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Posted 1/23/2006
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The hard truth about IBM and Intel
Managers at these giants have long been too focused on pushing up the stock price instead of running their businesses for long-term success. The bill for this folly is coming due.
By Bill Fleckenstein
Tech bulls have wrapped themselves around a comforting argument: Capital spending will pick up to offset what's going to be flagging consumer demand this year. It's not so much an argument as a concept, illustrated via IBM's (IBM, news, msgs) results last Wednesday.
IBM dampens IT-spending dreams
At $24.4 billion, the company's revenue was almost $1 billion lighter than the consensus analyst estimate -- with software, mainframe and services all seeing slower-than-expected growth. Software was up only a few percent year-over-year, and that's after 16 acquisitions. The fact that mainframe revenue was as soft as it was, given that we are in the teeth of a new-mainframe rollout, just shows you what corporate IT spending is really like.
There was nothing positive to take away from IBM, though that didn't stop folks from bidding it up last Wednesday, I guess because the company made the earnings-per-share number. However, that "victory" is meaningless, since it's basically achieved through tortured machinations that are impossible to follow. As I noted in "IBM: All Coattails, No Coat" (my daily column of July 19): "It's beyond me how the company could be a bellwether for anything, other than obfuscation."
For years now, the problem with IBM has been feeble revenue growth. Somehow, it manages to pull levers that keep the game alive. But one of these days, that will end -- just as it has for Intel (INTC, news, msgs). Both of these companies, and many others, are guilty of damaging their businesses in an effort to prop up their stock prices. In Intel's case, Craig Barrett and Andy Bryant basically ruined a monopoly (and a very fine company) by trying to boost the stock price rather than running the business prudently, in my opinion. This is a point I have been making for many years now.
Related news and commentary on MSN Money
The inevitable befalls Intel
Speaking of Intel, longtime readers should not have been shocked to see it blow up with an 11% decline last Wednesday, as I have written about that coming train wreck ad nauseam. Still, I'd like to make a couple of observations that I did not see covered in the mainstream press:
The deterioration on Intel's balance sheet. When you take your expected growth rate down, there is no logical reason for inventories to skyrocket. Thus, on the face of it, that is a future problem. (Editor's note: Inventories were up 11% from the third quarter to the fourth and 19% year over year.)
Of course, when receivables leap as they did (up 30.5% over a year ago), it suggests that a customer was enticed by sweetheart terms to be stuffed with product -- which also doesn't bode well for future demand. In addition, Intel looks like its burning through cash; its cash position dropped more than 25% in 2005.
Most amazingly, Intel missed the revenue target it had announced just one month before. For those of us who've long maintained that the company really doesn't have a good view of its own business prospects, because it lies at the back of the food chain, this is an example of what we mean. (Revenue for the quarter was $10.2 billion. On Dec. 8, Intel had projected it at $10.4 billion to $10.6 billion.)
Intel also announced that it will no longer issue midquarter updates. It's going to return to a past practice, which is to give midquarter updates in the form of pre-announcements (though Intel didn't describe it that way).
And you can expect to see them on a regular basis -- for the very same reason I just cited: Intel doesn't have good "visibility" into its business. From its position at the back of the food chain, it doesn't seem able to figure out what the front end is doing.
There will be a price war as Intel tries to unload parts that it has overproduced. The next big data point will either be when those parts turn up in the spot market or when Intel is forced to slash prices, or more likely, both. I don't think that price-slashing will be all that successful, because -- as Dell (DELL, news, msgs) has demonstrated by its price-slashing -- there are saturation issues to contend with. Saturation will prove particularly troublesome for Intel, since it's put up so much capacity and is now talking about increasing capital expenditures to slap up even more.
When you have overcapacity and a bad product mix, and then plan on spending more to make more of the weak products being sold into a saturated market, you have a recipe for disaster. In short, Intel is out of control, and this year is going to be a very ugly one for the company. (For more on Intel, see my column: "Intel: all risk, no reward.")
