Cycling Into a Big Year for Tech Stocks
Q&A with Michael Cahill, managing director of Manhattan-based Chilton Investment Co.
By Sandra Ward
Barron’s – Courtesy yahoo finance
You’d never know the tech sector has been in a slump from looking at the returns of this artful and exacting investor. Since Michael Cahill launched a global technology, telecommunications and media fund for $4.5 billion Manhattan-based Chilton Investment in 2000, he’s delivered returns of 119% net of fees, compared with a loss of 45% in the Nasdaq in the same span. Last year, his smart stock picking led to gains of 22.65% after fees. He accomplished that feat with a risk-averse 55% exposure to the market. That’s nothing new for Cahill, a veteran of some of the most outstanding investment shops on the Street, including Kingdon Capital, where he customarily turned in triple-digit returns, and Capital Research, where he was a protégé of media and entertainment specialist Gordon Crawford. He sees good times ahead and is betting on some powerful themes.
Barron’s: The Nasdaq has underperformed for some time, and tech stocks have gotten off to a bad start this year. Is this going to be the year for tech or not?
Cahill: From 2004 through 2006, the Nasdaq has been the single worst-performing major market index. The Nasdaq is up 23% in that time, versus 35% for the S&P 500. The Russell 2000 is up 47%, Japan is up 47%, and European Indexes are up in the mid 60%-range. The MSCI Pacific ex-Japan is up 73%, and the emerging markets are up over 100% during the three-year period.
Despite the performance of the last three years, the earnings growth has actually been pretty strong, and there’s been a tremendous amount of cash built on the balance sheets. The data through September puts cash at about 26% of the total assets of the average S&P 500 tech company. The average [Standard & Poor’s 500] company has about 8% of its total assets in cash. So tech companies have roughly three times as much cash as the average company.
In the last three years, we’ve had significant multiple compression at the same time there’s been a big buildup of cash, which if you strip it out, makes the valuations even more compelling. That combination is leading to massive amounts of buybacks and buyouts of technology companies by buyout funds or strategic acquisitions of technology companies. There’s also been an equity shrink going on, what the Financial Times called a “de-equitization of the public markets.” And there’s been very limited IPO [initial public offering] activity in the last couple of years.
Put that into perspective, would you?
In 1999, there were 282 tech IPOs; in 2000 there were 205; in 2005 there were 23, and in 2006 there were 26. Activity really fell off. So there’s been a shrinking of the supply of shares through buybacks, buyouts and strategic acquisitions, often for cash. There’s been a limited incoming supply of IPOs. On top of that, there’s basically been six years of liquidation in technology mutual funds. Fund flows started to stabilize for the first time in the fall, and while it’s a little too early to call that a trend, at least there was some stabilization.
This makes you optimistic?
Yes, after three years of underperformance and six years of mutual-fund liquidation. Even a great tech investor like Barron’s Roundtable member Art Samberg is pitching cotton futures over technology stocks. A lot of people have just flat out given up on the sector, and they’ve moved into energy or other areas just when we are about to enter what we consider to be one of the best years for new product cycles. We also expect the continuation of some big themes that started in 2005-’06 but are really going to hit their stride in ’07.
What product cycles are you referring to?
Prior to this year, we haven’t had many really exciting products, and certainly not as many as are coming all in the same year as we have in ’07. There have been one-offs like the iPod and Motorola’s (MOT) RAZR. But what will drive this year is Vista, which is Microsoft’s (MSFT) new operating system that’s been five years in the making. It is late, but from a timing perspective, they are hitting the PC refresh cycle almost perfectly. The last PC refresh cycle peaked around ’03. So here we are in ’07, and there are 411 million PCs that are 3½ years old or older and that are natural candidates for the Vista upgrade.
But is the refresh cycle still intact?
Last year was not a great year for PC sales, and maybe some people held off because of Vista. I think there is some pent-up demand. Another big product cycle is in video-game platforms; we’re now entering the third generation with Play- Station 3 from Sony (SNE), Nintendo’s (NTDOY.PK) Wii and Microsoft’s Xbox 360. That starts a whole new game cycle, which has been a big driver in the past. In 2007, we will also have a new second-generation DVD format with Blu-ray from Sony and HD-DVD from some other manufacturers. These new product cycles could drive some nice incremental demand that we haven’t had.
What are the themes you expect to take off this year?
Computing and the Internet are on the verge of going mobile, through 3G wireless or through Wi-Fi, where there is a brand new standard called 802.11n, and through WiMAX, which you’ll hear a lot more about in the next couple of months. Sprint and Clearwire, which is backed by Craig McCaw, will build out nationwide WiMAX networks. WiMAX is basically a wide area Wi-Fi network. Wi-Fi is mostly in homes or at Starbucks, but WiMAX covers a larger radius and can serve cities. We’re just on the cusp of a massive explosion in mobile Internet and computing and adoption taking off.
What’s another theme?
Another is the continued buildout in the emerging markets in wireless and Internet. India is growing basically at five million subscribers a month. China is booming as well, and many of these emerging economies are just seeing unprecedented levels of demand, and that’s good for technology.
