Do you live and breathe "tech"? Do you find yourself furiously debating the fate of Sun Microsystems
Then you've got tech stock fever, and here's a secret: The bear market has not killed this persistent affliction. Investors are still fascinated by innovative companies producing or enabling computer hardware, software or networking; communications equipment or services (including wireless); or semiconductors. Yet for most investors, any of those companies' stocks belong in the high-risk category and should only be a small part of a portfolio -- until or if the company becomes more successful and stable.
Let's identify the risks and then find a candidate for this more risky, but more fun part of a port.
Lack of familiarity with the products
These companies most often sell complex products to other companies for business use only, or incorporate them into other products for consumers. That means we don't truly see them -- even if a company's name might be somewhere on the case or box. Think a Cisco Systems
The more unfamiliar the product, the more difficult it is to understand its place in the market, competition, and potential for success or failure. You wouldn't need specialized expertise to tell if Starbucks
Constant change
Your company may have the greatest invention since the light bulb, but somewhere out there smart, inventive people are working to make your product look like an abacus compared to a PC. (And some of these off-the-beaten track newcomers will be brought to you in Tom Gardner's Motley FoolHidden Gems and Motley Fool Stock Advisor.) Venture capital will find them, and someday one of them will succeed.
For a while, patents may protect today's leader and its investment in research and development, but they are not the foundation of a long-term, sustainable business. No matter your product, the moment you catch your breath, you have only to glance over your shoulder to see the next advance gaining on you -- if you're lucky enough to see it at all. Ask any drug maker how long it can rest on its current blockbuster before shareholders are demanding the next one.
Familiarity that may fool
Most of us lack the specific technical expertise -- or the crystal ball -- to know when or if a new technology will ascend or how long a current technology will dominate. But even those who may possess specialized technical knowledge may mistake knowledge and technophilia -- love of a technology -- for an understanding of business reality.
These people often fall in love with (and invest in) what becomes the number two (or three) technology -- perhaps better and cooler, but a loser to one better marketed, even if it's a less-elegant or perfect product. Sometimes this goes hand in hand with failing to read the latest quarterly and annual reports and understanding the financials, which may reveal that the company may have the better mousetrap but also a flailing marketing or sales department.
For these reasons, many investors consider even profitable and free-cash-flow-positive tech companies to be risky. And like me, they keep these to small parts of a portfolio.
Here's an example of one company I've owned for several years that qualifies as a high-risk tech stock.
Well ARMed
ARM Holdings
Those were the days.
Since that fateful Dec. 10, ARM's stock has fallen 89% from a split-adjusted $32.20 to close yesterday at $3.39. Even after that dive, it's hardly a penny company, enjoying a $1.14 billion-dollar market cap, and ARM's business is a better risk today than it was in 1999, too. It has produced free cash flow since 1998 and around $50 million each for the last three years, when many semiconductor customers have floundered. Why?
World domination
Begin with the fact that personal computer microprocessors like the Pentium 4 are only 1%-2% of worldwide microprocessor sales, while the other 98%-99% are embedded microprocessors. The average American home has 40-50 of them (washers, dryers, VCRs, DVD players, remotes), a PC about 10, and a new car 50 or more, according to Jim Turley of ExtremeTech.
These are mostly 8-bit (each bit a "0" or "1" and 8 bits to a byte) devices, but there are growing numbers of 16-bit and 32-bit devices. ARM's goal is to "establish a new global RISC architecture standard for the embedded microprocessor market" and to dominate the coming 16-bit and 32-bit world. It's arguably already there in the wireless device world.
