The Weekly Sample - Week of 02/20/09

Fourth quarter earnings season has wrapped up and as expected most companies in the sector saw double digit revenue declines with additional double digit revenue declines to come. When someone who listened to the AMCC call prior to me indicated revenue was down 25% and would be down another 25% my reaction was - “Wow – revenues cut in half in 6 months” – and his response was –“Actually, it’s 46%, not half.” Ah, the glories of negative compounding.

What is most disturbing is the fact that participants appear to be viewing this slowdown as a traditional recession without addressing the extraordinary nature of its origins. This is not a recession, this is a credit crisis which among other things, has triggered a severe global recession. Failure to recognize this is equivalent to treating a viral infection with antibiotics.

The exception is Cisco. The press pegged Cisco's recent $4B bond offering as a war chest for acquisitions but we believe Cisco is responding to the reality of this recession. Read or recent article “Bank of Cisco” to learn more.

Unlike Cisco, many component and equipment manufacturers are re-using their playbooks from the 2002-2003 seasons when similar revenue declines took place. The problem then was one of severe overbuilding and overcapacity and things reached steady state several years later though sustained profitability is still a problem for many companies. An often heard refrain during the current earnings season was “We survived 2002 and this crisis isn’t as bad as there is no excess capacity'”.

References are made to carriers or enterprises pulling back on capex ‘temporarily’ only to possibly resume in 'in the second half’ as investment must keep pace with bandwidth or storage growth. There is little recognition that carriers and enterprises now must justify a 50% greater rate of return on any investment because their cost of capital has increased. Smaller carriers and enterprises are locked out from additional financing and are spending cash tightly with the knowledge that it cannot be replaced.

In a normal recession revenues go down and the cost of capital goes down. Companies rein in capex because revenues are down but eventually spend more (as a % of revenue) because the cost of financing is lower. The hurdle rate for new investments drops and projects that could not be justified before become feasible with cheap money looking for a return.

The credit crisis makes the current environment different. We have a a recession which brings revenues down (don’t listen to anyone who says their business is recession proof) coupled with much higher costs of capital. Example: a company with $1B in revenue that spent 15% on capex ($150M) now has $800M in revenue with 10% capex ($80M).

Anyone who cites the fact (and truly believes) that bandwidth growth requires capex investments to return is a fool. If anything was learned in 2002 it was that new capex must be tied to new revenue streams, and using proxies like user counts, eyeballs, pageviews, or bandwidth growth is bad business management. The only meaningful capex metrics are revenue growth and the percentage of that revenue allocated to capex, and unlike 2002 the current recession puts downward pressure on both. If it doesn't increase revenue, it doesn't increase capex. Period.

2002 was a problem of abundance, but having an abundance of anything in the tech business is a tractable problem. In tech, people find new applications to waste whatever is abundant. There was hope that eventually the capacity built in the bubble would be consumed and growth would resume.

This time is different as the macro economy is in a solid deflationary bust. Things will only turn around if the cost of capital to small and medium business is improved and if service providers can find new applications and new revenue streams that compel their customers to shift scarce dollars in the direction of Telecom services. While I am superbly confident companies will innovate in the long run, I fail to see any scenario where such a massive change can take place by the second half of this year, as many companies are outlining. It's just impossible.

More Stimulus

Our commentary on the stimulus last week garnered more interest that we expected. Lightreading decided to turn it into an article and I was contacted by Fox News to tape an interview about it last Thursday. The segment is supposed to air this week and if a link becomes available I'll post it. We'll be writing more on this issue going forward as it is a watershed event that has significant investment potential.

Links

Tech-Boom Flashback for Bankers - WSJ.com

When the dot-com bubble burst at the beginning of the decade, hundreds of technology companies folded and the flow of deals dried up. Those hard times seem to have returned, but bankers in the sector suggest the prognosis for technology is better than for other sectors, largely because tech companies learned some valuable lessons from the first crash.

Ridiculous. That’s like moving to Florida from California and claiming experience with hurricanes because you’ve survived an earthquake.

Employment Falls in Silicon Valley - WSJ.com

Nothing like 2001-2003 though. It's clear things have turned but at this point the depth of the decline is unknown. California tax receipts and government budget are also a good proxy and those aren't too rosy. Personally, my money is always on Silicon Valley. When that becomes a bad long term trade we have serious issues as a country.

Nyquist Small/Mid Cap Index Performance

You will notice that the table below looks a little different this week as there are only four rows in the “Gainers” portion of the table. Of the 53 stocks in the Nyquist sector, every one was down except for two unchanged (Including Nortel, which is bankrupt and should be zero), and two gainers. One of the two, Soapstone, gained because it announced the possibility of returning the remaining cash to investors and folding up shop. Safe to say it wasn’t a good week to be an equity investor.

Again, macro issues trumped all, making it difficult to commentate on individual stock performance. Occam Networks and Acme Packet trading volume was 2x normal levels due to large block trades. EZ-Chip, one of only a few companies with what we believe is an extreme overvaluation broke several technical trading boundaries.

To learn more about the Nyquist Index, including historical performance and what companies are included, please visit the dedicated page for The Nyquist Small/Mid Cap Index. It identifies the companies that make up the Nyquist Index universe and the methodology behind the calculation of this benchmarking tool.

Thanks for reading.

Andrew Schmitt