The Price of Tech: Is There a Ceiling In Sight for Firms On the Cutting Edge?

Source: Wall Street Journal
Date: January 10, 2000

Whether the Old Yardsticks Can Be Ignored for Some Is Key to Volatile Nasdaq - Digital Lightwave Is Aglow

Digital Lightwave Inc. has just 180 employees, $50 million (48.5 million euros) in sales and never turned a profit before September.

But it is one of the hottest stocks on Wall Street, racking up gains of more than 2,600% last year. It sports a market value of $1.8 billion, more than that of such established companies as Diebold Inc. or Sotheby's Holdings Inc.


That question is at the center of a much broader debate that has been raging as the Nasdaq Stock Market, spurred by technology names, soared 86% last year and then ran into a wall. On Tuesday through Thursday of last week, the index gave back close to 10% of its value - and then proceeded to bounce back 4% on Friday.

What makes Digital Lightwave - a maker of testing equipment for the proliferating webs of fiber-optic cable that form the Internet's backbone - and its huge stock gains so interesting, and so controversial, isn't that they are unique. Quite the opposite - it's that huge runups have become almost commonplace. On the Nasdaq market, more than 800 stocks, or about one in six, doubled in value last year; a remarkable 37 gained 1,000%.

Skeptics say these stocks are overdue for a much sharper decline than they had last week. Even if these companies have wonderful prospects, they say, there is a limit to what they are worth.

Whether they now have neared such a limit is at the center of a fiery debate, taking place not only on Wall Street but also in chat rooms and over dinner tables. The debate's outcome will determine whether the Nasdaq market can go still higher after catching its breath, or will run out of breath and fall on its face.

The doubters point out that Digital Lightwave, for example, would have to live up to lofty expectations to justify even its current price. It would have to fight off competition in the fiber-optics business, hold onto its rich profit margins and multiply its sales and profits by a factor of eight to 10 just to bring its current price into the realm of normal valuation - without even allowing for an increase in that stock price. This, say the skeptics, is hard to imagine, even in a world as hot as technology. Little wonder that Digital Lightwave is the target of numerous short sellers, who sell borrowed shares as part of a bet that the stock will decline.

But bulls on these highflying stocks say that the skeptics' fondness for such linear analysis helps explain why many have missed out on the tech-stock runup and its riches. Doubters are forgetting one big thing, the bulls say: innovation.

As the communications revolution advances, the technology bulls believe, companies will create entirely new products, services and markets, and do this so rapidly that trying to analyze stock value based on current products is futile. As the naysayers gasp at the gains and forecast a bloodbath, the stocks' proponents point to onetime small stocks - Microsoft Corp., Cisco Systems Inc., Dell Computer Corp., Tellabs Inc., Qualcomm Inc., MCI WorldCom Inc. - that have surpassed all expectations to become giants.

Using customary stock-valuation techniques, says Mr. Kang, who covers the industry for Cruttenden Roth in Newport Beach, California, Digital Lightwave's stock price looks, well, "ridiculous." Yet compared with some other fiber-optics companies, he says, it actually looks cheap.

Digital Lightwave sells, even after last week's Nasdaq decline, at around 140 times this year's projected earnings - and at around 25 times projected revenue. (A ratio of price to past earnings can't be figured because the company hasn't yet reported a full profitable year, although it is expected to, barely, when 1999 results come out.)

Stocks with price-earnings ratios in excess of 100, in fact, account for about 20% of the total market value of the Nasdaq market. For perspective, the Standard & Poor's 500-stock index has historically traded at an average of around 15 times its members' earnings; currently it trades at 29 times earnings - lofty but still far below the likes of Digital Lightwave.

"You look at everybody else in fiber optics and their prices are ridiculous too," Mr. Kang notes. "People are just paying for the future market." Until last week, he says, tech investors were "behaving like a runaway truck."

Is the truck skidding toward a ditch? Or will it right itself and speed on its merry way? The answer, according to him and to other analysts who follow the sector, may not be as simple as either fans or skeptics want to believe.

Few doubt any longer that we are in the midst of a technology revolution. With more people using the Internet each day, even huge companies such as General Motors and Alcoa are designing systems that integrate purchasing, distribution and an array of other business areas into the Internet. The question isn't whether the Internet will survive and flourish but whether the stock gains have gotten to such heights that they surpass any realistic projections for the medium's growth.

"I've been in this segment for a while," says Ted Moreau, a telecommunications analyst at Robert W. Baird & Co. in Milwaukee. "This is the most aggressively valued marketplace that I have seen."

And yet, he feels bullish about it. "It may look expensive when I try to apply any traditional valuation metrics or even new metrics, but I have example after example of companies that have emerged in previous years or over the past several years that have broken through valuation levels," Mr. Moreau says. "You are kind of looking for the next stocks of the decade, and the stocks of the decade are going to start at the level that Digital Lightwave is starting at."

So, how does a stock like Digital Lightwave actually measure up?

The company, based on Florida's Gulf Coast, was founded in 1991 by an inventive former Massachusetts Institute of Technology researcher named Bryan Zwan. Dr. Zwan helped develop its core technology, but he never got it to turn a consistent profit. In its early years, the company also became known in the marketplace for its founder's association with Scientology. Then, less than a year after Digital Lightwave went public in early 1997, a new chief financial officer concluded that some revenue numbers were overstated and insisted on revising them downward.

The stock tanked, the company settled a shareholder lawsuit, and a year ago, Dr. Zwan stepped aside. Although he still holds more than 70% of the company's stock, he was replaced as chairman by a veteran communications-technology manager and IBM alumnus, Gerry Chastelet, at the start of 1999. Dr. Zwan wasn't available for comment.

