FOOL ON THE HILL
Bottom Fishing in Tech

While he's not yet attracted to tech stocks in general, Whitney Tilson has found two bargain stocks in the beaten-down sector. E*Trade and Gemstar may be ugly stories, but they could be poised for a turnaround.

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By Whitney Tilson
September 4, 2002

While I've advised investors to avoid tech stocks on multiple occasions, with the Nasdaq now under 1,300 and not far from the multi-year lows reached a month or so ago, is it time to start getting greedy? In a word, no. I still think tech stocks, as a group, are likely to do poorly, given that fundamentals remain dreadful and valuations are far from cheap. (Be careful not to fall into the trap of thinking that because a stock has fallen 90% or more from its bubble-induced highs, that it must now be cheap.)

But there are a few bargains appearing among distressed, beaten-down stocks in the tech sector, so today I'd like to share two ideas, both of which I've been buying recently.

E*Trade
E*Trade
(NYSE: ET) owns the largest online broker, the largest online bank (and eleventh largest S&L overall), the second largest ATM network, and the No. 1 administrator of company stock/option plans. Yet the response I usually get when I mention E*Trade is, "Isn't that the company run by the CEO with the egregious pay package?" Yes, it is (though to his credit, he gave back $21 million, and now receives no base salary and an annual bonus based entirely on the company's performance). I normally won't touch the stock of a company with questionable compensation practices, but in some cases -- like this one -- the stock is cheap enough that I'll hold my nose and buy anyway.

E*Trade is profitable and cash-flow positive, has a net cash position of $321 million (equal to 20% of today's market cap), and has been buying back stock and paying down debt -- all wonderful things to see in a turnaround situation. As for management, while they get an "F" for compensation practices, lavish offices, and the like, I would give them good grades in terms of strategy and operational execution. Perhaps most importantly, they have been very conservative in assuming financial risk, a topic I discussed in a recent column.

The stock is cheap any way you look at it. At $4.30, it trades at 9.6 times this year's expected earnings (which the company reaffirmed in its Q2 earnings release in July), 6.8 times 2003 consensus analysts' estimates of $0.63, 1.04 times book value, and 1.55 times tangible book (excluding goodwill and intangibles).

Another way to value E*Trade is to look at the brokerage business and bank separately. The former is holding up fairly well in this dismal environment, and if one were to value E*Trade's 3.65 million brokerage accounts at $700 each, that would total $2.55 billion, or $7.05 per share. I believe that $700 per account is a conservative figure, given E*Trade's market leadership and that Ameritrade (Nasdaq: AMTD) paid $1,480 per account to acquire Datek, and Harrisdirect paid Morgan Stanley (NYSE: MWD) and Credit Suisse First Boston $706 and $1,113 per account, respectively, to acquire their online brokerages.

Looking at E*Trade's bank, it has about $800 million of tangible book value, rapidly growing interest-rate spreads (up 64% year-over-year, from 88 basis points to 144 basis points) and mouth-watering customer demographics. Good savings and loans tend to trade at 3 or more times tangible book, so I don't think it's unreasonable to assign E*Trade's bank a value of 2 times book, or $1.6 billion, equal to the entire company's market cap today. Thus, I think a sum-of-the-parts analysis shows that at today's price, you're either paying for the brokerage and getting the bank for free, or vice versa -- plus, getting a few other things for free, as well.

Finally, a comparison with two comparable companies, Schwab (NYSE: SCH) and Ameritrade, shows that E*Trade is trading for less than half their price-to-earnings and price-to-book values:

Company                  ET       SCH      AMTD

Share price            $4.30     $8.57    $3.40
Market cap ($B)         $1.6     $11.7    $0.74
Book value/share       $4.14     $3.14    $1.77
Tangible BV/share      $2.78     $2.69    $0.69
Price/BV                1.0x      2.7x     1.9x
Price/Tang BV           1.5x      3.2x     4.9x
P/E ('02 est.)          9.6x     26.0x    34.0x
P/E ('03 est.)          6.8x     19.0x    11.0x

Gemstar-TV Guide International
If you think E*Trade has hair on it, wait until you look at Gemstar (Nasdaq: GMSTE), which has dishonest and incompetent management, in my opinion -- far more troublesome issues than E*Trade's relatively benign excessive compensation -- not to mention warring owners and a management restructuring. In addition, because the company employed aggressive accounting techniques during its heyday (what a shocker, eh?), Gemstar is now in the process of restating its previous financial reports. Thus, the company has failed to report its Q2 earnings or file its 10-Q, so the stock is in danger of being delisted.

So what's there to like about this mess? The stock is really cheap, and I think many of these issues will be sorted out in the near future.

Gemstar owns a collection of assets, including TV Guide magazine, TV Guide channel, VCR+, eBooks, Superstar/Netlink (a C-band, direct-to-home satellite business), TV Games cable channel, SkyMall catalog, and a variety of interactive program guides (IPGs). It's the IPGs that caused so much excitement and drove the stock above $100 during the final burst of tech stock insanity in early 2000. You know the channel guide that pops up when you push the "Guide" button on your TV remote, if you have cable or satellite TV? Gemstar has a number of patents related to that technology and has been very litigious in trying to get cable and satellite companies and set-top box manufacturers to pay royalties. Unfortunately for Gemstar, it lost a patent case before the U.S. International Trade Commission in June, raising questions about the value of the company's patent portfolio -- one of a number of issues that have caused the stock to drop 86% this year.

At this point, however, I'm not too worried about valuing the IPGs, because I'm not paying for them at today's stock price. The Media and Services segment -- mostly the TV Guide properties, plus Superstar/Netlink, SkyMall, and TV Games Network -- generated $239 million of EBITDA last year and $50 million in Q1 (the last reported quarter), so let's assume a run-rate of $200 million this year. (I don't like using EBITDA as a valuation metric, but it's the data the company provides, and the business has minimal cap ex. EBITDA, in this case, is a reasonable proxy for pre-tax profit.)

So, what is roughly $200 million of pre-tax earnings worth, given a strong brand name like TV Guide and plenty of opportunity to stabilize, if not grow, the cash flows with proper management? I think an 8 multiple is conservative, which gets you to $3.86 per share, slightly more than yesterday's closing price of $3.84. Plus, you get $0.60 per share of net cash, eBooks, and the IPGs and associated 500+ patents (one analyst recently valued the IPGs at $13 per share).

The final piece of the puzzle is that I think current management is on its way out. News Corp., run by Rupert Murdoch, owns 42.5% of Gemstar, and Murdoch has been waging an aggressive campaign to oust Gemstar's current CEO and CFO, Dr. Henry Yuen and Elsie Leung. He appears to be on the verge of success, given that the Aug. 14 press release, in which Gemstar announced the delay in filing its earnings and 10Q, stated: "The News Corporation Limited (News Corp.) and Dr. Henry Yuen and Elsie Leung have submitted a joint proposal to the Company's board of directors to restructure Gemstar management. The proposal includes a settlement of the disputes among the parties." Rest assured that Murdoch would never agree to any settlement in which Yuen and Leung remained in control, so I expect an announcement shortly that they have been bought out, and News Corp./Murdoch is taking control.

Conclusion
Both E*Trade and Gemstar are complex, ugly stories, but if one can get past the short-term issues that have crushed the stocks, I think there's genuine value that far exceeds today's stock prices.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of E-Trade and Gemstar-TV Guide at the time of publication. 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. The Motley Fool is investors writing for investors.