Sector Investing

[Don Wennerstrom]

Here is an interesting article by Bill Fleckenstein

http://moneycentral.msn.com/content/P57009.asp?Rating=10&PageID=57009#Rating

Tech stocks: real risk, unreal prices
advertisement
Don't listen to the analysts who say rising stocks are sure to go higher. The risk of falling is greater, because unrealistic expectations are all that keep them up.

By Bill Fleckenstein

Thank goodness for info-tech experts who speak the truth. Without their testimony about the stark state of IT spending, who'd provide a reality check against truth-averse "analysts"? The latter reach resolutely into thin air for reasons we should buy tech stocks. It's the height of arrogance to try to pass off arm-waving as analysis. But true to form, that's what one dead fish did recently, the better to get folks excited about semiconductor-equipment maker KLA-Tencor.

Dead fish and a chip-equipment stock
Let's talk about KLA-Tencor (KLAC, news, msgs), not just because I am short the stock, but because it exemplifies the silliness rife within the dead-fish community. For those who have not checked “A Guide to Fleckisms," a brief word on how I came up with this label: In the mania, I first started calling "analysts" cheerleaders, but then I realized this was way too charitable, not to mention insulting to the cheerleading community. I then started to call them whores, but realized that was also an insult to the world's oldest profession. Finally, I came up with "dead fish," to get the flavor of basically inanimate objects that float with the prevailing current, while stinking, rotting and decaying over time.
Money 2004.
Smarter, faster and easier
than ever.


A magnificent specimen hails from a rather large dead-fish house that shall remain anonymous (though one of the names in its compound form bears a striking resemblance to a beloved children's character), and his recent report on KLA-Tencor is a fine example of dead fish on parade.

A few comments on KLA-Tencor itself: This is a wildly expensive semiconductor-equipment stock. The company sells capital equipment to a capital-intensive industry that has a fair amount of excess capacity at the moment (notwithstanding recent comments from Taiwan Semiconductor's (TSM, news, msgs) CEO, Morris Chang). For proof, look no further than all the semiconductor fabricators trading for pennies on the dollar. KLA-Tencor is not exactly what one would think of as an early-cycle stock, and one could see how it might be quite a cyclical business, because this is, in fact, the case.

KLA-Tencor’s earnings don’t justify the price
Right now, KLA-Tencor trades for about $52, which of course means nothing if we don't talk about its earnings. In the boom year 2000, the company made roughly $1.30 a share. I say "roughly," because when you get into all the ex-expense kind of numbers, it's really hard to tell what anybody really made. In its best year, the company did $1.85. So it’s now selling at about 28 times the best year it ever had. Now, I would argue that 2000 and 2001 (the company has a June fiscal year, which is why 2001 creeps into the picture) were years never to be seen again for many technology industries. That will be clear when we get to our next subject, as well.

Stepping back to 1999, an OK year for technology and the economy, KLA-Tencor made 37 cents. In 2002 and 2003, the company made more money than I would have expected, but it's because the massive excess capacity has continued to build up as chip companies attempt to spend their way through the downturn. So, to pay 28 times the best year a company is likely to ever have had seems a bit dangerous to me. Of course, if one wanted to do the math, the stock is now selling at 142 times its 1999 earnings.

Now, KLA-Tencor happens to be a very fine company. As a young, green stockbroker, I bought the stock when it first came public around 1980. In the past, I had money in several of the company's R&D partnerships. So, contrary to what some hate-mailers may think, I am not a Luddite. But all things have their price, and KLA-Tencor's is particularly risky. It’s not alone in this department.

Sleaze of a price-target tease
Back to the impetus for this lengthy diatribe -- the rot in our dead fish's report. “Estimates revised down to reflect our conservative (my emphasis) industry-growth forecast." Now another reason he may have lowered his forecast is because the company lowered its expected growth for next quarter. All of these tech companies have hockey sticks in Q3 and Q4 and into next year, because those numbers were set at a time when managements needed to set estimates like that to justify the stock prices. That's why the second half is so fraught with risk: Folks have expectations going up radically, when it looks like things are not getting better and maybe actually be worsening in certain areas.

However, I am getting to the summation. First, more rot: "Revising price targets from $42 to $58 reflects a combination of fair price-to-CY05-book value of 4.4 times (CY referring to "calendar year)." Here's a classic case of what we used to see in the mania -- taking numbers down and raising the price target. I picked this one today because it's particularly timely, but a lot of this "analysis" has been going on for quite a while now.

