Finding Tech Gorilla Stocks in the Midst of a Meltdown - TheStreet

Finding Tech Gorilla Stocks in the Midst of a Meltdown

Whether by accident or planning, some stocks excel in a downturn.
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Will you be sorry in a week if you buy

Inktomi

(INKT)

at $25? I can tell you that the stock just hit a new 52-week low, the chart shows that the stock has broken through critical support and Wall Street analysts currently can't downgrade it fast enough. But that's really not an answer to the question. Frankly, I don't know where this stock will be in a week or a month, and neither does anyone else.

Will you be sorry in a year if you buy Inktomi at $25 now? That's one question I think I can answer emphatically. Using even worst-case numbers, I get a target price of $33.25 for Inktomi next November. That's a 33% gain from a purchase price of $25 a share.

And the more you stretch out the time period, the more emphatic my belief in the rewards of owning Inktomi. Over the long haul, Inktomi is a must-own technology stock, in my opinion. The company is going to be a key player in building the Internet for the next decade.

And Inktomi isn't the only beaten-up, beaten-down technology stock that I'd put in that group. Nine other names in my updated Future 50 long-term portfolio come to mind:

America Online

(AOL)

,

Applied Materials

(AMAT) - Get Report

,

E*Trade Group

(EGRP)

,

Exodus Communications

(EXDS)

,

JDS Uniphase

(JDSU)

,

Metromedia Fiber Network

(MFNX)

,

PMC-Sierra

(PMCS)

,

RF Micro Devices

(RFMD)

and

Yahoo!

(YHOO)

. Five years from now, I think every one of these stocks will deserve a core position in the average technology portfolio.

From Pipsqueak to Gorilla

Why do I single out these names? Because, whether by chance or by conscious strategy, these companies are doing the right things even as the general market, and their industries in particular, suffer a down cycle. They're likely to come out of the bad times in stronger shape than they went in. And that's a critical part of becoming -- or remaining -- the 600 pound gorilla in any industry. (For more on finding "gorilla" stocks, see these recent

Tools of the Trade and

Stock Strategies columns.

I know it doesn't feel like anything positive is happening with these companies and their stocks right now. These seem to be stocks to run away from rather than shares that you should start accumulating. There's a Wall Street saying -- "Don't try to catch a falling knife" -- that warns investors not to buy a stock that's in free-fall. And frankly, all it takes is a glance at the charts of Inktomi or Exodus Communications to see that these knives are still plunging. They could fall even more in the short term, even from current price levels.

Or they could rally strongly in the short term. Mutual funds have built up large cash positions in the past month, and with the end of the presidential election, I'd expect them to put that cash to work in stocks. If a good portion of that cash goes into technology shares, the sector could rally. Of course, any rally could peter out relatively quickly if it runs into another wave of earnings warnings in December. Or it could run on for a few months if investors start to believe that the

Federal Reserve is likely to abandon its inflation-fighting bias in relatively short order.

That's a lot of "ifs" over the short term.

But I would say that it's at times like these, when the short term is so grim and painful and uncertain, that long-term investors need to remember that they do, indeed, invest for the long term. And over the long term, the goal is to buy shares of companies that are able to take advantage of a down cycle in their industry or in the stock market. The goal for long-term investors over the next six months to a year ought to be to add those names to their portfolios because those stocks are the ones that will perform best when the cycle starts to swing upward again.

I think the 10 stocks mentioned above pass this test, and I've given them best-buy ratings in this monthly update of the Future 50 portfolio. As always, I urge you to do your own homework and to pick your entry points for building positions in these stocks with more precision than I can do in a twice-weekly column. In this volatile market, I suggest that you use my buy flags more as indications that I think these stocks are worth accumulating over the next six months rather than as a buy-them-now signal.

(For those who have come in late, the

Future Fantastic 50 portfolio is a more aggressive version of my

50 Best Stocks in the World. I've picked stocks for both portfolios by looking for companies with a competitive advantage in their industry that's so significant, it can produce extra profits for the company. This advantage can be anything from a technology to a sales force, but it has to be an advantage that's clearly sustainable over the long term. The major difference between the two portfolios is that the 50 Best Stocks in the World list was put together by looking backward at companies that have already demonstrated a competitive advantage over the past five years, while the Future 50 -- which I compile with the help of an annual vote by readers -- focuses on companies that seem likely to have demonstrated such an advantage five years from now. Both are meant for long-term investors with a holding period of five years or longer.

