In the current slow- to no-growth economic environment, technology companies have a choice: Attack new markets with a flood of innovative products or cut costs. Depending on what path companies take, technology investors are left with four stock-picking options to consider. Option No. 1: Go with technology sectors that don't face a huge excess capacity overhang. According to Morgan Stanley, computer makers are running at only 61.8% of capacity, compared with nearly 85% during the tech boom years in the late 1990s. With demand expected to increase by only single digits this year, many technology companies won't be able to grow their way out of the slump. Many, but not all. Wondering why the much-maligned Internet group has outperformed the rest of the technology sector? Yes, many of these stocks were among the most heavily shorted in the market, and so they took off like rockets when the shorts were forced to buy shares to cover their positions. But stocks such as Yahoo! ( YHOO), up 53% year-to-date; eBay ( EBAY), up 40% in 2003; and Expedia ( EXPE), up 91%, aren't struggling with excess capacity. True, if the economy doesn't come through in the second half, Yahoo! won't pull in the huge increases in advertising revenue that Wall Street expects, but the company also doesn't face competitors that are cutting prices to keep factories running. In the case of a Yahoo! or an eBay or an Expedia, any pickup in unit sales will fall right to the bottom line. And these companies' business structures are leveraged so that increases in unit sales turn into bigger increases in revenue and even bigger jumps in profit. That's quite a contrast to the computer makers who could well see a 1% decline in revenue even with a 6% climb in unit sales. Option No. 2: Go with companies that have the ability to take market share from competitors while making a profit. That kind of attack can be especially lucrative if the company can go after the juiciest part of a competitor's business ... which is exactly what Dell Computer ( DELL) is doing to Hewlett-Packard ( HPQ) in the printer business. Dell recently launched the Dell A940 all-in-one printer. Priced at $109, after a $30 rebate, the machine combines an inkjet printer, scanner and copier. But the hardware is really just the foot in the door, because Dell knows that by far the most lucrative part of Hewlett-Packard's printer businesses isn't the printer itself but the supplies of ink and paper that a customer buys to keep the printer running. The A940 comes with software that automatically notifies the user when it's time to buy more ink and then lets the user click into Dell's online store to buy the needed supplies. Without any shipping or handling fees.
Any company, including Hewlett-Packard, is free to match that deal. But only Dell has the infrastructure to deliver at that price and make a profit. The threat to Hewlett-Packard is clear: Just about all of its profits in the last year have come from selling printers and printing supplies and just about half of printer revenue comes from the sale of supplies. (In the first quarter of 2003, $5.6 billion of Hewlett-Packard's total $18 billion in revenue came from the printer division, and $907 million of the company's total $1.2 billion in operating earnings were from that unit.) Option No. 3: Go with companies that are cutting costs in a lasting way. Letting go of workers that you'll have to rehire when business picks up or closing factories that you'll have to reopen certainly saves needed cash in the short run. But it doesn't make a company a leaner organization that will be able to sustain higher margins when revenue picks up. Creating lasting cost efficiencies is hard work -- and frankly, it's beyond many CEOs. But it's clearly not impossible. Cisco Systems ( CSCO) increased its gross margin to 71% in the most recent quarter from 64% in the same period a year ago. Net income was up 35% even though revenue fell by 4%. No magic here, just nitty-gritty changes: redesigning products so that they use more chips in common; or reorganizing the company to eliminate duplication in everything from design to customer service. The most impressive thing about Cisco efforts, to my mind, is that much of the effort on the engineering end hasn't yet shown up in products on the market. Cisco's margins should tick even higher when those products go on sale in 2005 and after. Option No. 4: Go with companies that are innovating around excess capacity -- but beware that the product cycle is shorter than ever. If a company is the only one with a new product on the market, it doesn't matter how much extra capacity competitors have available or how much they'd be willing to cut prices. For some period of time, they can't make the product, and they don't have any to sell at any price. The problem is that in an economy where the sector is using only 61.8% of its capacity, that period of exclusive ownership of a new product doesn't last very long. Competitors ramp up quickly, throwing whatever resources they have available at the problem. That reduces the glorious time of high margins that a first-to-market company can claim. Eventually, companies wind up in vicious technological cycles like the one Nvidia and ATI Technologies ( ATYT) are caught in now. Each quarter, one or the other produces a new, faster graphic processor, quickly outmoding the competitor's offering. Or where technology innovators are forced to constantly cannibalize their own market-leading product by turning it into a mass-market standard with higher mass-market volumes but, unfortunately, with lower mass market margins.
And the Winner Is... Which one of these four strategies will give an investor the most winners over the next year? A lot depends on which way the economy breaks. If the second-half recovery does materialize, still certainly a long way from certain, then I'd expect the Internet stocks of Option No. 1 to outperform along with the successful cost-cutters of Option No. 3. Both of those groups of stocks are highly leveraged to any uptick in revenue, and so even a modest recovery in demand should produce a much more than modest boost to the bottom line. The problem with stocks that represent these two options, however, is that they have already included some, perhaps much, of that increase in earnings in their recent price. In the Internet group, for example, eBay sells for 64 times projected 2004 earnings. And analysts are already projecting a 40% jump in 2004 earnings per share over 2003. Many of these stocks are now trading on price momentum -- and that leaves investors who buy at this point of uncertainty vulnerable if that better second half doesn't arrive. Many of the cost-cutting leaders have a similar problem. They trade at high multiples that reflect their continued popularity in investors' portfolios. Cisco, for example, trades at 26 times fiscal 2004 earnings per share -- and that assumes a 50% jump in earnings in fiscal 2003 over the year earlier. A disappointing second-half recovery would reduce the leverage that these companies could get out of their improved margins. And that could well lead to investor disappointment. The stocks of companies relying on taking market share or on technical innovation are less exposed to a second-half recovery for good and ill. They are less likely to disappoint since their fortunes aren't so reliant on the general economy. But on the other hand, they miss out on the upside leverage if the recovery is strong.
Stocks That Avoid the Either/Or Dilemma I'd prefer to go with the stocks of companies that draw their strength from more than one of these four strategies, preferably one strategy linked to a second-half recovery and one with more independence from economic trends. So I favor stocks of companies such as Xilinx ( XLNX) or Seagate Technology ( STX) that are cost-cutters and innovators. Xilinx's recent deal to partner with IBM to manufacture chips gives the company access to cutting-edge manufacturing that should drive down the price of its programmable chips. That's essential for keeping competitors such as Altera ( ALTR) at bay and also for preventing makers of application-specific chips from mounting a successful counterattack using price as their weapon. The company has also shown an ability to get a steady stream of new products to market on schedule and a willingness to cannibalize sales of once-marketing leading products in order to stay on top.
In the case of Seagate, the cost advantage was baked in when Silver Lake Partners and Texas Pacific Group took the company private in 2000 and restructured the business. Now that the company has emerged from that process, management seems determined to hold the line on costs. That, plus the company's ability to grab the lead in the hard drive's transition to a new, higher-density 80GB platform, gives the stock a place in two strategies. I'm adding Seagate Technology to Jubak's Picks with this column with a target price of $18 by September 2003.