Thanks to Nasdaq Composite Index's drop below 3000 Monday, technology stock prices are more confusing than ever.

Technical analysis has seemed like wishful thinking recently. Just when we thought the technology sector had settled into a trading range with a bottom above 3050, the Nasdaq drops to 2966. Individual stocks, moreover, have shown that they can cut through major support like a knife through butter. I've seen sound technical arguments that

PMC-Sierra

(PMCS)

, for example, had solid support at $187 a share, $160 and $140. None of that stopped the stock from closing just below $109 on Nov. 8.

And fundamental analysis hasn't done any better. Stocks that had been pounded so low that they seemed cheap on the fundamentals have gone still lower.

Dell Computer

(DELL) - Get Report

, for example, seemed like a bargain in September at $35, when it was down 40% from its March high near $58. The price-to-earnings ratio had dropped in half, to 47 in September and from 90 in March. Now, of course, Dell trades at just about $25 a share and shows a price-to-earnings ratio of just 31. And there's no guarantee that the stock won't get cheaper if earnings growth continues to slow in 2001.

Even stocks that have reported extremely strong fundamentals have taken it on the chin.

Applied Micro Circuits

(AMCC)

has fallen from $107 in September to about $70 recently despite reporting better than 200% earnings-per-share growth in its September quarter.

Why am I belaboring this point? Doesn't most any investor know from bitter experience just how difficult it's been this year to put a price on anything in the technology sector?

I've got two pretty strong reasons.

  • First, I think that the sector is poised for a decent rally from the Nov. 13 low. Money that has been sitting on the sidelines while Gore and Bush battle it out in Florida is seeping back into the market as investors acknowledge that there will be an end to this contest. With prices down enough to encourage bargain hunters and the traditional year-end buying season upon us, I think we could easily bounce back to 3500 and maybe even 3700 on the Nasdaq. With a rally a distinct possibility, knowing what a stock might be worth on the upside is fairly important.
  • Second, I don't think this rally will hold, and I believe we'll revisit the low that we saw on Monday. Maybe we'll even retest the September/October 1999 low near 2600 before we put in a real bottom on the bear market that has gripped the Nasdaq since March. And if this rally fails and some technology stocks are headed for new lows, it's important to know how low those might be.

That would seem to leave an investor trapped between a rock and a hard place. Successful investing in this market seems to require accurately valuing stocks. But this market and its volatility make that extremely difficult.

Well, as my grandmother always used to say, when they've dealt you a rock and a hard place, put a value on each and use the range to calculate the potential risk and reward in a stock. In other words, with such distinct tops and bottoms of valuation, do a best-case/worst-case valuation for a stock and see how much potential risk you're taking on for how much potential reward.

One way to do that for technology stocks in the current market is to break down the sector into risk/reward profiles. I've picked three stocks, Applied Micro Circuits,

Ericsson

(ERICY)

and

Lucent Technologies

(LU)

to illustrate my case. I picked these because I'm a big believer in the power of the long-term strength of the telecommunications-equipment sector and because these three stocks represent the major types of risk/reward profiles in the technology sector as a whole. In the progression from Applied Micro Circuits to Ericsson to Lucent, I think we can see most of the problems that are troubling technology stocks.

Applied Micro Circuits

Profile: Fundamental growth story intact but facing multiple compression.

Score: 50% upside, 40% downside.

Other technology stocks with similar kinds of risk/reward factors:

Broadcom

(BRCM)

, PMC-Sierra and

Vitesse Semiconductor

(VTSS)

.

Figuring out the downside on Applied Micro Circuits is relatively easy. If you look at a chart for the stock, you'll see that the stock has extremely strong support around $42. The shares bounced off that level repeatedly in the spring. That's also about where I'd expect the stock to settle if, despite statements to the contrary, the company starts to see a slowdown in growth over the next two quarters due to a buildup in inventory at customers. A 40% drop would take the stock back to $42 from a recent $70 a share, so I figure the downside on this one in a worse-case scenario is about 40%.

Figuring out the upside is a lot tougher. The stock is down better than 30% since it hit $107 a share on Sept. 28, based on fears that earnings growth would get bushwhacked by the slowdown in telecommunications spending. At that point, the stock traded at a P/E ratio of 396 on trailing 12-month earnings. If those fears are groundless, then in a year, according to analysts, earnings per share will be 65 cents. (Throughout this article I use earnings per share before one-time charges.)

You do the math -- 65 cents times 396 comes to a tidy $257 a share. With Applied Micro Circuits trading near $70 recently, that amounts to a 267% gain in a year. Back up the truck, Willie Sutton.

In fact, however, P/E multiples on technology stocks are coming down all across the Nasdaq. To my mind, that's the single most important thing to understand about the current market.

There are lots of reasons for this contraction. Some are technical. The latest leg down, which took the Nasdaq below 3000 last Monday, saw individual stocks crash through important support levels. That heightened risk in these stocks -- and investors decided to pay less for them. Other reasons are fundamental.

