Tech Stocks Provide Safe Haven in Downturn

The Dow continues its downward spiral. The financial, housing, and retail sectors are in the tank. Even high-flying oil, gold, and agriculture stocks have been pounded in recent weeks.

A few commentators have started comparing the commodity correction to the tech crash of 2001. That’s an overstatement. The declines are not vertical and there will be a time to reinvest in commodities.

For now though we’ve got one safe haven that has held up through it all: the tech sector.

The smart money is beginning to flow out of energy into tech.

Investors are just starting to catch on and there are some hefty gains to be had. Not in spite of the recession, but because of the recession. Let me explain.

Businesses are laying off workers. U.S. unemployment is up seven months in a row. Real average weekly earnings (inflation adjusted) fell 0.8 percent in July.

It’s time for some corporate belt-tightening. Everyone has to cut costs. And it’s tech to the rescue.

A lot has changed in a decade. In 2001 the tech sector was cluttered with public companies centered on dull-witted ideas. Seven years later, the technology sector is all grown up.

All of the things that the Internet was going to be, it has become.  The tech sector is now fat with increasing earnings and swelling operating margins.   And it’s starting to pay off for shareholders.

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Take a look at the Morgan Stanley High Technology 35 Index. The index is made up of tech giants like Cisco (NASDAQ:CSCO), IBM (NYSE:IBM), Dell (NASDAQ:DELL) and smaller business service providers like CA Inc (NYSE:CA). The index is full of businesses that help other businesses run smoothly.

The bull market allowed corporations to get fat and inefficient. But times have changed. Businesses are going into survival mode.  They have to slash costs to stay in the game.

In the current gloomy economic environment the biggest profit making opportunities are in companies that provide services enabling corporations to save money. This has already started to happen.

For example, Concur Technologies (Nasdaq: CNQR) has thrived by helping its customers save money. They have developed a system to help companies to combat their travel expenses.

For decades employees had to bundle up receipts, fill out expense forms, and send them over to accounting departments to get reimbursed. This took a lot of time. Employees would lose time filling everything out and accounting departments would spend hours double-checking everything.

It was an expensive process. Once employees’ time and effort was factored in, the total cost of each filing was $30. Concur automates that process. The cost of each expense report was reduced to less than $19 using Concur’s software.

That may sound like a niche market, but Concur’s customer base includes Dell, Texas Instruments, Eaton and JC Penney to name a few.  They have partnered with Oracle, Hyperion, Visa and MasterCard.

Concur’s business model thrives in times of corporate cost cutting. The key thing here is that Concur has been able to get top-dollar for its software and services. While sales were rising steadily, its profits were growing a lot faster. Over the last 2 years, Concur’s sales have increased 81% while profits have increased 167%.

Concur was selling more (that’s good)…but getting more profit for each new sale (that is great).

As a result, Concur shares soared 390% in just two years.  Concur has been on a good run, but with a P/E of 141, market expectations have already priced in.

Huge successes like Concur don’t come along often, but there are a few companies out there with Concur-like potential. Here’s three:

1) Taleo (NASDAQ: TLEO) specializes in talent management solutions. Basically, that’s co rporate-speak for getting the right people in the right jobs. If Taleo’s fundamental performance is any indication, their customers need the help.

Taleo’s customers include many of the industrial heavyweights Concur sold to when it was just getting started. AT&T (T), Merck (MRK), 3M (MMM), Honeywell (HON), Dell, IBM (IBM) (the list goes on and on).  They are all turning to Taleo to help cut human resource expenses.

And Taleo is turning its big-time customers into big-time profits. Sales have increased at a 27% average clip over the past three years.

More importantly, Taleo has been squeezing more profits from each sale. Operating margins surged to 2.9% in 2007 from a paltry 0.7% in 2005. That’s a 314% increase and shows how truly strong Taleo’s business is becoming.  On top of that, Taleo added another 225 customers last quarter taking its client list to a more than 1,900.

2) JDA Software (NYSE:JDAS) is a supply chain management company. It helps its customers keep inventories low, allocate resources, forecast demand, and adjust pricing. At the end of the day, JDA helps it customers run more efficiently.

JDA’s customer base is growing. Revenues increased 73% last year. Not bad, but that’s not what has gotten investors excited about JDA. Just like Concur, JDA has been generating more profit for each dollar of sales. Its operating margins have soared from an anemic 0.8% in 2005 to 12.8% in 2007.

Sales are up, profits are up.  JDA is a strong business that is adding even more muscle.

3) Longtop Financial Services (NYSE: LFT) is a software company that has integrated into the heart of China’s growing banking system. Longtop has developed software backbone necessary to run a modern bank. It’s a one-stop shop for technology support to banks.

So far business has been good. Tech research firm IDC calls Longtop the “most competitive banking IT solution provider” in China. Sales have grown at 63% on average over the past two years and Wall Street expects another 31% uptick this year.

But there’s a problem. Longtop’s selling, general, and administrative costs (very important to technology companies) have more than quintupled since 2005. As a result, operating margins have declined from 60% to about 9.5%.

Longtop might be selling more, but they’re spending a lot to do it. They’re offering incentives, discounts, and more to get more customers.

This company has the growth that Concur did a few years back, but its management needs to get costs under control.

In the last 100 days, the tech sector has been in a strong uptrend. It has outpaced the Dow by 17% and the fundamentals that have been driving it are still firmly in place. There will be a few winners here regardless of what happens to the overall markets.

Keep your eyes open. There are great bargains out there.  You just have to know where to look. At Q1 Publishing we believe that during good times or bad, a company’s operating margins always show the true health of a business.

Make money not war.

Disclosure: I have no positions, long or short in any of the companies mentioned in this article.