Merrill's Tech Guru Draws The Big Picture

Steven Milunovich is bullish on the Internet buildout

Wall Street brokerage firms employ armies of analysts to cover technology stocks, but nearly all focus on a narrow group, such as e-commerce companies, networkers, or PC makers. That's why Merrill Lynch (MER) named veteran computer analyst Steven Milunovich as its global technology strategist, a new position for the firm.

Milunovich's job is to synthesize the ideas of Merrill's 110 technology analysts who cover nearly 500 companies into coherent advice. He is to focus on big-picture trends, which are often neglected by analysts caught up in quarterly earnings forecasts. Given Merrill's vast reach, with 15,900 brokers serving over six million households, Milunovich's views could become influential. Personal Finance Editor Susan Scherreik recently spoke to Milunovich, 40, about technology investing.

Q: Are you bullish?

A: Over the long term, yes. Technology will continue to be one of the fastest growing sectors of the economy.

Q: What about the short term?

A: We might see a bounce between now and January because tech stocks have staged a yearend rally in eight of the past 10 years. But I doubt we will make new highs. Price-earnings ratios are still generally high by historic standards. Tech stocks have to fall another 10% to 15% before being fairly valued.

Q: How do you pick stocks?

A: Tech investing is thematic. If you can get the big-picture trends right, it quickly leads you to the baskets of stocks that should do well over time.

Q: What's an example?

A: Say you decided in the early 1990s that data networking could be a big thing. Back then, there were a handful of major players, like Cisco Systems (CSCO) and Cabletron Systems (CS). It wasn't clear how big networking would be or which companies would succeed. Over time, some went out of business or merged with others, and Cisco became the gorilla. If you had initially bought a basket of stocks of the major players, you could have narrowed your portfolio to the winners over time.

Q: What's today's key theme?

A: The buildout of the Internet will drive technology over the next five to ten years. It's not a new theme, but we are still early in the game. We argue that no more than 20% of the Internet's plumbing is in place in the U.S. Globally, the buildout is probably closer to 10%.

Q: Which stocks will best capitalize on this?

A: The infrastructure players are well positioned. Sun Microsystems (SUNW) could dominate the server category. In storage devices, we like EMC (EMC), Network Appliance (NTAP), and Veritas Software (VRTS). In communications equipment, Cisco (CSCO), Nortel Networks (NT), and JDS Uniphase (JDSU) are good choices. Software will be important, so Ariba (ARBA), Oracle (ORCL), and niche players like Pivotal (PVTL) and Mercury Interactive (MERQ).

Q: How about the wireless Internet?

A: The wireless buildout has barely begun. We think the device companies, such as Research in Motion (RIMM), Palm (PALM), and Handspring (HAND) will thrive, as well as new software names, such as (PHCM) and services companies like Aether Systems (AETH).

Q: Which sectors do you favor?

A: We think data storage will be one of the highest growth areas in technology and exceed our expectations over time. As Internet use becomes more pervasive, increasingly data will be stored digitally, fanning demand for data-storage devices.

Q: What sectors do you avoid?

A: We're underweighting Internet stocks. We've seen a bubble type of industry; first there was hypergrowth, and then the bubble burst. It's like in the early 1980s, when a hundred disk drive companies emerged and then collapsed. People were saying the PC thing is over--and that was before Microsoft went public. What happens after a bubble bursts is that the real business shows up 5 to 10 years later. So, Internet stocks will probably languish for a while.

Q: When Internet stocks revive, which will be the names to own?

A: Our inclination is to go with today's leaders, thinking that they will decline less and bounce back first. So America Online (AOL), Yahoo! (YHOO), and eBay (EBAY). But still be cautious.

Q: Are there cheap tech stocks that investors should buy now?

A: There are cheap stocks, but whether they are screaming buys isn't clear. For instance, Compaq Computer (CPQ), Dell Computer (DELL), Microsoft (MSFT), and Intel (INTC) have fallen to attractive levels, and they will probably bounce back a bit. But they were the leaders of the PC era of computing, and the fundamentals don't support investing in them over the next few years. You're better off buying high-quality companies, like EMC and Network Appliance, because they are in sync with the new trends.

Q: Are you sounding the death knell for PCs?

A: PCs will continue to be big sellers, but they will no longer drive technology. The tech industry changes dramatically every 12 to 15 years, and the market leaders of one period rarely lead the next. In the 1970s and early 1980s, mainframes were dominant, and companies like IBM and DEC emerged as the leaders. Next came the PC era, giving rise to Microsoft, Dell, and Intel. Now we're in the network-computing period, which is about building the plumbing of the Internet.

Q: What's the best way to value tech stocks?

A: Revenues are a better predictor than earnings of tech-stock prices in the short term. A good example is Nortel. Its third-quarter earnings beat estimates, but revenues were disappointing, and its share price has since fallen 29%. That said, we still think Nortel is a good stock to own because it's a leader in the high-growth fiber-optics area. If you look at the Merrill Lynch 100 Tech index, which represents the largest tech stocks, the top 10 stocks in terms of earnings growth rose an average 113% over the past three years. But the top 10 revenue growers rose 134%.

Q: Why are investors paying more attention to revenues than earnings?

A: One reason is because some tech companies don't have earnings. Another is because it's harder for management to manipulate revenues. But most important, revenues are a company's oxygen. You can't sustain high earnings without strong revenue growth. Look at some of the biggest tech blowups of the past year, such as IBM (IBM), Xerox (XRX), Lucent (LU), and Unisys (UIS). In every case, earnings growth handily exceeded revenue gains.

Q: Anything else important about revenues?

A: Be wary of big tech companies whose revenues are approaching $30 billion. A study by the Corporate Executive Board and partly funded by Hewlett-Packard found that the sales growth of Fortune 50 companies tended to stall at $30 billion. Compaq hit the wall around that mark, and sales are slowing at Lucent, Intel, and Dell. Companies I'd watch in here are Ericsson (ERICY), Nortel, and Nokia (NOK). Hewlett-Packard's (HWP) revenues slowed at $40 billion but then reaccelerated for a few quarters. However, its recent earnings disappointment shows the bigger you get, the harder it gets.

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