November, 2002 Update and Company Visits

 

Inevitable innovation continues despite the technology depression.  Those who have read The Innovator’s Dilemma by Harvard professor Clayton Christensen understand why QUALCOMM is reporting “upside surprises.”  Many investors apparently have not read this vital dissertation on obsolescence, wherein new inexorably replaces old, despite human resistance to change.  They continue to underestimate the innovator’s future, just as they did in the mid-90’s.  As CDMA spreads around the world, QUALCOMM’s revenues, earnings, and presence in our daily lives will continue to grow.

 

 

As the map below shows, CDMA is spreading all over the world, except Europe.  However, on November 19th, the regulators in France are to decide if they will allow CDMA2000 to be built on the 450 MHz spectrum owned by Dolphin – a heavy door is cracking open.

 

 

 

CDMA2000 has shown explosive growth in South Korea.

 

 

 

Company Visits

 

Broadcom (BRCM 14) owns an 80% market share in chipsets that enable cable and satellite set-top boxes to bring broadband to the home.  Broadcom designs the chips that make these products work, and then outsources the manufacturing.  This highly focused business strategy garners profits without requiring a large capital investment in commodity plant and equipment that can turn obsolete and/or be under-utilized tomorrow.  Where have we seen this strategy before?  QUALCOMM.  It is a key to solvency in bad times and high return on investment in good times.

 

Broadcom’s growth comes from its ability to integrate the many component technologies it owns into multipurpose products.  As telephones, Internet connections, wireless networking, television viewing, and movie recording converge into one product, Broadcom leads the way.  On a visit to the company, I held the new Motorola SURFboard SBG1000 cable modem built from Broadcom chips.  It does a lot more than just provide a broadband Internet connection for your computer.  It serves as an Internet gateway and router, provides a firewall to prevent unauthorized access to your computer, switches a five-port Ethernet network, serves as the access point for a wireless 802.11b/g network, and is an IP telephone hub.  Broadcom’s ability to design all these building blocks into one chip, and thereby into one product, erects sizable barriers to competition.  Spreading research and development costs over more components allows Broadcom to invest more on each individual component.  It lowers the price of products, both to Broadcom’s customer and to us, the end users.  The capabilities are all expressed in the form of Broadcom chips inside the product.Broadcom’s growth also comes from a vigorous corporate culture.  Talented engineers and managers are relentlessly recruited, the lead on competitors is relentlessly pursued, the needs of customers are relentlessly served, and product technology is relentlessly driven forward.  Broadcom’s customer list includes the best companies in technology: Cisco, IBM, QUALCOMM, Motorola, Dell, Nortel, 3COM, Hewlett Packard, Linksys, etc.

 

Broadcom’s stock was $275 at its 2000 high, but a series of overpriced acquisitions and the terrible tech environment brought the stock down to a low of $10.  Revenues have grown sequentially for five quarters straight, as market share has been taken from Conexant, AMCC, and other companies that supply fewer engineering components for products born from the convergence of technologies.  An estimate of intrinsic value is difficult, because the timing of a technology recovery is impossible to predict.  However, $16 is a rough, but reasonable estimate.  The company has $600 million cash, minimal debt, and can grow revenues and earnings substantially for years without needing more capital.  The company pays very low salaries; top officers are literally paid $110,500 per year.  Offsetting salaries is a high level of stock incentive compensation.  Virtually all of those options are “underwater” at the current stock price, but there will be a large amount of dilution if the stock appreciates.  Both the CEO and CFO have personally certified the financial reports of the company.

 

The convergence of telephony, the Internet, and cable television over the next ten or twenty years into one giant broadband IP network gives Broadcom and its shareholders great growth opportunities.

 

Starbucks (SBUX 22) is the leading premium coffee retailer.  It has popularized the gourmet coffee culture in the US, and has built a world-renowned brand name.  Over many years of visiting companies one observes that each company has a distinct culture and spirit.  Starbucks stands out for fervor - for the sense that serving the customer is serving a higher purpose.  And, an unusually large percentage of employees are very happy working for the company.  Founded in 1971, the company has an exceptional track record of sustained growth.  It will add another 1,200 stores worldwide in 2003 to the current 5,886.  The international popularity of Starbucks coffee houses continues to impress me, as does the consistency of both coffee quality and hospitality towards the customer.  We’ll soon see how they pass the toughest test ever: opening a store in France.

 

Financially speaking, Starbucks has been an excellent investment since it went public in 1992.  Revenues and earnings have grown at a rate averaging over 30%, and 20% is expected in the future.  85% of revenues come from company owned stores.  The remaining 15% is composed of whole bean sales in supermarkets and club stores, foodservice sales, and licensed units.  The licensed units, consisting of joint ventures to duplicate its familiar coffee house concept around the world, are of particular importance to Starbucks.  The return on capital employed on licensed stores is huge, like QUALCOMM’s royalties on cdma, because Starbucks’ country partners supply the capital.  Starbucks receives license and royalty fees while generating whole bean and product revenues.  The universal popularity of stores in markets as diverse as Osaka, Shanghai, Bahrain, and London hints the world may be Starbuck’s oyster.  Thus, the growth potential for the company remains considerable.  Starbucks has announced that it eventually expects to have 25,000 stores worldwide.

 

Based on an expectation of 20% revenue and earnings growth over the next five years, the intrinsic value of the company is estimated in the very high teens.  This estimate is highly dependent on the continuation of exceptional growth.  Interruption could come from a reversal in current high acceptance rates in international markets, appreciation in presently depressed world coffee prices, or U.S. consumers deciding to forgo the expensive luxury of a cup of Starbucks coffee.  The company is exceptionally generous in offering stock incentives to employees – the person who made your last mocha probably owns part of the company.  This causes dilution but also adds to the exceptional loyalty of employees.  Leases on all those stores constitute a substantial off-balance sheet liability.  I take this liability into account when I value the business, and give this financing vehicle partial credit for the ability of the company to grow at such a marvelous rate.  Management certifies company financial statements.

 

Business is exceptionally strong right now, but a slowdown in comparable store growth predicted by management next year could supply an opportunity to accumulate the stock of this terrific company below today’s deservedly expensive price.  Building a company of this sort is a great human endeavor enabled by free enterprise and conscientious capitalism.

 

A quick note on a personal finance issue:  If you have a mortgage, it is a great time to refinance!

 

Steven L. Ré, CFA                                                                     November 15, 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.