer proprietary content. No. 3, they offer ease of use and an easier user interface that allows people who are less experienced to get on the Web quickly and to navigate around and do what they need to do on the Web.
Q: Branded product. They advertise it?
A: Yes. Their advertising has been so successful over the last four or five years that at this point the brand is so powerful that it is bringing in subscribers even though the advertising growth rate has slowed.
Q: Doesn't their system crash more than others?
A: Those problems are actually behind them. It was most visible a couple of years ago when they had shifted from an hourly subscription product to an all-you-can-eat subscription product. And when that transition happened, the demand for the service went up dramatically over a very short period. At this point their service is actually one of the better regarded services.
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Chaudhri's Picks
Company Where Traded Recent Price
eBay NNM 175 1/2
America Online NYSE 120 11/16
Intel NNM 59 11/16
. . .And Pans
Company Where Traded Recent Price
Lam Research NNM 33
MindSpring Enterp NNM 86 9/16
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Q: Why else do you like the stock here?
A: These guys have built up a business model. They were the trend setters in terms of creating a business model. The first with subscriptions. And then with corporate sponsorships.
Q: What does a corporate sponsorship get you? Is this advertising?
A: It is advertising in a different way. It is a more effective use of advertising dollars than trying to make money from banner ads. The corporate sponsorships really represent strategic tie-ins with these corporations. In many cases they are exclusive, or semi-exclusive. For example, you have one corporate sponsor for credit cards on all of AOL, First USA.
Q: Meaning it's the only credit card that is offered on AOL?
A: Right. And of course that credit-card company gets privileged access to putting their ads on certain of AOL's sites, including in particular their financial sites.
But there is another aspect to AOL which we are talking about, which is the international dimension. AOL is already the No. 2 player in terms of Internet access in Europe. In fact, they are the No. 2 player in Germany, they are the No. 2 player in France, they are in the top two or three in the U.K. So they are building up an international presence that I believe is going to be similar to the Internet presence they have in the U.S.
Q: The last I looked, the stock was selling at over 350 times earnings. Is this an earnings story? Will the earnings catch up with the 350 multiple?
A: This is a growth stock, as well. The stock is up 80%-90%, year to date. I believe that the potential for earnings growth at AOL is 100% annually over the next several years. And my sense is that the stock probably will be in the 175-200 range by the end of 1999.
Q: What kind of earnings are you looking for?
A: I am looking for earnings of 38 cents a share this year, ending June, on a revenue base of $4.85 billion. And that is about 10% higher than consensus. For next year we are using 82 cents in earnings on a revenue base of $6.8 billion.
Q: What did they do for fiscal '98?
A: They earned 14 cents on revenues of $3 billion.
Q: What's the story on Intel?
A: The first part of the Intel story is that, contrary to popular perceptions, I don't think the PC platform is dead. I expect the PC market to continue to grow at 15% or so for the foreseeable future. And within that context, Intel over the next couple of years is going to be able to take back a substantial amount of market share from Advanced Micro Devices and National Semiconductor and essentially go from having about 75% of market share to maybe as much as 90%, and do it all while lowering their cost structure. So I expect very solid revenue and earnings growth out of Intel over the next couple of years. In particular, I think Intel's unit growth rates are actually likely to be 20% or maybe even greater than 20% per year. On top of that, the company has just started to ramp up production using its latest process technology, the 0.18 micron process technology, where they are at least six months or maybe a year ahead of their competition. And this technology will allow them to dramatically lower the cost of manufacturing these processors, which in turn will both help Intel's gross margins and allow them to increase the performance of these processors -- and finally also allow them to compete more price -- aggressively against AMD and National.
So the bottom line on Intel is that we expect their earnings numbers to be somewhat higher than consensus expectations. I think it can earn as much as $2.45-$2.50 this year. And for next year, we are looking for earnings in the $2.90-$3 range. We think the stock can support a price closer to 75 or 80.
Q: Let's turn to shorts.
A: One sector where we have been short is the semiconductor capital-equipment area. The commoditization of hardware has negative implications for the semiconductor capital-equipment companies. These companies provide the equipment that is used by chip companies like Intel, Texas Instruments and Motorola to make their products. And this industry consists of companies like Applied Materials, Lam Research, Novellus, etc. My premise is twofold. One, that because the demand for leading-edge semiconductor technology at end-user level is not as strong as it has historically been, the need for the chip companies to invest in vast amounts of the latest and greatest semiconductor capital equipment is also diminished. So the secular growth rates for the semiconductor capital-equipment sector have been negatively impacted.
Q: Is this a negative for all the companies you've named?
A: The negative secular growth rate impacts all of them. Clearly, some are much better positioned than others. And you have to differentiate between them. Applied Materials actually is very well-positioned because they have the broadest suite of products, the strongest management and historically one of the best records in terms of execution.
There is also a cyclical negative: D-ram prices have started to come down again. Now the semiconductor capital-equipment companies ship anywhere from a third to a half of their equipment to the D-ram makers. And the D-ram makers' capital spending plans are intimately tied to their cash flows, which in turn are a function of D-ram prices. So as D-ram prices have come down quite sharply in the last few months and look like they will continue to come down in the foreseeable future, that is going to put a crimp on the cash flows and therefore the capital-spending requirements of the D-ram companies. The bottom line is that the rate in which the capital-equipment sector will grow in the next couple of years is quite a bit lower than what Wall Street is expecting will happen.
Q: Would you care to mention a particular short?
A: Our one short in this space is Lam Research. They have lost market share to both Applied Materials and Novellus over the last several years. They have undergone a fair amount of restructuring in the past year as a result of that. It is not clear to me that restructuring has necessarily positioned them for revenue growth yet. And in fact, I believe in the next couple of years their revenue growth rates are likely to be quite a bit lower than the better-positioned companies.
Q: The stock is where?
A: In the low 30s.
Q: What is your target?
A: I think it can get down into the low 20s. It has been as high as 39. Basically, consensus expectations for revenues for next year are in the $850 million range.
Q: For 2000?
A: Yes. And they are on a June fiscal year. We think the right number is probably 10% less than that. And the consensus EPS number is $1.70 and we are at $1.25.
Q: That's one.
A: Another is a second-tier Internet service provider, MindSpring.
Q: Did that just go public?
A: No, but they did have an offering recently.
Q: How is it inferior to AOL?
A: First of all, they don't have a brand name. Second, they don't have the scale and scope to compete with AOL. And that is reflected most tellingly in the poor rate of subscriber growth they have experienced. In fact, the number of subscribers they are getting on their own is about flat with what it was last year. So their organic growth has stalled and they are having to beef up their subscriber numbers by doing acquisitions. Which, of course, has its own sets of issues in terms of their ability to generate customer loyalty, the ability to offer a decent service to these new subscribers who really did not sign up with them in the first place. Also, it is not clear to me that management has got the bandwidth to scale the company to a larger size.
Q: The stock is where?
A: It got as high as 133 and recently was 95. My target is 65-70.
Q: That's a good place to stop. Thanks
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