In its first year, the full Future 50 portfolio returned 56%. But each month or so, I pick the 10 stocks from the Future 50 that I think are best-priced for buying now. Those picks, plus 10 from the more conservative 50 Best, make up a strategy I call Core & Edge. I track the results of that strategy in the recommendation section of the MSN MoneyCentral community.)

Staying Alive at the Bottom

We all know how to look for companies that are thriving when business and financial conditions are good. We look for accelerating growth rates in revenue and earnings, increasing profit margins and aggressive expansion through acquisitions or capital spending.

But what exactly should an investor look for to find companies that are taking advantage of the bottom of a cycle?

Applied Materials is the prototype of this kind of company. Over the years, the company has become extremely adept at using the hard times at the bottom of a cycle to its advantage. When things are bad, Applied Materials makes acquisitions of troubled competitors, often at bargain-basement prices. Instead of cutting its research and development, the company continues to push new products to market. Capital budgets may get tighter, but they don't get slashed; Applied Materials continues to build new plants and buy new equipment when the investments will pay off in increased efficiency. And Applied Materials actually remains willing to cut prices and make deals in order to gain new customers or increase its share of an existing customer's business.

Because this strategy is so ingrained at Applied Materials, an investor doesn't have to dig very deeply to see it at work. Just reading the press releases will do the job. On Nov. 27, for example, the company announced that it would increase hiring and expand its Horsham, England, plant to triple production of ion-implant equipment for producing the next-generation of sub-0.13 micron chips. Oh, and the company is also adding a new manufacturing line in North America and constructing new labs on three continents. How's that for cutting back when times are tough?

This strategy is effective because it puts intense pressure on competitors exactly when they're under the most stress. Think about your reaction if you were the manager of an Applied Materials' competitor. Sales -- or, at least, orders -- start to slow as your company enters an industrywide slowdown. Analysts are asking if your company remains comfortable with previous earnings-per-share estimates. Cutting costs and spending seem only prudent if orders are indeed slumping and those savings might even be enough to get the company through the quarter without seeing its stock get savaged by estimate cuts. The last thing you want to do is actually increase your costs -- but that's exactly what Applied Materials is challenging you to do.

Even if you're up to the job, your company may not have the resources to match those of Applied Materials. That company has ample cash reserves, and with fingers in so many industry segments, it can often shift profits from a still-growing segment to one that has slowed but requires new investment. And with its size and track record, should Applied Materials need to go to the capital markets, the company is likely to find them willing to provide cash at a below-market price.

By contrast, if your company can't find the funds internally, it's almost certain to pay a higher price to borrow -- if it can borrow at all -- since the capital markets are leery of putting out money on the downside of an industry cycle.

Any CEO that either won't or can't match Applied Materials' moves in the tough part of the cycle will find out what so many of the company's former competitors have discovered in the past: When the good times return, there simply isn't any way to make up the ground that they've lost.

The Hunt for Accidental Strategists

Immature technology companies often haven't been around long enough to develop a formal down-cycle strategy like Applied Materials. They may be making the right moves now on an ad hoc basis or simply on gut feel. Or they could even be making them by accident if a move that was begun before the downturn happens to have a major strategic advantage now that growth has slowed. As an investor, I don't think you much care whether a young company is doing the right thing by strategy or accident. Either way, the good moves the company is making in the cycle's downside are what will give it the chance to grow up into the sort of company, like an Applied Materials, that has a conscious down-cycle strategy for dominating its industry.

OK, so how do you find these accidental strategists? Start with questions like these:

