BARRON'S: The Trader

 

  What Recovery? Asks The Technology Sector

  By Andrew Bary

 

  The economy may be expanding briskly, but the tech sector is showing scant

signs of recovery. Reflecting continued concerns about the tech profit outlook,

the Nasdaq slid 75 points, or 4.1%, last week, to 1770, trailing both the Dow

Industrials and Standard & Poor's 500. The Dow fell 132 points, or 1.3% to

10,271, while the S&P dropped 24 points to 1,122, a decline of 2.1%, hurt by

weakness in both the tech and drug sectors.

  On Friday, the Industrials gained 36 points, but that move was entirely due to

one stock, Minnesota Mining & Manufacturing, which rose 7.81, to 122, on news

that its first-quarter profit will beat estimates. 3M's gain lifted the Dow by

more than 50 points (each one-point move in a Dow stock translates into a

seven-point change in the index). The Nasdaq was off 19 points in the week's

final session.

  "There's a real disconnect between the overall numbers on the economy and

tech-company comments that suggest no real pick-up yet," says Steve Milunovich,

tech strategist at Merrill Lynch. Just last week came earnings warnings from

Peoplesoft and Compuware, which followed bad news from EMC, Oracle and others.

The economy, meanwhile, is expected to have expanded at a 5% to 6% real rate in

the first quarter.

  Goldman Sachs analysts cut profit estimates last week for EMC, Sun

Microsystems and the usually dependable Microsoft, while Nortel Networks, the

former darling in the telecom-equipment sector, fell to a multiyear low of 3.60

on Friday after its debt was downgraded to junk status by Moody's Investors

Service. Nortel peaked at 87 in late 2000.

  Reflecting the tough tech environment, the Nasdaq is off 9.3% this year, while

the Dow is up 2.5%. The S&P is down 2.2%. The big issue for tech investors is

whether weak corporate tech spending is a temporary first-quarter event or

whether there are structural issues that will impede a robust recovery in late

2002 and 2003 that many stocks still are discounting.

  Tech bulls are betting that spending revives later this year as cautious

information technology chiefs at major companies loosen purse strings. Their

view is that tech spending typically has rebounded one to two quarters after a

recovery in overall corporate profits.

  Milunovich, however, cautions that the tech spending boom of the late 1990s

may be followed by several years of restrained spending. The technology industry

rides on the health of three sectors: wireline telecom, wireless telecom and

personal computers. As recently as early 2000, all three areas were booming.

Now, telecom spending by major carriers is falling sharply while beleaguered,

debt-laden wireless operators are making cutbacks in their capital expenditures

in a bid to produce free cash flow as soon as next year.

  The personal-computer industry is hardly in robust health. J.P. Morgan

analysts recently estimated that North American telecom carriers will cut

capital spending by 32.9% this year followed by a drop of 3% in 2003.

Financially challenged companies like Worldcom, Qwest and Sprint are sharply

reducing 2002 spending, and even the healthier Baby Bells are cutting back

because of weak revenues and earnings pressure.

  Telecom-equipment suppliers such as Nortel and Lucent Technologies have been

desperately trying to trim their cost structures through layoffs and other means

in a so-far unsuccessful bid to generate profits at much lower revenue levels.

  Another tech problem is pressure on profit margins. With the industry

operating at just 60% of capacity, many companies are cutting prices. EMC, for

instance, is getting just 10% margins on hardware, down from 60% in 2000, amid

competition from Hitachi and others for data storage systems, Milunovich

estimates.

  The EMC situation shows that Dell Computer CEO Michael Dell was right about

the company when he reportedly said the initials EMC stood for "Excessive

Mark-up Corp." back in 2000, when EMC touched 100. EMC, down 0.80 to 11.12 last

week, now is expected to operate at a slight loss in 2002 and post about 25

cents a share in profit in 2003.

  Milunovich points out that the tech sector isn't cheap by any conventional

measure. It trades for about 40 times forward profits, compared with a

price/earnings multiple of 23 for the S&P 500. Only about a third of the 400

tech companies followed by Merrill are now profitable, he notes.

  Many companies, however, are being valued on estimated 2003 profits, with such

giants at Microsoft, Oracle, Cisco Systems and Intel commanding around 30 times

estimated 2003 earnings. Microsoft dropped 4.44 to 55.87 last week as Goldman

Sachs analyst Rick Sherlund cut his earnings estimate for Microsoft's next

fiscal year ending in June 2003 to $1.95 a share from $2.05 a share. Cisco

dropped 0.78 to 16.15 in the five sessions; Oracle declined 0.67 to 12.13; Intel

fell 0.36 to 30.05 and Sun was down 0.07 to 8.71.

