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Jubak's Journal
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What Intels 5 big problems mean for tech
Not all tech stocks suffer the same woes as Intel. But its weak spots can help you figure out what to expect for the sector for the rest of 2004.
By Jim Jubak
Technology is for stock pickers right now. And studying the problems at sector leader Intel (INTC, news, msgs) provides a road map to profits in the group over the next few months.
Since the Aug. 12 low, the Dow Jones industrial average ($INDU) has climbed 5% as of the close on Sept. 8. The Standard & Poors 500 Stock Index ($INX) matched that 5% gain.
Compare that to the retreat in some technology stocks. The Philadelphia Stock Exchange Semiconductor Index ($SOX.X, news, msgs), for example, has kept falling even as the rest of the market rallies. Its down 4% since Aug. 12. And Intel, the poster boy for bears take on the sector, fell another 7% in the period. Intel is now down 42% from its 2004 peak, which it hit way back on Jan. 8.
But the sector as a whole hasnt crumbled. The Nasdaq Composite ($COMPX), which contains a lot of non-technology stocks Ill grant, is up 6% since Aug. 12. The Merrill Lynch Technology 100 Index ($MLO.X) is up 7%. And shares of Cisco Systems (CSCO, news, msgs), as much a technology bellwether as Intel, are up 8%.
Bears, bulls both wrong
The bears who foresee trouble around every corner for the sector are wrong. Not all technology stocks are facing the problems that have plagued Intel.
But the bulls who believe that all tech stocks are due to rally into the end of the year as revenue picks up following the usual summer weakness are just as wrong. Not all technology shares are now bargains to be snapped up in preparation for a year-end rally.
Right now, its almost impossible to generalize about the sector. The problems that have crushed some technology stocks arent problems across the sector. But the good times for some technology shares have indeed come and gone, even though they may move up in an overall market rally.
In short, this is a sector for stock pickers who can separate the troubled from the trouble-free and who are ready to play the flows of good and bad news from the upcoming third quarter. Its also a market for investors who know what to look for in guidance for the last quarter of 2004.
Intels 5 big problems
Fortunately, if you dig into Intels problems -- and understand the extent to which other technology companies do and dont share them -- they provide a good road map for navigating the technology sector.
Id say Intel faces five major problems:- Execution. Intel has made major product blunders recently. It has missed product deadlines because of engineering failures, allowing competitor Advanced Micro Devices (AMD, news, msgs), for example, to field a 64-bit processor well before Intel has a competitive product. Intel, normally a master of product transitions, has made serious errors in product development. For example, the new Grantsdale chipsets, themselves delayed in getting to market, cost $5 more than the product they were set to replace at a time when computer manufacturers are being squeezed on margins and when computer buyers arent clamoring for the new technology. No wonder Intel, which had ramped up manufacturing of these new chipsets (and the Prescott processor at the heart of them), wound up with excess inventory as computer manufacturers kept buying the older and cheaper product.
These execution missteps are largely a company-specific problem. But still, theres no doubt that as technology gets more complex and as technology companies live through a cycle where consumers arent rushing out to buy the next big thing, these kinds of mistakes seem increasingly common. Id put the problems at Nokia (NOK, news, msgs) and Nvidia (NVDA, news, msgs) in this class. If Nvidias situation is any kind of a guideline, it can take a solid year -- or a product generation -- for a company to get back on track after such miscalculations.
- The revenge of large numbers. Its hard for Intel to grow sales by 10% a year when annual sales are already $33 billion. Intels sales grew by 12% in 2003, but that was off the bottom of a severe slump in the technology business. To turn in a number like that now that business has normalized requires perfect execution, relentless improvements in manufacturing efficiency and a constant stream of solid new products or a couple of really big hits. And when any of those legs crumples, theres no chance that a company this big will be able to deliver the growth that investors remember -- and have come to expect. Of course, the effort to meet those expectations stretches the company and increases the odds of a misstep.
