Jan 4, 2000 at 12:00AM
You see, this is what the Rule Maker and Fooldom is all about. Not the mindless aping of another person's portfolio but rather a series of tools that aid the individual investor in analyzing the potential for any company to provide market-beating returns. Rule Maker, Rule Breaker, DRIP, Foolish Four, and Boring provide the information and the criteria, as well as some of the candidates that the managers of these ports have identified as passing those criteria.
This does not mean that there are not many additional companies that meet these tests, just that we have either not elected to invest in them or that we are unfamiliar. These portfolios are real money, and just as the individual investor should be careful not to spread herself too thin, we must also maintain some restraint rather than chase every great company. But just because you don't find a company on OUR list doesn't mean that it isn't a perfectly situated Rule Maker company.
So, in my space today I am going to try to respond to some of the posts I have seen in the last four months by community members nominating this or that company. And here's the payoff -- I am officially going to throw my support behind the purchase of a NEW company for the Rule Maker Portfolio.
Several of the questions have been centered upon telecommunications services and infrastructure companies. This is the area of investing that I know most about, having come to The Motley Fool from international business development for a small telecommunications company. So, let's take a look at some telecommunications companies to try to identify the Rule Makers.
The companies I'm going to be looking at are Nokia (NYSE: NOK), Sonera (Nasdaq: SNRA), Qualcomm (Nasdaq: QCOM), AT&T (NYSE: T), and Cable & Wireless (NYSE: CWP). Three of these companies, to my mind, deserve further consideration for addition to the Rule Maker portfolio and two do not, for reasons to be explained. All have compelling business models, and on some levels provide compelling investment possibilities in perhaps the most important component in the world economy. But we're looking specifically for Rule Makers, which allows us to narrow the field without too much emotional exercise.
Let's talk about Qualcomm first. This is THE story of 1999, particularly at the end, as the share price increased more than 2600% for the year and then nearly 40% in the last week. The final surge came on the heels of a PaineWebber analyst raising his estimate on the company to $1000 per share, or, now that it has split 4:1, $250. I'm not going to make too many friends in the Qualcomm camp here, but this pricing is ridiculous.
Ridiculous because it is impossible? No, not at all -- Qualcomm has a gorilla technology, for sure. But I would call it highly unlikely that the scenario painted in the analyst rating will come to pass. And the current share price is at a level that leaves exactly zero room for error. This in the most competitive industry in the global marketplace, one where companies have proven in the past to be willing to replace existing plant and protocols with better ones if they roll down the pike.
Qualcomm is the owner of Code Division Multiple Access Protocol (CDMA), the most data-friendly wireless protocol in existence. Every company wishing to use CDMA must pay Qualcomm a royalty of 4.5%. Good stuff, that royalty. Qualcomm incurs very low cost of goods sold in receiving royalty payments, perhaps less than 3%. But the PaineWebber analyst's numbers are predicated on three billion phones sold in 2010 at an average price of $180, with a 60x terminal value thereafter. And that is complete bunk. Highly improbable, and most of all, extremely irresponsible. But analysts aren't paid for their responsibility, they're paid to move securities, particularly ones that their companies make a market in, which is the case here with PaineWebber.
Three billion phones sold in 2010. That, if you are counting, is nearly one cellular phone for every two people on the planet. But it's not just that, because they are predicting not the penetration level of phones, but the amount that will be purchased IN THAT YEAR. In 10 years we are supposed to go from the current level, in which India, China, Pakistan and Bangladesh (40% of the world's population) average less than one phone per 40 people to the general population purchasing several phones per family on an annual basis, at an average price of $180?
One of these targets will be missed, I guarantee it. Either the number sold will be low, or more likely, as CDMA devices become more pervasive, the price will drop, just as it has with every other revolutionary technology that has gained general acceptance. So OK, let's just say that three billion CDMA devices (phones and additional data-dependent devices) are sold in 2010. The analyst put a terminal value of 60x 2010 revenues after that, discounting back to today. If we put a 15x terminal value multiple on year 2030 revenues, that equates to a growth rate of 15% per year AFTER 2010, which means that in the year 2030 Qualcomm must sell 49 BILLION CDMA enabled devices, at the current equivalent of $180. If you believe that the company's products will have 100% penetration of the world's population, that will mean the company will have to sell five Qualcomm technology devices per every man, woman, and child on the planet that year.
