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Jubak's Journal
Recent articles:
• In this rally, dont spit into the wind, 5/9/2003
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| | Jubak's Journal
4 ways to unearth tech-stock winners
Some will benefit from a second-half economic recovery. Others will prosper because of cost-cutting or competitive advantages. And some will do both.
By Jim Jubak
In the current slow- to no-growth economic environment, technology companies face two strategic choices -- attack new markets with a flood of innovative products or cut costs. Depending on what path companies take, technology investors are left with four stock-picking options to consider.
Option No. 1: Go with technology sectors that dont face a huge excess capacity overhang. According to Morgan Stanley, computer makers are running at only 61.8% of capacity, compared with nearly 85% during the tech boom years in the late 1990s. With demand expected to only increase by single digits this year, many technology companies wont be able to grow their way out of the slump. Many, but not all.
Wondering why the much-maligned Internet group has outperformed the rest of the technology sector? Yes, many of these stocks were among the most heavily shorted in the market, and so they took off like rockets when the shorts were forced to buy shares to cover their positions. But, stocks like Yahoo! (YHOO, news, msgs), up 53% year-to-date; eBay (EBAY, news, msgs), up 40% in 2003; and Expedia (EXPE, news, msgs), up 91%, arent struggling with excess capacity. True, if the economy doesnt come through in the second half, Yahoo! wont pull in the huge increases in advertising revenue that Wall Street expects, but the company also doesnt face competitors that are cutting prices to keep factories running. In the case of a Yahoo! or an eBay or an Expedia, any pickup in unit sales will fall right to the bottom line. And these companies business structures are leveraged so that increases in unit sales turn into bigger increases in revenues and even bigger jumps in profit. That's quite a contrast to the computer makers who could well see a 1% decline in revenue even with a 6% climb in unit sales.
Option No. 2: Go with companies that have the ability to take market share from competitors while making a profit. That kind of attack can be especially lucrative if the company can go after the juiciest part of a competitors business . . . which is exactly what Dell Computer (DELL, news, msgs) is doing to Hewlett-Packard (HPQ, news, msgs) in the printer business. Dell recently launched the Dell A940 all-in-one printer. Priced at $109, after a $30 rebate, the machine combines an inkjet printer, scanner and copier. But the hardware is really just the foot in the door, because Dell knows that by far the most lucrative part of Hewlett-Packards printer businesses isnt the printer itself but the supplies of ink and paper that a customer buys to keep the printer running. The A940 comes with software that automatically notifies the user when its time to buy more ink and then lets the user click into Dells online store to buy the needed supplies. Without any shipping or handling fees.
Any company, including Hewlett-Packard, is free to match that deal. But only Dell has the infrastructure to deliver at that price and make a profit. The threat to Hewlett-Packard is clear: Just about all of its profits in the last year have come from selling printers and printing supplies and just about half of printer revenue comes from the sale of supplies. (In the first quarter of 2003, $5.6 billion of Hewlett-Packards total $18 billion in revenues came from the printer division and $907 million of the companys total $1.2 billion in operating earnings were from that unit.)
Option No. 3: Go with companies that are cutting costs in a lasting way. Letting go of workers that youll have to rehire when business picks up or closing factories that youll have to reopen certainly saves needed cash in the short run. But it doesnt make a company a leaner organization that will be able to sustain higher margins when revenues pick up. Creating lasting cost efficiencies is hard work -- and frankly, its beyond many CEOs. But its clearly not impossible. Cisco Systems (CSCO, news, msgs) increased its gross margin to 71% in the most recent quarter from 64% in the same period a year ago. Net income was up 35% even though revenue fell by 4%. No magic here, just nitty-gritty changes: redesigning products so that they use more chips in common; or reorganizing the company to eliminate duplication in everything from design to customer service. The most impressive thing about Cisco efforts, to my mind, is that much of the effort on the engineering end hasnt yet shown up in products on the market. Ciscos margins should tick even higher when those products go on sale in 2005 and after.
Option No. 4: Go with companies that are innovating around excess capacity -- but beware that the product cycle is shorter than ever. If a company is the only one with a new product on the market, it doesnt matter how much extra capacity competitors have available or how much theyd be willing to cut prices. For some period of time, they cant make the product, and they dont have any to sell at any price. The problem is that in an economy where the sector is using only 61.8% of its capacity, that period of exclusive ownership of a new product doesnt last very long. Competitors ramp up quickly, throwing whatever resources they have available at the problem. That reduces the glorious time of high margins that a first-to-market company can claim. Eventually, companies wind up in vicious technological cycles like the one Nvidia and ATI Technologies (ATYT, news, msgs) are caught in now. Each quarter, one or the other produces a new faster graphic processor, quickly outmoding the competitors offering. Or where technology innovators are forced to constantly cannibalize their own market-leading product by turning it into a mass market standard with higher mass market volumes but, unfortunately, with lower mass market margins.