Its striking how many of the technology leaders are now huge and rapidly maturing. (Only in the technology sector is mature an insult.) Companies like Intel, Microsoft (MSFT, news, msgs), Nokia, Cisco Systems, Oracle (ORCL, news, msgs) and Texas Instruments (TXN, news, msgs) certainly dominate their industries, but they also are struggling to find sources of growth that will make a difference when annual sales are $20 billion or $30 billion. (Oracle is the smallest in revenue with just $10 billion in annual sales.) Part of the reason that many investors feel there is a technology growth crisis is that the leaders all seem to be maturing at once. (Microsoft publishes MSN Money.)
- The lack of a next big thing. Big innovations are relatively rare. Even rarer are innovation surges like the period that saw the introduction of the personal computer, the Internet and the wireless phone. Most of the history of technology is devoted to periods that developed, consolidated and extended those big ideas. In periods of rapid innovation, the next big thing drives demand: Think of it as a pull economy where customers demand products from companies that rush to supply them. In periods of consolidation, companies often have to drive demand: Think of this as a push economy where companies such as Intel or Nokia have to spend their marketing muscle convincing customers that they need to upgrade.
Theres nothing wrong with incremental product improvements, except that its hard to get 10% revenue growth at a company with $30 billion in sales out of product extensions. Theres nothing wrong with trying to push demand except that it can be an expensive proposition with a delayed payoff: Intel is likely to succeed in creating a huge new market for computers and other devices with wireless Internet connections, but the payoff to the company wont come tomorrow. Its also much harder to gauge actual customer demand in a push market than in a pull economy. Part of Intels inventory problem in the second and third quarter is the inevitable fallout as the company tries to push the development of markets.
If this is indeed an era of consolidation and product extension, then the case for buying shares in smaller rather than larger technology companies becomes even stronger. Thats true both because the new revenue from a product extension is much more significant to a smaller company and because the market often continues to pull for product improvements even when it isnt showing significant demand for next big idea candidates. So, for example, moving from chip-based storage in wireless phones and camera phones to storage that uses very small hard drives isnt a huge change. But consumers who adopt camera phones and iPod-like music-storage devices are pulling demand for the shift. And the shift will make a huge difference for a company such as Marvell Technology Group (MRVL, news, msgs) with its relatively modest $1 billion in annual sales.
- Inventory: Too much of a good thing? Theres no doubt Intel finished the second quarter with too much product on its shelves. And the problem has continued into the third quarter. But the reasons for the buildup are as important as the magnitude of the buildup itself. If Intel simply misread demand in the push markets that it hoped to create for its high-end chips and chipsets, then investors are looking at a company-specific problem. Theres certainly evidence that Intel did produce more of its new chips than customers demanded. But if the inventory problem was a result of weaker-than-expected demand, then the sector has a problem. Numbers from industry watchers show that demand for PCs and PC motherboards was stronger than Intels revenue growth, suggesting the problem was in Intels misreading for its market.
Theres a third possibility that bears more on the technology sector than on Intel. Partly as a result of the current consolidation of technological innovation, an extraordinary number of high-technology products are moving to commodity status. Thats bringing scores of new competitors into each technology sector and making it harder for established players to judge demand. For example, Huawei Technologies, a Chinese maker of telecommunications gear, has zoomed out of nowhere to take the No. 2 slot globally in the market for optical networking gear, ahead of both Nortel Networks (NT, news, msgs) and Lucent Technologies (LU, news, msgs) and behind only Alcatel (ALA, news, msgs). Think that makes it easier for Nortel and Lucent -- or their suppliers -- to figure out the appropriate inventory levels?
- The incredible falling margin. As part of the third-quarter warning from Intel that knocked the stuffing out of the stock, Intel lowered its projected gross margin for the quarter to 58% from 60%. Some of that was the result of the shortfall in sales of more-expensive, higher-margin processors and chipsets. But some of it was the result of competitive price cutting in the flash-memory business where Intel competes more directly on price with companies such as Advanced Micro Devices and Samsung Electronics (SSNLF, news, msgs). To restore margins and keep them above 60%, Intel is relying on its manufacturing prowess. It leads the chip sector in the race to use 90- and 65-nanometer technologies to pack circuits more tightly on a chip.
