Tech May Be a Wreck, But This Isn't 2001

I have been negative on Tech as a sector relative to the market as a whole, but I am no longer so. I shared my reasons over a year ago (too early), arguing that the strong balance sheets and high exposure to international sales were masking high valuation and significant but under-appreciated exposure to the consumer.  I noted that recessions had never been kind to tech stocks and this one wouldn't likely be different. 

2008 hasn't been kind at all to Tech, as it is actually the third worst sector year-to-date (after Financials and Materials), down almost 46% and trailing the S&P 500 by over 5%.  Most of the poor relative performance has actually taken place recently.  At the end of May, when the S&P 500 was down about 5% year-to-date, the Tech sector was down the same. 

I believe that the poor relative performance as the market has plunged has been a function of the sharp appreciation of the dollar as well as P/E ratio contraction in general.  I think that there is now a greater appreciation as well for how much more consumer-oriented the sector has become.  The major consolidation in the banking industry has also hurt many software firms.

Given how poorly Tech stocks did after the Internet Bubble popped, it isn't surprising to see a lot of wild predictions that Tech could end up declining 80% again.  I don't believe that to be the case at all, and those waiting for such price declines are likely to be disappointed. 

First, the post-2000 experience was a correction from insane prices, while in recent years, and certainly now, valuations aren't as extreme in absolute terms or relative to the market.  Second, the fundamentals aren't nearly as bad today as they were then.  You may recall the significant forward buying, double ordering and large up-front license payments that took place back then.  While demand today is weak and likely to remain so, companies aren't competing with their recent sales to the extent they were from 2001 through 2003.

I don't have exact data for how expensive Tech stocks were in 2000, but it is easy to go back and look at valuations today for leading companies compared to how they were valued then.  Of course, this omits the billions of market cap in companies that no longer exist except perhaps as minor fractions of their former valuations (Remember Nortel (NT), JDS Uniphase (JDSU), Lucent?). 

The table below compares the year-end 2000 forward P/E and trailing P/S ratios with those of year-end 2002 and today for the top 12 companies in Market Cap today (out of 76 total).  Only Google (GOOG) wasn't around then (can you imagine where it would have traded?), and each of these companies has a market cap in excess of $20 billion.  In total, these companies comprise 74% of the total value of the sector:

So, the largest Tech names are trading at 56% lower on a P/E basis and 39% lower on a P/S basis than they traded at the end of the last bear market.  While the P/E of 11.6X is a premium to the market's P/E of about 10X, I would argue that the group's highly superior balance sheets more than justifies this small additional price. 

I don't exactly trust the numbers to be precise, but I believe that on an Enterprise Value to EBITDA basis, the group is significantly lower than the S&P 500 in aggregate.  For those not familiar with this metric, it attempts to adjust for the presence of cash and debt to make a more accurate comparison across companies with different financial leverage. 

As I stated above, the fundamental situation for these companies is not nearly as dire as it was in 2000 and beyond.  Think back to all those boxes of testing equipment, routers and other devices.  In software, we have seen a major transition over the past few years away from up-front licenses to subscription models for many companies.  This should provide some cushion in the downturn. 

The table below (click to enlarge) lists all of the S&P 500 Tech companies that have inventory and ranks them on it relative to sales.  You will note that most of the large companies (the ones with green highlighting) have relatively low inventory exposure.  You may also note that it is relatively lower than earlier this decade as well.  I am not suggesting that there aren't some problems and that most of these companies won't be facing earnings pressure, but I do believe, especially for the largest companies, that a lot of this appears to be priced in.

You may also note that these stocks as a group, like the large ones as I demonstrated above, are trading at steep discounts to their median valuations over the past 5 or 10 years.  I recognize that it can be a challenging game to figure out when a group has discounted the bad news and fully expect the next 6 to 12 months to be ugly, but I am warming up to the sector.  For those interested in considering the group, I would recommend the following:

• Pay close attention to Inventory
• Pay even closer attention to Debt 
• Favor Enterprise vs. Consumer exposure
• Bigger is probably better

Disclosure:  Long CSCO and NTAP

Comments

[Dr. O:]

Nice number crunching. However, how much will sales and earnings decline next year? No one knows just yet. How much hardware and software will Lehman Brothers be ordering? Bear Sterns? Fannie Mae? GM? The unemployed millions?