And all of this is assuming that CDMA will retain its sleeper-hold on the wireless application protocol (WAP) market, an assumption that is reasonable, but not by any stretch of the imagination a given.
I'm running down the rabbit trail a little bit to make a very simple point about Rule Makers: They are companies that control their given markets and have significant potential for future returns. Qualcomm has the first point down but fails miserably on the second with its share price at current levels. It is the true definition of what Burton Malkiel called a "castle in the sky," but one that is based upon a very solid foundation. The thing that disturbs me the most about Qualcomm is that its management has done nothing to keep expectations from getting unreasonable. This doesn't mean cutting the legs out from under its current shareholders, but guiding analysts to reasonable levels of expectations, which is in the management's best interest. Microsoft (Nasdaq: MSFT) has been very good at this, and the end result is that the largest company in the world (by market cap) has never had to deal with irrational expectations for returns.
In the end, this fact discounts Qualcomm for inclusion, as I do not see the potential for fundamental appreciation in the company's share price, only continued speculative surge. What I see is a company that has an extremely aggressive growth target placed on it for the next 30 years and a price that has the majority of that growth already built in. This is not a scenario that a Fool should want to jump into at this stage.
I'll tell you what IS being said, and is nearly guaranteed -- wireless infrastructure will continue to explode, whether Qualcomm benefits from it or not. The companies that are situated on the infrastructure front have much higher probability to provide long-term asset appreciation. The best of these companies are Nokia, Ericsson (Nasdaq: ERICY) and Alcatel (NYSE: ALA). Each of whom will be providing services to the winning protocol provider, no matter what. That's Rule Making, folks.
The next company that does not quite make the test is Sonera, the former Telecom Finland, the monopoly telecommunications service provider in Finland. Sonera is, by all measures, a Foolish company. It has transformed itself from being a sleepy government entity into a dynamic provider of fixed-line and wireless services in Finland, the former Soviet Union, and Turkey. This company listed on Nasdaq in October and has gone flat berserk ever since, appreciating by nearly 200%.
Sonera offers a service called SMS (Short Messaging Service) in tandem with Nokia and is in the forefront with other WAP services. In Finland, for example, Sonera has developed a Public Key Infrastructure (PKI) that will allow all sorts of transactions to be made using a cell phone. These transactions would allow Sonera customers to use their cellular phone like a credit card, with the transactions showing up on their cellular phone bill. This type of thinking and inventiveness make Sonera an extremely compelling company. Unfortunately, Sonera is not providing these services on a worldwide stage as of yet, which means that they lack the inevitability that we would ideally like to see in a Rule Maker.
The thing I keep coming across in regard to Sonera is that it has tied its fortunes very closely with one company -- it's Finnish brethren, Nokia. They released SMS in tandem, and Sonera is relying on Nokia's sales force and its leadership in the mobile communications arena. Sonera -- a great investment? You bet. A Rule Maker? Not yet. But there is plenty of time for us to revisit this one, since the company's greatest products seem yet to come. I just hope that Sonera doesn't get priced into the stratosphere like Qualcomm before that time comes. For now, I'm content to kick this one over to the place where it really belongs, as a potential Rule Breaker.
Over the next three weeks I will be reviewing the other three companies that should be considered for a Rule Maker investment: Cable & Wireless, Nokia, and AT&T. One of these three companies, Nokia, makes a strong case for itself as a Rule Maker by being a key component for continued development of wireless, whether Sonera or Qualcomm ascend that mountain or not. The others make their cases in other realms of telecommunications, C&W in wireline and fiber-optics, AT&T in fiber-optics and value-added services, such as broadband and broadcast.
I'm looking forward to the inevitable storm of opinions that will arise from this piece (join us on the boards). Certainly, telecommunications is huge, and certainly there will be many winners. We're looking for the Rule Makers of the bunch, the ones we could buy and forget about for a decade, and that's no easy task.
- Bill Mann (TMFOtter on the boards)