Last month, astute observers (defined as those with a pulse) could notice that there were an awful lot of companies in the wireless food chain announcing disappointing results. Last week Motorola joined the club, and yesterday we got news from the third-largest US wireless carrier. Sprint to Cut 5,000 Jobs; Stock Plunges: Financial News - Yahoo! Finance

Sprint Nextel Corp. reported Monday that its cell phone business suffered a net loss of 300,000 monthly subscribers in the fourth quarter and that the struggling wireless company will cut 5,000 jobs.The company’s stock plunged more than 8 percent after the financial update, which included a 2007 outlook shy of many Wall Street forecasts.

Last month we suggested that several high-multiple names might be worth avoiding. None of those stocks has since blown up, but that doesn’t mean they aren’t standing in a mine field.

Our regular readers know that we have our fears about the state of the semiconductor industry. Since the cliche says that Wall Street is driven by fear and greed, it seems only fitting that our concerns were answered by Andy So of Raw Greed who says:

I once worked for the CIO of GMAM and I fondly remember him repeating his views on technology:

“Technology is a tool and nothing more. Technology is an enabler. Technology in and of itself is not a business. Technology cannot succeed without needed applications.”

The required business formula seems to be Technology + Applications = Probable Success.
We couldn’t agree more with the quote, but when we read it we think more of Pip Coburn’s The Change Function: Why Some Technologies Take Off and Others Crash and Burn. Pip says:

However, a key problem – for starters – is that most potential users of technology products are quite afraid of new technologies. The creators are not afraid, but the users are, and it is the users who matter. SO it seems obvious to creators that this new thing will sell, and then, it doesn’t. Even during the fabulous 90s when nine or 10 technologies finally hit a major commercial inflection, most of the emerging technologies failed to get anything resembling lift off. We have written extensively on 10 failures of the last decade and in no case was technology the problem. All the technologies worked. The engineers indeed developed a cool massive disruptive so-called 10x change in technological capability.

So what went wrong?

Well… we think the implicit thinking – build cool technologies and watch price reduction contribute to generate lift-off for the market – is limited. Creating cool technology is a necessary condition but not sufficient. To consider what is “sufficient” we must bring the user into the equation.

What The Change Framework says is that we only really need to care about what goes on with the users prior to their handing over money for this new thing. Technology demands a change in habits. So… we want to consider why someone would change habits – something I have observed as veeerrrryyyy difficult but that the technology industry implicitly considers rather easy to pull-off.

So… when does a person change a habit?

When the pain from being in a certain state today is greater than the total perceived pain of adopting a solution to today’s pain. If today’s crisis is greater than the total perceived pain of adoption change will occur.

Change = f (user’s crisis v user’s total perceived pain of adoption)

So… let’s suppose [Pip’s nephew] Dylan and my 78-year-old Uncle Jerry have precisely the same desire to have their music with them at all times. Then let’s suppose I offer to help them set up an iPod. I first tell them to go get all their CDs cuz they will need to load them on their computer. Dylan scurries off to get his vast collection. Uncle Jerry says no thanks. He is far more terrified of interfacing with a computer than Dylan. Dylan adopts. Uncle Jerry doesn’t. Uncle Jerry’s total perceived pain of adoption is higher.

In most cases, incidentally, we see price as being less than 10% of the total perceived pain of adoption although folks in the technology world have it burned into their brains that if it is a good idea, all the hold up will be about cost. But, we have been reminded that there is no low enough price for an ugly shirt.

Andy So’s equation leaves users out of the picture, which doesn’t seem to us to be a really logical way of anticipating technology adoption. So what does he suggest will drive technology growth?

We can look at what lead up to the most recent inventory glut in the semiconductor industry and extrapolate which applications are aging. Standard definition DVD, standard definition TV’s, 2G mobile phones, portable audio players and Microsoft Corporation’s (MSFT) Windows XP associated computer hardware lead the inventory glut in consumer applications. In the business world we saw networking, security, Windows 2000 and Windows XP server and workstation platforms as the leading applications. New semiconductor processes and technologies were created for an aging consumer and business application cycle. These aging applications are experiencing ongoing declining profit margins and demand. Currently we are on the verge of a new application cycle that will undoubtedly refresh both profit margins and demand.

There is very little problem with demand, and we apologize if we ever left anyone with that notion. Demand for semiconductors has been growing at just under 6% annually for the last ten years. This implies far greater than 6% unit growth due to the inevitable price declines technology brings. Our problem is that the 6% growth in demand is being met by 70% growth in supply.

