On Jan. 12, you could have bought the future of
RF Micro Devices
-- the future earnings per share, the earnings growth rate, the acquisitions and partnerships, the new products -- for $74.88 a share. Turns out that would have been a pretty good bargain. The stock closed at $172 a share on March 7.
So now anyone who wants to own the same future of RF Micro Devices has to pay 132% more than it cost a little less than two months ago. Is that still a good bargain?
That's a question worth asking about any of the stocks that have delivered a year's worth of gains in the first two months of this year and about the technology-laden
market as a whole. After all, the 17% returned by the Nasdaq so far in 2000 isn't far off the 24% that the index has returned on average in each of the last 10 years.
No one wants to overpay for a stock's future, especially when many technology stocks are trading at historic highs and unprecedented price-to-earnings ratios. On the other hand, no one wants to sell too soon out of a vague fear that a stock has peaked.
My advice: Once again, follow the money. Only this time, instead of following money flows in and out of market sectors (see my column
Tech's shooting stars could keep rising) or into the pockets of big acquisition-hungry telecommunications companies (see my column
Catch profits by following telecom dollars), investors should follow projected future cash flows. To decide whether to hold or sell when a stock hits one of your solid and carefully thought-out target prices, look to see if you can find evidence that the company's future cash flow will be higher than you expected when you set the target. If you find signs that it will be, consider holding. If you can't, consider selling.
Keep It Simple
Projecting future cash flows then discounting those future dollars back to the present is one of the core methods of valuing a stock. It's also sufficiently mathematical to discourage most investors from employing it. And frankly, when you're making all the assumptions you have to make in dealing with very young technologies and very young technology companies, I'm not convinced the method results in particularly solid numbers.
So I'm going to suggest instead a simplified version that concentrates not on calculating the precise value of any change in cash flow but on detecting any significant change in direction or magnitude. Think of it as a way to look at the momentum of a stock's fundamentals. To illustrate how it works, I'll begin with RF Micro Devices, work my way to other Jubak's Picks such as
and then take a look at a few recent big winners outside my portfolio such as
In the case of RF Micro Devices, the analysts who put a price on the future of the company early this year underestimated its value. The analyst at
, who set a 12-month target price of $84 a share on Jan. 12, was clearly too conservative. So was the analyst at
First Union Securities
, who set a target price of $109 on Feb. 23. And so was I when I put a target price on the stock of $165 by June.
But as "wrong" as those numbers were, we all got the direction right. We all saw that a raft of new products was increasing revenue at the company and that the accelerating growth of the wireless phone market would also lead to accelerating growth at RF Micro Devices. The deal with
to integrate RF Micro Devices' amplifiers into Qualcomm's CDMA chipsets was the capstone to that growth story.
However, at least some of the value of this news is already in the stock. On the announcement, for example, Prudential Securities raised its target to $175 from $104. And the market drove the stock to $175 on March 3 from $138 on Feb. 29. Sure, the effect of the deal's announcement hasn't played out completely --
USB Piper Jaffray
raised its 12-month target price for the stock to $200 on March 7, a 14% gain from here -- but I don't think I want to hold on to this one unless I'm convinced that the story of upward momentum in the cash flow is intact.
And I think it is. Once again, I believe analysts are being too conservative in their targets and that the company has a solid shot at accelerating its earnings growth. RF Micro Devices still has excess capacity at its first chip plant and has a new plant under construction. A large percentage of the costs in the chip business are fixed costs -- a factory costs $2 billion to build whether it runs at 10% capacity or at full speed, for example. That means that the value of new business that RF Micro Devices has won from Qualcomm,
and others is greater than what the mere volume of new revenue would indicate, because each new dollar of revenue will have a disproportionately greater effect on the net income line of the company's financial statements. That should keep the cash-flow momentum going at RF Micro Devices. Even at $175, I think the market is undervaluing the future for this company, which is why I raised my target price for the stock to $195 by June.
I'd make the same argument for LSI Logic. Again, the stock has had a wonderful run from $33.44 on Jan. 3 to $73 on March 7. I think it could well dip in the March quarter, which is traditionally flat for the company, but the stock price still doesn't fully include the effects of the launch of the
PlayStation II and the company's increasing penetration of the communications sector through chips such as its new product for the fiber channel market. That's why I raised my target on March 7 to $84 for June.
How much momentum is enough? It's extremely hard to judge. Sometimes you can look to a competitor for a clue. BroadVision was up 43% this year as of the close on March 7 -- and that's after a 1,491% gain in 1999. With the stock trading at a market capitalization of about $22 billion and projected to show just 28 cents a share in earnings for 2000, BroadVision is clearly trading on its future. With the astronomic price appreciation of the last 14 months, I'd sure like to see evidence that BroadVision has enhanced its future prospects recently.
