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Thursday, November 19, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

What Is a Tech Stock?

With the Nasdaq index and Internet stocks going nuts recently, eliciting headlines like "Tech Stocks Hurdle Ahead," I thought the nature of tech stocks and the mischaracterization of them deserves another visit in this space.

What is a tech stock after all? It seems that anything with four letters in the trading symbol and sequential revenue growth rates of 10% or more qualifies as a tech stock to many observers. And I'm not being hyperbolic in making that statement, either. A better definition might be a company that sells products with high intellectual property content or high value-added or whose revenues are mainly the result of applied scientific research and development.

For instance, take Pfizer (NYSE: PFE). Why does nobody say, "Tech stock Pfizer rocketed ahead today," when this company spends billions of dollars per year on research and development. Last year Pfizer spent $1.93 billion on R&D, about 82% of what tech stock king Intel (Nasdaq: INTC) spent in fiscal 1997. As a percentage of sales, that's 9.3% for Intel versus 15.8% for Pfizer. Looking at how much a company spends on R&D as a percentage of revenue, Pfizer is much more the high-tech oriented company than is Intel.

Sure, shooting electrons across circuits 3.6 one-thousandths the width of a human hair sounds pretty neat, but so is successfully sending a couple of hundred milligrams of active drugs into a 100,000,000 milligram human body to hunt down and kill a disease. The yearly R&D necessary to turn out a relative handful of blockbuster drugs per decade costs as much and necessitates as many or more skilled scientists to push ahead as does a dominant semiconductor company.

Measuring by margins who adds more value is trickier, though. Semiconductor companies are more capital intensive than pharmaceutical companies, so the costs associated with turning out the products are larger, as a percentage of revenues, than for the pharmaceuticals industry. Intel last year generated a 60.3% gross margin while Pfizer spent less than 20 cents per sales dollar to turn out its goods. The easiest conclusion to make would be that Pfizer adds more value to its products, but does the cost of goods sold for a pharmaceutical company really capture the investment needed to produce those revenues? I would argue not. If the industry were to capitalize its long-term investments in drug development programs, the gross margin would be lower as operating expenses actually move up into the cost of goods sold line.

In any case, both Intel and Pfizer add value to their products and show operating margins that reflect the high value-added content. Last year Intel achieved an operating margin of 39.4% while Pfizer reported an operating margin of 25%. Not that that's always the best indication of high-tech. Look at Boeing (NYSE: BA). Is this a tech stock? You had better hope so when you're 38,000 feet up in a 777 and one of engines goes out. The intellectual property content in commercial aircraft is huge. But when you happen to only make a couple of hundred planes per year, the leverage on manufacturing them isn't ridiculously good and the number of planes needed to cover the spread-out expenses of developing a plane is pretty high. The 747 is a high-margin aircraft, as far as these things go, because the main development costs were covered long ago and there is no long-range wide body that does everything the 747 will do. So even though commercial aviation design and manufacturing is a capital intensive business with not-so-great margins or asset turnover, it's still a high-tech industry.

The worst example of a company characterized as "high-tech" that I've ever heard is Amazon.com (Nasdaq: AMZN). Amazon.com is a consumer of high-tech products, not a producer. Sure, it has some software units, but the overwhelming majority of the company's revenues are generated by retail sales. Amazon.com is a retailer where you just happen to shop using a different medium than actually driving to the store. Technology is an input, not an output, at Amazon.com. If we were to characterize firms as tech companies by their spending on inputs, Procter & Gamble (NYSE: PG) would be considered a high-tech company with all of its spending on enterprise resource planning software and systems and tens of thousands of PCs/

Speaking of that, the PC industry really isn't that high-tech, anyway. Where does the value-added come from in a PC? It's the operating system and the CPU. A company like Dell (Nasdaq: DELL) spends very, very few sales dollars on R&D. Dell is a precision manufacturer whose process engineering puts the rest of its peers to shame. Its value-added comes from its ability to service customers and not from products that are pretty much the same as everyone else's. Dell makes money because it knows how to put fewer dollars of capital into a business that turns out many more dollars of revenues and return on capital than anyone else. It doesn't make its money by providing a physical product that you can't get anywhere else -- it makes money because it provides service that no one else can touch.

What's the grand conclusion on all of this? I dunno. I guess I just had to gripe about this. Being a curmudgeon can be fun -- you might want to try it sometime. I think the lesson that can be taken away is that one should at least examine the premises of how a company makes money before putting it into a box that identifies it as "high-tech," "pharmaceuticals," or "aerospace." How anyone can think of something like Amazon.com as a tech company is really weird. What does that tell you? The usefulness of that characterization is negative because you might start comparing Amazon.com to Intel or Pfizer before you compare it to its real competition, which is other retailers. When you hear "tech stock," it's almost always useful to tune that out. If there is a tech sector, it's not the monolith that it's always identified to be. And if there is a tech sector, it should rightfully include a heck of a lot of companies that normally aren't thought of as being technology companies.


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