To understand the dilemma facing investors after a 22% rise in the Nasdaq Composite this year, consider the manic-depressive trading of network-management software maker Micromuse ( MUSE).

In October last year, the market seemed to believe Micromuse was going out of business. Shares that had traded as high as $108 in 2000 had fallen to $1.37, valuing the company for less than its stash of cash.

Now, nine months later, feeling more buoyant as the decline in corporate technology spending has appeared to flatten out, investors have pushed the company's market value up sevenfold, to around $10.

So were investors more right about Micromuse at $108, at $1.37, or now, near $10? And what does trading in the stock augur for its peers among high-flying technology stocks, if anything?

The answer is critical, at a time when stocks appear ready to take a breather.

Among experts signaling for a timeout is Mr. P, a veteran hedge fund manager who has anonymously made accurate market-timing calls in this column over the past three years. Regular readers will recall he became a raging bull last October after a two-year bout of bearishness, and he reiterated his positive view on equities in February, March and April. (His billion-dollar fund, available only to offshore financial institutions, is up about 35% this year, after a 100% advance last year.) But he called this week to say he's finally pulling some chips off the table.

Mr. P expects a correction, starting between now and June 17, that could potentially take the broad averages down as much as 20%, or to their March lows. "I'm taking profits, because I'm up and I'm not stupid," he said. "The market has moved a long way in a short time. We're still constructive on stocks, but not as much as three months ago."

If bulls like Mr. P pull in their horns a bit, the tempting whiff of 1999, that has intoxicated traders in momentum stocks like Micromuse in recent weeks, could take on a very nasty new smell. Like napalm. Chartists and market semioticians will note that the S&P 500 index, a key market bellwether, rose to the semi-magical 1,000 level on Friday for the first time since last June, then backed off. They might also observe that S&P 1,000 was the level from which stocks broke out from the decline precipitated by the Sept. 11 terror attacks. For the Nasdaq, the equivalent number is 1,640 -- around the current level. If the smart money wants to step back and consolidate gains, this would seem to be a convenient crossroads at which to loiter.

Poised for a Pullback

Investors pausing to reflect soberly on Micromuse could well conclude that its recent hot streak owes more to the general swoosh of enthusiasm for technology stocks than to individual merit. To be sure, the company in March announced a new multimillion-dollar contract for its Netcool suite of products with the U.S. Navy -- an undeniably positive deal that cemented its relationships with lead military contractors Electronic Data Systems ( EDS) and Cisco Systems ( CSCO). But the announcement also highlighted the extent to which the company relies on making a handful of large deals every quarter, rather than signing a lot of smaller deals with a wide variety of clients.

Bulls in the stock point to sequential growth of the company over the past half-year and insist that quarter-over-quarter growth is the correct metric to watch now. But bears persuasively point out that the company has, more broadly, recorded three consecutive years of declining revenue. Micromuse has only recently stabilized its business, in other words, putting it in the early stages of proving that it will even be around three years from now. And yet, it trades for a forward price-to-earnings multiple of around 60, the sort of valuation given to the most stable high-growth companies.

Nitsan Hargil, senior technology analyst at Friedman Billings Ramsey, notes that if the company were to reverse its decline in annual revenue and suddenly double its earnings per share over the next two years, it would still trade at a rather lofty price-to-earnings multiple of around 30. That means a lot of positive conjecture is required to justify the current price at a time when even the most optimistic analysts of the information technology industry suggest that, at best, the market for network-management software is stabilizing -- but surely is not improving.

"Normally we don't pay much for companies that are moving in the wrong direction," said Hargil. "A company that is not growing should not trade at a P/E of 30." The company reported $212 million revenue in fiscal 2001, $139 million in fiscal 2002 and is on track to deliver $118 million in 2003.

Hargil has a $5 target for the stock, which he considers a "very healthy valuation." As for why other analysts, not to mention the market, have a different view, he says: "The reality is that analyst estimates are being dragged along by the craziness of the Street. Some analysts are raising their price targets not because they think the value is higher, but because they see the Street taking the stock price higher and don't want to look like idiots to their company's stock brokers."

Micromuse's major problem is common to other software and hardware companies that rely on sales to telecommunications carriers: It has as many as 100 aggressive competitors, all of whom are focused on driving prices down in a relatively small niche. And at the same time, investment in network management, about a $3 billion market, is not a high priority for chief technology officers today, according to industry surveys. "It is one of the worst sectors known to mankind," says Hargil. "Stagnant is too aggressive a word. It's the opposite of robust. It's dead. You generally already have one of these things running, so there's no need to buy more."

Riding the Tech-Stock Wave

Richard J. Sherman, an analyst at Janney Montgomery Scott, says Micromuse has benefited in part this year from the simple fact that many mutual funds came into 2003 underweight technology and felt obligated to rapidly achieve a market weighting as stocks advanced from the March low. As a leader in the network-management space, Micromuse shares became a buy simply on the basis of internal market mechanics. Also, he believes the company has benefited by the increase in optimism -- fueled by sparse evidence -- that telecommunications carriers will boost their spending in the fourth quarter of the year.

Sherman upgraded the stock at $6.30 but downgraded it last week at $9.50, as he sees little room for improvement either from economic optimism, mutual fund reweighting or a lift in the perception of the value of the company itself. A good software stock, he said, should trade at six times revenue -- and that's exactly where Micromuse is today, with a price-to-sales multiple of 5.97. To rise from here, the company would need to show steady annual revenue growth of 20% to 25% and operating margins of 25%, neither of which is on the horizon.

Meanwhile, Micromuse is being nipped at the heels by small, voraciously hungry private competitors such as Singlestep Technologies. Last week, I attended an investor briefing by Singlestep Chief Executive Chris Noble in the company's Spartan offices, on the second floor of a downtown Seattle office building that has seen better days. Noble said that his software, which acts as a manager of other network-management software, could be installed in a day on top of existing infrastructure software.

Similar systems from Micromuse, Hewlett-Packard ( HPQ) and IBM ( IBM) require customers to rip out their current investments and commit to a six-month rebuild. Already, Noble said, his company has sold its Unity suite to Alaska Airlines ( ALK), Shurgard Storage Centers ( SHU) and others. Cost savings vs. Micromuse, he says, amount to hundreds of thousands of dollars. In a world where budgets are shrinking, not expanding, threats from battle-tested entrepreneurs like Noble are not just meaningful, they are life and death, if they steal away just one or two potential deals a month.

It seems clear that much of the move from the market's lows to the present reflects the erasure of fear that companies like Micromuse would disappear from the face of the Earth. But from here on, companies must prove to investors that they are not just alive, but also prepared to thrive and grow in a hyper-competitive, winner-take-all, profit-deflating environment. Until evidence is more persuasive -- perhaps with the announcement of another quarter of great growth and realistically optimistic comments about the future -- then all but the mostly wildly speculative stocks are likely to stall for a while around the current level.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund was neither long nor short any stock mentioned in this column, but positions can change at any time.

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