QUALCOMM has taken quite a beating lately, and is worthy of some comments. With the first quarter's technology stock sell-off as the background, a spate of negative interpretations about the rollout of CDMA has proliferated. Those of us who have owned the stock for several years have been through these periods before, and the similarities are painfully familiar.
Innovation is normally a laborious process. Humans do not enjoy changing the habits that work and make us feel secure. Innovation starts small. Emerging from beneath established institutions, it quietly displaces legacy leaders, regardless of their size and power. Innovation is powerful, and inevitable. It is hard to understand, and even harder to execute. If the innovation improves the lives of its users, they carefully, and inevitably, accept it. Established institutions tend to fail to understand the disruption until it is too late, because both they and their customers are succeeding with old habits. When they detect the change, they often try anything to delay it until they have time to understand and participate, so as to prevent damage to both wealth and ego. We have seen telecom giants profess that CDMA will not work, influence their standards bodies and governments to exclude CDMA, and even attempt to invent new flavors of CDMA of unproven viability, all to slow the disruptive innovation. This disruption continues nevertheless, because it gives the service providers better economics and the end user new services.
Based on my background checks, I am comfortable that major long-term growth drivers remain in place for QUALCOMM. The fact is that the legacy technology getting disrupted, TDMA and its GSM variant, cannot handle Internet data at a useful speed. The world is going to CDMA sooner or later, QUALCOMM’s IPR’s and right to receive royalties are secure, the wireless Internet will be huge, EDGE (Enhanced Data rate for Global Evolution) is not a sensible step in the evolution to CDMA, the world will get much smaller as a result of universal connectivity, and, in time, third generation CDMA phones will work on any and all CDMA systems, regardless of geography.
Gillette's (G 33) ten years of steady 15% eps growth ended in 1998, concurring with the retirement of then Chairman and CEO Al Zeien, who had run the company brilliantly over this period of great growth. There were several reasons for the slowdown, including continuous currency hits and the commodity nature of two of Gillette's businesses, stationary and Braun household appliances, both of which are now for sale. However, I think another factor was at work also. I have observed a certain phenomenon over my 25 years of studying businesses. Sometimes the first couple of years of the succession period are pretty tough on financial results. Studies of organizational behavior postulate that nobody wants to disappoint the boss, especially one who soon will be appointing his successor. When the boss sets aggressive growth objectives, his employees do everything they can to achieve them. Thus, two years after succession, we find Gillette making drastic reductions of inventories and accounts receivable. Accounting-wise this means that past sales exceeded "customer-takeaway", what customers really took off store shelves. To correct this overstuffing of the sales pipeline, current sales must be under-reported until receivable and inventory levels fall into line. For Gillette, this process is nearly complete.
The gradual reduction in these working capital items would have been less noticeable had not foreign exchange also cost about 5 percentage points of sales growth each of the last three years. Because foreign exchange is a bit of a pendulum, it is improbable that it will continue to have deleterious effects over the next several years.
The hopeful sale of the stationary and Braun
household appliance businesses will refocus Gillette as the leader in three
large global businesses: grooming (razors, blades and electric shavers),
batteries, and oral care devices (toothbrushes, both electric and manual). These three businesses have great long-term
business characteristics:
1.
Pricing
power and high profit margins due to brand name exclusivity.
2.
Volume
growth and multi-dimensional future growth opportunities.
3.
High
return on capital employed in the business.
Gillette is taking steps to improve its overall
return on capital employed:
1.
Reduction
of investment in inventories and accounts receivable.
2.
Squeezing
costs out of all administrative functions.
3.
Investing
in efficiency by deploying SAP enterprise software throughout the company.
(finally!)
4.
Cutting
manufacturing costs to increase gross profit margin by ½% per year.
5.
Increasing
advertising expense to promote sales
6.
Pushing
forward a strong new product pipeline to keep new products at 40% of revenues.
These steps should initiate a resumption of mid-teens earnings growth and boost return on capital employed from the current 15% to about 25%. Since P/E ratios have a very high correlation to return on capital employed, Gillette shareholders could benefit both from an increase in eps and an increase in the p/e ratio. I think we will make a lot of money on Gillette over the next five years.
I have a lengthy report for you, stemming from my attendance of the Bernstein Strategic Decisions Conference, a forum that brings the top management of leading companies together with portfolio managers. These meetings allow me to screen a lot of companies in a relatively short period of time, 20 on this trip, 19 that I will comment on. Most company managers are very intelligent, far-sighted, and sincere. Be mindful that their jobs require they be optimists, and good salesmen. I like an opportunity to look them in the eye, because it helps me evaluate the genuineness of their stories. This will be presented in two installments, in view of the number of companies I want to discuss. If you just can’t wait for the next report, you’ll find the second installment on qgmi.com.
Here’s the list: Analog Devices, Cardinal Health, Coca Cola Enterprises (not the Coca Cola Co.), du Pont, Human Genome Sciences, Lucent, McDonald’s, Medtronic, Merck, Palm, Pfizer, Qwest Communications, Staples, Walt Disney Co., and five computer hardware vendors, Sun Microsystems, IBM, Hewlett Packard, Dell, and Compaq mentioned in one section. Let's get to that first.
