The Bubble Has Burst!

Well, the technology stock bubble has well and truly burst. The NASDAQ has tumbled from over 5000 earlier this year to approaching the 2500 level. Of course, NASDAQ is heavily into technology issues so once the shine was off the apple the result was inevitable. While completely understandable, the damage was greater than it needed to be and the fallout far-reaching. Let's take a look at what happened and where we're headed.

Excessive Capitalization

I've been lamenting for some time how I felt that technology stocks as a group were grossly over capitalized. Everyone thought that they were going to get rich as some stocks enjoyed phenomenal performance in the days following the IPO. Everyone, from the investors to the principals to the employees, had dollar signs dancing in their heads. People were trading the promise of cold, hard cash compensation (salary) for stock options and the possibility that they'd become overnight internet millionaires.

Winners and Losers

The truth of the matter is that some companies are going to do very well for themselves in the "new economy" built on the foundation of the internet. It's also true that we're starting to see the demise of companies which just couldn't make it. There failures can be traced to a variety of causes, ranging from a poor product or poor management to simply running out of money. In the age of immediate gratification, investors don't want to wait two years or more before seeing a return.

Some industry fall-out was inevitable since the 'net is just not the right vehicle for the sale of certain goods. At one point, people thought that they could sell anything and everything on the 'net and people would flock to their site, credit cards in hand! The truth turned out to be very different, especially for those would hadn't done their market research. Trying to sell clothes on-line is a typical example. While Victoria's Secret was able to buck the trend (after all, you can't return underwear,) most people want to try clothes on and get an idea of how the clothes look on them. Also, a size 6 from one manufacturer might be a size 7 from another!

Investors

As I said, failures were bound to occur. A shrewd investor would have researched the company, the market, the principals and arrived at a considered opinion as to the viability of the venture. Of course, that's not the kind of investor we're dealing with these days. In the not too distant past, trades required the services of a broker and there was a delay between the time an order was placed and the time it was executed. The delay forced people to think before the acted. New tools permit investors to respond immediately to the market fluctations.

As I've mentioned before, day traders introduce even greater volatility to the markets. These people buy and sell stocks, trying to leverage the smallest price movements, while knowing absolutely nothing about the companies behind the symbols. Seeing these people with their eyes glued to CRTs reminds me of bingo or keno players. These people could care less that they are playing with the livelihoods of people who work for the companies being traded. An astonishing 70% (according to numbers I've heard) of day traders are going to lose money in the long term. See why the comparison to bingo players is so apt?

Market Saturation

The domestic home computer market is fairly well saturated. Some large American cities boast that more than 70% of residences have computers in the home; the national average is roughly 50%. In 1997 we witnessed the introduction of the sub-zero PCs (priced under $1,000.) The machines, often shipped with Windows 95 or 98 pre-installed, were practically flying off dealer's shelves. This introduction coincided with the increasing popularity of the internet. Buying a home computer for web surfing and e-mail became financially viable for many.

The success of the last few years has meant that the profit margin for desktops has been dropping precipitously. The shift in emphasis to the portable market has driven down prices there too. Not only that but the portable market is much smaller than the desktop one, consisting primarily of road warriors and students. Except for gamers, most home users don't feel any pressing need to upgrade their hardware every other year. We're seeing a decrease in the growth rate as an inevitable result.

Upgrade Issues

In some ways, the computer industry has been a victim of its own success. The original 5 MB hard drive for the Radio Shack TRS-80 cost $5,000, or $1,000/MB. Customer installable hard drives are now selling for less than 1¢/MB. I just saw a 40 GB drive listed at CompUSA for $169.99 (less than ½¢/MB.) Similarly, good quality 17" monitors can now be purchased for around $230. Even the flat panel displays (15") have come down from $1,050 to $800 in the last year.

Assuming a CPU speed of 350 Mhz or higher (typical if purchased within the last three years or so,) outright purchase of a new system can't be justified. Add more memory, install an extra hard drive, perhaps install a CD-RW or CD-DVD drive and your hardware is good for at least another two or three years. If you currently dial-up to an ISP, you might have to purchase a NIC in order to upgrade to ADSL or cable modem but that's about it.

With the exception of gamers, what was driving the hardware purchases was software. For each release of system software, Microsoft would publish the Minimum Hardware Requirements list. Support for AGP and PCI cards as well as USB and FireWire (IEEE 1394) had to be incorporated into the operating system which gave us the string of Windows 95, 98 and ME, along with the various editions and service packs. If you just had to have support for the lastest Microsoft O/S then you had to purchase new hardware.