Another big trend we see is video-on-demand over the Internet. This is putting a tremendous strain on the backbone, but even more so on what I call the off-ramps, which are the pipes into people’s homes. An average e-mail takes up about 10 kilobytes and a five-minute MP3 file is about five megabytes, but a full-length movie is 2.5 gigabytes. So we’re moving from e-mail-dominated traffic to the MP3 player, and we are going ultimately to video, and that is going to consume massive amounts of bandwidth. With Google’s (GOOG) YouTube acquisition and Ericsson (ERIC) buying Redback Networks, we’ve witnessed companies positioning themselves for video over Internet.
Any more themes?
The last area I’ll mention that we as a firm have spent a decent amount of time on is alternative energy. There is going to be a boom in alternative-energy technology, particularly solar. We have worked a lot on the solar industry, because solar is effectively a semiconductor technology that is put to a new use. The same wafers used for semiconductors go into photovoltaic cells.
Let’s get down to some picks and start with your mobile Internet theme.
We hunted around to find a company that could capture the Internet-going-mobile theme and found a semiconductor company called Anadigics (ANAD). They’re in the sweet spot of 3G cellular, Wi-Fi and WiMAX. They have the reference design wins at Qualcomm (QCOM) for 3G phones and Intel (INTC) for Wi-Fi and WiMAX chip sets. On top of that, they are also a play on video-over-Internet as they make the chips for the video infrastructure for Cisco Systems’ (CSCO) Scientific-Atlanta division, and they also make chips that go into the advanced set-top boxes of Motorola.
Anadigics is a small-cap pure play on some of the biggest trends we can find. It has 45.2 million shares outstanding and trades at about $9 a share for about a $400 million market cap. They have got a good balance sheet with a dollar a share of net cash. There is very little Wall Street coverage, which we think is great. We own about 11½% of the company, so we are believers.
What’s the earnings outlook?
We think they are going to earn close to 50 cents in 2007 and between 90 cents and a $1 a share for 2008 if events play out the way we see them. That’s up from break-even in 2006, so they are on the verge of massive earnings acceleration. Anadigics is leveraged to many of the markets that have the most favorable growth prospects. A little more than 60% of all the announced 3G phones are using Anadigics chips. They are winning huge share. The company is also a big play on 802.11n, the new Wi-Fi standard. When we move to the “n” standard, the coverage increases and the speed increases. In ’08, the WiMAX stuff will start to kick in.
How much equipment does Anadigics supply to these different products?
The beauty of these new standards is it actually doubles and, in certain instances, it quadruples the content Anadigics has in these devices. That’s driving tremendous earnings leverage at Anadigics.
Didn’t they recently do a shelf filing that upset investors?
What that’s about is that all their customers are huge companies: Intel, Qualcomm, Motorola, Cisco, Samsung Electronics and LG Electronics. Cisco and Intel are looking at huge growth prospects, and they are looking at Anadigics as a critical component to that growth. But Anadigics is a company that has got basically $45 million to $50 million of net cash on their balance sheet, so the customers want Anadigics to raise more cash and bolster their balance sheet to ensure they will be able to keep up with the large orders from their big customers.
At some point in the next couple of weeks or months, we will see them come with a share offering to bolster their balance sheet. While people are concerned about the potential share overhang, we’ve factored the additional share count into our earnings projection.
Where do you see the stock headed?
We estimate the top-line is growing about 30%, and that’s well in excess of consensus. Earnings will be going from zero to 50 cents to about a $1 a share in 2008. What multiple do you want to put on that? I think it should be significant. This company is growing very rapidly, and it is not expensive. It is trading at nine times our 2008 number, and earnings are exploding. A multiple in the high teens or even 20 could be possible.
EchoStar Communications (DISH), which I think is a great play on a possible takeout. The stock is attractive on a fundamental basis at current levels. It is trading at 7.7 times ’07 Ebitda [earnings before interest, taxes, depreciation and amortization] and 6.7 times ’08 Ebitda, and the Ebitda should grow at about 18% in ’07 and 15% in ’08. EchoStar should generate about $2.50 of free cash flow per share in ’07. Based on the $40 where it is currently trading, it is at 16 times free cash flow. The company is executing really well; in the September quarter they put up one of the best quarters they’ve ever delivered.
What about subscriber growth?
Their subscriber numbers have been fantastic. They added 295,000 net subscribers in the September quarter, versus 165,000 for DirecTV. The stock should appreciate 20% if it just holds its current multiple over the next 12 months. There is also a lot of additional upside, because we think this is the year AT&T (T) buys EchoStar. It just makes too much sense for the deal not to happen.
We are really bullish on video over Internet, as I said. This is why AT&T and Verizon (VZ) are deploying their fiber-to-the-home strategies and why the cable companies will ultimately have to upgrade their networks from 750-megahertz systems to one gigahertz.
