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Jubak's Journal
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| | Jubak's Journal
5 stocks for the skeptical tech investor
Techs haven't done much this year, mostly because last year's tremendous growth is hard to repeat. But companies that can wring more profit out of every dollar are still a buy.
By Jim Jubak
After a red-hot 2003, the technology sector has gone stone cold this year.
The Philadelphia Stock Exchange Semiconductor Index ($SOX.X), which was up 76% in 2003, is barely even so far in 2004. The technology-heavy Nasdaq Composite ($COMPX), down 5.6% from its late January high, is teetering on the brink of a correction.
Whats fueling the anxiety: worries that declining gross profit margins will prevent tech companies from producing enough earnings growth to support the lofty prices they currently command.
But theres a silver lining for investors looking for a tech stock bargain or two. To find them, all you have to do is look at that same number, gross profit margin: The stocks to buy are those that will be able to grow those margins in the quarters ahead.
In fact, that margin number is the key Ive used to put together a five-stock portfolio I call the Skeptic's Tech Stock Portfolio.
To see why investors are so worried, just consider SanDisk (SNDK, news, msgs), up 201% in 2003. After reporting blowout fourth-quarter earnings on Jan. 21, the company said gross margins would fall from 36% in the quarter to 32% to 36% in the first half of 2004 and 28% to 32% in the second half. Obviously, that will make it to tough, to say the least, to keep the operating profit margin at the 28% level it achieved in the fourth quarter.
Of course, a company could make up the difference by increasing revenues, but it requires a huge boost in revenue growth to make up for even a modest drop in gross margin. At an operating margin of 28%, SanDisk would have to grow revenue at an average annual rate of 25% a year through 2014 to justify its Jan. 21 closing price of $34.795, according to Briefing.com. If its operating margin falls to 23%, revenue growth would have to increase to an average of 30 to 35% a year. And if operating margin falls to 18%, the revenue growth has to average 50% to 55% a year, according to Briefing.com.
SanDisk has grown revenue at an average rate of 37% a year over the last five years.
No wonder that as of Feb. 26, SanDisk shares were down nearly 26.5% from that Jan. 21 close.
This margin problem isnt unique to SanDisk, which produces flash memory chips for things such as storing photos in digital cameras. The squeeze on operating margins has turned into an epidemic across the technology sector. Producing the squeeze is too much manufacturing capacity that came on line in the 1990s and continues full-throttle today. That has sent many companies on desperate searches for any products that they might be able to make in an otherwise empty factory at any kind of profit.
Are technology stocks priced for this kind of profit margin squeeze? On average, the answer is no.
According to a Sanford C. Bernstein study, estimates for technology earnings in 2005 assume an average net margin of 10.7%, up from a projected 8.9% in 2004. In 2003, it looks like that net margin will be about 6.6%, Bernstein calculates. So at a time when margins are being squeezed, technology stocks are priced for a huge rise in net margins. (By the way, the 10-year average for net margin is about 6%.)
So why should you invest in tech stocks in the midst of a profit squeeze?
Because some individual tech stocks look like they can avoid the squeeze on average profit margins. These profit margin winners fall into three groups.
Focuses on higher margins, lower prices
In the first group, Id put Intel (INTC, news, msgs) and Dell (DELL, news, msgs), two companies with viable long-term strategies to increase margins.
Intel: An obsession with cutting manufacturing costs. Look at what Intel has been able to accomplish recently. Revenue climbed 22% in the fourth quarter from a year earlier; earnings per share were up 106% year to year. But most telling, gross margins climbed to 60% in the quarter from 57% a year earlier. And Intel told Wall Street that gross margins for all of 2004 should come in at about 62%.
Intel has been able to turn its huge share of the PC processor market into higher profits (which in turn help it defend that share) by relentlessly driving its own manufacturing technology.
The company just announced four new Pentium 4 processors using 90 nanometer technologies that make it possible to cram circuits more tightly together. Combined with other new technologies, Intel can now cut more chips out of a single piece of silicon.
Thus, the new Centrino chip adds wireless capability to Intels processor. That added capability means more of the price of a PC goes into Intels pockets instead of being split with another supplier.
The thing I like about Intel's margin-enhancing strategies is that they will work this year and the next and the next.
Dell: Tight control of production flow is the key. Dells ability to increase its gross margin doesnt look quite as impressive as Intels until you consider that Dell plays in the PC sector, the toughest, most commoditylike part of the technology industry. Dell managed to increase its gross margin in the quarter that ended on Jan. 30, 2004, to 18.2% from the 17.8% in a year-over-year comparison. And I think Dells ability to grow its gross margin has every bit the staying power of Intels. Perhaps more.
Every time overcapacity causes some supplier to cut its already rock-bottom price even further, Dell is able to use its just-in-time manufacturing system and bare bones inventory to capture that price cut almost immediately. Dell then cuts its own prices to pass on much of the savings -- but not all -- to customers. The end result is higher unit volumes for Dell and a slight uptick in Dells own profit margin. Dell is now busy expanding this model from PCs to servers to printers and beyond.
Operates in a business that supports just a few players
In the second group, Id put companies that operate in specific markets that are relatively immune from the overcapacity profit squeeze.
Analog Devices: Custom-designed products are a protection. There arent a lot of these companies, but Analog Devices (ADI, news, msgs) is one. The company manufactures customized chips that manipulate analog input such as sound. Its business is shielded from the worst of the global price squeeze because analog chips are custom-designed for specific products, are produced in relatively small batches and have long product lives.
