Profitless Prosperity vs. Lean-and-Mean

The tech bulls are getting pretty lathered up these days.

On the first day of trading this year, the Nasdaq shot up by 38 points, followed by pretty solid gains almost every day since.

An analyst from Piper Jaffrey threw even more gasoline on the Nasdaq fire when he pulled a “Henry Blodgett,” proclaiming that Google would hit $600 before the end of 2006. (Blodgett, as you’ll recall, is the now-shamed analyst who said Amazon.com would surge to $400. Instead, it plunged to $6 per share.)

Meanwhile, the latest Investors Intelligence survey of investment newsletters showed that the percentage of bulls reached 60.4% — the highest reading it’s seen in the last year.

And if you’ve been listening to CNBC, busily marching out a steady parade of tech market cheerleaders, you might think the tech train has long-ago left the station.

That’s bad news if you’re sitting on the sidelines, right?

Nope! Count yourself lucky. Because from where I sit, the tech world doesn’t look nearly as rosy as Wall Street would have you believe.

Creative Destruction and
Profitless Prosperity

For those of you who don’t know me well, I should tell you that my wife and I own two private tech businesses.

We have a small investment software company. And we have an Internet hosting company that provides web-based communication tools such as online meetings, remote desktop access, and live online customer support.

I don’t tell you that to brag. Heck, the technology garbage dump is filled with companies that fell prey to somebody with a better, faster, mousetrap.

If you remember once-hot-now-defunct names like Atari, Commodore, Tandy, Kaypro, or Amiga … you know exactly what I’m talking about.

But one thing my personal investment in technology should tell you is that my family’s financial future depends upon my understanding of the industry. Not just the hot trends. Also the hidden landmines.

Let me tell you — the tech world is still full of landmines! And there are two in particular that you must understand before venturing into this area — creative destruction … and the worst tech enemy of all, profitless prosperity.

Creative destruction is the process of killing off old industries with new technologies.

For example, the invention of the refrigerator killed the ice business, and the invention of the automobile killed the buggy whip business.

Technological innovations are great. They make our tasks easier, cheaper, and/or faster. What investors often overlook, though, is that …

And too many analysts can’t seem to separate the old dying technologies from the new, emerging ones.

Example: Personal computers pushed out an old mainstay of corporate America — the typing pool. All those people, especially women, who made a living by typing, were forced to develop new skills and find new jobs.

And don’t forget the typewriter companies, such as Smith-Corona. The death of the typing pool also meant the death of typewriter manufacturers.

But Smith-Corona wasn’t put out of business strictly because of the personal computer. It went out of business because it thought it was in the typing industry, when, in reality, it was in the word processing industry. By the time it figured out the difference, it was too late.

After closing his very last plant, the president of the company put it this way: “This (typewriter) is the best product we have ever produced. But what we ended up doing is perfecting the irrelevant.”

The Smith-Corona managers weren’t the only people who didn’t see the change.

The bankers and bondholders that loaned them money … the investors who traded their hard-earned savings for paper shares in the company … and a host of Wall Street analysts … all missed it. In retrospect, it seemed obvious. But at the time, they had no idea.

And today, when I glance at the Nasdaq ticker moving across the bottom of my TV screen, I see a lot of future Smith-Coronas.

The Top Line Is
The Wrong Line

One of my good friends is a big wig at a grocery store chain. In order to draw customers, he regularly sells staples like milk and sugar at or below their cost. His goal, of course, is to sell enough of his other products with higher profit margins.

If handled properly, this loss-leader strategy can work. But if mishandled, it can have disastrous affects.

Among the first to feel the pinch is the competition. Wal-Mart, for example, used popular toys as loss leaders and, in the process, torpedoed competitors like Toys “R” Us and FAO Schwarz.

But any company that concentrates more on the top line than the bottom line is opening up a Pandora’s box of potential troubles.

