It's a Prime Time for Tech Turnarounds

It has been a very long time since I wrote a column recommending stocks. Too long. But you know my investment process by now: Look for stocks that are down a lot, cheap and have decent fundamentals. Unfortunately, very few have hit my buy screen for quite some time. I rarely violate that process, and it has kept me silent.

But now things have changed. The "new bull market" ads have disappeared and cavalier forecasts of 30% returns have evaporated. The talking heads have tempered their enthusiasm. The tech stock bullies' chest-thumping on national TV has been replaced with fidgety defenses of their positions. Wall Street analysts slash ratings and stock targets, and jockey over the most bearish call on the tech cycle. And this is good.

For the first time in over a year, I can recommend shares that fit my investment discipline. The frustrating churning of the equity markets has generated solid opportunities in a few sectors: financials, technology, consumer goods and health care.

With an economy in recovery and still-healthy profit growth, I am particularly interested in economically sensitive technology turnaround situations. I believe more stock price leverage exists in this sector than conventional industrial and raw material stocks, which already discount much of the recovery. Here is my primer for turnaround investing.

The Turnaround Challenge

For many investors, one of the most frustrating investment concepts is handling a company's stock in a turnaround situation. Distressed fundamental situations often get much cheaper and take longer to resolve than investors anticipate. But once the market acknowledges a turnaround situation in progress, the shares become and remain expensive, well ahead of the actual turnaround process. As challenging and irritating as turnarounds can be, they can also be very lucrative.

Let's take Tyco ( TYC) as an example. Tyco's well-documented management and fundamental problems surfaced in 2002. The shares plunged from the $60s to under $10 in by June of that year as profits dropped some 50%. The stock traded in a single-digit price-to-earnings ratio and was universally despised, especially by the shorts who maintained an active journal of the company's misdeeds and potential failure. Clearly the stock got much cheaper than many value investors expected it to.

Nine months, a new management and a restructured balance sheet later, the stock could still be purchased for under $13. Tyco had always been a solid collection of decent businesses, but now the balance sheet and management issues had been resolved.

Why didn't the investment community get it? As one of few vocal longs, I was annoyed and frustrated by the market's unwillingness to recognize the improvements. I still had to wait, but not that long.

By the second half of 2003, the market started catching on. Despite an ever-lowered earnings forecast for that year, the stock surged to $25. At that point one could have made the case that Tyco was fully priced. Many value investors, myself included, pitched the shares on a valuation basis.

The stock has risen another 23% this year and continues to gain sell-side sponsorship on a regular basis. A company promoted by the shorts as worthless 18 months ago now sports a P/E of 20 and a $65 billion market cap. So much for cheap. My guess is that many Tyco players, both longs and shorts, got a healthy dose of frustration on this trade.

Be Skeptical

What actually happens to many stocks in this situation? We believe that company managements and analysts' published reports tend to underestimate changes in fundamental conditions, both positively and negatively. When things turn sour, corporate managements often deny the true scope of the problem. With bad managements, they may even be the problem. Analysts tend to give their companies the benefit of the doubt. It is only after the problems are severely obvious that the official party line finally changes.

Investors, however, have long recognized that the fundamentals swing more rapidly. Therefore, they tend to factor a worst-case scenario into share prices as the problems develop. They place little emphasis on the party line or Wall Street forecasts.

Once the fundamental issues have been corrected, they acknowledge normalized earnings power much faster than just-burned management or sell-side analysts. Investors realize that the "growth" of a successful turnaround is much higher and more visible than conventional growth. Growth and momentum investors place a premium valuation in highly visible recovery stories and keep the stocks ahead of the fundamentals.

Value investors would do themselves some good by understanding the dynamics of the turnaround situation. Stocks in deteriorating fundamental situations often get much cheaper than a rational view of normalized profits would suggest. And when a fundamental recovery is nascent, the stock recovery will not be. After reacquainting myself with the turnaround conundrum of too cheap, too long and then too expensive, I will offer some of my firm's portfolio's more interesting turnaround situations.

Real Examples

Motorola ( MOT), currently the subject of a hedgie bear raid, seems to present an interesting opportunity. After two quarters of strong revenue and profit gains, the market seems to doubt the staying power of this turnaround.

But adjusting for its semiconductor spinout Freescale ( FSL), the stock trades for roughly $13.50. If Motorola continues progressing towards its 15% handset and corporate operating margin goals, the company could earn $1 per share in 2005. With double-digit revenue and earnings per share growth in store for next year, the shares should command a higher "turnaround" multiple. Why not the same 20 P/E multiple Tyco sports today?

Solectron ( SLR) is another turnaround position my firm has established in its portfolio. The current $5 price seems expensive for a fiscal 2005 consensus EPS estimate of 26 cents untaxed. Here the market is in a normal turnaround valuation mode.

My firm's estimate of "normalized" fully taxed profits, assuming 15% revenue growth over the next 2 years, is 50 cents per share. That run rate could be hit in six quarters. A prominent Wall Street firm recently reiterated its $10 price target on the stock over the next year. It would not surprise me to see the stock go from the outhouse to the penthouse in that short time.

MRV Communications ( MRVC) has been unprofitable for so long, who knows what the stock will do when the company achieves GAAP profitability in 2005. The company is a leading manufacturer of optical systems and components and should benefit handsomely if and when the major telcos ever build out their FTTP (fiber to the premises) systems.

The telcos have no choice but to replace their twisted pair "pipe" for an optical one or face complete obsolescence by the cable companies. At current prices, the shares trade for 70% enterprise value to 2005 estimated revenue. Most of their competitors trade for multiples of 2 to 5.

Finally, the sell side appears to be underestimating the recovery earnings potential in Asyst Technologies ( ASYT). This leading maker of semiconductor and flat-panel display capital equipment trades for a true turnaround multiple of 20 times fiscal 2005 consensus earnings estimates, although these estimates are too low. However, the company should approach its $1 per share normalized profit run rate in the next three or four quarters.

The stock would have a decent run when the Street sees sustainable improvement in the company's margin structure. The company trades for around 50% of run-rate revenue but has hit 200% in each of the last 10 years. Even adjusting for a business shift mix, a trade to 1.2 to 1.5 times would represent a double in the shares from today's depressed levels.

Naturally, these turnaround ideas require a healthy economy and continued traction in the recovery for capital spending to come to complete fruition. But if past is prologue, don't expect to purchase turnarounds cheaply on a reported P/E basis. By the time a recovery is well established, the peak in the stock may have already occurred. That first big dip may represent another trading opportunity, but the profit-taking panic is gist for another column. Stay tuned.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider MRV Communications and Asyst Technologies to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Marcin was long Motorola, Solectron, MRV Communications and Asyst Technologies, although positions may change at any time.

Robert Marcin is the founder and general partner of Defiance Asset Management. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to robert.marcin@thestreet.com.

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