What we are witnessing today in the technology sector is a speculative bubble bursting. I believe the process is still underway, which has important implications for investors, especially those still clinging to the few blue-chip tech stocks that are still relatively unscathed. But one need not abandon this sector entirely -- in fact, there are wonderful bargains available to courageous investors with a time horizon beyond a quarter or two.
Turmoil in the tech sector
As evidenced by the Nasdaq's 17.4% decline this year (and a 33.4% fall from its peak on March 10th -- all figures as of Friday's close), technology stocks have been hit hard recently. We're all familiar with the demise of the dot-com sector, which I touched on in my column, Twelve Internet Myths. Leading Internet companies like America Online (NYSE: AOL), Amazon (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and Yahoo! (Nasdaq: YHOO) have been whacked badly, and lesser companies are being obliterated (deservedly so by and large). Nor has the carnage been limited to dot-coms. Highly profitable stalwarts such as Microsoft (Nasdaq: MSFT), Dell (Nasdaq: DELL), Intel (Nasdaq: INTC), Qualcomm (Nasdaq: QCOM), Worldcom (Nasdaq: WCOM), and Lucent (NYSE: LU) -- plus a host of solid second-tier companies like Apple (Nasdaq: AAPL), Lexmark (NYSE: LXK) and Boring Port holdings Gateway (NYSE: GTW) and American Power Conversion (Nasdaq: APCC) -- have all been taken out and shot due to various hiccups (or worse) in their businesses.
Many of these companies were and still are outstanding, but they were bid up to valuations ranging from very rich to utterly preposterous by na�ve or cynical investors -- a frenzy cheered on by Wall Street and the media. These stocks were priced for perfection -- but perfection, for most, proved impossible to achieve. This should not have come as a surprise, given the ferociously competitive and unpredictable nature of the fast-moving technology sector.
A bifurcated market
Curiously -- this is why I think the bubble hasn't finished bursting yet -- some stocks have remained relatively unscathed, with their enormous valuations intact. In part, this is because these companies are in exciting sectors and have continued to deliver outstanding results. But I suspect it is also because investors have been conditioned for too long that tech stocks are the only way to make money, so instead of fleeing the sector entirely, they -- like those caught in a flood where the waters are continuing to rise -- have crowded onto a small handful of islands, a few blue-chip tech companies, that offer the illusion of safety.
But these stocks are not safe at all. In fact, they are extraordinarily risky. Not because there are problems with the companies -- these are exceptional businesses with marvelous economic characteristics and bright future prospects -- but because of the nosebleed valuations caused by all the investors piling into them.
Examples of the companies I'm talking about (I'm bracing myself for the hate emails) include Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), EMC (NYSE: EMC), Sun Microsystems (Nasdaq: SUNW), Nortel Networks (NYSE: NT), and Corning (NYSE: GLW). What do these six have in common? As the chart below shows, they are very richly valued by any measure, in part because they have not been hit as hard as many stocks in the tech sector. They are also large companies -- the smallest has $5.6 billion in trailing sales -- which is important because size will almost always act as a brake on high percentage growth rates. (That's why I didn't choose to highlight much smaller companies like JDS Uniphase (Nasdaq: JDSU), Juniper Networks (Nasdaq: JNPR), Palm (Nasdaq: PALM), Veritas (Nasdaq: VRTS) and Brocade (Nasdaq: BRCD), which have even higher valuation multiples, but which have the potential -- that doesn't mean it's likely -- to grow at very high percentage rates for a long period of time.)
Consider the following data on the first six companies I mentioned:
% off Sales Market P/S P/E P/E
Company Price peak (TTM$B) Cap($B)(TTM)(TTM)(Future)
Cisco $56.19 31% $18.9 $396 21 156 75
Oracle $67.63 27% $10.4 $190 18 87 68
EMC $89.19 15% $7.6 $194 26 156 87
Sun $107.50 17% $15.7 $173 11 99 81
Nortel $62.31 28% $26.5 $185 7 88 64
GLW $90.44 20% $5.6 $80 14 144 67
Note: Prices as of Friday's close. Oracle's and Nortel's TTM (trailing 12-month) EPS are adjusted to exclude one-time events. Future P/E based consensus analyst estimates for the fiscal years ending 5/01 for Oracle, 6/01 for Sun, 7/01 for Cisco, and 12/01 for the others.
