Stephen Schurr

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Skipper Sees Another Year of 'Tough Sledding' for Big Tech

Stephen Schurr

And now, the bad news on technology.

In the first part of this week's 10 Questions, tech investor Roger McNamee sounded a positive note on many areas of consumer-oriented technology. In Part II, McNamee, the co-founder of Integral Capital Partners and Silver Lake Partners, discusses technology companies that primarily serve corporate America. His outlook for 2003 and beyond isn't exactly rosy: McNamee doesn't see IT spending picking up, and he expects the Nasdaq to trail the S&P 500 this year.

Nonetheless, McNamee does find a few stocks worth buying, including Cisco (CSCO) and Microsoft (MSFT). For a better understanding of the tech environment, read on.

1. OK, let's talk about the enterprise side. You haven't sounded many cheery notes on this area. What do you envision going forward?

Well, I wanted to start with the positives, so I focused on consumer stuff. (Laughs.)

The enterprise side we'll start with something positive, also. The difference between January 2002 and January 2003 is that a year ago, there were a huge number of companies that were committed to the notion that the bad news they saw everywhere around them was merely a blip down in an otherwise upward trend. In short, they were expecting some kind of return to the late 1990s, which they perceived as normal.

Roger McNamee Co-founder of Integral Capital Partners and Silver Lake Partners

Today, I don't think there's anybody who believes that. Everyone has recalibrated their business using the current environment as a new baseline. Although cost structures are not uniformly in line with the current level of business, people are committed to getting there. This is a huge change.

If you want to understand why there were so many upside earnings surprises in the September quarter, all you need to know is that the largest companies were the ones that started making those rightsizing changes first. Wall Street's estimates for the quarter were based on spreadsheets. Spreadsheets just don't do a good job of capturing cost-structure subtleties, where very small favorable variances in revenue produce huge changes in profitability.

September earnings were terrible, right? But they weren't as bad as Wall Street expected, particularly on a market capitalization-weighted basis. And that's a huge deal.

2. So they're doing better on the cost-structure side, but what about demand?

On the demand side, 2003 is likely to be better than 2002. How much better is hard to say. On average, I don't think it's going to be much better. What you're going to see is a very large standard deviation.

So, you would expect average growth will be very low, but some people are going to benefit disproportionately. People don't buy a little of everything, except when they aren't buying anything.

Companies have gotten their IT spending down to a much lower level. Now, let's remember one of the rules of enterprise sending: It's a capital expenditure, which means it comes out of profits. In the last three years, there hasn't been much in the way of profits among Fortune 500 companies.

People have been cutting costs and headcounts willy-nilly to get their cost structure in line. Tech's been an easy place to cut back because the budgets were bloated, a lot of the things they were buying weren't providing a decent return on investment and, if you will, people wanted to just put it behind them.

Now, companies are deferring some projects that probably are very viable. They're doing so because corporate politics currently is more driven by the cost side. But if you read the data, the economy is starting to perk up a little bit. If you get two or three quarters of expansion even a little bit, you'll get companies saying, OK, we're past the bottom. I can gain competitive advantage through technology. What can I do to do that?

I think this will start as a trickle, not a flood. I don't expect anything like ERP [enterprise-resource planning] or Y2K in 2003 and maybe even in 2004.

But some companies are going to start using new tech spending to gain competitive advantage. You see it already in the tech industry itself, companies like Microsoft and Dell(DELL) investing and putting a world of hurt on their competitors. Some of their customers will start to do the same thing. That'll provide the signal as to what the next big things are going to be.

You're going to move from an environment where people are spending on stuff like security to something else. I mean, companies have solved the supply-chain problem, so maybe they'll spend some of it there. They still haven't solved the customer-relationship management problem. And they have to figure out what those problems really are.

Part of the problem was that companies defined the problems incorrectly. For instance, they thought that the supply-chain problem was solved by B2B Web sites and that customer-relationship management was solved by sticking a gun at the head of your sales guy and saying, "Give me your contacts."

They ignored some really obvious lessons. The thing that made Amazon.com(AMZN) so compelling was one-click ordering. How many guys besides Amazon had that, you know? That's customer-relationship management: making the customer happy.

In turns out there are a couple guys who have the equivalent of that. One of the reasons Ameritrade(AMTD) has been so successful is that they execute orders a lot faster than their competitors do. Their competitors were sitting there trying to give customers 10,000 pieces of research, Ameritrade figured out that the Internet is the world's largest repository of research. That's not what their customers wanted. They wanted fast execution.