By spring, Digital Lightwave was announcing a product-sales agreement with Lucent Technologies Inc. Digital Lightwave's stock had traded at $1.75 a share on Nov. 18, 1998, but one week ago it hit $75. After last week's stormy weather, it closed Friday at $60.125.

Why the sudden reversal of fortune? Investors looking over the summer for real-world investments linked to the Internet discovered the fiber-optics business and began bidding up those stocks. Digital Lightwave makes small electronic units - some portable, some installed in telephone switches - that monitor effectiveness and find problems in fiber-optic cable networks. At the moment, at least, its technology is on the leading edge.

As telecom firms madly boost capacity to deal with the demand for higher and higher speed to handle Internet traffic, sales of fiber-optic equipment are growing 20% to 30% a year, sometimes faster. Digital Lightwave's gear is much in demand at telecommunications giants.

But how close is the stock price to a real reflection of Digital Lightwave's value? One way of measuring that, the traditional way, is to relate stock price to forecasts of profits and revenue, and compare those figures to benchmarks of the overall market or of companies in similar businesses.

Analysts expect Digital Lightwave to post around $74 million in sales this year, and maybe $13 million, or 43 cents a share, in earnings. Suppose all goes well and the young company manages to build sales as fast as the optimists think the fiber-optic-equipment market could grow. At a gain of 30% a year, sales would be $274 million at the end of 2005, at which time, the stock - if unchanged - still would be trading at an enormous seven times revenue. In traditional stock valuation, a 2-to-1 ratio of stock price to per-share revenue has been considered high.

Even Lucent didn't fetch seven times revenue early last week, prior to its Thursday warning of a profit shortfall and quick tumble. Although Digital Lightwave and many other tech stocks didn't follow Lucent down, Lucent's 25% stumble late Thursday reminded skeptics of how quickly a highflier can fall.

Another way to look at Digital Lightwave is to focus on its latest product, which investors hope will become its prime profit vehicle. This is a measurement technology that tracks both old methods of transmission on fiber-optic lines and the newest methods, which involve splitting the light patterns to let more data move faster on the same cable.

The new equipment costs about $70,000 a unit, and Digital Lightwave hasn't sold any yet, although Lucent plans to buy some. Digital Lightwave has been selling current-generation equipment at the rate of around 1,200 units a year. Assuming that customers migrate to the new and more expensive units, that sales nearly quadruple over that time in line with optimistic market projections, and that the per-unit price doesn't fall, Digital Lightwave would pull in $336 million in revenue in 2005 by selling 4,800 units. Even if the stock didn't budge a penny from here, it would stand at almost six times revenue. For it to be just two times 2005 revenue, Digital Lightwave would have to sell 13,000 of the new units a year, or more than 10 times as many as it is now selling of the current-generation product.

Similar calculations could be done for any of several hundred tech highfliers. And the conclusion for those who use classic valuation methods would be the same: The prices aren't grounded in reality.

But classic valuation techniques have a big hole in them, say those who invest in the technology revolution: They don't take into account innovation.

Digital Lightwave, this argument runs, won't still be selling the same equipment in 2005 that it sells today. Assuming it isn't taken over by a larger player (an outcome that probably would benefit investors), it could use its hot stock to take over other businesses, or use its technical prowess to develop new generations of products.

Asked about Digital Lightwave's stock price, Mr. Chastelet, the CEO, says, "In our case, it is not a straight-line extrapolation of our existing product into the future."

At its high stock price, Digital Lightwave could issue new shares to pay for both invention and acquisition. "We were very widely unnoticed even 10 or 12 weeks ago" by analysts, says Steven Grant, chief financial officer. "Now we are getting phone calls" from investment banks wanting to help raise money.

A decade ago, if investors had calculated how many PCs Dell might sell or how many chips Intel might sell, based on a projection that every person might one day own one computer, they would have vastly underestimated the market. Anyone who analyzed Microsoft simply as a maker of operating systems would have sold that stock way too soon. And if one had used classic valuation methods in the early 1990s, adds Mr. Moreau of Baird, one would have stayed away from Cisco, MCI and Tellabs, some of the hottest stocks of the decade.

"I don't think you can quantify it," Mr. Moreau says. "I think it boils down to the intangibles, the intellectual property, the technology." Investors who avoided a Dell or Tellabs because the price looked high by usual standards missed out on huge gains, and many are determined not to make that mistake again.

The question is, are the bulls, as a result, overvaluing tech stocks now?

For all the innovation in this field, there also is plenty of competition. To get into the revolutionary industries of the 19th and early 20th centuries - railroads, steel, cars, the telephone - lots of capital, over many years, was needed. A fiber-optics maker doesn't need as much, or a right-of way either. In any case, capital is much more readily available today.

Even if the fiber-optics business delivers on its promise, there is nothing to guarantee that Digital Lightwave or any other particular company will be the big winner. For every Microsoft and Dell, dozens have fallen by the wayside, although some were acquired at a premium. One solution some investors suggest is to diversify: If you had bought the stock of a dozen PC makers 10 years ago, you would have done fine, as long as one of your picks was Dell.

If Digital Lightwave's business prospers, its fans should ultimately reap the benefits. But there is another wild card: It is hard to predict what Dr. Zwan, the 70% holder, will do with his stake. Any big sale by him obviously could affect the stock.

And if the stock stumbles, for whatever reason, other holders could get cold feet. Digital Lightwave's investor base is changing fast. As some bottom-fishers who bought it take their profits, they are being replaced in part by "momentum" players who buy stocks that are showing big gains. Some of those investors do only cursory analysis of the company involved, as reflected in this message, recently posted on a chat-room message board by a confident new investor:

"I'm in at 69 and plan on holding into the 100s. This company is on the verge of some great growth and I've heard two analysts pick this stock as top for the year."