Applications could and did limit the O/S under which they could be run. Minimum software requirements ("requires Windows 98") made applications dependent on the underlying O/S which would be dependent on the underlying hardware. You can imagine the frustration and cost of having to replace your system unit just to run an application. Things were changing so rapidly, however, that this was often the case.

We've seems to have reached a lull in the software race. Apart from Windows 2000, all that has come from Microsoft recently are upgrades. These upgrades are increasingly difficult to justify, both from a cost and a convenience stand-point. Potential problems with migration from NT to Windows 2000 have resulted in many companies taking a wait-and-see attitude. Until and unless there's a compelling reason for an upgrade, most consumers are unlikely to shell out annual payments to Microsoft for upgrades of questionable value.

Impacts

While the decrease in the growth rate of system purchases has driven down the value of manufacturers such as Dell and Compaq, even Microsoft has not remained untouched. After warning of less than expected fourth quarter profits, Microsoft closed down more than 11% on Friday and has bounced between 52 and 72 within the last 30 days. And so it goes down the line, hitting the component manufacturers and even the shipping companies such as UPS and FedEx.

The other side of the coin is quite bright, however. Oracle beat the Wall Street estimates and grew their application business (Oracle Financials, e.g.) considerably. Demand remains high for people with Java, C++ and CORBA skills with starting salary ranges up into the lower 6 digits. Now that Y2K is behind us, companies are trying to leverage their software investments and preparing to deploy new "web-aware" application.

Estimates

In the last two weeks I've read about many companies revising their fourth (calendar) quarter earnings projections downward. For a variety of reasons, companies have not been able to make the earnings and profits estimated by Wall Street. While some investors greet the news by pummeling the stock price, perhaps we should be looking to the analysts and asking whether their estimates were based on a realistic determination of the markets.

While I don't claim to understand how analysts arrive at their figures, I must assume that they take into account various economic indicators. Various government agencies generate estimates regarding anticipated growth in GDP, trade balances, crop yields, same-store sales, etc. When these estimates a proven to be erroneous then the assumptions underlying earnings estimates are also incorrect.

Let's take a concrete example. The Federal Reserve reported that industrial production for the month of November dropped by 0.2%. It seems that most analysts had expected the rate to increase. Instead, due to waning consumer confidence, which I believe bodes ill for retailers this Christmas, automotive sales were down this fall. In order to avoid excess inventory, production had to decrease.

So? All this proves is that I've got 20/20 hindsight. What concerns me is that so many elements of modern life are intertwined that even so-called experts can miss the ball. Why should we expect analysts to be able to estimate company earnings when they're based on figures which turn out to be incorrect? And why do people assume that a company is under-performing just because the actuals are less than the estimates?

To go back to the Microsoft example, for the quarter ending in December they've revised their earnings to be $1.80-1.82 per share, rather than the $1.91 Wall Street estimate. Can someone please explain how that 5% difference can result in a drop in market capitalization of 11%? This is a company which expects revenues of $25.2-25.4 BILLION for the year ending in June, 2001. Does this make sense to you?

Futures

I expect that the domestic market for home computers will remain soft. With people downloading vast quantities of multi-media content from the 'net, especially MP3s, I expect that component sales (especially hard drives) will remain fairly strong. Given the penetration of computers in American homes, I'm leery of the prospects for "internet appliances". If people have a PC then they don't really need such a device, no matter how nifty it looks. I see a huge potential for sales of flat panel displays, however, once the price comes down below $500.

Most home computers are used for light-weight word processing, e-mail and 'net surfing. The application focus has shifted onto the web since almost every computer already has the "universal client" (a web browser.) Apart from some niche markets, I don't see a huge potential for software for home PCs. Image processing packages are included with scanners and digital cameras and the only really hot market right now is anti-virus software (which everyone should have, by the way.)

The next version of the internet is rapidly approaching. Deployment of high-speed residential internet access is accelerating. This bodes well for manufacturers of switches, routers and access devices. Edge and backbone hardware sales are going to experience healthy and sustained growth. As companies switch from leased-line and frame-relay PVCs to VPNs across the internet, the companies involved in these fields are going to reap the rewards. This applies equally to hardware and software vendors.

Finally, the prospects for those experienced in implementing web-based solutions are exceptional. E-commerce as well as B2B will continue to grow in volume over the next few years. Familiarity with the tools and techniques will ensure that your skills will be in great demand. Key technologies include Java, CORBA, XML and, to a lesser extent, C++. N-tier and object-oriented design methodologies will be important as will practical experience with deployment of mission-critical web-enabled applications.

Copyright (c) 2000 by Phil Selby