Here's How To Discover Value In Tech -- Even At Current Prices

The recovery in the technology industry is just beginning, yet the tech-rich NASDAQ index is up 46% for 2003 and the search for value is tough. Laura Conigliaro, Goldman, Sachs & Co.'s (GS ) technology strategist, can name lots of great companies she thinks are just adequate investments at current prices. "Where is the valuation reasonable?" she says. "A well-hidden company nobody knows."

Or maybe not. There are still tech companies whose stock prices are reasonable -- considering their bright prospects. First, find companies riding genuine long-term trends such as the growth of e-commerce, the fight against hackers, and the search for technology to store -- and crunch -- ever-expanding files of corporate data. Then look to see who outspent rivals during the downturn. A 2002 BusinessWeek study of the 1985 and 1990 tech downturns showed that companies that outspent rivals on research & development and marketing during busts outperformed in recoveries. Finally, look for operating leverage -- a cost structure that will give them big profit gains on small sales boosts as business investment turns up in 2004. That search leads to companies in network security, the consumer Internet, and data storage, which are all bets on fundamental changes in how consumers and companies do business.

The best security company out there is Symantec Corp. (SYMC ), maker of the Norton antivirus suite, says analyst Rob D. Owens of Pacific Crest Securities. Besides consumer software, Symantec has made a big push into corporate-security products such as firewalls and intrusion detection. Analysts say profits will rise only about 11% in fiscal 2005 beginning in April, to $1.19 a share, but Owens points out that Symantec has beaten calendar 2003 estimates by 8 cents a share through the first nine months and thinks more of the same is ahead.

With such customers as Symantec and H&R Block (HRB ), Digital River Inc. (DRIV ) is the pioneer in the new method of delivering software: downloading it over the Net, rather than going to the store and buying it. The Eden Prairie (Minn.)-based company says revenue will grow about 20% next year, to $120 million, but it has a history of beating forecasts. "Our philosophy is to underpromise and overdeliver," says Chief Executive Joel Ronning. And Digital River has lots of operating leverage, allowing profits to rise sharply as revenue turns up: The company has boosted its top line by 70% in the last two years without major hiring, Ronning says. Analysts say earnings will jump 34% next year; the stock trades at 28 times 2004 earnings.

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The company best-positioned to exploit a rebounding market for Web advertising is Yahoo! Inc. (YHOO ) U.S. Bancorp Piper Jaffray (USB ) analyst Safa Rashtchy expects the Web ad market to rise 21% next year, to $8.1 billion. Street consensus says that will boost Yahoo's earnings by 50%, to about 54 cents a share, or $345 million. No one is saying Yahoo is cheap at 80 times 2004 earnings estimates, though it's nowhere near its 2000 peak p-e of 1,979. But Rashtchy points out the company owns 34% of Yahoo Japan, worth more than $12 per Yahoo share. Subtracting the value of the Yahoo Japan stake pulls the multiple down to 54. Adjusted for Yahoo Japan and for profit growth, Yahoo is about as expensive as IBM (IBM ). "Our estimates may be conservative," says Rashtchy, whose 60 cents a share forecast is the Street's highest.

Investors who can't stomach Yahoo's valuation but believe in the Net can follow Legg Mason Value Trust's (LMVTX ) Bill Miller into InterActive Corp. (IACI ). IAC is Barry Diller's vehicle that owns Hotels.com, Ticketmaster, Expedia, and cable-shopping channel HSN. It trades at 32 times 2004 earnings estimates. Factor out more than $7 billion in cash and securities on the balance sheet, and the p-e is more like 21, which Miller says is too low for a company where he expects 30% a year average annual profit growth. "It's a Berkshire Hathaway (BRK ) for the New Economy," he says. IAC has grabbed 50% of the Web travel-agency market by investing more in marketing and R&D than Orbitz and Travelocity.

The rap on IAC has been that Diller issued too many shares in deals to acquire Expedia, Hotels, and online loan exchange LendingTree. That's why the stock has slipped from $42.88 in July to $30.51 in mid-December. But watch for a major stock buyback in 2004. IAC has the money to buy back as much as 20% of the company, Miller says, and management predisposed to aggressive moves. "Like Berkshire, it has a fortress balance sheet and lots of free cash flow," he says. "I wouldn't be surprised to see a major shrink in the number of shares." Diller said in September that aides were pressing him to buy back up to 25% of IAC stock, but he expected the final number to be smaller.

By making data storage that works on open-source software such as the Linux operating system, Carlsbad (Calif.)-based Dot Hill Systems Corp. (HILL ) is a beneficiary of two big trends: the demand for storage and the shift to Linux. With a market capitalization of only $700 million, it's followed mostly by regional brokerages. But analysts say Dot Hill will earn 62 cents a share next year, up from 26 cents in 2003. That's a 138% jump, yet the p-e ratio for 2004 is just 26.

One PC giant is worth considering: Dell has made hash of rivals such as Gateway and Compaq Computer and is now turning to consumer electronics. Frank Gens, senior vice-president of research at tech-consulting firm IDC, says Dell will win by applying its low-cost manufacturing and direct distribution model to products such as big-screen TVs and portable music players. Goldman's Conigl- iaro likes Dell because she expects revenue growth to accelerate next year. "If they've been able to grow 15% despite the slowdown, they can grow more than that in an upturn," she says. Dell will probably underperform if the NASDAQ has another hot year. But it's a solid stock at 28 times estimates for the year ending January 2005.

These scenarios can blow up if the economy stumbles. High valuations can curtail the NASDAQ, too. But except for Yahoo, and on some days IAC, these stocks are cheaper than the 29 p-e of all tech stocks in Standard & Poor's 500-stock index. And they're riding more than a hot market. That combination makes them pretty good bets.

By Timothy J. Mullaney

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