May, 2002 Update and Company Visits

The last couple months have been particularly painful for owners of QUALCOMM and other technology stocks. The price of QUALCOMM reflects the current weak capital-spending environment for telecommunications infrastructure. CDMA2000 and W-CDMA, the drivers of the next great period of growth, have been delayed, as wireless providers are just plain scared to spend money. The delays postpone earnings growth for QUALCOMM, causing a decline in the present value of this cash producing entity. However, we are finally seeing a number of new systems built, including those of Sprint and Verizon in the US. With a surge of system rollouts in April, there are now fifteen CDMA2000 systems worldwide, with more to come. The only system open for a full year is SK Telecom’s in South Korea. It is a huge commercial success, with over 8 million users and an increase in average revenue per user (ARPU) of 30%. ARPU’s are very important for wireless providers, because the extra revenues go straight to the bottom line, touched only by taxes. If the other CDMA2000 systems are half as successful, we will not have to worry much longer about QUALCOMM’s stock price. I will keep you posted.

Bristol Myers (BMY 30) is a blue-chip pharmaceutical and health products company that has declined from last year’s $70 high due to a series of product disappointments. The current price is somewhat under my estimate of the company’s intrinsic value. Since company finance officers use similar analytical methods when searching for an acquisition bargain, I know Bristol is a prime takeover candidate. John Coombe, GlaxoSmithKline’s Chief Financial Officer commented yesterday that Bristol is on their radar screen. "Everyone accepts that Bristol-Myers Squibb is now vulnerable, and for good reason," he said. Combining the two would take the market share crown away from Pfizer, plus replace revenue losses that will occur as GlaxoSmithKline loses patent protection on top-selling antibiotic Augmentin and antidepressant Paxil.

Bristol’s bad news: Inventories of its primary care pharmaceuticals have risen to excessive levels, leading management to project a sales decline of 7% over the next four quarters to get inventories back in line. This will cost per share earnings about $.47, contributing to a $800 million to $1 billion inventory write-down and a projected operating earnings decline this year to $1.70 compared to $2.41 in 2001. Largely responsible is the expiration of patent protection for Glucophage for diabetes, Taxol for breast and ovarian cancer, and BuSpar for anxiety disorders. The decline in sales of these three products from $888 million in the first quarter of 2001 to $87 million in the first quarter of 2002 shows the impact of generic competition when patent protection expires. Erbitux’ approval by the FDA has been delayed for at least a year, causing Bristol to have appeared to have overpaid for its related investment in ImClone. Finally, the FDA has required more clinical data on important cardiac drug candidate Vanlev. A couple senior people have recently been replaced at the company. There is some concern that the top guy needs replacing, too.

Bristol’s good news: Bristol is seeing increased demand for a number of important drugs: Pravachol for lowering cholesterol, Avapro for angiotensin, Plavix and Coumadin for clot prevention, Sustiva and Videx for HIV, Glucovance and Glucophage Extended Release for diabetes. Excedrin is the company’s best-known over-the-counter medicine. Bristol’s new-product pipeline is led by Aripiprazole for Schizophrenia, Vanlev for hypertension, Atazanavir for HIV, and Garenoxicin antibiotic. Bristol is in a partnership with controversial ImClone to develop Erbitux for colorectal cancer.

Bristol is a great company with a decades-long heritage of excellent shareholder returns. Most great companies that have a string of bad news are able to regroup and recover. A rare purchase opportunity is created, because great companies are seldom cheap. Although I find Pharmacia’s and Pfizer’s growth prospects more interesting, Bristol stands out as the cheapest of the major pharmaceutical companies. It yields close to 4% at the current share price and should be able to grow earnings per share to about $3.00 over the next five years. The risk is that once the string of bad news starts, it is difficult to predict when it will end.

Avanex (AVNX 3) is a leading provider of photonic modules that maximize the performance of optical communications networks. That translates into getting more data and phone calls onto a fiber optic network, similar to the capacity multiplication for cellular phone systems resulting from CDMA. Service provider economics come down simply to how many paying customers can get onto one unit of infrastructure. Avanex’ DWDM and QUALCOMM’s CDMA make communications service providers more competitive.

Avanex was one of the darlings of the tech craze two years ago, when the stock peaked at $268 (and I thought QUALCOMM hurt!). Fortunately, the company sold stock to then insatiable tech investors, providing it with a cash nest egg of $3 per share to get it through the current hangover period. In 1999, phone companies wanted their optical networks built overnight, creating shortages and huge revenue increases for companies ranging from Cisco to Avanex. The oversupply of optical capacity is now being worked off in a depressed telecom market, and when the regurgitation process is over, surviving telecom infrastructure suppliers will thrive. Proprietary product positions, big cash cushions, few surviving competitors, and big, well-capitalized customers will characterize the survivors. Avanex fits this bill, and counts the world’s leading network builders, Cisco, Fujitsu, Nortel, Alcatel, and Worldcom, as customers.

