FOOL ON THE HILL
Beware of Tumbling Tech Titans

What do Dell, Intel, IBM, Microsoft, and eBay have in common? Rising share prices and probably your money as they are among the most widely held tech stocks. That doesn't mean they're a good value, though. Whitney Tilson offers up a strong warning on tech stock valuations.

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By Whitney Tilson
January 22, 2002

Over and over again in my columns, I've argued that the greatest risks generally lie in buying the most popular companies in the hottest sectors, and instead encouraged investors to seek values in unknown and/or unloved companies, where the greatest values typically lie. Alas, the herding tendency of human beings is a powerful impulse, so I can find no evidence that investors as a group -- both individuals and professionals equally -- have learned much, despite the shellacking they've taken over the past two years.

In particular, I am fascinated with the love affair that investors continue to have with technology stocks, despite the especially awful tumble stocks have taken in this sector, the fundamentals, which remain crummy, and the high valuations that have returned, thanks largely to the huge bounce since September 21st (the Nasdaq is up 45% since then).

Investors aren't completely crazy, however. While refusing to abandon the sector altogether, the herd does make significant moves within the sector based on whatever the consensus thinking is about risk and reward. Understanding these moves might help you avoid a great deal of pain in the future. (I first addressed this topic in October 2000 in "Perils and Prospects in Tech," and draw now upon some arguments presented by Fred Hickey in his newsletter, The High-Tech Strategist.)

Moves of the tech stock herd as the bubble inflated
The tech stock bubble began to inflate in the mid-1990s, but really took off in 1998 and 1999. At first, investors sought out the largest, most dominant and profitable stocks in the sector such as Dell (Nasdaq: DELL), Intel (Nasdaq: INTC), IBM (NYSE: IBM), and Microsoft (Nasdaq: MSFT). (eBay (Nasdaq: EBAY) was not yet a blue-chip tech stock, but it has become one, as I discuss below, so I'd like to include it.) These stocks all significantly outperformed the Nasdaq in 1998, the first phase of the bubble's inflation, as the following table shows:

Stock      Performance in 1998
Dell             248.5%
Intel             69.0%
IBM               77.5%
Microsoft        114.6%
eBay             409.2%

Nasdaq            39.6%

In 1999, true madness took over and tech investors -- without any concern for valuations or risk -- grew bored with the old stalwarts and piled into "new stalwarts" like Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), Sun (Nasdaq: SUNW), EMC (Nasdaq: EMC), Nortel Networks (NYSE: NT), and Corning (NYSE: GLW), which all rose between 131% and 306% in 1999. But even this wasn't enough, as investors sought out smaller, faster-growing (and, of course, even more richly valued and riskier) stocks such as PMC-Sierra (Nasdaq: PMCS), Veritas Software (Nasdaq: VRTS), and BEA Systems (Nasdaq: BEA), each of which rose more than 400% in 1999. While their valuations were ridiculous, at least these three companies had real products and revenues that year of at least $280 million.

Ah, but revenues (and certainly profits) in some ways acted as a ceiling for valuations because some curmudgeon (like me) could always say something like, "This stock is wildly overvalued because it's trading at 1,000 times sales." So, investors piled into even riskier companies with totally unproven business models and negligible revenues like Liberate Technologies (Nasdaq: LBRT), Infospace (Nasdaq: INSP), Clarus (Nasdaq: CLRS), Globix, and Internet Capital Group (Nasdaq: ICGE), all of which rose more than 1,000% in 1999.

With capital pouring into the riskiest stocks, the tech stalwarts all underperformed the Nasdaq in 1999:

Stock      Performance in 1999
Dell              39.4%
Intel             39.0%
IBM               17.6%
Microsoft         68.4%
eBay              55.7%

Nasdaq            85.6%

Moves of the tech stock herd as the bubble deflated
As the tech bubble burst, the entire process reversed itself almost precisely. First, the most speculative stocks were crushed (the five I mentioned above all fell more than 83% in 2000). So investors fled to the next tier of companies in the hopes that these supposedly less-risky stocks would provide shelter from the storm. Consequently, some of these stocks held up well: BEA Systems was up 96% in 2000 and PMC-Sierra and Veritas each fell less than 10%, while the Nasdaq tumbled 39%. But the laws of economic gravity eventually caught up with these stocks. Similarly, the next tier of "new stalwart" stocks initially held up well, but then plunged.