  • Have recent acquisitions brought in major new capacity that competitors will be pressed to match? Exodus Communications is a good example here. The company's purchase of Global Center, the Global Crossing (GX) Web-hosting business, was a bold move to gain enough size to distance Exodus from its competitors. At the time, the deal's price raised eyebrows. But recent comments that the acquisition would be accretive (on an EBITDA basis -- earnings before interest, taxes, depreciation and amortization) indicate that Exodus negotiated 10 year's worth of price concessions for using Global Crossing's broadband network as part of the deal. I think those cost savings will amount to a sizeable hunk of change over the life of the agreement. But whatever the price tag or the cost savings, the acquisition gave Exodus a huge jump in capacity. Instead of finishing the year with 36 data centers, the combined company will have 46 that offer a total of 4.9 million square feet of space for locating servers and other equipment. That amounts to an 88% increase over the space that Exodus had before the deal was announced. That sheer size will enable Exodus to add more big customers that demand multiple sites. Geographical reach is just as important, and here, also, Exodus made huge strides with this deal. Exodus will now have data centers in North America, Europe and Asia, and access to a broadband network that will link them all. A multinational Web-hosting company to serve the needs of multinational corporations -- not a bad marketing hook, I'd say.
  • Have recent acquisitions added major new product lines that competitors must match? In the case of E*Trade, I'd point to the acquisitions of Telebanc, Card Capture Services and PrivateAccounts and say, yes. All are part of a move to turn E*Trade from a simple electronic brokerage firm that executes trades into a money-management firm that provides brokerage services along with banking, an ATM network, private account management and more. The benefits are obvious: The more services the company can offer, the more services an individual customer might be persuaded to buy. And the more money-management services the company offers, the more different types of customers the company can go after with its marketing efforts. Competitors in the online brokerage business will be at a disadvantage if they don't add those services, and yet with trading volume and revenue down, and their stock prices depressed in turn, buying or building those pieces now will clearly be beyond some players in the industry.
  • Is the company adding new capacity? There's no doubt that adding more manufacturing space when sales growth is flagging is counterintuitive. Why not wait until demand picks up before building a new plant? Well, that would be great if a company could go to a store, order a new factory, take it home and set it up overnight. That's just not possible, however. The lead time for getting a complex chip-manufacturing operation up and running is closer to a year, for example. But waiting to add capacity until the company is already running out of room also ignores one of the key facts of modern, high-technology manufacturing. New factories are almost always more efficient than old factories. The best high-technology manufacturing companies constantly push their costs lower by building new plants with cutting-edge technology for their leading products, then moving simpler-to-make products to its older plants. The constant renewal of the manufacturing infrastructure is a key part of the continual effort to drive down costs at Intel (INTC) - Get Report, for example. I'm also pretty sure that RF Micro Devices wasn't counting on slowing demand in the wireless-phone market when it began building the new factories that will come on line in the first half of 2001. Certainly adding capacity right now hasn't done anything to make analysts like the company's stock any better. But I think the accidents of timing will work to the company's advantage by giving it more control over its own manufacturing and reducing product costs. Both of those should be solid pluses when the cycle turns upward again, which could happen as soon as the spring of 2001.

Right now, when so many tech stocks

look

like bargains but so few actually

are

, I'd use this down-cycle checklist to figure out which to add to the long-term core of my portfolio. For example, in looking once more at Inktomi, I find positive signs in the company's recent acquisition of

FastForward Networks

. FastForward's MediaBridge and Broadcast Manager products distribute, monitor and control live and on-demand streaming media, and adding these products helps Inktomi raise the bar on its competitors. The company's new Content Bridge effort makes it possible for content distributors to share each other's networks when they deliver Web pages or streaming media -- and to get paid for the specific content that they send across the network. Initial Content Bridge partners include Exodus,

Digital Island

(ISLD)

and America Online.

I think the strongest of its competitors will match Inktomi's moves and then counterattack. The company is in a developing market with fast-changing technology, and

Akamai Technologies

(AKAM) - Get Report

and

CacheFlow

(CFLO)

aren't about to roll over and play dead just because Inktomi has acquired new technology.

But when a company continues to make smart moves even when growth gets iffy, I think investors have learned something important about the likelihood that it will be around for a while. By itself, that's certainly no guarantee that Inktomi or any other company on my list will grow into a gorilla. But I can guarantee that no company that fails to thrive in a downturn will ever dominate its sector.

(For those who are interested, I arrived at my $33.25 target price for Inktomi by starting with an estimate of $461 million in revenue for fiscal 2001, taking 10% off that to account for a worse-than-expected slowdown in growth and then applying a figure of 10 times revenue -- down from analyst estimates of 22.5 at the end of October and 17.3 in early November. That gives me a projected market capitalization of $4.15 billion. Divide that by 124.9 million outstanding shares, and I get just under $33.25 for a target price.)

Eight of the stocks I've named in this column were already buys in the Future 50 portfolio. The two new names, Inktomi and Exodus Communications, replace

Nokia

(NOK) - Get Report

, which, while still down slightly since it was added to the portfolio, has appreciated 48% since I made it a "buy" on Oct.12, and

EMC

(EMC)

, which has recently started to show signs of weakness that suggest it could be headed for a further correction.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: America Online, Applied Materials, Atmel, EMC, E*Trade, Exodus Communications, Global Crossing, Icos, Inktomi, Intel, Metromedia Fiber Network, Nvidia, Nokia, PMC-Sierra and RF Micro Devices.

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