But I'm not especially impressed by what the company has done lately. For example, a deal to integrate its software with
Directory Services, the leading directory software for networks, is important, but it's primarily defensive in nature to my thinking. The launch of a one-to-one billing software product again will help keep existing customers from straying, but the market for billing software is crowded with competitors. I don't see this as a big addition to BroadVision's future either.
Compare that with the action at Mercury Interactive. This stock hasn't been exactly stuck in the mire either -- it was up 228% in 1999 and another 120% for 2000 as of March 7. Mercury's Topaz 2.0 software, planned to launch in the second quarter, will significantly improve the stock's future. The company's current software examines the performance of a Web site and tells the owner if the performance for the user was below par. The new generation not only reports on performance, but goes on to figure out the source of the problem. Perhaps a single image on the Web site is causing the shortfall in performance. Topaz 2.0 will point out the culprit. The next generation product, now in the pipeline under the code name Falcon, will go even deeper into a site's architecture to address such problems as load-balancing.
Mercury Interactive is considerably cheaper than BroadVision at the moment -- the stock has just about half the market capitalization and the company is projected to earn 58 cents a share in 2000 compared with 28 cents at BroadVision. Given the relative "improvements" the two companies have made to future cash flow recently, at March 7 prices I'd rate BroadVision a sell and Mercury Interactive either a hold or a buy, depending on whether you already own it. I'll be selling BroadVision out of Jubak's Picks with this column and adding Mercury Interactive.
Draw Your Own Conclusions
Be careful to draw your conclusions from this kind of comparison in the widest context. For example, at the recently concluded
Optical Fiber Communications
conference in Baltimore, SDL introduced new products for OC-192 optical fiber networks and two new optical amplifiers and new power pump modules for dense wave division multiplexing, all of which are among the hottest areas of the fiber network market. But at the same conference, JDS Uniphase introduced 30 new products, including OC-192 modules and dense wave division multiplexing components for 80-plus channels.
JDS Uniphase certainly seems more aggressive in this space. But before I dumped SDL or traded SDL for JDS Uniphase, I'd want to think about the relative valuation of these two companies. At $100 billion against SDL's $14 billion in market capitalization, JDS Uniphase is about seven times larger. Adjusting for relative size, the two companies' different numbers of product introductions are about equal in their potential effect on future valuations. Before I made any buy/sell/hold decision, I'd also take a look at the growth rate of the market in which these companies compete. Fiber networking equipment is about as fast-growing a market as I can think of right now. I certainly think there's a strong argument for overweighting this industry by adding JDS Uniphase to a portfolio that already contains SDL, rather than replacing one stock with the other. In fact, that's the strategy I'm going to pursue with Jubak's Picks. I'm going to hold SDL though the current volatility and hope I can pick up JDS Uniphase within the next 10 days or so.
Comparing a company's recent product momentum with its own past product momentum is also a useful indicator. For example, recently Texas Instruments introduced a new high-performance digital signal processor, the C64x, a successor to the company's C62x chip that is the leader in the third generation wireless base station and digital subscriber line markets. Analysts had expected the chip, so it was already figured into their target prices. But at the same time Texas Instruments introduced a new, low-power digital signal processor, the C55x.
That took analysts aback because introducing two major new chips at once was unusual for the company. Analysts suggested -- and management confirmed -- that the company had succeeded in speeding up its ability to crank out new products. That's a major indication of increasing momentum at Texas Instruments. I'd rate this stock a hold even after its 70% appreciation this year. The future is more valuable than it was just a little while ago, in my opinion.
Of course, product announcements aren't product sales. So it helps to dig deeper and look at design wins: How often is the new product getting designed into a computer, a fiber network or a wireless phone? And how does that rate compare with previous product introductions at the company? Sometimes, I grant you, this isn't the easiest data to find, but an investor can get lucky.
Xilinx, for example, has told Wall Street analysts to expect rising revenue growth rates -- a jump to 10% quarter-to-quarter from 7% -- because of the speed with which its new Virtex-E chips are racking up design wins and producing real orders. Sales of the new generation of Virtex chips are growing twice as fast as those of the previous generation. That's easily believable too, since the new, low-power line is designed to go into Internet appliances and portable devices where battery life is critical. Xilinx is up 75% this year, but I still think it's got a future that the March 7 price of $82 a share doesn't fully include. I'd certainly hold Xilinx through the current turmoil.
With the technology part of the market near record highs and with a
rate increase looming on March 21, I think it would be smart to do this kind of analysis for every winner in your portfolio right now. You want to make sure that if the market dips, anything you're holding will bounce back. And you want to be sure that you have the confidence to hold on to the stocks in your portfolio if the going gets rough.
Think of this kind of analysis as insurance in what may remain a tough market for a while.
Jim Jubak is senior markets editor for MSN MoneyCentral. At time of publication, he was long American International Group, Broadvision, Global Marine, JDS Uniphase, LSI Logic, MCI WorldCom, RF Micro Devices and Texas Instruments, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
Rowland's Watch Portfolio