And the winner is
Which one of these four strategies will give an investor the most winners over the next year?
A lot depends on which way the economy breaks.
If the second-half recovery does materialize, still certainly a long way from certain, then Id expect the Internet stocks of Option No. 1 to outperform along with the successful cost-cutters of Option No. 3. Both of those groups of stocks are highly leveraged to any up tick in revenue and so even a modest recovery in demand should produce a much more than modest boost to the bottom line.
The problem with stocks that represent these two options, however, is that they have already included some, perhaps much, of that increase in earnings in their recent price. In the Internet group, for example, eBay sells for 64 times projected 2004 earnings. And analysts are already projecting a 40% jump in 2004 earnings per share over 2003. Many of these stocks are now trading on price momentum -- and that leaves investors who buy at this point of uncertainty vulnerable if that better second half doesnt arrive.
Many of the cost-cutting leaders have a similar problem. They trade at high multiples that reflect their continued popularity in investors' portfolios. Cisco, for example, trades at 26 times fiscal 2004 earnings per share -- and that assumes a 50% jump in earnings in fiscal 2003 over the year earlier. A disappointing second-half recovery would reduce the leverage that these companies could get out of their improved margins. And that could well lead to investor disappointment.
The stocks of companies relying on taking market share or on technical innovation are less exposed to a second-half recovery for good and ill. They are less likely to disappoint since their fortunes arent so reliant on the general economy. But on the other hand, they miss out on the upside leverage if the recovery is strong.
Stocks that avoid the either/or dilemma
Id prefer to go with the stocks of companies that draw their strength from more than one of these four strategies, preferably one strategy linked to a second-half recovery and one with more independence from economic trends.
So I favor stocks of companies such as Xilinx (XLNX, news, msgs) or Seagate Technology (STX, news, msgs) that are cost-cutters and innovators. Xilinxs recent deal to partner with IBM to manufacture chips gives the company access to cutting-edge manufacturing that should drive down the price of its programmable chips. Thats essential for keeping competitors such as Altera (ALTR, news, msgs) at bay and also for preventing makers of application specific chips from mounting a successful counterattack using price as their weapon. The company has also shown an ability to get a steady stream of new products to market on schedule and a willingness to cannibalize sales of once-marketing leading products in order to stay on top.
In the case of Seagate, the cost advantage was baked in when Silver Lake Partners and Texas Pacific Group took the company private in 2000 and restructured the business. Now that the company has emerged from that process, management seems determined to hold the line on costs. That, plus the companys ability to grab the lead in the hard drive's transition to a new higher density 80GB platform, gives the stock a place in two strategies.
Im adding Seagate Technology to Jubaks Picks with this column with a target price of $18 by September 2003.
Updates on previous columns
Spot the winners, cut the whiners
In its May 8 earnings report, Comcast (CMCSK, news, msgs) hit all the targets that matter most to me for this stock. The company made huge progress in improving the performance at the cable systems acquired from AT&T (T, news, msgs). Margins for the acquired systems climbed to 29%, up from 19% in the first quarter of 2002. Comcast also remains on track to complete its upgrade of those AT&T systems in 2004. The combined company added 417,000 high-speed data subscribers in the first quarter, compared with 229,000 added by the combined systems in the same period in 2002. Management also increased its projections for that business, saying that it would end 2003 with 5.2 million cable modem subscribers, up from the 5 million projected earlier. As of May 13, Im keeping my target price of $34 for Comcast by December 2003. (Full disclosure: I own shares of Comcast.)
Changes to Jubak's Picks
Buy Seagate Technology Holdings
Seagate Technology Holdings (STX, news, msgs) has managed two tricky transitions: First, going from public to private to public company again. And the second: shifting from the prevailing 40GB hard disk technology to a new 89GB product. The first process allowed management to restructure the company and reduce costs. The second has given Seagate a lead, almost certainly temporary, over competitors Maxtor (MXO, news, msgs) and Western Digital (WDC, news, msgs). That temporary lead, however, looks likely to help Seagate increase its market-leading share of the hard drive segment from the current 30%. Hard drives arent the commodity, PC-only product of a few years ago with new higher capacity drives showing up in video-on-demand cable TV set top boxes and in game consoles. But Seagate is still priced like the maker of a commodity product: the stock currently trades at just 9.6 times projected fiscal 2004 earnings per share and at just 0.9 times projected 2004 sales. Im adding the stock to Jubaks Picks with a target price of $18 a share by September 2003.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Comcast and Xilinx. He does not own short positions in any stock mentioned in this column.
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