Are techs worth their stock prices?

Summary:Despite poor sales and little hope for near-term growth, the technology sector has charged ahead on Wall Street in the past two and a half months. But many analysts wonder whether it's too much too soon.

Tech companies have a long way to go to justify their latest stock prices.

Despite poor sales and little hope for near-term growth, the technology sector has charged ahead on Wall Street in the past two and a half months. But one thing's for certain: Technology companies need a lot of growth if they're going to generate as much cash over the next few years as shareholders have plowed into their stocks over the last two and a half months.

"Based on pure fundamentals, on a company-by-company basis, tech stocks are ahead of themselves," said Bill Schaff, manager of the Berger Information Technology Fund. "Investors made a rally just because they were afraid to miss one."

The Nasdaq composite index rose more than 37 percent from Sept. 27 through Tuesday. The Pacific Stock Exchange Technology Index gained almost 40 percent. And many leading tech names did better.

Cisco Systems' market capitalization rose by three-quarters, Intel's by almost two-thirds. Dell Computer, Sun Microsystems and Applied Materials are now worth more than 50 percent more than they were at the end of September. Even Microsoft, encumbered by the uncertainty of an unresolved antitrust case and questions about the success of its most significant product launch in years, advanced 39 percent since late September.

Some of these stocks now carry price-to-earnings, or PE, ratios not seen since the tech bubble burst last year. Cisco's closing price Thursday at $18.29--actually down from two weeks earlier--means Wall Street valued the network equipment giant at 70 times First Call's earnings estimate for Cisco's next 12 months. Sun's price of $11.85 represents a forward PE ratio of 1,185 percent, given that analysts, on average, expect the server company to earn 1 cent per share over the next four quarters.

Going into this week, the 78 technology stocks in the S&P 500 collectively were valued at 57 times estimated earnings for the coming year, noted David Readerman, equity growth strategist for Thomas Weisel Partners. That viewpoint assumes technology spending next year will return to 2000 levels, followed by growth in 2003.

It might not be a very pragmatic assumption. "This outlook is highly optimistic," Readerman wrote in his weekly report.

Recent announcements, especially in the communications-equipment industry, give pessimists fodder. Qwest Communications cut its capital spending budget. Ciena Systems slashed $700 million from its prediction for fiscal 2002. And Lucent Technologies recently warned that its December quarter sales would be far below many analysts' expectations.

Technology analysts generally have written off 2002 as a retrenchment year. Conventional wisdom predicts corporate spending on information technology won't start increasing until the second half of next year, although sales declines may have ended; most major tech companies (outside of communications equipment vendors) have been reporting for the past few months that they don't see demand getting worse.

But until sales start improving (as opposed to treading water) each quarter, many investors will be wary of technology companies at their current prices.

Some analysts believe the recent surge in tech stocks is based on ignoring 2002 completely and hoping for the best the following year. Because stocks have risen even though few people expect growth for much of next year, the majority of sector-specific analysts remain pessimists.

SoundView Technology Group estimates that from mid-November to mid-December, there were 1.8 downgrades of a stock for every upgrade. More often that not, downgrades were issued because of a stock price rising too fast, rather than worsening business for the company itself, according to Arnold Berman, SoundView's chief strategist.

Situation improved
Yet Berman remains optimistic, as he has been over the past few months, about much of the tech sector. He believes that the inventory glut that killed sales for many technology companies this year has largely been erased. If excess product on the market has been used up for the most part, revenue for many tech companies should increase even if overall demand does not.

Berman is particularly encouraged by the tech industry's foundation--chipmakers.

"By our reckoning, chip industry fundamentals showed signs of turning in the June quarter," he wrote. "More than any other technology sector, the chip industry has seen a more dramatic change in fundamentals, for a longer period of time, with the most dramatic earnings revisions, and likely revisions going forward."

For example, the two largest makers of PC processors, Intel and Advanced Micro Devices, recently raised their expectations for the December quarter. And Taiwanese chip foundries have been using more of their chip manufacturing capacity in recent months, according to industry reports.

Schaff isn't ready to jump back into semiconductor stocks yet, though. In this recession, shares of chip manufacturers and chip capital equipment companies have not dropped as low as they did during previous slowdowns in their industry and so haven't reached realistic valuations yet, Schaff said.

"Just because (the percentage of chip foundries') capacity utilization goes from the mid-50s to the high-50s, it's nothing to get excited about," Schaff said.

In the end, judging the value of tech stocks depends on earnings growth and how long shares are owned. UBS Warburg's chief investment strategist, Pip Coburn, believes the Nasdaq is valued fairly if you make a few assumptions, the most important of which would be companies' profit margins in 2004 returning to 60 percent of their peak last year. "We think returning to 60 percent in 2004 is a relatively doable, but a less controversial assumption than what some investors are contemplating," Coburn said.

Of course, predicting the future always leaves a lot of leeway.

"Whether tech is cheap or expensive is truly in the eyes of the beholder," Coburn said. "You can easily make arguments on both sides of this debate."

Topics: Intel, Cisco, Hardware

Kick off your day with ZDNet's daily email newsletter. It's the freshest tech news and opinion, served hot. Get it.

Related Stories

The best of ZDNet, delivered

You have been successfully signed up. To sign up for more newsletters or to manage your account, visit the Newsletter Subscription Center.
Subscription failed.