Making the Tech Slump Pay Off

It's a risky gambit--sometimes fatal, in fact--but stepping on the gas when others hit the brakes can allow a company to overtake its mightiest rivals

A year ago, nearer the start of this deep tech slump, Gary L. Bloom got the surprise of his life. The newly appointed CEO of storage software maker Veritas Software Corp. (VRTS ) told analysts during a conference call that, in spite of deteriorating market conditions, he didn't plan on slashing expenses.

Instead, he would remain "fully invested" in research and development and sales operations, accepting a temporary decline in profits. Ultimately, he said, the company would be better off for it. Bloom thought investors would applaud. Instead, they dumped Veritas stock like yesterday's lunch, sending the price down 26%, from $50 to $37, and cutting its market cap by more than $5 billion in one day. Today, the stock is even weaker, trading at $21.

Bloom regrets the beating his stock has taken, but he vows to stick with his plan. "It's better to take a margin hit and keep your ability to innovate," he says. Indeed, Bloom's moves seem to be paying off. Thanks in part to a spending increase of 36% in R&D last year that funded new storage products, Veritas' revenues grew 24%, to $1.5 billion, in 2001.

Making the Tech Slump Pay Off

Meanwhile, the overall market for storage software grew only 3%. Veritas gained nearly 2 points of market share, solidifying its position as No. 2 with a 20% slice, according to Gartner Dataquest. Due to weakening demand, revenues shrank 4% in the first quarter. But Bloom isn't backing off. "We're ready for a better economy. Bring it on!" he says.

Bloom may go against the herd on Wall Street, but if history is a guide, his instincts are spot on. With help from sister company Standard & Poor's, BusinessWeek conducted a detailed analysis of the performance of 2,000 U.S. info-tech companies during the past two downturns. What the analysis found is that the players that performed the best following the 1985 and 1990 slumps typically turned a deaf ear to Wall Street's urgings to cut costs across the board.

Instead, these companies hit the gas while their competitors were slamming on the brakes. They pioneered the next generation of technology while their competitors cut back on research. They staffed up while others were laying off. They made strategic acquisitions and invested in more efficient factories while rivals conserved their cash. The result: Those that were gutsy turned in impressive stock gains following the slumps. After the 1990-91 slowdown, for example, the top 10 tech companies saw their stocks climb anywhere between 103% and 221% in three years.

Many of those that dared to defy Wall Street are now household names: Microsoft (MSFT ), Apple Computer (AAPL ), Compaq (CPQ ), EMC (EMC ), and Cisco Systems (CSCO ). They didn't cower when hard times loomed. Instead, they craftily found ways to make the downturns pay off for them. And not just by outspending timid rivals. Some devised strategies and products tailor-made for tougher economic times and cost-conscious buyers.

Others fed off the misfortunes of rivals by snapping up distressed companies at fire-sale prices or by buying advertising on the cheap, establishing brands while rival products went unsung. "Great leaders don't manage for the present. They manage for the future," says Dennis C. Carey, a vice-chairman at management consultant Spencer Stuart Inc. "The ones who play defense will be on their own five-yard lines when this thing turns."

Those who played too conservatively in the past paid a steep price. IBM (IBM ) in the early 1990s tried to cling to the status quo by continuing to focus on its expensive mainframe computers rather than birthing new technologies. By 1993, the company was in disarray and searching for a new CEO. "The conventional wisdom is to pull the wagons into a circle and hunker down and try to keep the cash up. But it's a losing strategy," says Larry Downes, co-author of the newly published management book, The Strategy Machine.

So which companies will come out of this downturn best-positioned for the upturn? BusinessWeek applied the lessons from the past to figure out which companies are best preparing for the future. We pored over the most recent financial statements of today's top tech companies for those that showed characteristics similar to the winners from 1985 and 1990--who spent an average of 8% of sales on R&D, 9% on capital expenditures, and perhaps most surprisingly, 40% of revenues on sales and other overhead.

Sure enough, dozens are pursuing bet-the-farm strategies that paid off after earlier downturns. There are plenty of fresh faces, including Leap Wireless International Inc. (LWIN ), a little-known wireless-services operator that last year defied conventional wisdom and more than tripled its sales and marketing spending, to $115 million. That helped it boost its customer base from 190,000 in 2000 to 1.4 million now. For every new name, however, there is an old one. This time around, the industry's giants are among the aggressors--Microsoft, Intel (INTC ), and Dell (DELL ), to name a few.

The giants can afford to play rough when times are tough. With billions in cash, they are rich enough to invest while weaker rivals are busy surviving. No company has used its financial strength more to its advantage this time around than Dell Computer Corp., which ranks No. 5 on BusinessWeek's annual Info Tech 100 list. When the recession began, Dell did a sharp about-face and dropped its prices to become the low-priced PC brand. The goal: to grab market share while others struggled.

