Assessing the Likelihood of a Turnaround in the High-tech Sector

Journal Issue

Jun 1999

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Financial Statements

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The technology sector poses many interesting situations relative to defining adequate performance. Finding a margin

of safety in companies that trade at 40 times their book value and 10 times their sales does require some creativity,

if not antacid tablets. The technology sector of the U.S. economy is a major driving factor of GNP and a place

where re-emerging companies tend to trade based on their prospects rather than general market direction.

In assessing a turnaround opportunity, growth investors tend to shy away from battered technology stocks,

preferring companies with bright prospects; they often believe that once a technology stock has fallen, it is very hard

for it to regain its position. Value investors, on the other hand, tend not to mind taking a chance on a fallen angel,

particularly those companies that are not heavily covered on Wall Street (albeit most are covered closely).

In attempting to assess the likelihood of a turnaround for a technology company, a stakeholder should consider

whether the company has enough cash to stay solvent while management figures out what is wrong and how to fix

it. Consider our example for the assembly and test equipment companies in the Integrated Circuit Manufacturing

Sector chart.<a href="#1" name="1a">1</a>

Companies operating in an environment where the supply and demand factors are severely cyclical need enough

cash and credit to survive the massive swings in the cycle. This phenomenon is quite curious as a smoothing of

book-to-bill indicates that overall demand in this sector has been growing at a greater-than-17 percent compounded

annual growth rate. Interestingly, deep trough periods of nine to 15 months have been experienced during the same

period. This cyclical swing creates havoc for a short-term investor and creates uncertainty among stakeholders as to

whether the trough is really a cliff!

It is the management of these companies that must make the critical decisions on how best to survive the trough

periods. Unlike most industrial companies, high-tech companies must continue to invest heavily in research and

development (R&D) despite downturns in demand. Fortunately for most technology companies and unlike

manufacturing companies, high technology companies tend to have low fixed costs. Therefore, by reducing labor

requirements during trough periods (layoffs), technology companies can reduce their variable costs low enough to

withstand the down periods and buy the time to turnaround the business. Of course, this logic doesn't help if the

technology company has loaded itself up with debt and can't meet debt service payments. Of relative importance in

considering the likelihood of a turnaround in the technology sector is whether the company has another form of

financial life support that it can rely upon when its primary market is weak or under pressure. Service agreements,

maintenance contracts and software/ hardware upgrades may provide enough revenue to help buy time.

<h3>Got Something to Sell?</h3>

Of course, as with any business, a key criterion in assessing technology companies is determining if the

company still has something to sell. Cash alone will not drive a technology stock's value up in the marketplace;

you must determine if it has niches and viable products. Unlike manufacturing companies that tend to generate

products that an investor can fundamentally understand, technology companies reinvent themselves on an almost

daily basis. Therefore, it is important to assess a company's track record in bringing out products to market. If

"research and development is the touchstone of a technology business,"<a href="#2" name="2a">2</a> then it is important to validate a

company's ability to achieve significant returns from its R&D spending. The "investment" in R&D must be

carefully scrutinized, similarly to how an investor in a manufacturing company looks at capital expenditures to

determine if management has been reinvesting in the business.

More importantly, when things are not going well for a technology company, consider whether the company has

increased its R&D spending (generally in excess of 7 percent of sales) or if the company has decreased these

initiatives. Naturally, you need to look at R&D spending relative to industry competitors to benchmark the

situation.

Percentages of spending are not everything. You need to consider whether the R&D spending has been spent

wisely. To assess this, we like to revisit the annual reports to see whether the company was able to deliver on

projects it had under development in past years. Companies with rampant R&D expenses and little to show for it

may be facing a date with the bankruptcy court.

<h3>Management, Management, Management</h3>

Many high-tech companies faced with poor performance tend to need new management before a

turnaround can begin. The boost a new CEO can give a company faced with first-time underperformance should not

be underestimated. The key action a new manager can bring to an underperforming technology company is cost

containment.

When technology companies are thriving, management's focus tends to be on keeping the engineers happy and

cost control takes a backseat. However, when the company gets into trouble, management needs to focus and control

costs. Many times a new manager or consultant is brought in to do the layoffs and cost containment because prior

management either did not recognize the problem or refused to do it.

<h3>Technical Analysis</h3>

Perhaps a critical factor to assess in a high-tech company is whether the company's balance sheet is

strong enough to withstand a down period. In this situation, we suggest a sector chart analysis in which you can

benchmark the company's balance sheet and income statement performance relative to perceived competitors, as

indicated in the ROA charts.

The sector charts help management to analyze the company versus the competition. For instance, in looking at

the balance sheet performance, companies operating in the top-right region of the Inventory Turns versus ROA chart

are the strongest performers of the group in terms of inventory utilization as their investment in inventory is

minimized.

For most high-tech companies, minimizing the investment in inventory can be beneficial because not only does

it require less working capital financing, but the company minimizes an investment in a product that may be

becoming obsolete as new variants are seemingly created every day.

A company in the top-left region of the Days of Sales vs. ROA chart not only is yielding strong returns on

balance sheet assets but also is in a favorable position in terms of keeping customers on a tight leash. The further

you yield credit to your customers, the more subject you are to a downturn in the economy. For instance, in the

capital equipment sector of the integrated circuit industry, many customers are global and heavily concentrated in

the Pacific Rim. Weakness in global economies and specifically in the Pacific Rim may not only make it more

difficult for these customers to pay for products, but the devaluation of their currency can further exacerbate a

tenuous situation.

In considering the amount of selling, general and administrative (SG&A) expenses a high-tech company invests

in, one has to understand the relative components of sales expense. Is the level of sales expense appropriate for the business? Will the investment in R&D bring immediate

results? Careful scrutiny as to the underlying fundamentals involved in the income statement side of our analysis

must be performed. High-tech companies, in particular, may require incremental R&D spending, even though the

company may be facing a liquidity crisis.

<h3>Heard It on the Street</h3>

Of course, notwithstanding all the fundamental analysis in the world, when you are in the technology sector, a

successful turnaround must also be played out in the public arena. The CEO/CFO team must not only direct a

successful turnaround inside the company but outside the company as well. The credibility of the management team

should not be underestimated, particularly in technology companies that may not have a long track record. As the

darlings of the investment community, technology companies are closely scrutinized and in almost all instances

valued far in excess of current financial performance. With price/earnings in the stratospheric 40 times range, it is no

wonder that when the technology company announces weak or lower-than-expected results, the stock can plummet

by more than 50 percent of its market capitalization.

In assessing these situations, the management team cannot lose sight of what led them to this stage of demise.

Rather, a concerted effort to focus on the fundamental aspects of the business is critical. Typically the CFO,

"guardian of the numbers," must placate the technology community, analysts and investors to drive a turnaround

plan. Moreover, continued investment in R&D, the lifeblood of most technology businesses, must continue to be

made. Assessing the likelihood of a turnaround in the technology sector often boils down to the key ingredient: Is

management credible?

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Source: Morgan Stanley Dean Witter Research, Assembly and Test Equipment. <a href="#1a">Return to article</a>

<a name="2">2</a> Murphy, Michael, Every Investors Guide to High-Tech Stocks and Mutual Funds, Broadway Books. <a href="#2a">Return to article</a>

Journal Authors

Dominic M. DiNapoli

Elliot Fuhr

Journal Date

Tuesday, June 1, 1999 - 12:00