In the quarter ended Jan. 31, the company reported gross margins of 57.1%, up from 55.8% in the prior quarter and up from 54.2% in the same quarter a year earlier. Operating margin climbed to 24.1% from 20% in the prior quarter and 15.8% in the year earlier quarter.
Because the company operates in the market for analog chips -- about 78% of sales in the most recent quarter -- theres good reason to believe those healthy margins are here to stay and could even inch higher. Its extremely difficult for an analog competitor with extra capacity to shift to making an existing analog product -- it often simply wont pay -- and digital manufacturers cant turn their lines into analog factories.
Have a window to expand margins for now
The third group consists of companies in the sweet spot of their product or market cycle that have a temporary window to expand margins.
Marvel Technology: riding the wi-fi boom. Marvel Technology Group (MRVL, news, msgs) is riding hot markets for wi-fi, wide area networks (WLAN) and high-capacity mobile hard drives. The company has recently entered the market for power management devices. These growth areas should lead to higher margins. Power management chips carry a 60% gross margin compared with the current company average of 53%. Goldman Sachs forecasts that Marvel should be able to increase operating margins to 19% in fiscal 2005 from about 17% in fiscal 2004. (The company reported earnings for the first quarter of fiscal 2004 on Feb. 26.) Some analysts believe that operating margins are headed to 20%.
How long those margins will keep expanding depends on how long Marvel can crank out new products at the cutting edge of the technology curve. The key to making a profit in a stock such as Marvels is to exit, at least temporarily, when margins peak. The stocks high multiple, 45 times projected fiscal year 2004 earnings, doesnt leave the stock any room for error.
Marvels margins could expand for the next year or even more. But you can still make a good profit on a stock with a shorter run of rising margins ahead of it.
SanDisk: Flash memory supports gains. SanDisk also falls into this camp. It increasingly looks like the drop in margins that management predicted in its Jan. 21 guidance to Wall Street wont show up until the second half of 2004. Competitor Samsung recently reported that it expects steady pricing in the NAND flash memory market through the first half of the year. And extra supply from companies such as Micron Technology (MU, news, msgs) and Infineon Technologies (IFX, news, msgs) is coming on line more slowly than expected.
In the short term, then, the market may have over-reacted to an overly cautious projection from SanDisks management, and the stock could see a jump if margins dont fall as expected in the quarter that ends in March 2004.
Buy or wait to buy?
Should you buy any of the five stocks in this Skeptic's Tech Stock Portfolio now?
Thats a tough call. The entire sector is under pressure, and it is quite possible were only about halfway through what will turn into a classic 15% correction.
Given the risk, Id use this rule of thumb to guide any buying:- Calculate a 12-month target price.
- Look to buy at about a 25% discount to that price.
- A potential 25% return is the minimum Id look right now for a stock in this volatile sector.
Nothing in this list quite makes that cut, although Intel and Analog Devices come close. My $35 target price for Intel is up about 19% from the Feb. 25 price of $29.47. My $60 target for Analog Devices is about 20% higher than its Feb. 25 price of $50.05.
But I think Ill wait. Im skeptical, you see, that weve witnessed the end of this correction.
| Jubaks Skeptic's Tech Stock Portfolio | | Company | Last Price | Change | 52-week High | 52-week Low | Market cap in millions | | SanDisk (SNDK, news, msgs) | $25.67 | $1.56 | $43.15 | $7.72 | $3,659.60 | | Intel (INTC, news, msgs) | $29.76 | $0.14 | $34.60 | $15.59 | $192,963.80 | | Dell (DELL, news, msgs) | $33.59 | $0.29 | $37.18 | $25.14 | $85,836.80 | | Analog Devices (ADI, news, msgs) | $50.46 | $0.24 | $52.37 | $25.75 | $19,076.10 | | Marvel Technology Group (MRVL, news, msgs) | $42.94 | -$0.19 | $46.63 | $17.52 | $5,600.70 |
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Changes to Jubaks picks
Sell Smithfield Foods
The piggies came through for Smithfield Foods (SFD, news, msgs) in the quarter that ended on Jan. 31. Most of the growth in earnings to 38 cents for the quarter (from 3 cents a share a year ago) resulted from a swing in the companys pig business. That business improved from a loss of $64 million a year ago to a loss of just $8 million in the recent quarter.
But this still marks the second quarter in a row that Smithfield Foods has missed Wall Street earnings estimates. I take that seriously, because I think its an indication of just how tough the meat market has become. With mad cow disease shutting down U.S. beef exports and outbreaks of avian flu in Delaware and Texas resulting in new bans on chicken exports as well, its become extremely hard to tell where meat prices will head next.
That volatility reduces the attractiveness of Smithfield as a safe growth stock. So Im selling the shares with a 28% profit since I added them to Jubaks Picks at $19.55 on Jan. 7, 2003. (Full disclosure: I will be selling my personal position in Smithfield Foods three days after this column is posted.)
New developments on past columns
A safer way to play higher oil prices
On Feb. 25 Tsakos Energy Navigation (TNP, news, msgs) reported earnings of $1.88 a share (excluding a one-time charge of $1.72 for writing down older, single-hulled tankers). That was about 7 cents a share above the Wall Street consensus. Spot-market revenue came in softer than in recent quarters on a decline in day rates, but contracts for the companys fleet leased on longer fixed rate contracts more than made up the difference. With new ships about to be delivered, the fixed-contract fleet should grow revenue by almost 50% this year, according to J.P. Morgan Securities. That should help the company successfully weather the weakness in spot rates that some analysts are expecting for the second quarter. The shares were up 8 cents at $30.05 on Thursday.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Smithfield Foods. He does not own short positions in any stock mentioned in this column.
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