It worked. Dell dropped its average prices by 17% last year, gaining 2.5 points of share, according to researcher IDC. What made it all possible was that Dell started off the recession with the lowest costs in the industry and $5.4 billion in cash so it could invest in technology and plant upgrades to improve its already efficient supply chain. It was the only PC company that could slash prices and still make money.

Other top-ranked companies in this year's Info Tech 100 have learned from history, too. No. 1 Samsung Electronics Co. of South Korea has continued to invest in its memory-chip business even while competitors bailed out. Samsung figures the strategy will pay off when demand returns and chip prices rise. And No. 8, Taiwan's Elitegroup Computer Systems Co., is rapidly building plants in China in anticipation of a boom in its motherboard business.

Still, even the wealthiest players can't spend willy-nilly in a downturn. The winners of the past cleaned house at the first sign of a tech wreck. They quickly brought costs in line with lower demand and overhauled their operations to make them more efficient. Then they blazed new paths. In 1985, Apple Computer Inc. found itself with bloated costs when PC demand shriveled, so it laid off 1,200 workers. Then Apple primed a new market, desktop publishing, by training the sales staffs of hundreds of retailers. Demand returned, and Apple's stock price soared 75% in three years. "In high tech, when you have tough times, it's smart to focus and build," says former Apple CEO John Sculley.

There's no guarantee--especially this time--that using the tactics of the past will produce tomorrow's powerhouses. This downturn is the worst the industry has endured. It's broader than ever before, slamming not only computers, software, and semiconductors but also telecommunications. It's longer and deeper, too. U.S. corporate tech spending has plunged nearly 17% from its peak in the fourth quarter of 2000, according to the Commerce Dept., vs. less than 5% drops in the two previous slumps. And now the downturn is dragging through its sixth quarter, exceeding the past two. While a few markets have recovered a smidgen, Goldman, Sachs & Co. (GS ) doesn't expect a return to 2000 tech spending levels until 2004.

That means some of the bold spenders may find their investments were either too big or made too early. A few will pay the ultimate price and go out of business. Already, some companies that were aggressive early on aren't able to keep it up. Take Inktomi Corp. (INKT ), a maker of Internet search and content transmission software. A year ago, CEO David C. Peterschmidt vowed to invest in the future. Last month, after failing to make a single sale of the latest video transmission software to spending-averse corporations, he put the next version on ice.

"You need to get your R&D down to the essence, where there's clear and present demand today," he says. Still, Peterschmidt figures his roll of the dice will pay off. When the economy improves, he says, Inktomi will again push its video transmission software--ahead of rivals.

Still, downturns can provide the perfect conditions for changing the rules of the game. Lower demand and depressed prices can alter market dynamics overnight. Market leaders can be caught off-balance as boom-time CEOs struggle to figure out what works in a more sober environment. This set the stage for Singapore-based contract manufacturer Flextronics International Ltd. (FLEX ) to pull ahead of Solectron Corp. (SLR ) as the market leader in the first quarter of 2002. Flextronics' sales rose 6%, to $3.3 billion, from a year earlier, while Solectron's revenues fell 44%, to $3 billion.

Flextronics did this by using the downturn to transform its business. The company has been shuttering plants scattered across high-cost areas while opening huge factories in less-expensive places such as Southeast Asia. The new plants cluster Flextronics' assembly lines with the company's components factories and the plants operated by its parts suppliers. Other suppliers store inventories there, too. The cozy setup has helped the company to dramatically improve its efficiency. It increased the number of times it turns over inventory from six to nine last year, while Solectron's turns stagnated at four.

At the same time, Flextronics is investing in an even bigger future. It just spent $26 million on the first phase of a five-year project to build an industrial park in Shanghai. In May, it paid $364 million for NatSteel Broadway Ltd. to add to its manufacturing operations in China and Hungary. Investors are skittish, having dropped the company's stock from $30 last year to $10, but Flextronics vows to stay the course. "This market has the potential of being worth half a trillion dollars in 10 years. We're putting in the systems to handle that growth," says Jim Sacherman, a senior vice-president for Flextronics.

Companies that understand the new cost-conscious customer better than their rivals can also turn bad times into good. Rather than taking cell-phone giant Nokia Corp. (NOK ) straight on, Wavecom (WVCM ) of Issy-les-Moulineaux, France, No. 51 on the Info Tech 100, is trying an end run. It's designing and selling simple, inexpensive kits that contain the guts of mobile phones. Those modules can be popped into mobile-phone shells and sold cheap by outfits in Korea or mainland China.