The lowest P/E multiples among these six are 87 times trailing earnings and 64 times (very optimistic) estimated earnings for next year. Where, pray tell, is any margin of safety? Such an antiquated notion! What an old fogy I am, and still in my 30s!
Beware of tumbling tech titans
To some extent, this is an unfair chart. I could have included growth rates, margins, returns on capital, etc., and the picture would appear much brighter. I didn't because I don't question that these are great companies -- the only issue is whether the stocks are attractive at today's prices. I would argue, absolutely not! In fact, I'll go so far as to say that it is a virtual mathematical certainty that these six companies, as a group, cannot possibly grow into the enormous expectations built into their combined $1.2 trillion dollar valuation. That doesn't mean they're all going to crash -- in fact, one or maybe two of them might end up being decent investments -- and I make no short-term predictions. But long term, even if the companies perform exceptionally well, their stocks -- in my humble opinion -- are likely at best to compound at a low rate of return, and there's a very real possibility of significant, permanent loss of capital.
Investing is at its core a probabilistic exercise, and the probabilities here are very poor. If you own any of these companies and, for whatever reason (such as big capital gains taxes; hey, I don't like paying them either) haven't taken a lot of money off the table, be afraid. Be very, very afraid. (And please, if you disagree with me, that's fine, but don't spam me with hate emails accusing me of trying to push the stocks down because I'm short any of them. I've never shorted any stock.)
Opportunities
If the few remaining tech stalwarts left standing are taken down, it will probably ripple through the entire sector. That being said, if I can find particular companies that I think are very attractively priced today, I'm certainly not going to hold off on buying them because of my predictions -- or anyone else's -- regarding the sector they belong to.
This schizophrenic market is offering wonderful bargains everywhere I turn. One example of a stock I've been buying recently is American Power Conversion (Nasdaq: APCC), which is now down 64% since an earnings warning a few months ago. This company is a market leader in its niche, has enormous margins, a pristine balance sheet, and has been growing like gangbusters for more than a decade (and, I believe, will continue to do so in the future, despite a weak second half of this year). I wrote about the stock in July after it had been cut in half after an earnings warning. At that time, with the stock above $25, I said "it's not quite cheap enough." Since then, the company has not announced any change in guidance, yet the stock has fallen another 31% to $17.50. Trading at 12.3x next year's earnings, it's plenty cheap enough for me now.
An even cheaper stock I just bought for the first time this week is Apple (Nasdaq: AAPL). The company has a market cap of $7.2 billion, $3.8 billion of cash and $300 million of long-term debt, for an enterprise value of a mere $3.7 billion. Over the past four quarters, Apple has generated $807 million of free cash flow (cash flow from operations minus net cap ex) -- and that isn't an aberration either: free cash flow for the four quarters before that was a comparable $886 million. So, Apple today is trading at an enterprise value to trailing free cash flow multiple of 4.6. That's absurdly cheap. Think about your downside protection this way: with its net cash on hand, Apple could buy back nearly half of its outstanding shares right now.
Sure, Apple's recent earnings warning could be the sign of tough times to come, but at today's price, I believe that anything except a total meltdown scenario will result in returns that are at least satisfactory and possibly exceptional. And I think a worst-case scenario is quite unlikely. It's not as if Apple preannounced a huge loss -- just that sales would be weaker than expected for at least one quarter, leading to earnings per share of $0.30-$0.33 -- in line with the $0.31 in the same quarter last year -- rather than the expected $0.45. And let's not forget what an innovative company Apple is, the new products that are hitting the market (did anyone read Walter Mossberg's rave review of the new G4 Cube in The Wall Street Journal recently?), and the company's pipeline of forthcoming new products.
I think American Power Conversion and Apple represent very high probability bets for investors with a time horizon beyond a quarter or two.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