The problem with the fiber-buildout strategy is that it is slow. While the phone companies are building, the cable companies are taking their telephony subscribers every single day with their triple-play voice, video and broadband offering. Buying EchoStar solves a lot of problems for AT&T. It immediately gives them a fully integrated video offering with scale as they pick up EchoStar’s 13 million subscribers.
Remember, AT&T is all about scale. Using a great hybrid strategy of using satellite for broadcast and high-definition channels into the home, they then can use their fiber platform for broadband Internet access. This is critical, because when the world goes to high-definition TV channels, it is unclear what the impact is going to be on the broadband connection, but by leaving high-def channels on the satellite, it frees up the broadband connection so they could potentially have the most superior product offering.
The third point is that AT&T has achieved such massive scale by buying BellSouth that buying EchoStar is no longer a big deal for them. EchoStar has a $17.7 billion market cap. AT&T’s market cap is $235 billion. Their enterprise value [market value plus net debt] is $290 billion. They could pay a big premium for EchoStar, and it would barely be dilutive.
And why this year? Because of the more favorable climate in Washington before the next election?
Yes. There would not really be any competitive-overlap issues, so there wouldn’t be any regulatory hurdles. But, nonetheless, the deal would take probably nine to 12 months to close. If you think about the timing until the next election, they have to do it to ensure that this deal would be announced and closed prior to November 2008.
What could trip it up? There’s been talk that the satellite companies might merge, and John Malone is always a threat.
John Malone is always a threat. If it could get through the Federal Communications Commission and the Justice Department, the merger of EchoStar and DirecTV would be one of the best deals ever done. There are so many synergies between the two companies that Malone could pay $80 a share for EchoStar and have the deal still make sense. EchoStar will have about $2.85 billion of Ebitda in ’07 and DirecTV will have close to $4 billion, and there is roughly $3 billion in annual synergies by combining the two companies. I’m not sure given the rhetoric out of Washington that it would be a doable deal, although the synergies are so great it is almost worth a shot to try. But the more likely scenario is AT&T buys EchoStar. There are no regulatory hurdles, it is not overly dilutive, and it solves a lot of AT&T’s problems.
On to alternative energy.
The solar space is an area that is going to be a huge growth industry for many years to come. Yet a constraint on solar’s growth is a shortage of polysilicon. Polysilicon is a critical component in solar cells. Polysilicon is also what semiconductor wafers are made of. One of the leading polysilicon producers in the world is MEMC Electronic Materials (WFR). MEMC has about 230 million shares outstanding. The stock is at $44.70 right now. They haven’t reported their fourth-quarter earnings yet, but I estimate they are going to end up earning about $2 a share in 2006, which is up from $1.14 in 2005.
[After our conversation, MEMC reported fourth-quarter earnings of 68 cents a share and 2006 earnings of $2.07, and the stock rose to 52 as a result; we asked Cahill to update his views on MEMC, which follow].
It has about a $12 billion market cap. They have $585 million in cash, or about $2.40 a share in net cash.
We think they are going to earn $3 a share in 2007 and $4 a share in ’08. That puts the stock at 17 times ’07 earnings and 13 times ’08 for a company that is growing 45% in ’07 and 33% in ’08. MEMC is trading at what we consider to be a very significant discount to both the semiconductor industry as well as its own unbelievable growth rate. That is because historically it has been a company with extreme earnings volatility through up and down cycles.
Where are we in the cycle?
The semiconductor industry is going through a bit of an inventory correction, and we think the cycle will trough in the first half of ’07. MEMC might finally get some multiple expansion during this inventory correction because it is demonstrating its ability to grow its revenues and margins and earnings through this downturn. It has a lot less cyclicality than it has had historically. In MEMC, we have a company growing its earnings as fast as Google, but trading at 17 times.
How about an emerging-market pick?
Sify (SIFY) is a play on the Internet and Internet infrastructure of India. It is a restructuring story. The last couple of quarters have been a little choppy, but beginning in June, they hope to see some acceleration in earnings. That said, they still doubled their Ebitda from ’05 to ’06. They figured out a long time ago that most people in India don’t have a PC, so they built Internet cafés. They have 3,552 Internet cafés. The No. 2 player is Reliance with 240 cafés, and there is no No. 3. Sify has leveraged their Internet cafes to create several portals like SifyMax.com, which is the leading broadband portal in India, and Sify.com, which is an e-commerce and mobile-game portal.
Beyond that, they started building data centers to host their own data, and now they are providing the service to some big companies. They also have 208,000 broadband subscribers. They are one of the largest broadband providers in India, and they do that by working with the cable companies, which are highly fragmented in India. They are getting into travel and have a pact with the Indian railways to sell and distribute tickets through their cafés.
They have also announced a deal with Western Union for money transfers. This is an important service, because very few people in India have credit cards.
What’s this mean for the stock?
Sify has 42.8 million shares outstanding, and it trades at $7.60. They’ve got $53 million in cash. They generated $13 million in Ebitda in ’06. We think that will increase to around $20 million in ’07. It is trading at 13 times ’07 enterprise value to Ebitda. This is not something you put all the college savings into. But on a multiyear basis, this could appreciate very, very significantly.
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