The secret to success in Silicon Valley on the enterprise side has always been about making enterprises more successful through technology. The problem is, we're coming off a period of time where we sold them a bunch of technology that didn't help them. (Laughs.) So they're suspicious of what we offer, and we're not quite sure what we ought to be offering.

I suspect we're going to spend most of 2003 figuring that out. This means 2003 is going to be a better year for the incumbents than it is for the start-ups.

3. Which incumbents specifically will benefit?

That means market share for guys like Cisco, Microsoft, Oracle(ORCL) and SAP(SAP) is going to go up. [McNamee owns shares of Cisco and Microsoft, but not Oracle and SAP.]

I don't expect a significant PC upgrade cycle this year. The thing that people are missing is that, again, the law of large numbers has gotten in the way. The PC industry is so big that it's hard to move the needle. They look back at all those PCs bought in 1999 as part of Y2K. Half those people no longer work at those companies. You don't need to upgrade a computer for a guy who's not working anymore. So, these upgrade cycles just feel like business as usual. They're happening, they just don't move the needle.

It may move it a little this year if people are sufficiently confident because a lot of deferred purchasing may take place.

Prices are down a ton, right? In an environment where units aren't growing because business is too big and prices are falling, that's a formula for an ugly environment.

4. Why, in this environment, do you own Cisco as a top 10 holding? This time a year ago, you were saying Cisco wasn't a good bet. What's changed?

We bought Cisco back in September.

Here's the way I look at Cisco: They have more cash than their competitors have in market cap. They're really smart. They're doing things designed to make them stronger.

Their competitors have been weakened by a lot of factors, not the least of which was the apparent fraud of many of its customers, right? You can say what you will about the folks at Lucent(LU) and Nortel(NT), but their customer base included a lot of people who appear to be very dishonest.

Cisco was less exposed to that. You can say that Cisco was lucky in this regard, but the reality is, they're taking advantage of that good fortune.

I'm of the view that when the market bottoms and starts back up, you want to start out by owning the most-liquid, best-known things. That's where the money goes first. And it eventually broadens out.

In this first phase, you want to own companies like Cisco and Microsoft. We own both of those companies. There are reasons why we don't own Oracle and SAP. We think valuations relative to the prospects for the coming year aren't right. Dell is somewhere in between. The stock is OK, and it's a great company. You can't get a more appealing fundamental situation.

Hewlett-Packard(HWP) may work as a stock over the coming year because they can make the numbers work. But, boy, are they going to give up a lot of market share. Heck, they've already given up a lot of market share.

5. You have mentioned recently the disparity between large-cap tech stocks and smaller-cap tech stocks. Is this still the case, and do you think the small-cap and mid-cap tech companies will represent a better opportunity?

It's less [of a disparity] since October because you had a great bounce across the board in the little ones.

I think inevitably over the course of the cycle, the smaller guys will be a better opportunity. The problem with the big companies is they're at some level an index. Also, technology has gone from 4% of the economy to 10% in the course of 20 years. And it won't go from 10% to 20%. It'll go to 12% or 14%. That'll be great, but it will be a lot better for smaller companies.

Here's the problem: In the public markets, you have to be a stock picker. I think the average tech company is going to underperform the market over the next year or two. But, again, the standard deviation is going to be really high. If you can pick someone with a really good product cycle, you're going to do great, just as you did in 2002.

One of our funds was up in double digits, the other was basically flat. I'm not going to tell you what the returns were, but I will say it was a really good year for us. There were two reasons. One, I think we had an appropriately cautious view all year. And two, we concentrated our bets most heavily in the consumer area, and that turned out to be right.

It looks like another tough year for most companies on the enterprise side. The really big incumbents will do relatively better, and some folks who have good product cycles will do well. And it's tricky to predict who those guys are going to be.

We happen to be very fond of some folks that I can't talk about, sadly. But the pattern-recognition filter you want to have is: You want to find a company that's gaining market share in an industry that is at least stable, which has demonstrated profitability at current business levels.

That package should be the core of your portfolio. Then you can pick a moderate number of smaller-capitalization folks where there is an opportunity for a product cycle that will cause the company to go from unprofitable to profitable. With the latter, you'll make a larger percentage return but you're also going to have some that don't work out.

There is an amazing number of really cheap stocks. And the beautiful thing is that the market is far more democratic. As an individual investor, the amount of data that you can get over the Internet is breathtaking. You can get on all the conference calls. But one of the things you learn pretty quickly when you look at all that stuff: It's not really that valuable.