Let me give you three quick examples:

• Intel pulled in $33.7 billion of sales in 2000 but only sold $34.2 billion of chips in 2004, the last full year for which data’s available. In 2000, Intel made $1.51 per share of profits but saw that number shrink to $1.16 in 2004.

• Oracle has grown its sales from $10.1 billion in 2000 to $11.7 billion in 2004, but saw its EPS fall from $1.05 to 55 cents.

• EMC went from revenues of $8.8 billion to $8.2 billion in the last four years and saw its profits shrink from 79 cents to 36 cents per share.

I’m even seeing a similar pattern in my own company: My sales are booming, up roughly 40% from 2004 to 2005. But we made less in 2005 than in 2004.

Reason: The value of our average sales has dropped by more than 25% in the last 12 months.

And I can assure you we’re not the only tech company seeing the price of its products fall.

Think about it: How much cheaper are PCs today than they were a couple years ago? How much lower is your cell phone bill today than it was when you bought your first one? What about flat-screen TVs?

The irony is that prices start falling the fastest right before the process of creative destruction eliminates entire industries.

For example, what do you think happened to the price of radios once black and white TVs starting showing up in the display windows?

Bubble-Level Valuations

Add it all up, and you can see that most tech companies come with a lot of risk.

If they’re mature companies, they risk getting stuck with mature technologies that can be snuffed out in a heartbeat.

If they’re new companies, they can put their shareholders at risk by aiming at top-line growth and neglecting the bottom line.

And every new era of innovation comes with a new generation of so-called “can’t-miss” companies. But they do miss. And the cycle of innovation, boom, competition, and bust is as natural as it is inevitable.

Historically, investors usually understood all this. So despite the high profit potential, they discounted tech stocks to account for the extra risk.

Instead of selling for 20, 30, 40 or more times earnings like they do today, tech stocks have customarily sold for 10 or 12 or 14 times earnings instead. Big difference!

It is only during the frenzied booms that tech stocks surged to high valuations. And it’s only been in recent years that they have continued to maintain unusually high valuations even after a big bust.

This tells me that most investors still don’t get it. They don’t realize that, with the unique opportunities, there’s also a unique kind of risk that’s an integral part of the technology world.

Am I suggesting that you should completely avoid tech stocks?

Heck no! I love technology and I think you can make a mountain of money by investing in the right ones. But not by investing in the Smith-Coronas of our time.

Instead, what you need to do is expand your tech universe and consider markets where tech stocks are reasonably valued, delivering a growing bottom line as well as a growing top line.

That’s not happening very much in the U.S. It’s happening more among America’s lean-and-mean, low-cost competitors, especially in Asia.

Compare the share prices of Intel vs. the shares of Taiwan-Based Siliconware Precision Industries (SPIL).

While Intel’s shares have stumbled and tumbled for the past twelve months, SPIL’s shares have been skyrocketing.

This is not just due to the vagaries of the market. There’s a fundamental reason behind it and a major lesson to be learned from the experience.

Siliconware Precision is a support player in the semiconductor world.

It receives unfinished chips from its customers, tests them, and then puts them into specialized protective casing for use in products like computers, digital cameras, cell phones, and cable modems.

For example, the “Intel Inside” logo that you’re so used to seeing is stamped on a Siliconware Precision casing.

Business is booming. Annual sales have jumped from $650 million in 2002 to $1.1 billion in 2005. More importantly, the bottom line has tripled from $60 million to $202 million.

Last quarter, Siliconware Precision reported third-quarter profits of 14 cents per share, which was 8% above consensus.

Another big difference: Despite its rapid growth, Siliconware Precision is selling for only 12.8 times forward earnings. For a company that just reported a 27% quarterly increase in revenues and a 64% increase in quarterly profits, that’s a heck of a lot cheaper than most U.S.-based counterparts.

Now, I am not suggesting that you rush out and buy Siliconware Precision right now. The stock has run up too far too fast for my blood, and a correction is due.

All I’m trying to point out is how important it is for tech investors to think globally.

And more importantly … to think Asian.

Best wishes,

Tony

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