Margin pressure is actually a bigger problem for the technology sector as a whole than it is for Intel because many technology companies now let outside manufacturers make their products. That removes any chance that a company can up its margins by improving its internal manufacturing processes as Intel can. This rests the pressure to keep margins high almost totally on research and development. Only companies that can keep adding new intellectual content to their products can hope to prevent erosion in profit margin.
What it means for the tech sector
What does all this add up to?- The price-to-earnings multiples that investors should pay for technology companies should continue to decline, but the biggest effect may be on the multiples of the big, maturing technology names.
- Small technology companies riding hot product extensions and with the ability to add a constant stream of new intellectual property are the most likely to command high and expanding multiples.
- Volatility in the sector is likely to continue to remain high as investors who long for yesterdays price-to-earnings multiples drive the market higher than justified on good news, and investors who believe that multiples should be lower counter-attack on bad news.
- The next few weeks of earnings warnings are likely to be extremely hard on many technology stocks, but that bad news will make it easier for technology companies to meet expectations in the actual reporting of third-quarter results and in their projections for the fourth quarter.
Ill return in three weeks with a column on specific stocks that have set themselves up for a big bounce on modestly good news.
Changes to Jubak's Picks
Sell Southern Peru Copper
Shares of Southern Peru Copper (PCU, news, msgs) have blown through my $45-a-share September 2004 target price and Im going to take my profits here. In the long term I still think shares of copper producers are a great way to hedge against a weaker U.S. dollar and to profit from growth in China. Copper supply could run as much as 3% behind copper demand next year, for instance. But in the short run, I think the stock looks relatively unattractive. Within the next four to six weeks, I expect the stock market to swing toward growth stocks and away from inflation/commodity plays as it has done so often this year. (Id expect a return swing in January or so and Ill be looking to see if I can buy Southern Peru Copper again then.) The proposed asset/share swap with Grupo Mexico also raises short-term uncertainty for the stock. Shares of Southern Peru are up 30% since I added them to Jubaks Picks on April 20, 2004, at $35.80. (Full disclosure: I will sell my personal position in Southern Peru Copper three days after this column is posted.)
Buy Main Street Banks
In my Sept. 8 column, 5 bank stocks to buy as rates rise, I said that with the odds of the Federal Reserve raising interest rates aggressively falling, its a good time to buy shares of banks that combine high growth in deposits with high demand for loans. That pretty much describes Main Street Banks (MSBK, news, msgs). As the dominant franchise in Atlantas suburbs, Main Street Banks has been able to grow loans faster than its small-bank peers. And it certainly doesnt hurt that Wachovia's (WB, news, msgs) pending acquisition of SunTrust Banks (STI, news, msgs) will create turmoil in the Atlanta market that will work to Main Street Banks' advantage. Loan balances grew by 21% (annualized) from the end of 2003 through the end of June 2004. As of Sept. 10, Im setting a target price of $34 a share by March 2005 for shares of Main Street Banks. (Full disclosure: I will buy shares of Main Street Banks three days after this column is posted.)
New developments on past columns
Im insuring my portfolio with land.
Ive been waiting to see what damage Hurricane Frances might have inflicted on the operations of the St. Joe Company (JOE, news, msgs) before revising my target price. Now that the company has said damage was limited to landscaping, Im raising my target price to $52 a share by December from the prior $48 target. Demand continues to run way ahead of my expectations: For example, recently the company announced it had received more than 500 reservations for phase 2 of its RiverCamps on Crooked Creek development. Not bad considering that just 27 home sites have been released for development by the company so far. On July 21, the company announced that earnings for fiscal 2004 would be at least $1 a share. The Wall Street consensus projection had been 95 cents. (Full disclosure: I own shares of the St. Joe Company.)
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: Marvell Technology Group, Microsoft, Southern Peru Copper and The St. Joe Company. He does not own short positions in any stock mentioned in this column.
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