Furthermore, look at the list of aging applications and compare it to the replacements: more of the same. Standard def to high def is an incremental rather than a revolutionary change. So is 2G to 3G mobile or Windows Vista. None of these are the kind of “killer app” that the original spreadsheets and DVD players or the Internet were. Will people buy them? Sure. Will they change the world and usher in a new era of technology wonderfulness? Unlikely. (Note: we have said that if anything will drive a new tech cycle it is Vista.)

Consider, for example, the move to high-def. There is no doubt that the world loves its TV and DVDs. There are also many shows that many people would like to see in high-def. So when it is time to buy a new TV and DVD player, most people will probably buy high-def. But so far, it appears to be just that - replacement demand. By the time the standards war is over, people may have skipped DVDs altogether in favor of downloaded content.
As to Vista, Andy says:

If we take a look at enthusiast websites like HardOCP that have posted a preliminary performance preview of Intel’s Core 2 Quad processor we can already see tangible benefits from running the CPU on the aging Windows XP platform. Multicore processors will be ubiquitous, since there will no longer be any availability of single core processors in due time. The marriage of an OS that natively supports multicore processors with applications that also take benefit of multicore processors represents a staggering cost-benefit relationship that I believe most consumers and businesses will find hard to ignore.

Back to Pip:

Well… we think the implicit thinking – build cool technologies and watch price reduction contribute to generate lift-off for the market – is limited. Creating cool technology is a necessary condition but not sufficient. To consider what is “sufficient” we must bring the user into the equation.

Will the advantage of multi-core processors running code natively be enough of a crisis for most business spreadsheet users to throw away their existing systems and install all new ones, train their employees on how to use them and suffer the lost productivity while the transition is going on? Or will it be something that gets rolled out as the old machines wear out and need to be replaced anyway?

Unlike Andy and his fellow enthusiasts, there just isn’t that much of a crisis to “simply download the free public beta of Windows Vista RC1 here and download a 1080p Windows HD video here.”

And that is why while we agree with Andy’s assertion that semiconductor expansion is still needed, we continue to believe that any capacity growth greater than demand (remember - that is 6% annually) will simply destroy pricing and margins.

Disclosure: Author is short put options on DELL and long put options on the Semiconductor HOLDRs (SMH).

Disclosure: William Trent has a long position in SMH.

We really love accounting arcana, because investment opportunities frequently get buried under the accounting choices that companies make and that are routinely ignored by investors. The differences can become more pronounced when certrain ratios are reported using standardized services such as Yahoo! Finance.

Our friend Doug McIntyre at 24/7 Wall St. is great at spotting industry trends that affect stock prices. He discusses one such trend (broadband strategies at telcos) in his post AT&T: New High Every Week.

AT&T trades at 2.24 times sales. BellSouth trades at 3.64 times. AT&T must have paid a premium. But, Verizon trades at 1.22 times. And, Qwest at 1.2 times. Qwest, being the smallest of the lot does not have the balance sheet or revenue to compete with cable, WiMax, and VoIP as well as the rest. Or, at least that is the conventional wisdom about why it carries no premium….

Verizon says it will spend $20 billion building its fiber system according to the company’s public statments. It also says that the service is now available to six million homes, about 20% of their customers. Of course, that does not mean that the customers are using it.

AT&T and BellSouth have not announced intentions anywhere near as agreesive for upping the ante to get faster wires into their customer’s homes. And, that may be why Verizon trades at a discount.

However, Verizon’s significant discount only applies on the basis of price/sales. On a trailing P/E basis it is actually cheaper, and on the basis of price/book it is just a smidgeon more expensive than AT&T. As it turns out, accounting arcana are largely responsible for the price/sales differential. Specifically, the method each company uses to account for its majority (60% for AT&T and 55% for Verizon) stake in its wireless operations. Let’s have a look.

On page 24 of their 2005 annual report, Verizon says:

Our Domestic Wireless segment provides wireless voice and data services and equipment sales across the United States. This segment primarily represents the operations of the Verizon Wireless joint venture with Vodafone. Verizon owns a 55% interest in the joint venture and Vodafone owns the remaining 45%. All financial results included in the tables below reflect the consolidated results of Verizon Wireless.