2008 Nov 16 06:36 PM

[investor88:]

Agree caution expressed by Dr O in spite of apparently good valuations currently.

2008 Nov 16 06:43 PM

[Alan Brochs...:]

Thanks, Dr. O. I surely appreciate your point and believe it is mainly priced in, but, as you say "no one knows", certainly not me. An interesting aspect of technology is that it theoretically allows a company to "do more with less". To that extent, tech companies might surprise us.

2008 Nov 16 07:49 PM

[Steven Hansen:]

alan, if you wanted some more comments you should have incorporated GM and F into your analysis. (joke, not funny)

leading into 2000, tech was an emerging industry which normally means high p/s and p/e. now they are a more mature industry with lower p/s and p/e. this does not make them good buys yet. this industry is still maturing, and there will be more shake-outs.

but i love this kind of analysis. thank you for the work.

2008 Nov 17 12:16 AM

[Alan Brochs...:]

The hand, thanks for your comments. You make an excellent point - the industry is more mature indeed. I think it is a pretty bad industry quite frankly - way too much competition in many segments (semiconductors come to mind). I have just started warming up, having maintained zero or relatively low exposure for the past 15 months. One of the nice things about a recession is that it eliminates some of the weaker competitors, a process that allows the "survivors" to capture more share when the market resumes its growth. While I question the innovation at MSFT, many of the others in the large-cap Tech space will no doubt be selling things tomorrow that are quite different from today.

2008 Nov 17 08:22 AM

[tipalia:]

Hi Alan, great work ,a lot of anticipation in your work and people with a vision like you usually succeed. It s no good to be too aggressive but not being aggressive enough coud be missed opportunities. What about YHOO
in anticipation of a takeover by MSFT? Do you think it could still happen? and if it does it should be at a nice premium isn t it? Many thanks for taking the time to answer to the questions of the small investors like me.

2008 Nov 17 09:52 AM

[Alan Brochs...:]

Thanks User 138602. I don't have an opinion on YHOO that is informed at all. I surely wouldn't want to own it if success depends upon being acquired. By many metrics (beyond PE), the stock looks very inexpensive, not surprisingly.

2008 Nov 17 10:27 AM

[mollytjm:]

and...APPL has an extra cushion that extends profits because of the kick-back arrangement with AT & T for it's iPhone. And..they have profitable retail space just for their brand. those stores are still heavily frequented, even when malls are slow, leading one to expect a lot of pent up demand that will manifest in holiday sales.
in addition, purchases from the itunes and apps stores are enormous and growing. these are relatively inexpensive items so once the initial product (ipod, computer, iphone) is purchased, it doesn't seem like much of an expense to 'shop the stores'.
It'll be after Christmas that will tell more of a story. The top well funded players will survive nicely...i think the others will be in trouble.

2008 Nov 17 11:05 AM

[brewer:]

Apple is stealing Microsoft's bacon. 'Enterprise' has gone Mac already, it's just not hit the CW yet. Just wait for the next earnings release.

There is a pattern with Apple products. Everyone on the 'street' dismisses them universally, until they become phenomena. Then the 'street' questions if they can ever come up with another mac/ipod/iphone, etc... Then the next game changer comes out and the cycle repeats itself. Eventually attitudes change, but that change is glacial.

iPhone has totally redefined the 'smart' phone as we know it. Same as the Mac did to the old fashioned DOS based computer, same as the iPod did to mere 'MP3 players'.

2008 Nov 17 02:56 PM

[Jason Rines...:]

You got it Brewer, it's called a Tipping Point. Apple relies on outside developers for a large portion of it's digital content such as games and apps. They have shrewdly harnassed a global online collective at minimal cost. On another article here someone else pointed out that MSTF may face competition from Google on OS. Also, outsider developer strategy or what some refer as open source strategy. The trend is established and has proven successful thus far, no doubt about it. Come to think of it, IBM does a lot of this as well.

2008 Nov 17 05:05 PM

[Tom Armistead:]

Good article, I have been getting into some tech lately, attracted by the balance sheets which have a tendancy to be fairly strong. It is reassuring to see some numerical confirmation that it is not sky high like it was at the end of the bubble.

Some articles have suggested that tech never really bottomed after the bubble burst, but maybe now it has.

2008 Dec 20 06:04 PM