So where has the fleeing tech herd ended up? Right back where it started: The original four blue-chips -- Dell, Intel, IBM, and Microsoft -- plus I would argue that eBay has now emerged as the premier stalwart in the Internet sector.

The critical insight here is that at each step of the decline, investors fled to stocks that appeared to offer safety -- but didn't. Will this pattern continue? I think so.

The fab five
What do Dell, Intel, IBM, Microsoft, and eBay have in common? Each is a highly profitable, dominant company. Each stock rose at least 40% in 2001 (with the exception of Intel, which was up 5%) and, in fact, Microsoft and IBM were the two best-performing stocks in the Dow -- in a year in which most tech stocks fell sharply (the Nasdaq was down 21%). Finally, each of the five is followed by at least 19 Wall Street analysts, who recommend them highly (the average rating for each stock is between 1.8 and 2.0, with a 1 being a "strong buy" and 2 being a "buy").

So what's not to like about such universally beloved stocks? The valuations! Consider the following data:

                   Sales  Market   P/S    P/E
Company     Price (TTM$B) Cap($B) (TTM) (Future)
Dell       $28.10  $31.8    $73    2.3     38
Intel      $33.48  $26.5   $225    8.5     54
IBM       $114.25  $85.9   $197    2.3     24
Microsoft  $66.10  $26.8   $356   13.3     34
eBay       $60.18   $0.7    $17   22.1     80

[Note: Prices as of Friday's close. Future P/E based on consensus analysts' estimates for the 2002 calendar year.]

For tech investors accustomed to seeing triple-digit P/E ratios (if any earnings at all), these valuations might not appear to be unreasonable, but take it from a value investor: They're very high -- and even higher than they appear. Don't forget that the P/E ratios in the table are based on consensus analysts' estimates, which are invariably too high. In addition, these companies are issuing a blizzard of stock options to their managements and employees which -- if accounted for properly as the expense that they are -- would reduce earnings to a material degree. Buried deep in the footnotes of each company's 10-K shows exactly how much earnings per share would be reduced:

             EPS reduction if
Company   options were expensed
Dell              -20%
Intel              -7%
IBM               -10%
Microsoft         -13%
eBay             -317%*

Source: Companies' 10-Ks for calendar year 2000.]
* Had the cost of stock options been expensed, eBay's EPS in FY '00 would have been -36 cents vs. the reported 17 cents.
Note: I believe the real earnings haircut for these five companies is even greater for two reasons: 1) the data in the table is from 2000, and I expect that when the 2001 10-Ks are filed, the earnings reductions due to stock options will be even greater; and 2) all of the figures are based on estimates calculated using the Black-Scholes option valuation method, as required by the Financial Accounting Standards Board. This approach, in my opinion, significantly understates the true cost of options for a number of reasons.

Conclusion
For each of these companies, I am a customer and former shareholder (in both cases, with the exception of IBM), so count me as an admirer. But I wouldn't touch any of their stocks at anything close to today's valuations. I'm particularly bearish on eBay, due to its extreme valuation, and IBM, which recently reported fourth-quarter sales that were lower than those five years ago. With no growth whatsoever in the top line, and the bottom line only up slightly (due primarily to lower taxes and various accounting gimmicks), is IBM really worth nearly triple the price it was back then? I think not.

At Intel, the story is similar, as fourth-quarter sales were up only fractionally over the level four years ago, earnings have plunged, yet the stock is up 75% since then. And, as Fred Hickey notes, back in 1997, "Intel was still a growth company and the PC industry was still a growth industry." He concludes, "It's not easy to find companies that have the same sales levels as four years ago, but Intel and IBM fit the bill."

I don't mean to pick on these well-managed, highly profitable companies. In fact, forced to buy any technology stocks, these are among the ones I'd consider. But fortunately, when it comes to investing, there are no called strikes. I don't have to buy these stocks -- or any stocks for which I have doubts about either the company or the valuation. As I argued last month in "Are Investors Being Duped Again?," the entire technology sector appears to be fully valued (if not wildly overvalued) so investor beware!

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any company mentioned in this article at press time.Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.