Saturday, August 11, 2012

Why These Tech Stocks Look Undervalued

Ever since the dotcom bubble burst, investors have been wary of technology company evaluation methods. Back in the roaring late '90s it was commonplace for analysts to create all kinds of creative techniques, most of which only seemed to serve the purpose of justifying an already sky high stock price. Now we seem to have gone the other way! This post was originally published n May but the methodology is still useful.

Quite frequently, investors are advised to sell or even short a technology stock because the PE is high, without any recourse to understanding the underlying fundamentals of the business. Whilst I sympathize with the principle of staying true to the hard numbers, there is a lot more to evaluation than just looking at a PE and concluding that a stock is expensive.

For example, anyone can draw up a table like this and argue that these stocks are hugely expensive.

Unfortunately, investing is not that easy. However, it is even harder for some investors, particularly when they deliberately ignore the difference between GAAP and non-GAAP earnings. For example, Riverbed Technology $RVBD is sometimes described as being on a 44x PE. Of course on a GAAP basis, it is. However, no serious investor ignores the fact that stock option expenses (which usually make up the difference between GAAP and non-GAAP) are non-cash expenses and are usually ignored by analysts.

Allow me to put it another way, in 2011, Riverbed generated 8.8% of its Enterprise Value in free cash flow whilst General Mills generated 2.7%. In other words, assuming no growth in earnings or cash flow, Riverbed will generate its company value in 11.4 years. It will take General Mills 37 years to do the same.

Still think that only looking at GAAP based PEs makes sense?

Why Tech Investors Get Confused with Revenues

Another issue that is confusing is that with technology stocks, there are revenues and there are deferred revenues and investors can only really see the underlying picture if they look at both. So what is the difference between them?

Essentially, technology companies sell products (hardware and software) but they also sell services which tend to be long term. So when a customer is taken on, the company books revenue for the products and bills for the full service contract. However, the full contract is not recognized as revenue until the service work is incrementally done. No matter, the work is billed. Therefore, investors can’t just look at revenues.

Moreover, the mix of sales between services and product sales, will dictate the mix between revenues and deferred revenues. I will articulate this better below, but first I want to show a chart of the growth of a selected metric. This chart shows the growth rate of revenues plus the change in deferred revenues. I think it is a good way to see how a technology company is trending.

Note that Check Point $CHKP is experiencing a sharp move upwards, yet the market was disappointed with its recent results. The reason for this discrepancy is that product sales were only up 4% and some investors panicked. However, the company bundles product and software services together and, with more software blades being offered, more of the revenue is being recognized as software. This is evident in the metric shown above. Increased deferred revenues are dragging this metric up and this is good for Check Point.

It is a similar story with rival network security company Fortinet $FTNT. It too, tends to recognize service revenues over the course of the contract. However, Riverbed is not faring so well, according to this graph, but the company is in the process of realigning its product offering and, this slowdown will possibly prove temporary as its sales force adjusts to the new products and sales approach.
It’s interesting how Citrix $CTXS seems to be accelerating growth and, Salesforce $CRM remains on a very high growth trajectory. All of which is fine, but investors should be loathe in making their decisions without looking at the most important metric of all.

Cash Flow Really is King

Ignore price to eyeballs. Ignore price to users. Ignore price to how many likes Mark Zuckerberg gets on Facebook for the color of his new hoodie. The key metric in investing is cash flow. With that in mind, here is the free cash flow generated in terms of the percentage of the company’s Enterprise Value.

A few things are immediately apparent

Firstly, Riverbed is being priced in as a company set to experience falling earnings. So even if you share my opinion that the company will struggle to hit its revenue target of mid teens growth, the stock seems like a genuine value prospect. Secondly, with 10% growth forecast for the next two years, Check Point also looks good value. Thirdly, the case for Fortinet and Citrix is based on a combination of its growth and cash flow generation. Neither stock looks expensive, provided it can hit its forecasts. And lastly, whilst Salesforce does look expensive, investors would do well to remember that its growth rates are hugely impressive.

More than Just PE

In conclusion, there are many facets to investing technology rather than just looking at the PE. Indeed, on certain metrics there are some technology stocks that are notably cheaper than so many of the ‘defensive darlings’ that the market is piling into right now. At least I hope so, because I have been picking up some technology stocks in the current market weakness. I happen to think that a diversified and balanced approach is needed in investing, so ignoring a technology stock just because its headline PE looks expensive is not a sensible strategy in my view.

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