  Even in a tough tech market, there generally is one strong sector favored by

momentum-oriented investors. The current favorite: semiconductor capital

equipment makers, including Applied Materials and KLA Tencor. The group is up

nearly 30% this year, with Applied Materials, at 52.40, up 31% and KLA Tencor,

at 65.63, up 32%. Both KLA and Applied Materials have doubled from their

September lows.

  The irony is that semiconductor-equipment makers are expected to have posted

their worst revenue declines in the entire tech sector during the first quarter,

but forward-looking investors focus on orders, which bottomed in the fourth

quarter.

  "The momentum guys don't give up. They drive up stocks, no matter how stupid

the story," says Fred Hickey, editor of the High-Tech Strategist, a Nashua,

N.H., newsletter.

  Hickey calls the valuations of the equipment stocks "insane" given the overall

health of the tech sector and the state of their customers, the semiconductor

industry. The bull case is that semiconductor companies must spend heavily to

upgrade their product lines regardless of their own profitability. Among the

only semiconductor producers with ample current earnings is Intel.

  Applied Materials was favorably profiled in Barron's a year ago, when it

traded at 46, but it may be time to take profits in the industry leader. At 52,

Applied commands nearly 200 times projected earnings of 27 cents in its current

fiscal year ending in October and for 40 times projected profit of $1.30 a share

in the following fiscal year.

  The bull case is that Applied should trade for 30 times annualized second-half

2003 profit of $2 a share, or $60 a share. But why should a cyclical company

like Applied Materials trade for 30 times a very optimistic earnings projection

in 18 months? The company's peak profit was $2.39 a share in 2000 -- a level

that may not be reached for years. With a market value of $43 billion, Applied

Materials trades for nearly 10 times estimated 2002 sales and 1.7 times total

industry spending on semiconductor equipment.

  Hickey points out that KLA Tencor recently touched 70 -- back where it traded

at the height of the tech mania in March 2000 -- despite a materially worse

outlook now. Hickey thinks KLA is ludicrously priced, trading for about 65 times

projected profits in its current fiscal year ending in June and for about 10

times estimated 2002 sales.

  Most investors focus on earnings when valuing stocks, but it's also important

to pay attention to sales.

  Stocks of companies valued at high multiples of their annual revenues can

prove dangerous because of the risk of contracting profit margins in a

competitive economy. In recent comments to Business Week, Sun CEO Scott McNealy

warned investors about buying stocks of firms valued at 10 times sales or more.

He noted that at its peak, Sun traded at 64, or 10 times sales, a valuation that

he now suggests was "ridiculous." Sun now fetches a more modest two times

revenue, while companies like Nortel fetch about one times sales.

  Merrill Lynch recently compiled a list of 15 tech companies trading for more

than 10 times sales (see table). The list includes such well-known companies as

Microsoft, Yahoo, Qualcomm, Veritas Software and semiconductor maker Maxim

Integrated Products.

  Some investors are willing to overlook Microsoft's high price/sales ratio

because its profit margins are enormous -- software gross margins are about 85%.

This results in a moderate P/E of around 30. Yet Microsoft's growth has slowed

markedly in recent years and Milunovich thinks the company could be entering an

era of best-case 10% annual earnings gains. Companies with high price/sales

ratios typically have lush margins, but those margins attract competition.

Witness the margin collapse at EMC, which once was viewed as invulnerable.

Investors can make money in these pricey stocks, but the odds are low for

outsized returns over the long haul.

  Milunovich favors Hewlett-Packard, which at 17, trades for less than one times

sales. H-P's jewel, the printer business, could be worth 13 a share even after

the Compaq Computer deal, providing downside support to H-P at current levels.

  McNealy's argument against stocks with high price/sales ratios is

sophisticated but worth reprinting:

 

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BARRON'S: The Trader -2-

 

  "Two years ago we were selling at 10 times revenues when we were at $64. At 10

times revenues, to give you a 10-year payback, I have to pay you 100% of

revenues for 10 straight years in dividends. That assumes I can get that by my

shareholders. That assumes I have zero cost of goods sold, which is very hard

for a computer company. That assumes zero expenses, which is really hard with

39,000 employees. That assumes I pay no taxes, which is very hard. And that

assumes you pay no taxes on your dividends, which is kind of illegal. And that

assumes with zero R&D for the next 10 years, I can maintain the current revenue

run rate. Now, having done that, would any of you like to buy my stock at $64?

