Investing
What's Wrong With Tech?
By Jim Jubak
MSN Money Markets Editor
2/22/2006 7:05 AM EST
It's not impossible for the stock market as a whole to go up if technology stocks don't. But it sure is hard for a short-term stock rally to turn into an honest-to-goodness bull market without the sector of Cisco (CSCO:Nasdaq), Intel (INTC:Nasdaq) and Microsoft (MSFT:Nasdaq) leading the way. That's especially true if the financial sector, that other great bull-market leader, is struggling under the weight of more-than-expected interest rate increases from the Federal Reserve.
So even if you don't own a single technology share, you'll want to know the odds that technology stocks will get it together and take on the role of bull-market leader that the sector so often assumed in the 1990s.
Here are two possible outcomes:
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If tech stocks do lead the market, the pattern -- if not the absolute magnitude of the gains -- will look like 2003, when the technology-heavy Nasdaq Composite returned 50% and the Standard & Poor's 500 Index returned 26.4%.
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If tech stocks continue to show only periods of modest gains separated by steep declines, then 2006 will look like a replay of 2004 or 2005, when the Nasdaq returned 8.6% and 1.4%, respectively, compared with 31.8% and 47% for the Philadelphia Oil Service Sector Index (OSX). (The S&P 500 returned 9% and 3%, respectively.)
Unfortunately, the odds of technology stocks continuing to struggle in 2006 are pretty high. If that's true, investors such as you and I need to search for the sectors or sector that will outperform the market if we're looking for anything more than modest returns.
Analyzing why technology stocks are likely to struggle again in 2006 also suggests a strategy for the years ahead. I'll follow up what is a fairly pessimistic analysis of the near-term prospects for the sector with, in my next column, a way to patiently invest now for the better returns that are due closer to the end of the decade. And I'll give you three stock picks for doing just that.
Maturation, Stagnation
So what's the matter with technology stocks?
The conventional analysis fingers two culprits:
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The technology sector has matured, and sales and revenue growth have slowed.
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Even after the huge selloff in the sector that began in March 2000 and ran through the first part of 2003, technology stocks are still overvalued, especially in light of the slowdown in sales and earnings growth.
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Dell (DELL:Nasdaq), which reported earnings on Feb. 16, is a good example of both problems.
The company managed to beat Wall Street earnings estimates of 41 cents a share by 2 cents. Earnings grew by 16% year over year.
But the positive earnings surprise didn't survive even the usual cursory Wall Street analysis. A lower-than-expected tax rate -- the result of more of Dell's sales taking place in lower-tax countries -- was responsible for a penny of the surprise. And 2 to 3 percentage points of the company's growth resulted from the 2006 quarter running a week longer than the 2005 period.
And the earnings report turned positively gruesome when Dell started to talk about the rest of 2006. The current quarter, Dell CEO Kevin Rollins said, would show revenue growth of just 6% to 9%. That's big bad news at a company that grew revenue by 18%, 21% and 16%, respectively, in comparable quarters in 2003, 2004 and 2005. Earnings, the company projected, would be 39 cents to 41 cents for the quarter, flat with the January quarter and only 5.4% to 10.8% ahead of earnings for the April 2005 first quarter.
If growth in revenue and earnings is slowing to a single-digit pace, then Dell's shares at $30.38 aren't exactly cheap, even if they are down from a high of almost $42 in July 2005. After a decline of almost 28% from that date, the shares are still trading at 23.6 times trailing 12-month earnings per share.
That's certainly not a bargain price if Dell is growing earnings at 12%, as Wall Street now projects for fiscal 2007 -- or maybe less if the downturn projected by the company for the April quarter lasts longer than just a quarter.
OK, that's the conventional explanation of why technology stocks can't get a rally going. Earnings growth in these mature businesses is too low, and the stock price is still too high -- given that slower growth.
Amazon, Disrupted
But I've got a third culprit to blame. In the technology cycle, there are periods of upheaval when new disruptive technologies emerge to destroy the profitability -- and sometimes the very existence -- of established businesses. And then there are alternating periods of consolidation when companies emerge from the competitive scramble to take commanding leads in specific technology sectors, often at the expense of past leaders.