The really valuable stuff is insight. Figuring out, look, wireless is going to be a much bigger deal in five years than it is today. That doesn't mean that everything in wireless is going to be successful. Quite the opposite, in fact: A lot of things in wireless are not going to be successful. The most successful things in the technology economy are most likely in wireless. Ditto with the consumer.

But on the enterprise side, we're in a period where there is no obvious next big thing, other than wireless data. But that's OK.

6. What sort of returns do you expect from the broader market this year?

We're looking at a year of tough sledding, but people who pick the right stocks are going to have a terrific year.

My guess is that the S&P 500 actually has a nice positive return -- something in the teens. I think we're due. We've had three negative years in a row, and not just a little negative -- a lot negative. Maybe it's back-end-loaded, who knows? But I think it has a pretty good year.

But I think tech doesn't do as well. The reason is so much of the resources are on the enterprise side, and the big-cap guys have already moved. So it feels to me that tech probably lags. But you know what? That doesn't mean every tech stock lags. There are going to be some tech stocks that go up 200%, 300%. If you own one of two of them, you're going to have a great year.

We've made a bunch of bets, and I'm prepared to have to change them as the year goes on. I think some new things are going to emerge.

You know when the Apollo astronauts were returning from the moon? There's a part of the Earth's atmosphere where they lose communication. We're kind of in the stock-market equivalent of that. There's a lot of stuff going on, and it's really hard to tell what it all means. Each passing month is going to tell us a lot.

For example, it's very hard to tell what the impact of Iraq and North Korea will be. I can't imagine that it'll be good. But I don't know how bad it will be or for how long. It depends on how it goes. And there's a bunch of stuff going on like that, where you look at it and say, "Don't know!"

We don't have a crystal ball here, and survival as a tech investor is as much as anything a function of knowing when you're in one of those periods where what you know isn't worth much, and what you don't know is really important.

For sure, we are in one of those. So our investment time horizon is uncharacteristically short; we normally think in multiyear blocks.

7. Any stocks you feel comfortable with for the long haul?

We have a few things that look good for the long term -- things like Overture Services(OVER), which we've owned for several years. We've cut way back on Take-Two(TTWO), but we've owned that for years. We have owned Symantec(SYMC) for a couple years, and we own a ton of Verisign(VRSN). At the price that thing was at in October, it was like we would own it for years. Now, I don't know how long we'll own it, but you know what I mean.

A lot of these investments get down to P/Es of 4 or 5 and you say, "That can't be right." Either the E is wrong, or the stock's cheap.

You have to face up to what a friend of mine says: There are no cheap stocks, only wrong estimates. The reality is, we have just come off a prodigious bear market and there were some incredibly cheap stocks. And it's not obvious to me that the ones you want to own for the next five years will get back to the lows of September. And that's a really important point.

If you're only willing to buy stocks at September valuations, you probably shouldn't be looking at tech. Because the things you're likely to buy, you probably don't want to own.

This is the point in the cycle where P/E has less meaning than normal. The reason is because the Wall Street estimates are all done on spreadsheets and are all normalized, and it's really hard to forecast the impact of fundamental cost reductions. You have two levels of problem: First, you can't forecast the impact of incremental revenue. Second, you have no idea whether there's incremental revenue or not. You have two ways of being wrong.

The spreadsheet tends to cause you to hedge your bets both ways. So when people have upside surprises, they tend to have huge upside surprises.

8. Recently, you've expressed concerns that some of the governmental attempts to reform Wall Street and corporate governance are misguided. Would you elaborate?

It is really important that we reform the securities industry. During the bull market, there were several flaws in the regulatory fabric that were exposed. They were compounded by bad behavior by what appears to be a small number of very influential people.

My concern is largely that regulators appear motivated by as much political concerns as a desire to make the securities business a better place. In the process, they've chosen a set of issues that to me don't feel like the most important ones.

To me, the American capital markets are the greatest in the world and are a crown jewel in our economy. Protecting the integrity of the capital markets is the prime directive of the Securities and Exchange Commission, the accounting industry and the brokerage industry. That's how we make our livelihood and it's really important that we all protect it.

When it comes to issues like financial disclosure and all that, we should always err on the side of more disclosure to the extent that new regulatory efforts induce greater levels of transparency.

What we shouldn't lose sight of is that most of what Enron did was actually legal. It is alleged that they looted the company. But those off balance sheet things, where they owned 97% but got to remove it from the balance sheet, that was perfectly legal! You know who allowed that to happen: The Financial Accounting Standards Board.

They actually passed specific rules to enable that during the 1990s! People are not paying attention to the role the accounting industry, in particular the FASB, played in the financial shenanigans of the past few years.