Avanex’ has announced the acquisition of Oplink, a supplier of passive components for fiber optic networks, the network building blocks one level below the modules Avanex manufactures. Although components are less proprietary, and carry smaller profit margins, there are strategic considerations that are interesting in this merger. Oplink brings Avanex the ability to supply 80% of the parts of a fiber optic network, making it more of a “one-stop shop” like its somewhat larger competitor, JDS Uniphase. It adds Lucent and Agere to the customer base, two important network builders conspicuously absent from Avanex’ current list. It brings established Chinese manufacturing capacity, a cost-cutting step management has long said Avanex needs to bring down is product prices. Along with it come the typical integration challenges. The combined sales forces must retain the relationship oriented sales style that Avanex has used so successfully to get great customers. Redundant factories must be closed in San Jose, no longer an easy market to sublet space. There is little product overlap, serving to minimize revenue penalties due to the merger. Oplink has no debt, and is being purchased for shares of Avanex worth slightly less than the amount of cash Oplink has on its balance sheet. The merger is to be completed by the end of the June quarter.

As an investment, Avanex is fundamentally very cheap. Buying a company at cash per share is rare, even when it is accompanied by a business slowly consuming that cash. So, intrinsic value calculations yield a number above the current stock price. The reason it is cheap is that as yet there is no light in the end of the optical network overcapacity tunnel. However, when the speed of your broadband cable connection disappoints, you know the day approaches. Improvement in the company’s business and stock price depends on improvement in the optical networking industry. A highly pessimistic environment has created a substantial bargain, accompanied by substantial risk.

Verisign (VRSN 11) owns infrastructure components central to the workings of the Internet. A very expensive multi-year campaign to acquire the building blocks that make digital commerce and communications possible destroyed shareholder value as the stock declined from its Internet craze high of $260 to a recent $8 low. This same decline has created the possibility of exceptional returns for those who take the risk of buying now. The CEO has told me that no more acquisitions are necessary or planned. A change away from this newfound conservatism is the primary risk to today’s buyer of the stock.

The company’s ascendance to dominance in Internet security started with a timely insight in 1994, as Verisign successfully lobbied web browser software creators to include SSL “Secure Socket Layer” security into their browser programs. This success has since been parlayed into a 90% market share in sales of web security certificates, used to prove identity and secure online commerce. Verisign’s name is now synonymous with Internet security.

When the stock was close to its high, Verisign acquired Network Solutions, the sole custodian of the .com, .org, and .net Internet names databases. The acquisition was unbelievably expensive, even though it was paid for in the unbelievably high stock of Verisign. The expense of the purchase might have hit home had management looked at it correctly - as paying cash, then financing it by selling their own stock to the market. They did not look at it that way, and the shareholders, including management, have paid the price. I’m glad we weren’t shareholders; their loss is our potential gain.

Strategically, the purchase was excellent. With the Internet names registrar came the computer database system that reliably connects the majority of worldwide Internet queries, currently 6.4 billion transactions per day. Capacity was recently upgraded to 200 billion (!) transactions per day. When you click to go to a website, you have, in most cases, done a transaction called DNS resolution on Verisign’s computers. Verisign also has acquired numerous other building blocks central to Internet and telephone connections, such as Illuminet, a provider of services to phone companies, and H.O. Systems, a wireless phone/device-billing platform. These acquisitions were followed by a commensurate decline in Verisign’s stock price. They give Verisign the ability to extend its security, billing, payment, and transactions services to wireless carriers, a business Verisign believes will grow enormously over the next 5 to 10 years. And, this is but a fraction of Verisign’s opportunities.

Recent financial reports from Verisign have disappointed Wall Street. The cessation of Internet excitement has squelched Internet name speculation, causing a contraction in Verisign’s biggest business, Internet name registration. Just as Verisign has finished investing $400 million in the infrastructure necessary to make secure digital commerce and communications possible from one source, Wall Street can’t look beyond the coming quarter or two. But, I find the long-term future of Verisign very interesting. 1) It leads in all its markets, 2) its customer base ranges from every company in the Fortune 100 to 95% of Internet transaction sites down to home Internet users, 3) it can now offer a myriad of products and services that save its customers money and reduce their risk, and 4) its reputation for trustworthiness is unmatched in the Internet space. But what interests me most is the scalability of the business: for all the additional revenues it can generate, the cost is low and profit margin high.

The difficulty of estimating future growth makes the intrinsic value estimate difficult. If the company finishes writing down the overpayment for its acquisitions and staunches the current decline in cash flow production, its intrinsic value will increase dramatically to a number somewhat above the current stock price. Verisign is THE Internet play, and finally, the uncertainty regarding the Internet’s growth has made this stock’s price attractive.

Steven L. Ré, CFA

May 16, 2002

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.