While the strategy was launched in 1997, Wavecom is pressing hard to take advantage of a penny-pinching climate now when cheaper phones are in demand. It doubled sales and marketing expenses last year, to $11 million, partly to expand its presence in Asia. Its moves have paid off: Revenues nearly quintupled last year, to $283 million, and net income hit $8.3 million after a $12.9 million loss in 2000.

The biggest gambit of all, though, is to spend boldly on radical new technologies or manufacturing techniques, not knowing if they'll catch on or even work. Compaq Computer Corp. did just that in 1985. Up until then, Compaq and other PC makers followed IBM's technology lead. But during the slump, Compaq's then-CEO, Rod Canion, rolled the dice. While IBM was building PCs based on Intel Corp.'s 286 microprocessor, Compaq spent heavily to develop PCs using the more powerful 386 chip. When Compaq released its products in the summer of 1986, it was the beginning of the end of IBM's dominance of PCs. Ultimately, Compaq became the largest PC company until the current downturn, when Dell Computer stole its thunder. "The things we did in the '80s moved us to the head of the pack," says Canion.

These days, two of the industry's most entrenched players are trying the same tactic: Microsoft and Intel. On the surface, this seems like bewildering behavior from two companies that are rolling in monopoly dough. Why take any big risks when things are so dicey? But Microsoft Corp. Chairman William H. Gates III is a student of what ailed IBM in years past and has vowed never to fall into its trap of complacency. And Intel Corp. Chairman Andrew S. Grove went through the fiery 1985 downturn and made the drastic move of getting out of the memory-chip business--which was to pay sizable dividends.

Microsoft, No. 27 on the Info Tech 100, is pouring gobs of money into complex technologies code-named Longhorn. Microsoft hopes to tackle 10 big initiatives, including the much-ballyhooed but elusive "information agents"--digital servants that might one day do all your computer bidding. To reach such technical zeniths, the software giant is investing a staggering 17% of revenues in R&D. "If we're right, we'll emerge stronger," says CEO Steven A. Ballmer.

Intel has the same idea. The chipmaker, No. 56 on the Info Tech 100, has been battered by falling demand and prices. On June 6, it warned of lower revenues, marking six quarters of depressed results. Yet the 34-year-old chipmaker remains undaunted. Intel is investing in three manufacturing techniques that could ultimately lower the company's costs. Last year, during the worst of the downturn, Intel spent $7.3 billion on new plants and equipment, up from $6.6 billion in boom times. Now, six new chip plants with the latest manufacturing technology are nearly finished. Once they're humming, Intel will be able to churn out chips at a lower cost than most competitors.

To get an even quicker payday, some companies are snatching undervalued businesses. Many tech stocks have dropped 50% or more during the past two years. Those who acquire now--when there's scant competition from other buyers--can come away with bargains. Online auction giant eBay Inc. (EBAY ), No. 83 on BusinessWeek's list, has bought up auction sites in Germany, France, and Korea, quickly landing the top ranking in each country. For just $133 million, it bought French auctioneer iBazar last May, gaining a presence in France, Italy, and Spain. EBay's dominance in Europe last month forced Yahoo! Inc. (YHOO ) to shut down its European auction sites.

Downturns can even provide the opportunity to make wrenching changes that may not be possible in normal times. EMC Corp., the leader in the market for storage devices, did just that. After revenues dropped precipitously last fall, it announced an $825 million restructuring plan that included firing 4,000 people and consolidating factories. Altogether, the moves have slashed about $200 million from EMC's quarterly expenses.

EMC isn't just trying to save a few bucks, though. The company is using the savings to retool its business to become a stronger player when the economy bounces back. It's investing heavily in new software and services so it won't be as reliant on the cutthroat storage hardware business. Gross margins on hardware plummeted from a peak of 60% to about 25% now, while the storage software EMC is working on will carry margins close to 85%. The cost-cutting will help EMC keep R&D spending at about $200 million a quarter.

"We're saying we're going to do this kind of spending, continuing to lead and innovate to make sure we come out with the innovations first," says Chief Executive Joseph M. Tucci.

To keep his people focused, Tucci literally has executives walking on hot coals. During a May 29 off-site meeting at The International Golf Club in Bolton, Mass., he challenged his 160 top managers to fire-walk with him. Everyone traversed the 15-foot path of glowing embers without injury.

In the dark days of this technology slump, it's worth remembering the lessons of 1985 and 1990. For those with the money and the gumption, this is a rare opportunity to race ahead of the competition. In some ways, it's like fire-walking. Trust your instincts--and don't slow down.

By Steve Hamm in New York, with Faith Keenan in Boston, Andy Reinhardt in Paris, and bureau reports

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