Do you realize how ridiculous those basic assumptions are? You don't need any

transparency. You don't need any footnotes. What were you thinking?"

  Cable-television stocks were rocked last week in the wake of Adelphia

Communications' disclosure that it is liable for about $2.5 billion of debt

carried off its balance sheet that was generated in part to finance Adelphia

stock purchases by the controlling Rigas family.

  Adelphia fell 4.48 to 10.42, capping a 50% drop in two weeks as investors

worried that the previously undisclosed debt will add to the company's already

hefty burden of debt and preferred totaling nearly $15 billion.

  The Rigas situation also showed the dangers of the cable industry's ownership

structure, which is dominated by strong-willed families who may put their own

interests ahead of public shareholders. Comcast and Cablevision Systems also are

run by powerful families.

  Wall Street also may be starting to lose patience with the industry, which has

sucked up capital in recent years for plant upgrades for digital services and

Internet access and which is supposed to start generating free cash flow in 2003

or 2004.

  The drop in Adelphia may seem extreme, but it makes some sense when the

company's high leverage is considered. Adelphia's market value has fallen by

about $2.5 billion in two weeks -- about the same amount as the newly

materialized debt. Stocks of highly leveraged companies are very sensitive to

good or bad news.

  Some investors argue that the net new debt is closer to $1.5 billion because

of the value of certain cable assets held by the off-balance-sheet partnership.

  Adelphia bulls argue that the stock is relatively cheap, trading for about

$3,000 per subscriber. AT&T sold its cable properties to Comcast in a deal

valued at more than $4,000 per subcriber. Adelphia has 5.8 million subscribers,

including a valuable cluster in the Los Angeles area. Adelphia's debt didn't

weaken too much, trading at a 12% yield, because investors figure its cable

systems are easily worth the debt on its balance sheet.

  Cablevision, which dominates the New York market with three million

subscribers, fell 4.40 to 29.60 last week and is off 37% this year. It was

favorably profiled in Barron's last fall when it traded at 43. Cablevision is

now valued at $5.3 billion and its adjusted enterprise value (reflecting debt

and other assets) is about $14 billion.

  Merrill Lynch analyst Jessica Reif Cohen last week said the company may

consider a sale of its wireless licenses for personal communication services

(PCS) in the New York area and elsewhere in the U.S. for $1 billion or more. She

said the sale of the licenses would cut the company's cash needs, projected at

over $1 billion this year and $800 million in 2003.

  By selling the licenses, Cablevision would avoid the heavy cost of building a

wireless network that would face fierce competition from the big national

players. The talk is that Verizon Wireless would be interested in Cablevision's

New York licenses to expand its network.

  There's speculation that the controlling Dolan family may sell the licenses,

which would play well on Wall Street.

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                      VITAL SIGNS

 

                      FRIDAY'S   WEEK'S    WEEK'S

                       CLOSE     CHANGE    % CHG.

 

DJ Industrials        10271.64    -132.30   -1.27

DJ Transportation     2778.41     -139.55   -4.78

DJ Utilities           304.01       -1.72   -0.56

DJ 65 Stocks          2987.14      -58.78   -1.93

DJ US Total Mkt        261.18       -5.73   -2.15

NYSE Comp.             590.76       -9.67   -1.61

Amex Comp.             898.61      -11.88   -1.30

S&P 500               1122.73      -24.66   -2.15

S&P MidCap             530.38      -10.72   -1.98

S&P SmallCap           244.82       -3.10   -1.25

Nasdaq                1770.03      -75.32   -4.08

Value Line (arith.)   1285.21      -24.79   -1.89

Russell 2000           497.76       -8.70   -1.72

Wilshire 5000         10551.43    -224.31   -2.08

 

                                 Last Week     Week Ago

 

NYSE Advances                     1,625          1,951

NYSE Declines                     1,745          1,410

Unchanged                           100            109

New Highs                           331            328

New Lows                            112            145

Av Daily Vol (mil)                1,398.6        1,397.5

Dollar

(Finex spot index)                  117.69         118.62

T-Bond

(CBT nearby futures)                100-19          98-05

Crude Oil

(NYM light sweet crude)              26.21          26.31

Inflation KR-CRB

(Futures Price Index)               201.54         204.92

Gold

(CMX nearby futures)                300.10         302.60

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