The consolidated wireless results (100%) were revenue (in $millions) of $32,301. Of that, Vodafone’s 45% share amounts to $14,535. Were this excluded from Verizon’s total revenue of $75,112 the adjusted revenue for Verizon would have been $60,577. Instead of 1.37x sales (using 2005 revenues and the current share price), Verizon’s market cap would represent 1.70x sales.

Turning to AT&T things get a bit murky. To start with, AT&T (the long distance company) is only included in the merged company’s 2005 results for 45 days. Fortunately they do provide pro-forma data as though it had been included for the full year. A second issue is their method for reporting their wireless operations. We present their comments on their wireless division (p. 28 of their annual report):

We account for our 60% economic interest in Cingular under the equity method of accounting in our consolidated financial statements since we share control equally (i.e., 50/50) with our 40% economic partner BellSouth in the joint venture. We have equal voting rights and representation on the Board of Directors that controls Cingular. This means hat our consolidated results include Cingular’s results in the “Equity in net income of affiliates” line.

In layman’s terms, this means that they don’t record any of Cingular’s sales (but they do record 60% of its net income.) Here’s how this is described in Financial Statement Analysis: A Global Perspective (pp. 561-562):

There are three approaches to accounting for (investments over which the company has significant influence): the equity method, proportionate consolidation, and consolidation.

Each of these three methods yields the same amount of net income for the period. Likewise, each yields the same amount of net assets (or equity) for the period. However, the methods yield different cash flows for the period. Additionally, the details may be different. Consequently, key financial ratios differ under the various methods.

Specifically, under the equity method AT&T doesn’t record any revenue, and records its share of Cingular’s profits as a line (Equity in net income from affiliate) on the income statement. Meanwhile, Verizon records all of Verizon Wireless revenue and profits, and deducts Vodafone’s share as a line (Minority interest) on its income statement.

So what adjustments need to be made for AT&T? First we need to start with the pro-forma income statement, which treats the long-distance business as though it had been included for the full year. This gives us a revenue line of $66,061 rather than the $43,862 reported in 2005. This adjustment alone reduces AT&T’s price/sales (apples to apples for the way we calculated Verizon’s) to 1.86x.

Now we need to add in the proportionate (60%) share of Cingular’s revenue of $34,433, or $20,660. Now our total proportionate revenue for AT&T is $86,721. After this adjustment, AT&T’s price/sales is 1.41x, lower than the apples-to-apples 1.70x for Verizon.
Since both methods result in the same net income and equity, neither the P/E multiple nor price/book multiples are affected by the accounting choice. So we can accept at face value (at least with regard to their accounting for the wireless divisions) the Yahoo! Finance TTM P/E of 18.81x and P/B of 2.22x for AT&T, and the 14.98x P/E and 2.30x P/B for Verizon. Again the multiples end up being fairly close when the accounting treatment is apples to apples. Verizon is more expensive on price/sales and price/book but cheaper on P/E.
This is one of the cases where the market has largely picked up on the accounting difference. This doesn’t mean that investors understand the accounting intricacies, but more reflects the fact that investors more frequently use P/B or P/E rather than P/S. In fact, if Doug is correct in his assessment that Verizon has chosen the wrong strategy, this could be a great investment opportunity since Verizon is trading at about par with its more conservative peer.
So you can see why we like to dig into the numbers - sometimes you dig up a nugget that is pure gold.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

With all of the consolidation among their customers allowing for network efficiencies, along with a dramatic decline in revenues following the telecom bubble, telecom equipment makers have increasingly been joining forces. Alcatel/Lucent, Tellabs/Advanced Fibre, Cisco/Scientific Atlanta, and now Nokia/Siemens.

The current deal applies only to their network equipment, not to handsets.
Nokia, Siemens in $31.6 billion deal: report. - Jun. 18, 2006

Nokia and Siemens AG agreed to combine their phone equipment units in a deal worth around $31.6 billion, the Wall Street Journal reported on Sunday, citing people familiar with the matter.

The combined company would contribute both of their network equipment operations into a new entity to be based in Nokia’s home country of Finland, the Journal reported, with Nokia retaining a majority of board seats.

InfoWorld notes that many carriers are trying to spur 3G adoption with unlimited plans - unlimited, that is, unless you are a bandwidth hog who is constantly streaming movies or hosting your web site over 3G.