Trust cannot be downloaded
Even the dead fish have finally gotten that message; eight investment analysts downgraded the stock on Wednesday. I'm not sure whether they understand the ramifications of what lies ahead for Intel, but I would say that the company has blown its credibility with them for quite some time. Maybe they just feel duped by the yarn that Intel has been spinning about what its problems are -- in an attempt to mask the real ones -- so now they feel like they can't trust management. Thus, like lovers scorned, they've downgraded the stock.
I believe it was a variation on that theme last Tuesday that drove Merrill's Joe Osha to downgrade Advanced Micro Devices (AMD, news, msgs) (prior to Intel's quarterly update). He managed to miss AMD's transition, I assume, because he was blinded by Intel -- an example of loving a loser and refusing to like the winner.
A bullish word or two on 3Com
On the subject of taking the other side of what's popular, as I did when I bought AMD last spring, I recently made a small purchase of networking manufacturer 3Com (COMS, news, msgs).
First, let me address the mistaken belief that the company's outgoing CEO, Bruce Claflin, is retiring under an apparent "dark cloud." He isn't. But it has been characterized that way by Wall Street for the same reason that, until recently, the dead fish (see my aforementioned comments on Mr. Osha) never liked Advanced Micro Devices. Just as they didn't like it because they loved Intel, they don't like 3Com because they love Cisco Systems (CSCO, news, msgs). They presume that Cisco buried 3Com ages ago. (At some juncture, a Cisco short will be a nice complement to a long 3Com position. It's too soon for that idea just yet, though I am short a bit of Cisco for other reasons.)
I am less than sanguine about the economic background, and, to repeat what I said above, I'm also less than sanguine about the much-ballyhooed pickup-in-capital-spending theory. (There appears to be even more excitement about the pickup in telecom spending in particular, though I don't believe that is occurring -- and the recent pre-announcement from Lucent Technologies (LU, news, msgs) reinforces my view.)
Having said that, 3Com is quite cheap. If you subtract the cash from its market cap, you're basically buying the company for about one times revenue. Whether one times revenue is truly cheap, you never know until after the fact, but I think that multiple does afford quite a margin of safety. And all that cash provides a nice cushion for 3Com from an operational standpoint.
A match to light up revenues
However, the real reason to own 3Com is because of its very exciting joint venture with Chinese telecom powerhouse Huawei, which has thus far been underappreciated. In the last three quarters, that joint venture has seen its quarterly revenues grow nicely -- from about $82 million to $95 million to $111 million. And revenue is expected to grow by double-digits again this quarter.
3Com owns 49% of this joint venture, with the option to acquire an additional controlling 2%. Huawei has reportedly approved the purchase, but 3Com must wait to see if Beijing says it's okay. I'm hopeful that will occur within the next couple of quarters. If it does, that will give greater visibility to this joint venture. Of course, 3Com will then be able to consolidate its portion of the joint venture's revenue into its own earnings statement. It appears that the joint venture is on track to make a profit this quarter.
With an annual run rate of about $450 million to $500 million, the joint venture isn't that large yet, but it's not nothing, either. 3Com believes it has 20% market share in China, though one needs to take those kinds of estimates with a grain of salt. In any case, depending on how you want to torture the math, you could make the argument that you're getting this joint venture essentially for free. And if you want to talk about exciting potential, owning a premier networking company in China for nothing, or for not much, sounds like a pretty attractive proposition, even if one is negative on the sorts of things that I am negative on.
3Com's good karma?
Were the macro backdrop different, I would own a lot more. (And I would still own AMD.) I believe that I am early on this idea, and I believe that Fred Hickey, who brought it to my attention, thinks he's early as well. But I felt like I had to buy some because I didn't want the stock to take off without me. The potential is just too exciting, and who knows, I could be wrong about my concerns. (Though I don't think so, it has happened before.)
A word of caution: I bought 3Com at roughly $3.70. It was about $4.15 when I wrote about it in my daily column last week, and it was at about $4.50 on Friday. Folks who wish to own the stock should make their purchasing decisions accordingly and plan on being patient.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily "Market Rap" column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC or MSN Money. At the time of publication, Bill Fleckenstein was short Intel and long Intel puts, Long 3Com, short Cisco and Long IBM puts.
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