Almost all the efforts for reform so far have been more along the lines of putting the fox in charge of the chicken coop -- or the inmates in charge of the asylum, as it were.

They had that guy from TIAA-CREF [John Biggs] that they were talking about putting on the accounting board -- that would've been great. I don't know that guy at all, and I think CREF has been a little bit crazy on their corporate governance stuff. But I'd rather err on the side of caution than having the way things are currently going, which is to pretend that the accounting industry is part of the solution, not part of the problem.

There are several levels of things that went wrong in the accounting industry. The most obvious is that the industry was allowed to consolidate too far. There are just too few firms. Second, they were allowed to build consulting businesses serving both information-technology consulting and financial-accounting consulting that operated in direct conflict with their public-accounting mission. They did this to the point where they effectively hollowed out their audit and tax practices to bolster the profitability of these, shall we say, unregulated consulting practices. And they were aided and abetted in this by FASB.

It would be interesting to get a stack of FASB regulations from the 1990s and see how tall the stack is. Back in 1982, when I started my investment career, the accounting industry was black and white. It was limited, but really clear. Accounting today is needlessly complex and frequently the subject of negotiation. Nothing is black and white anymore.

As a result, financial statements don't mean much. That is really dangerous. The fact that regulators don't see this scares me. The idea that FASB is independent and doing great things is a joke. If you put a bullet in FASB's head and started over, that would be a great outcome.

9. What do you make of the push to tax options?

Whether we tax options is less significant in the long run than it's being given credit for. You can see what's going on: FASB has proposed taxing options so that they can declare victory on an issue and deflect attention from their own guilt.

Regulators love this thing because it appears to be a way to help balance budgets and all that stuff. The reality is: It's not the issue. It wasn't the problem. They'll do this, declare victory and move onto some issue like housing. And they'll leave behind this incredible mess and pretend like they've taken care of securities regulation. That's nonsense.

The reason why you don't want to tax options is very straightforward. Thirty years ago, we viewed the economy in terms of labor and management: Management was the owners; labor worked. Thanks to Silicon Valley and the broad distribution of options that accelerated in the late 1980s, everyone's an owner. It's really democratic. If you tax options, you're not going to cut the amount of options that the management team gets because they hand out the options. You're going to cut the options that they give out to everyday people -- it's less democratic.

I don't care if that's inconvenient for the accountants. Deal with it! But this will result in more pro forma accounting, because no two companies will do it the same way.

This whole pursuit of analysts is silly. Did some analysts do things that were really wrong? I suspect they did. Was that really the core of the problem? You must be kidding. When those guys touted stocks up $100 a day, people loved them. The people who hung around the party too long now want to blame everybody but themselves. The analysts are easy people to pick on. The idea that investors didn't know that analysts were being paid by brokerage firms who did investment banking is silly. They weren't paying anything for the research; why did they think it would be unbiased?

I think it's amazing that the attorney general of New York hasn't figured out yet that the smoking gun is on the investment-banking side.

Am I surprised by these regulation attempts? No. Am I disappointed? Sure, I'm depressed about it. I thought this was the administration's big chance to do something great for the economy and business, and they just mangled it.

10. How do you assess management when investing in technology companies, and does it differ at all when viewing a venture opportunity or a mega-cap company?

This is a great question. I have a new prime directive. The old prime directive is: Technology is always at the top of the list. Here's the problem: The world has changed.

The analogy I would use is the military in World War I. Between the American Civil War and World War I, the technology of armament progressed very rapidly, and military strategy didn't move at all. In Europe, almost no lessons were learned from the American Civil War.

The result: People persisted with outmoded strategies in the face of mass destruction. The incredible tragedy of World War I is that, for all intents and purposes, nobody figured it out. They just stopped the war. Incredibly, the French replicated the problem with the Maginot Line. And Hitler was the first guy to figure out...

Just go around it.

Yeah, the technology allows you to fight differently. During the course of World War II, various armies made progress in direct proportion to how quickly they incorporated these lessons.

We have a similar situation today in Silicon Valley. The rules have changed. The skills that made people successful in the late 1990s are not particularly useful right now. We look for executives who have the insight and flexibility to change with the times or companies who make, in effect, battlefield promotions of people who are willing to take the world as it is and make the best of it.

It's not just that management is at the top of your list -- the skills are also different. In the late 1990s, it was people who showed well. Now it's about people who actually get something done -- it's a lot like it was in the 1980s. It's: "I don't care what you're going to do next month, what are you doing today?"

The sense of urgency in the late 1990s was about marketing communications. The sense of urgency today is about the substance of your business.