It is absolutely outrageous what has continued to go on in the dead-fish community, in light of what has happened. They have done nothing more than react to rising prices and become more bullish as stock prices have gone up, even though as stock prices rise, the risks get larger, not smaller. These guys should all be required to buy every stock they recommend. That'll make them a little more careful … or broke.

Upending the IT-spending myth
I have often quoted a fellow who was in charge of information technology spending at one of America’s largest companies that has been one of the biggest consumers of IT. He recently took a job with a huge government agency that also consumes an enormous amount of IT. In a recent e-mail, he tried to expose some of the lunacy pervasive in the dead-fish community by articulating what takes place in the real world.

"Although I now work in the government IT sector, I have had some interesting meetings with colleagues and vendor reps, as many people I know work in government IT now, and hordes of vendor reps descend on these multibillion-dollar government contracts. I have had some informal talks with people on a few topics; thought I'd share. …

"One concerns the idea about companies' intention to spend and what that means for the second half. People do not understand quite what being a CIO/IT manager is. Having the intention to spend does not mean we are going to spend. It just means we would like to requisition additional funding so that we can take on additional projects. It does not mean a bottom in spending, because intentions cannot get translated into spending unless we go through the funding increase process.

"Another idea is on the IT employment issue. It has certainly been a major issue that has just started to gain attention, and it is certainly a topic that is well discussed by many of us in the industry as a potentially devastating trend. First, what I would tell anyone in IT who frets about this trend, as I see from e-mailers, is get a job in government IT. There is no outsourcing risk in government work; the Department of Defense or Treasury or other government agencies will not be pushing any work out to India or China; they can't. In corporate IT, though, that is the prevailing trend for the future, and nothing (lowering visa quotas, laws, etc.) will stop it.

"A huge side effect, though, that people do not seem to talk about is the after-effects of this cost-cutting. People consistently focus on cut costs as one of the reasons that earnings will gain leverage once demand picks up. Tech workers have some of the highest incomes in the U.S. And as those incomes erode due to cost cutting/outsourcing, I think it becomes a major factor in the so-called consumer-spending recovery. I have read with interest your ideas on how individuals have driven some of the consumer-spending cycle through home refinancing. This allows them to maintain their lifestyle.

"Well, in info-tech, that is certainly the case. And its effects are hard to quantify, because I know few if any in the tech industry who feel they are moving forward in terms of salary. Yet repeatedly I find people who are trying to hold onto pre-bubble-popping lifestyles. I think as job loss from the outsourcing picks up (it has only scratched the surface), this invariably has some effect on the economy. All this bothers no one, of course, because I believe they are extrapolating a virtuous cycle to everything and everyone.

"I think two factors people keep forgetting, though, are: No. 1, we just went through a bubble that was heavily concentrated in IT. Tax cuts, low rates, more money supply, mergers, etc. have no effect on IT spending. None. Give me 0% or 30% rates; it does not matter. Any IT manager worth his salt is not going to ask company management to borrow money to spend on IT unless ROI outweighs the interest rate. Tax cuts; great, helps in depreciation. But we can depreciate slower because info technology maintains its usefulness longer. Money supply; just shows up in the tech stocks, not budgets. Mergers; as stock prices rise, the old ego effect I talk about in tech takes hold; why merge if the market feels you will survive? And why merge when the job market is simply not strong enough to support a new tech worker influx?"

They don’t have to spend it
"No. 2," the e-mail continues, "just because companies make more money does not mean they have to spend it. Even if industries that spend on info-tech increase earnings, I see no signs whatsoever that they are hard up to spend that money on new productivity-enhancing tools. One of the main cost-cutting measures they used to increase those profits was cutting info-tech spending; why would it be increased without need? …

advertisement
"Info tech is a tool, in the end, to increase productivity, through data management, faster processing, etc. … And right now, we have more than enough. PC replacement cycles are and never have existed like Wall Street imagines (the emphasis is mine). … That's the part I cannot understand. We basically are telegraphing our intention not to increase IT spending regardless of profits, due to the fact that we do not NEED new equipment (we are already productive).

"Yet no one listens. They think a profit recovery leads to an IT spending recovery. They think that things are looking great in tech because the stocks look great. They do not care about the fact that the bubble we went through was largely centered in IT spending. Despite the fact that IT spending is not coming back (again, understand intentions vs. spending), it's automatically extrapolated and assumed that things are going to grow, that we suddenly will just increase our budgets.

"And when I speak of 'they' (Wall Street) and 'we' (IT departments), I make generalized statements, because I know from industry trends that these are the general views of most who work in the industry. Things have stabilized; yes, they have, and it's undeniable. But stop extrapolating stabilization with growth. Again, it's not that we do not have the money to spend. It's that we do not need or want to spend it.“