ARM doesn't do this by manufacturing microprocessors; rather, it designs them and then offers its design to other companies for their use. So ARM is an intellectual property (IP) company, composed mainly of engineers who design better and better RISC (reduced instruction set computing) microprocessor systems and advise licensees how to incorporate those systems into products. Promising the convenience of proven designs and quicker time to market, ARM licenses its inventions to more than 100 companies including Intel, Motorola
Licensees pay a large fee at signing for multi-use licenses that allow them to design ARM's technology into chips for cell phones, PDAs, digital TVs and the like, or they may pay a smaller fee for a limited license geared to a specific ARM design and use. When licensees ship ARMed chips, ARM earns a small royalty -- estimated at about 1% of the selling price, from $0.10 to perhaps as high as $2.00 depending on volumes. The licensing/royalty model gave ARM a fabulous 91% gross margin and 21% net margin for FY 2002.
Short take on ARM's challenge and potential
Briefly, ARM's future depends on two broad themes. First, the company estimates that it has signed up more than a third of an estimated 300 potential licensees for its IP. That third itself includes just over a third of the 150 largest semiconductor companies. The more new licensees, the more current revenues and the more future royalties from products they build.
Second, ARM arguably dominates the RISC microprocessor market for wireless devices, but to grow, it must enter and dominate the worlds of networking, consumer entertainment, storage, imaging, automotive, secure, and industrial devices. There, ARM must sustain the competitive advantage that has made it number one in wireless: offering a sufficient value proposition to keep customers wedded to its designs and upgrades rather than create their own innovations.
How big can it be?
ARM adherents avidly follow ARM and debate furiously its path to domination of the 16-bit and 32-bit device world. Will it simply do well for a while until superseded, or will it become a Microsoft
I bow before some of the best and brightest ARM investors on our New Paradigm Investing and ARM Holdings discussion boards. Here are just a few of the fantastic discussion threads on this fascinating company -- and don't forget to use the "whole thread" feature to more easily read the conversation.
Some people missed the ARM tornado (beginning 1/30/03)
ARM warns: Royalties Up! (beginning 4/19/03)
More ARM Discussion -- Just Because (beginning 4/30/03)
ARM News (beginning 6/16/03)
(Any of these threads is worth the annual subscription to the boards alone. Join our Motley Fool Community today!)
Keeping track
But while ARM is risky, it is no gamble. Investors may not know the ins and outs of ARM's microprocessor core technologies -- ARM7, ARM 11, ARM and Hammer (not really) -- but we can easily understand ARM's licensing/royalty model and follow its business progress the way we do for any company through its reports and financials.
Caveat: Because the company as a foreign issuer need only file only an annual report with the SEC by June 30 of the following year, investors must rely on the company's comprehensive quarterly press releases and conference calls. (I recently caught up with ARM's courtesy of the Fair Disclosure Financial Network, which offers a terrific analyst call transcription service.) While press releases are not quarterly reports, ARM's allow you to do the usual -- note new licensees, watch licensing, royalty and service revenue, and track margins and even free cash flow.
Risk versus reward
I first bought shares in July 2001. Even after directing outrage at company management last October when business news cut the stock price by 66%, I doubled my holding at $2.31 and $2.51 because the company's enterprise value to free cash flow ratio in the low teens was simply too enticing. With an average price of $4.95 a share, I have a compound annual growth rate (using internal rate of return) of -26%, versus a gain of 1% for the S&P 500 (dividends added).
Not great to date, but from today forward, I'm happy to hold about 6% of my portfolio in the stock at the average purchase price given little downside risk and significant potential upside. The company has crushed expenses, maintained margins and free cash flow, and produced stable to slightly rising revenues at the same time the worldwide semiconductor market has been on the critical list. It doesn't take a genius to posit that any kind of upturn -- let alone ARM progress in even a couple of new markets beyond wireless -- could well bring market-whomping rewards for a long time to come.
Next Tuesday, more on tech. In the meantime, have a most Foolish week -- and holiday weekend!
Writer and Senior Analyst Tom Jacobs (TMF Tom9) loves technology but knows his limitations -- even an electric can opener is beyond him. He owns shares of ARM Holdings, as well as other companies listed in his profile . Motley Fool writers are investors writing for investors .