For example, investors are worried that the economy will slow more rapidly than expected in 2001. Right now, earnings for the stocks in the

S&P 500

index are projected to grow by 12% next year. But a few analysts on Wall Street are whispering that earnings growth could be nil in 2001. I think that's extreme and unlikely, but, in the stock market, worry counts.

Individual sectors, especially among technology stocks, have specific worries. In my last two columns I've written about an expected slowdown in spending on telecommunications equipment that could reduce earnings growth at companies ranging from

Cisco Systems

(CSCO) - Get Report

to Applied Micro Circuits. In the last month, we've seen capital spending cuts from

AT&T

(T) - Get Report

,

WorldCom

(WCOM)

,

Sprint

(FON)

and a host of smaller service providers. And we've seen an inventory buildup at almost all the big equipment makers. Cisco's announcement may have received the most attention, but that company isn't alone. From the second to the third quarter, Cisco's days of inventory jumped by 35%, Ericsson's by 9%,

Nortel Networks'

(NT)

by 36% and

Tellabs'

(TLAB)

by 26%.

All this makes investors less certain about Applied Micro Circuits' ability to deliver the earnings growth now projected. And when a dollar of future earnings is less certain, investors will pay less for it.

How much less is the question, and unfortunately, there's really no final answer. Clearly the stock should trade at some premium to the S&P 500 since the company is projected to deliver 81% growth over the next 12 months -- far higher than the index. I think a P/E ratio equal to that growth rate is also low. There simply aren't that many stocks that can deliver growth at this rate, and they historically sell at two times their growth rate or better.

Using an estimated P/E ratio of 162, two times Applied Micro Circuits' growth rate and the 65-cents-a-share earnings estimate, I get a target price of $105. That would be a 50% gain from recent levels.

Ericsson

Profile: Growth story in doubt due to tough but fixable business problems.

Score: 50% upside, 50% downside.

Other technology stocks with similar kinds of risk/reward factors:

Motorola

(MOT)

,

Oracle

(ORCL) - Get Report

, Dell Computer.

If only Ericsson didn't make wireless handsets. The company's wireless infrastructure business is tops in the world and the company is likely to reap a lion's share of the profits from the global build-out of third-generation wireless systems. Fifteen of the 20 agreements signed to date for third-generation systems have been for Ericsson equipment.

The handset side of the business, however, is a swamp of red ink. In the most recent quarter, the company reported an operating loss of almost 29% in its handset division. Component shortages. Product delays. Bad marketing. A horrible product mix. You name it, Ericsson has seen it. The company expects to report another loss from the division in the December quarter.

For investors, the problems in the handset division completely overwhelm the strengths of the infrastructure side of the company. Visibility is so poor in the handset division that Ericsson hasn't been able to accurately project losses. That's meant a series of negative surprises like the one reported for the September quarter.

Ericsson has been trying to turn around the handset division, and announced another restructuring plan in October. The division would concentrate on GSM phones, the European standard, and scale back sales of CDMA and TDMA models. In addition, Ericsson would outsource production of its entry-level phones to other manufacturers, while moving its own high-volume production from Europe and the United States to Asia, Eastern Europe and Latin America in an effort to cut costs.

Still, analysts are skeptical that the company can reach even its limited goal of breaking even in the second half of 2001. Wall Street much prefers the option -- discussed by Ericsson, but so far put on the back burner -- of simply selling off the handset business entirely to concentrate on infrastructure products that account of 70% of the company's current revenue.

Downside? Yes, there is a downside even for a stock selling recently at $12.38, down 50% from its 52-week high of $26.31. I think Ericsson could easily revisit its low from the summer of 1999 around $7.50 if the company continues to fritter away its strengths through a stubborn refusal to get out of the wireless handset business. Every time the company reports another round of losses in that business, analysts lower their earnings projections. The stock still trades at a P/E ratio around 38, largely on the strength of a projected 56% earnings growth rate for 2001, despite projected growth of just 11% this year. But if that growth comes in nearer the 21 cents projected by the most pessimistic analyst on the stock, then growth for the year might well be zero. And at 21 cents a year and a P/E ratio of 30 on the strength of promises for 2002, Ericsson's stock would be worth just $6.30 a share. That's about a 50% decline from where it's been trading recently.

And the upside? If Ericsson dumped its handset business tomorrow, I think the company could actually see an increase in its multiple to 40, since earnings predictability would improve so markedly for the company. Without the losses that the handset division would contribute in the first half of 2001, earnings at Ericsson could hit 46 cents a share in 2002, easily surpassing the 43 cents now projected by the most optimistic Wall Street analyst. At a 40 multiple, that would take the stock to $18.40, about a 50% gain from here.

Lucent Technologies

Profile: Busted growth story due to tough business problems not susceptible to a quick fix.

Score: 36% upside, 20% downside.

Other technology stocks with similar kinds of risk/reward factors: AT&T,

Amazon.com

(AMZN) - Get Report

and

Apple Computer

(AAPL) - Get Report

.

