Golden Capital Securities

 

 

Investment Outlook

April 2001

We are going to stick our necks out and say that "we have reached the bottom of the market and, after some gyrations, there is no where left to go but up".

It may be a little early to call the true market bottom, but many of the signs of the capitulation of the market seem to have occurred: frantic selling, high volatility, and headlines in the news.  Historically, as markets ebb and flow, there are logical points in a stock's retracement which tend to hold: 38%, 50% and even 62%.  However, when we get 90%+ retracements in stock prices, it tends to point to the idea that it is truly over for those equity issues.  (Insert name of last year's next best thing here: CMGI, BUY.com, PetSmart.com, etc).

For these "ninety-plusers", any bounce in the stock price is largely speculative or wishful thinking, rather than a discovery of unrealised value.  We can safely say that for the vast majority of dot.com business plans, the internet bubble has burst.  Even for the business models that seem to have initially worked: Amazon.com and Ariba, there seems to a general mistrust by investors and these stocks' performances have reflected this.

The problem, no ... the challenge, is to decide how much the "legitimate" stocks have been discounted and what their fair enterprise value is.  Excellent, well managed companies with profits, like Cisco and Oracle have had their stocks been pushed down deeply.  Investors must attempt to determine whether this decrease in price is due to investor perception or reality.  Let's take Cisco Systems (CSCO-Q) as an example.  Cisco had an incredible run last year, up to a high of $82 almost exactly a year ago, down to its current level of under $16.  The stock has been cut to a fifth of its 52 week high; have its fortunes been cut in a fifth as well?

Historically, Cisco's revenue has been growing at 30 - 50% annually, while its earnings have been growing at dramatically less than that, recently 10 - 20%.  Much of the past and even current valuation of the Company has come from its robust revenue growth, however, looking forward into this new period of "Investor Enlightenment", we hope that companies will be evaluated on how profitable they are, rather than how much marketshare or how many eyeballs they can capture.  

A Company could dominate the widget industry, grow at 100% annually, but if you can't make any money at it, it's a bad business concept.  Many investors, and Analysts, have tried to justify this valuation with the mistaken view that once the rapidly growing company dominates the industry, it can change its pricing structure and become profitable.  However, generally speaking, it was the pricing structure that allowed it to become the dominant player - offering more than its competitors could, at a lower price.  But if the dominant Company moves away from their competitive advantage, they will likely not be the dominant player for too long.

But I digress, ... Cisco is profitable, so we'll focus on that.  On a fundamental basis, Cisco is spinning off relatively large amounts of cash, and this is what should be important to investors.  Assume that the economic downturn is over and that the demand for routers and other network devices picks up, closer to its long-term average growth rate of around 30%.
 

July 31st, 2000 

 Actual

July 31st, 2001 

GC's Estimate

July 31st, 2002 

GC's Estimate

Annualised Growth

 Rate
Revenue per Share $2.74   $3.76 $5.10 36.4%
EBITDA* per Share $0.51   $0.66 $0.87 30.6%
Earnings per Share $0.41   $0.44 $0.53 13.7%
Cash Flow per Share $0.89  $1.00 $1.20 16.1%
Return on Equity (ROE) 11% 10% 11%  

*EBITDA is Earnings before interest, taxes, depreciation and amortization.  It is often used as a proxy for the profit generated directly from the core business.

 

Since it will likely be years before Cisco begins paying a dividend on its stock, if ever, the options available to us for calculating the value of the Company on a fundamental basis are limited.  As we just discussed, using a multiple of revenue, although simple, is not a good describer of value.  Earnings can be used, but they take into effect non-cash expenses like amortization and leave out increases in inventory and accounts receivable and payable.  Plus, for a high-technology company, like Cisco, we want to be able to consider the risk associated with market volatility (the stock's Beta (b)), its growth rate (g) and perhaps the industry growth rate as well.  

 

Without going into a long diatribe in financial mathematics, we will try to make this as painless as possible.  After much hemming and hawing about how to approach such a high growth company, it really came down to one simple statement.  "The market has priced in a value on Cisco that requires it to achieve growth rates at or above its Cost of Capital" for the foreseeable future.  Cost of Capital is how much investors will expect to receive from their investment over and above what they could do in a government bond for the same period.  Cisco's Cost of Capital is almost 28%. Therefore, depending on the factor one chooses, whether EBITDA or Earnings or Cash Flow, you have to believe that the Company will achieve over 27% growth for the next three to five years.  

 

Therefore, if we base our valuation on Revenue (but don't do that), Cisco is currently under-valued. Based on EBITDA, CISCO is currently fairly- to under-valued.  If we base the valuation on Cash Flow or Net Earnings, the Company is actually over-valued.  

Now having said that, a large portion of Cisco's stock price is based on momentum investment and as we have discussed in this previous Investment Outlooks, momentum players have a tendency to bid a price too high up and the sell it too far down.  So, based on a fundamental basis, by the end of July 2002, one could expect Cisco to be worth around $50 (based on 2002 EPS of 53¢).

To be realistic, the NASDAQ, the Technological Marvel, as it was 12 months ago will not return. Waxing philosophically about when CMGI will hit $120 again will not change the fact that they are a holding company of multiple, unprofitable business models. What is more likely is that a new group of stocks, currently under covered and not previously well understood, will emerge to set off the next round of near-term market highs.    What those stocks are, we do not know, but we're working diligently on finding them.  Some might even be in this quarter's Micro Cap report. (So read it! Click here).

Our Favourite Stocks Portfolios

March was another disasterly month our picks for Core Holding Favourites.  Within the Canadian Portfolio, Nortel announced that they will earn less, sorry lose more, than previously thought.  Celestica, and therefore Onex (its major shareholder), were downgraded on speculation that the Contract Electronic Manufacturers would all see a decrease in revenue, the same as Solectron, the industry leader, had.  Add to these the general softness in the market and it was a month of painful drops.

In the US Core Portfolio we had one bright star in Adobe Systems and ultimately didn't have the stock in the portfolio for even a full month, but it reached our target in less than two weeks, so we sold.  The rest of the stocks came down with the market in general.  For the future, we are looking at the Semi-Conductor stocks and the PC Makers as the likely leaders to take us out of this Bear (with a Capital B) market.

Until next month.