Sun Microsystems (SUNW 94), IBM (104), Hewlett Packard (HWP 133), Compaq (CPQ 27) and Dell (DELL 53) are all affected by Intel's graduation to powerful RISC technology. Intel’s next generation chip, code name IA-64, based on Reduced Instruction Set Computing technology, will commoditize the Server market, just as succeeding Pentium’s commoditized the workstation market. That caused the near demise of workstation companies such as Silicon Graphics and Apollo. Sun Microsystems escaped by using their Java software as a door opener to graduate up to the server market. In turn, it is the server company most at risk as Compaq and Dell use the IA-64 to make a PC into a server. In addition to running Windows NT, IA-64 runs all versions of the robust UNIX operating system, including Linux, which is available for free on the Web. This has two effects: 1) it allows IA-64 server vendors to break Microsoft’s operating system stranglehold, and 2) it commoditizes the UNIX operating system. Sun, Hewlett Packard, and IBM have worked hard to proliferate their own incompatible dialects of UNIX to lock-up customers. Now, the power of this differentiation fades before the growing popularity of Linux. Linux is even being offered on portables now.
This is causing the Hewlett’s, Sun’s, IBM’s, and Compaq’s to develop broad software and professional service offerings to replace lost workstation profits. It appears that IBM has a significant head start in this regard, and is probably the safest investment of the computer "metal benders".
Analog Devices (ADI 84) is a leading chip designer with a rare ability to integrate high performance analog with digital signal processing (DSP). Digital signal processing enables the conversion of voice signals into data bit streams, which in turn allows multiple users to share single channels. These chips are used in cell phones, cable and DSL modems, computer motherboards, and motor controls. ADI has a chipset for GSM phones and is working on one for CDMA. The telecom business is hot right now, and so is this stock. Visibility is limited to six months in the chip business and the cycles are extreme. When business is good, manufacturing capacity strains develop and semiconductor prices rise. Then, a lot of capital rushes in, overbuilds capacity, leading to overcapacity, falling product prices, and plunging stock prices. So, a trader could try to buy these stocks when newspaper articles say the overcapacity is never going away, and then sell when the same papers say it's different this time, that no end is in sight for the strong part of the cycle. To quote T.J. Rodgers, Chairman and CEO of Cypress Semiconductors, this is a "treacherous business." It is also a treacherous way to try to make money.
Cardinal Health (CAH 70) management, ever cognizant of the concept of return on capital, continues to execute. This is one of the best managements I have met. The last quarter continued a ten-year string of sustained 20% earnings growth. Please refer to last November's report or November '99 Update on qgmi.com. All I need say is whoever sold it to us in the high 30's and low 40's did not do their homework.
Coca-Cola Enterprises (CCE 18) bottles 20% of the world's Coca Cola products, such as Coke, Diet Coke, Sprite, etc. (Distinguish this company from the Coca-Cola Co., which sells syrup to bottlers like Coca-Cola Enterprises.) North America and Europe are its markets. Price increases and increased support from the Coca-Cola Company should help grow economic profits from current uninteresting levels. Coke Enterprises took a hit last year on their bottling problem in Belgium and France. It now is suffering disintermediation in its UK sales, as the weak Euro allows British retailers to purchase Coke products at a currency discount from the Spanish bottler. Long-term economic profit should improve here and the stock should reflect it. I just cannot get motivated to buy a poor return on capital employed.
DuPont (DD 47) is the largest chemical and polymer company in the
U.S. Products include Lycra and other
nylon, polyester, and acrylic fibers, chemicals, oil and gas through the Conoco
subsidiary, seeds through the Pioneer Hybrid division, pharmaceuticals, and
even some technology products like flat panel displays, portable energy
devices, photoresists, and biosensors.
The majority of sales are in low growth areas, so, despite product
development efforts, revenue growth is expected to be under 5%. Projections for earnings growth are somewhat
rosier due to a profit improvement program called "Six-Sigma." Over the next several years, eps growth
could hit the very low double digits, as earnings grow from last year's $2.58
to as much as $5.00 in the next five years.
Although I see little risk in the stock at $47, 16 times this year's eps
consensus projection is pretty much in line with comparable companies. The sale of the pharmaceutical division
would potentially add $10 to the stock price, making capital appreciation
potential more interesting. Perhaps the
stock could return to the old high of $84 reached in 1998.
Human Genome Sciences (HGSI 150) Chairman and CEO William A. Hazeltine, Ph.D. described the dramatic increase of drug prospects that will be created by the mapping of the human genome. The number of possible receptor sites will expand from the current 500 to between 10,000 and 25,000. Along with their competitors Celera and InCyte, Human Genome Sciences uses automated gene sequencing technology to build a database of human and microbial genes. Genomics-based drugs will create a new way of treating disease. Instead of introducing foreign chemicals to the body, genetic medicines will use the human body's own proteins and antibodies to repair diseased and aged tissues. These medicines can be very focused, hopefully allowing a lower degree of side effects. The profit potential from selling such drugs, and from collecting royalties on the database from which these drugs are screened, is enormous. However, drug development is a slow, expensive process: ten years and $300,000,000 to develop a drug. So it is difficult to place an intrinsic value on human genome companies, which have both large market capitalizations and large losses.
In the interest of not giving people more pages to read, this report will end here. It will continue in about six weeks with Lucent, McDonald’s, Medtronic, Merck, Palm, Pfizer, Qwest Communications, Staples, and The Walt Disney Co. If you wish, you can read ahead at qgmi.com.
Steven L. Ré, CFA
July 14, 2000
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.