I'm not sure that I could get anyone at Lucent Technologies to agree, but I know I'd rather be Ericsson. It's not that Lucent's problems are really any deeper than Ericsson's; it's just that the fix is so much harder. Ericsson could simply sell off its failing business and concentrate on its strengths. Lucent's failing business is at the core of the company. It can't simply walk away from the problem.

The trouble at Lucent is in a business called the

Service Provider Networks

, and it appears to be concentrated in two important segments.

  • First, there's the switching business, which has been an important profit center ever since the company's spin-off from AT&T in 1995. Revenue in this business -- the meat and potatoes of Lucent's revenue from its traditional customers, the large telephone companies -- declined by 13% in the most recent quarter.
  • Second, there's the optical-systems business, where revenue actually declined by 26% in the most recent quarter. That's shocking since in that same period the market grew by better than 100%. What happened? Older products didn't sell and new products weren't ready for sale in volume. Highly touted new products such as the high capacity OC48 dense wave division multiplexing system weren't ready to ship at all.

What's Lucent's downside? You can see it in the extraordinary spread between the high earnings-per-share estimate by Wall Street analysts of $1.03 for the fiscal year that ends in September 2001 and the low estimate of just 10 cents a share. Lucent is expected to spin off its profitable microelectronics division in March 2001 and some analysts, such as

Lehman Brothers

, are forecasting that the rest of the company will show declining sales from the year-earlier period and actual losses for all four quarters in 2001.

Given the utter lack of visibility in Lucent's business beyond the fourth quarter of 2000, the company could certainly disappoint analysts again. If it does, Lucent could become an $18 stock, about a 20% decline from its recent price.

On the upside, perhaps the best thing that a Lucent investor has going is the proposed spin off of the fast-growing microelectronics business next March. Analysts estimate that the stock could be worth $13 to $18 a share. I think the last year has shown how dangerous it can be to count on the price of an IPO before it's actually sold to the public, but I do think that even assuming the issue sells at the low end of that range, the market is assigning a very low value of about $10 a share to the rest of Lucent's businesses.

The problem, though, is that even with this low valuation, it's hard to see a quick improvement in the company's fortunes. A company doesn't roll out a new optical product overnight, especially when its engineering talent is walking out the door in scary numbers. Employee turnover is now up near 20% at Lucent.

Still, even a little leadership at the top and some visibility on the earnings front could help this stock a great deal. If new management can come in and announce a plan to turn the core business around and then execute for a quarter or two, this could become a $30 stock. That would be a 36% gain from recent prices.

What's Next

How do these calculations help you?

You can use the upside/downside projections as a way to decide which stocks to buy. So Lucent, with an upside gain of 36% and a downside loss of 20% (for a ratio of 1.8) would be a better buy than tossup Ericsson, with its 50/50 potential for going up or down (a ratio of 1). What ratio you choose to set your buys in this market is dependent on your own tolerance for risk and appetite for reward, but, from a long-term perspective, I'd certainly think of snapping up any stock that showed a reward to risk ratio of 2 or better. That's a significant tilt of the playing field in an investor's favor.

But I also wouldn't use that number as my sole guide in deciding which technology stocks to buy.

  • First, the ratio doesn't address the odds for and against the best- and worst-case scenario. For example, the odds are better that the tech bear market will be over in a year and Applied Micro Circuits will be pushing $105 next November than the odds that Lucent will have made sufficient progress on its problems to convince investors that the stock is on the road to recovery.
  • And second, the ratio doesn't capture the possibility that the stock will be dead money. That is, that its price won't go anywhere for a year. In general, I think the odds that a stock will be dead money increase as you work down these profiles from Applied Micro Circuits to Lucent. A stock like Applied Micro Circuits is more volatile than Lucent -- on the upside as well as on the downside. Lucent has been so beaten up that it's hard to imagine the stock going much lower, but the problems that have brought the price so low are important enough to limit the stock's upside volatility as well.

The other way to use this potential upside/downside profile is in timing buys and sells of technology socks during what remains a very volatile market. For example, look what happens to the reward/risk ratio as the price of Applied Micro Circuits fluctuates. At $70 a share, the stock shows a reward to risk ratio of 50% upside to 40% downside or 1.25. If the price drops to $60, however, the potential upside return goes up to 75% (the gain from $60 to the $105 target price) and the downside declines to 30% (the loss from $60 to the worst-case price of $42). That pushes the reward-to-risk ratio to 2.5 and makes the stock an attractive buy. But if the stock climbed to $90 in quick order during an end-of-year rally, the reward-to-risk ratio would flip (17% potential upside vs. 53% potential downside) and I'd say the stock would be a definite sell.

I think this discipline is especially useful for stocks like Applied Micro Circuits that are the most likely to rally hard and fast if we get a year-end rally. I'll be using this discipline myself with

Jubak's Picks

like PMC-Sierra,

Mercury Interactive

(MERQ)

and

Ariba

(ARBA)

--

if

we ever get that long-delayed rally.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Applied Micro Circuits, Broadcom, Cisco Systems, Nortel Networks and PMC-Sierra.

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