To get subscribers to buy the high-speed services and start using them, mobile operators are offering some “unlimited” data plans that allow as much streaming, uploading and downloading as the customer wants in the course of the month — within certain terms of service. Some uses, such as hosting a Web site, typically aren’t allowed.

At least one carrier, Verizon Wireless Inc., (VZ - Annual Report) is looking the other way when users go wild. Verizon has allowed subscribers to use its BroadbandAccess service for capacity-intensive applications such as streaming TV to their notebooks from Slingbox video distribution devices, even though the terms of service forbid this, Executive Vice President and Chief Technical Officer Dick Lynch said at the CTIA Wireless show in April.

The most shocking thing about this is why are they letting bandwidth be too plentiful in the fist place? Instead of the limited unlimited bait and switch, Verizon, why don’t you try a more reasonably priced service? DSL speeds are not worth twice as much just because they are mobile. Fill up those networks - the incremental cost per magabit is awfully low.

The iPod initially got its success by being the largest MP3 player - one that used a hard drive rather than a flash drive - and by having a strong content library of songs legally available at a price consumers were willing to pay. Its continued success is due in part to its continued stylish innovation, in part to its position as the leader (whose iTunes-purchased titles cannot be played on other players) and in part due to the fact that it has avoided the kind of quagmire described in this Fortune story:

It seemed like a routine marketing ploy when Finnish mobile-phone giant Nokia (NOK) trumpeted a global survey in early June showing that two-thirds of handset users think music-playing phones will replace standalone MP3 devices like Apple’s (AAPL) iPod. After all, Nokia is hoping for a high-margin revenue stream from new computer-like telephony devices.

Not to mention the story is in sharp contrast to this one.

But look between the lines of the survey results, and you see a ferocious tug of war breaking out between handset companies like Nokia (NOK), Motorola (MOT), and Sony Ericsson on one side and their longtime customers, mobile operators like Vodafone (VOD), Orange, and Verizon (VZ), on the other. They’re grappling for control of the $42 billion worth of entertainment that Informa, a London market research firm, says mobile phone consumers will purchase by 2010.

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Growth of smartphones is rising rapidly, and if an investor takes an industry-centric point of view the idea that most new phone sales are smartphones would be easy to accept. However, the latest data shows that while smartphone sales grew a whopping 68 percent to 18.9 million units in the first quarter, compared to the estimated billion total mobile phones expected to ship this year they grew from being a drop in the bucket to somewhat more than that.
Global smartphone shipments continue to grow - Yahoo! News UK

Smartphone shipments rose by a whopping 67.8 percent during the first quarter of 2006, versus the same period a year ago.

According to IDC’s Worldwide Quarterly Mobile Phone Tracker, the number of converged mobile devices or “smartphones” as they are more commonly known, sold during the first three months of the year totalled 18.9 million units, up 7.5 percent from the fourth quarter of 2005.

Smartphones are mobile phones that have their own operating system, can download applications, have large memories and can be synchronised with personal computers.

PC Magazine reviews the Lenovo 3000 V100 laptop and calls it “very good.”

Cingular Wireless now has the Pantech C300 Prepaid GoPhone - the world’s smallest camera flip phone.

Sprint now has the BlackBerry 7130e.

Verizon has the Motorola Q, which could be a BlackBerry killer if it had better software.

And Cingular has the Ogo, which could be a BlackBerry killer if it could do voice, now that it can do push e-mail.

TechDirt reports:

In what I see as one of the more delicious ironies of the month, the Verizon Communications CFO, Doreen Toben, basically said that analysts have ‘overvalued’ the company’s wireless subsidiary. Now when was the last time you heard a CxO say their company is worth less than what people think? The comments came after Verizon was courting Vodafone to buy out the latter’s minority stake in VZW. Apparently, analysts and press were bandying about $38-50 billion as the possible price, and so the CFO is trying to cool down the hysteria by assuring the market that 45% of VZW is not worth that much. Just after the AT&T BellSouth merger, when rumors of this buyback were rekindled, I wrote that I don’t see the value for Verizon in buying Vodafone’s 45%, and that the Billions would be better spent on upgrading fiber and other infrastructure. Clearly Verizon disagrees with me in general, but there are limits to what they will pay.

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The 3G Americas organization, which is composed of carriers using the GSM wireless standard and its successors, offered up a breathless press release we just had to share. The best thing about it is that most potential readers will have no idea what they are talking about, while those that do understand will automatically know how silly the claims are. It is almost as though they released the news so they could have something to high-five over. More »