Slowdown Sticks PC Stocks in Same Boat as Whirlpool, Ford

What do Gateway (GTW Quote - Cramer on GTW - Stock Picks), Illinois Tool Works (ITW Quote - Cramer on ITW - Stock Picks), Whirlpool (WHR Quote - Cramer on WHR - Stock Picks) and Compaq (CPQ Quote - Cramer on CPQ - Stock Picks) have in common?

Well, for one there's the thing about all four companies warning of earnings misses in recent weeks. Then there's the basic fact that none of them would have done a portfolio any good this year. And finally -- and this is the thing that investors in the personal computer half of this quartet have only recently discovered -- their businesses all wax and wane with the economic cycle.

That the PC eventually would become cyclical always has been something of a given, if not to those in the business of making computers themselves, then to outside observers. Just as the radio, the telephone, the automobile and the television went from being high-tech items to the things of everyday life, so, too, would the computer. If there is a surprise, it's that the PC and PC-related stocks, which have come to be known as "old tech," have run out of steam only fairly recently.

Making the Rules

This does not mean the PC doesn't have a lot of growth left in it -- it almost certainly does. Analysts expect Dell's (DELL Quote - Cramer on DELL - Stock Picks) revenue, for example, to grow by 18% in fiscal 2001. Not bad, considering a slowing economy. But not so hot compared with its blistering past.

At first blush, one still doesn't want to chuck the PC into the same group as the washing machine. Sure, sales may be similarly tied to the economy, but Dell's revenues still are supposed to gain about as much next year as Maytag's (MYG Quote - Cramer on MYG - Stock Picks) gained in 1998, and 1998 was Maytag's best year of the decade. To put it another way, although PC sales rise and fall with the economy, the long-term, or secular growth pattern remains robust. Because of this, some strategists term old-tech companies "growth cyclicals." They follow a slightly different set of rules.

"The problem with a growth cyclical is that during the expansion phase of the cycle, investors convince themselves that it's pure growth," says Banc of America Securities equity portfolio strategist Tom McManus.

Recent experience bears this out. When the economy was thriving, posting growth in excess of 5%, old-tech companies were putting up some pretty amazing numbers. But if you suggested that the good times would not persist in a cooling economy, people would tell you about how consumers and companies couldn't afford not to buy technology, or you'd hear about how the adoption of the PC was still at an early stage.

Dependence

Once the economy started to slow, however, investors realized how dependent on the economy the PC stocks are. In the last two quarters, virtually every PC maker has either missed its numbers or had to guide the Street lower. The Philadelphia Stock Exchange Computer Box Maker Index has been more than halved since hitting its all-time high on Sept. 1.

Now, with the Fed likely to cut rates at its January meeting, there's a good chance the economy will reaccelerate sometime next year, and when that happens, PC sales should get a boost. The rule of thumb is that you buy cyclical stocks when the Fed starts cutting, so will it be a good time to buy PC stocks? There is a possible problem. Even while the economy boomed over the last five years, revenue at the boxmakers steadily declined. While the PC stocks may be growth cyclicals, at the same time it looks like they're turning into regular old cyclicals.

"The PC," says Merrill Lynch chief quantitative strategist Rich Bernstein, "is going to head more and more in Maytag's direction." The average computer still costs more than a washing machine, which means that, through planned obsolescence, you're asking the household to put out a pretty significant amount of cash on a fairly regular basis. In a slowing economy, households are resistant to that. As a PC maker, you've got two choices. You can either keep prices high, and become more cyclical, or you can undercut prices, which brings your business that much closer to maturity. Although prices are still high relative to the cost of your washing machine, your television or your VCR, they are coming down.

That all adds up to a continued secular decline in revenue growth, one that will remain in place even when the economy reaccelerates. An already-mature cyclical sector like the automobile industry, on the other hand, already has settled into a steady secular growth trend. Some years are up, some are down, but in general, Ford's(F Quote - Cramer on F - Stock Picks) sales are going to grow at about 9%. Because it doesn't have to deal with the headwind of secularly lower growth, it may well be that Ford will get a bigger sales boost, relatively speaking, than the PC makers.

Modern Maturity

There is, however, one last catch, notes McManus. "Investors in growth cyclicals tend to underestimate the secular growth rate during periods of contraction," he says. And one can argue that investors have gone so far as to underestimate the secular growth trend of PC sales, even allowing for the maturation of the industry.

A year ago, Dell had a forward price-to-earnings multiple of about 54. Now it's around 16. That's pretty severe compared with that of the S&P Consumer Cyclical Index, which went from 23 to 17. And revenues among companies in the index have been growing at only about 7.8% over the past five years. To take a look at another classically cyclical area of the economy, the forward P/E on the S&P Capital Goods Index is down to 22 from last year's 27. Revenues there have grown by 25% over the last five years.

It may be seem strange to say it, but against those other groups, Dell, one of the more richly valued PC stocks, almost seems like a bargain.