What? JDSU Has No 'Real Income??'

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By AugustusCyr
March 2, 2001

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The other day I was dragooned at a horrible Manhattan cocktail party where the conversation alternated between Hillary "my friends call me Lucrezia Borgia" Clinton and the demise of the Nasdaq (which continues unabated at this printing). Most of last year's crop of tech-head investors (who couldn't have told you back in March 00 what a router or a passive fiber optic receptor was, but hey, they were fully invested, baby!), who have been a quiet lot lately, were glum and full of nasty jibes aimed at John Chambers, Alan Greenspan, Jeff Bezos, and even Maria Bartiromo. Indeed, the Bartiromo quote isn't printable.

Anyway, one fellow ambled over, plopped down on the couch, and said, "The point here is to invest only in companies that have REAL INCOME!" He said it with the kind of prepossession common to kings, popes, fascist dictators, or Alan Greenspan, which prompted me to assail him with my...well, not 99 theses, but five.

1) What is 'Real Income?' Do you mean gross revenues, operating profits, EBITDA, profit after taxes (PAT), net income...or none of the above? JDSU generates more than $3 billion in sales a year---that's fake?

2) What constitutes 'Real Income?' Is there such a thing as fake income? If so, how can I tell the difference -- and does the IRS get to tax my fake income?

3) I suspect you're trying to say that people should invest in companies that have net income, as opposed to losses, as JDSU is currently posting. But -- is that to say that I should invest in Yahoo, which does have net income, as opposed to JDSU, despite the fact that JDSU has a business model which is both proprietary and has high barriers to entry? (It ain't easy to just go out and set up a fiber optics switching manufacturing plant, but it sure as #### ain't hard to put together a b2c website.)

Coke and Proctor & Gamble have 'Real Income,' yet their performance over the last five years pales with the best growth stocks (like MSFT, CSCO, INTC, DELL, etc.) over a similar period of time...and over a longer period of time, if you're so inclined. So, again -- what do you mean 'Real income?'

4) If your little comment is shorthand for 'don't invest in companies with losses,' then I think you've just revealed how little you understand the dynamics of growth companies, which expend vast amounts of working capital on new accounts, inventories, and capital expenditures in order to fuel their own growth. So...that said, then, if I buy JDSU or CMTN or RMBS, I am not buying this year's FCF (that's free cash flow), or even next year's, or the year after's FCF...rather, I am buying the stream of cash flows extending, theoretically, into infinity.

So, the fact that JDSU is losing money right now doesn't concern me, given, a) That revenue growth quarter-to-quarter and year-to-year is exceeding 80% (and JDSU is right now a company that generates greater than $3 billion in revenue per year); b) My own forecasts show that JDSU will be FCF-positive in less than a year; c) The present value of those future cash flow streams (which is, naturally, dependent on superlative growth) is greater than the equity value of the company today.

So, Coke may churn out more FCF today, but its rate of growth will be slower over the next ten years, and thus JDSU is the better investment...even though its bottom line would suggest otherwise.

5) Final point: Again, net income (and the whole lame cult of P/E, which follows from it) is missing the point entirely. Net income is an accounting fiction which is driven by the accrual system of accounting -- it does not reflect cash basis. That means a host of non-cash items -- like depreciation and amortization, growth or decline in working capital, and MERGER COSTS -- are included in that bottom line number. That means that the P/E is not very useful if you don't have a particularly sophisticated understanding of how business and accounting (and finance) works.

Anyway, as J.P. Morgan said, "When there's blood in the streets, I buy." And I agree, even if some of that blood is mine.