Where's the Beef?

Recent announcements by core-technology blue chips have caused shock, surprise and a lot of anxiety for investors. Dell, Hewlett-Packard, Sun Micro Systems, Intel and Texas Instruments, to name a few… have reported dramatic drops in sales and earnings, along with the inability to forecast where the bottom may be. This sharp drop off is from last year's record levels of sales and earnings. Leading analysts and strategists draw the conclusion that the economy, in its broadest sense, is falling at the same rate. We think it's time to take a hard look at the facts and try to get a more reasonable perspective.
The technology sector—which includes semi-conductors, computer manufacturers, telecommunications equipment makers and all service providers—is coming off a very unusual three-year high. This abnormal period led investors to believe that the technology business could sustain growth rates that were prevalent in 1998, 1999, and 2000. A closer look at the facts reveals the hand of government crafting an unnatural environment that benefited the short-run results of technology companies in those years.

The Internet innovation created a wave of enthusiasm that focused on efficiency and productivity enhancement and a new way of life. Congress—along with the FCC-enacted the 1996 Telecommunications Act which mandated free access to all Bell operating companies’ facilities. In short, new ventures were allowed to take a free ride on installed telecommunications plant facilities around the country. In the interest of leveling the playing field, our politicians prohibited any one entity from making any real money in this area. Propriety positioning was forced to give way to free access, and Internet usage went through the roof. Consumers were able to make use of this technology with little or no cost. This was fine in an altruistic sense, but in a capitalistic society, long-term funding requires that there be a profit and a reasonable return somewhere in the equation for risk takers. Technological start-ups sprouted everywhere and where funded by venture capitalists that seized on the moment, attempting to get an early start in the race for market share. Billions of dollars were invested through venture capital firms and investment bankers toward the building of a huge Internet infrastructure. Naturally, these ventures had no profits and were living off finite capital, but they all bought equipment. Computers made Dell, chips by Intel, routers by Cisco, printers by Hewlett-Packard...fed this cradle industry and its massive appetite.

The preparation for Y2K also unleashed a bubble of demand as businesses attempted to get their technological houses in order. Once again, this Y2K-ignited demand was met by the same manufacturers already feeding the Internet frenzy.

Earnings and future projections were ramped up by analysts who dubbed the environment as “the new economy”…Sound familiar? Lofty valuations were placed on all companies in this sector and investors flocked to the trumpet of higher growth rates and yet higher valuations. Business was very good in Silicon Valley.

Meanwhile, back at the Federal Reserve Board, Alan Greenspan tightened the reins on the money supply. As a result, lenders became reluctant or unable to continue funding profitless ventures. Likewise, venture capitalists began to experience some drying up of funding and the world lurched back toward real rates of returns. The many start-ups were “burning” capital; and at a burn rate that was unsustainable. As the century ended, we began to see the actual demise of the .com start up.

Congress and the regulators still have a heavy hand in making sure that no one person or entity gets a proprietary grip on any part of this wonderful technology. Recently, the AOL/Time-Warner combination was ordered to offer at least one non-affiliated competitor direct access to their facilities before using them itself. As long as government keeps this attitude and prohibits any kind of real profitability, the Internet-related sector of our economy will be capital starved. Venture capitalists and bankers will be reluctant to invest or lend without visible profit margins for paybacks. Equipment purchase plans will be canceled and the like of Dell, Hewlett-Packard, Sun Micro Systems, Intel and Texas Instruments will be hard-pressed to maintain last year’s level of sales and profits.

Combine this problem with the fact that Y2K has passed and the computer budgets for businesses have been pared to lower, sustainable levels. It’s no wonder that technology companies cannot see the bottom. Lastly, the economic slowdown engineered by Alan Greenspan is causing the consumer to take a second look at computer purchase plans, adding to the slow down.

All of this is, unfortunately, happening at once. Companies that benefited from a strong economy and the inflated market for Internet services are now feeling the brunt of a free-market slowdown. Last year, we didn’t believe that these companies would grow at 50% per year, nor do we presently believe that there is not growth potential into the future (as many pundits are now advocating). We also don’t think the overall economy is suffering to the same degree as technology companies. However, slowdowns in this sector are apt to add to unemployment and affect the overall economic slowdown. Accordingly, we feel that more interest rate cuts are imminent in order to sustain the economy at large. It would help if we would get retroactive tax cuts as a follow-up dose to monetary accommodation, but the outcome of the tax battle remains questionable. In short, we feel we’re in a recession, but one does not yet mirror the degree of slowdown in Silicon Valley. We will keep you posted…

By Harlan J. Cadinha