The huge technology profits of the late 1980s and the 1990s were the result of the consolidation after a competitive scramble. Today's big technology names -- Cisco, Intel, Microsoft, etc. -- came out of that competitive scramble with control of key and very profitable parts of the new technologies.
I'd argue that today we're in the disruptive phase of the cycle. The positions of mature technology companies are under assault from new upstarts or from established technology companies that have decided they have no intention of being the IBM (IBM:NYSE), the Eastman Kodak (EK:NYSE), the Compaq Computer, or the Xerox (XRX:NYSE) of the next wave of disruptive technologies.
Disruptive technologies are now reshaping the technology sector. Let me pick one to show you how a disruptive technology works.
The technology in this case is the Internet music download most brilliantly exemplified in Apple Computer's (AAPL:Nasdaq) iPod. The business it's disrupting is that of Amazon.com (AMZN:Nasdaq) and other Internet retailers that now sell CDs through their Internet stores.
Amazon is currently in the advanced stages of negotiation with four music companies -- Universal Music Group, Sony BMG, Warner Music Group and EMI Group -- to set up a music download store to compete with Apple Computer's iTunes, and a spring launch is scheduled.
Amazon is also rumored to be planning to sell its own branded MP3 player that would come preloaded with music selected by Amazon.com on the basis of the customer's prior purchases from Amazon.com. That would launch -- if it is more than a deliberate piece of misdirection intended to unsettle Apple -- in September. (Apple has a tiny head start, with 42 million iPods already sold.)
So why would Amazon go to all the trouble of negotiating with the notoriously difficult music industry and of launching hardware that would compete with the MP3 players it already sells online? Because the company sees the potential for online music downloads -- and the quickly following online video download -- to erode the most profitable parts of its business, the online sale of prerecorded CDs and DVDs.
In the U.S., sales of prerecorded CDs have fallen 21% since 2000, according to Nielsen SoundScan, and dropped 7.2% in 2005 alone. In contrast, 353 million songs were downloaded online last year onto iPods and MP3 players, up 153% from a year earlier.
If Amazon doesn't do something, the online download technologies for music and video will gobble up its CD and DVD business.
But investors in Amazon don't have to worry about the possibility that Amazon will lose out to the disruptive technology. Even if the company does manage to defend its turf, it will have to spend more money to do so. That means lower earnings, and lower earnings mean a lower stock price.
When Amazon announced its fourth-quarter 2005 earnings, it reported that fourth-quarter spending on technology and content -- money spent to improve customer service, offer new products and fend off competitors -- climbed to 4.4% of sales. That was 1.2 percentage points higher than in the fourth quarter of 2004. And that certainly contributed to the drop in profit margins to 6.6% in 2005 from 7% in the fourth quarter of 2004. Amazon's projected range for its profit margin in 2006: 5.1% to 6.2%.
In periods of technology consolidation, earnings growth trends get more certain, and earnings themselves grow faster as clear technology leaders emerge from the fray. In some areas, a single company -- Cisco Systems, Intel and Microsoft come to mind -- manages to corral the majority of the profits as a technology matures.
In periods of disruption, earnings growth trends get less certain. What growth rate should investors count on from Dell or Amazon over the next couple of years? And that makes earnings less valuable. Investors pay less -- a lower multiple of earnings per share -- when earnings are less predictable.
And in periods of disruption, earnings growth rates actually fall as companies either lose to disruptive competitors or are forced, as Amazon now is, to spend more to fend off the challenge of disruptive technologies.
The one big surprise in all of this to me is that we didn't get a longer period of consolidation out of the Internet technologies. eBay (EBAY:Nasdaq) and Yahoo! (YHOO:Nasdaq), two of the most successful companies to emerge from the Internet generation, didn't get much chance to rest on their leadership positions before the disruptive Google (GOOG:Nasdaq) emerged.
I don't know whether the consolidation period for the Internet technologies was so short because of something about the technology itself -- low barriers to entry by new competitors seem to be part of the character of the technology -- or because of the way the crash of 2000 interrupted the revenue growth curve so that many companies didn't mature before the next wave of disruptive technologies emerged.
But we are back in the disruptive phase of the technology cycle.
At the time of publication, Jim Jubak owned or controlled shares of Microsoft and Yahoo! He does not own short positions in any stock mentioned in this column.
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