FOOL'S EYE VIEW
Tech Shares -- Time to Buy?

By Alan Oscroft
January 3, 2001

Liverpool -- Technology shares continue to fall in price, but is that good or bad for investors? That depends on your approach to valuation, because valuation counts. If you make it a rule to only buy shares when they are good value and never pay over the odds for them no matter how good the company itself looks, then times like this are definitely good for you.

Further to Go?

I consider many fallen technology shares to still be overvalued, as anyone who has read the latest Duelling Fools battle over GEO Interactive Media (LSE: GIM) will realise. I also reckon that some tech companies, like QXL Ricardo (LSE: QXL) for example, look like they may be doomed and I wouldn't buy shares in them at any price. (Remember, no matter how much a share price has fallen, the maximum possible future loss always remains unchanged at 100%).

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But I'm also convinced that there are some bargains out there for astute value-driven technology investors, and information management guru Autonomy (LSE: AU.) might be one such possibility.

Risk is the other side of the valuation coin and the two need to be in step if investment is to be successful. I've always had an admiration for Autonomy's technology, but I've never much liked its valuation/risk balance. I highlighted what I saw as the main risks back in this September Rule Shaker article. James Carlisle (TMF JimmyC) subsequently offered his analysis of my fears.

Every risk has its price, though, and if the risk level suits you then there is surely a price at which you should consider buying. With the share price having fallen all the way from last year's high of over £40 to today's price of under £15 (at the time of writing), it's well worth having another look at the company from a valuation point of view.

What's It Worth?

Autonomy's third quarter 2000 sales, for the three months to September 30th, came in at £11.9m. Sales have been growing steadily quarter on quarter, and the latest figures make for a pro-rata annual sales figure of £47.6m (though the actual full year figure will probably come in a little lower due to lower sales in the first two quarters).

Autonomy is still a highly-valued company and with a current market capitalisation of £2.1b, that pro-rata sales figure indicates a Price to Sales Ratio (PSR) of 44 (the market average being around 2 or 3).

Unlike many other technology companies, Autonomy has reported profits, both operating profits and bottom line earnings per share (EPS), for two straight quarters now. The risk of burning out before becoming sustainably profitable is receding quickly. Third quarter EPS, at 0.5p, suggests a pro-rata full year Price to Earnings (P/E) ratio of about 730. That's astronomical by normal standards, but is actually pretty meaningless when a company first moves from loss into profit.

High Gross Margin

The latest figures show a gross profit margin of 95%. Not only is that one of the highest gross margins to be found on the planet (due to Autonomy's intellectual property business model with its very low cost of sales), it is also improving, having risen from 81% the same quarter last year, and 90% the previous quarter this year.

What that means is that Autonomy's bottom line profit should rise significantly faster than its sales with, say, a 50% growth in sales resulting in a percentage growth in profits that might be several times that figure. Autonomy probably needs profit to grow 20-fold to get its P/E down to something sustainable, but it is likely to require a considerably smaller percentage growth in sales to achieve it.

A Bargain?

All in all, I think Autonomy is getting close to a reasonable valuation these days, a valuation that is at least in the kind of ball park that is commensurate with the long-term risks it faces. The shares may well fall further before they start to move up, but technology investors looking for a bargain might do well keep Autonomy on their list of possibilities.

Where Next?

• Rule Shaker -- Understanding Autonomy
• Rule Shaker -- Playing the Probabilities with Autonomy
• The Autonomy discussion board
• Duelling Fools -- GEO Interactive Media