Replacement Value

Tech strategist Arnie Berman tells Duff McDonald how corner-office carnage can lead to big tech stock gains.

The movers have been busy lately in the corner offices of technology companies. Whether it's Meg Whitman announcing that she'll step down at eBay, or anxious Motorola shareholders showing the once-revered Ed Zander the door, there certainly seems to be healthy turnover in the executive suites. It raises the question: Is there opportunity for investors in such change?

Cowen & Co. chief tech strategist Arnie Berman addressed the issue with a February 12 report, Regime Change. In it, he identifies the best time to buy into management change at a technology company, criticizes mere "reshufflings" of the deck chairs, and figures out which Steve Jobs has been best for Apple-the founder or the savior. sat him down for a review of his key findings. You've just completed an exhaustive analysis of stock price returns in technology and telecom companies that have recently turfed their C.E.O. It turns out that there is serious opportunity for upside, but only if you wait a little after the replacement, so the stock can really hit bottom. Why shouldn't we just buy the day of the announced change?

Arnie Berman: As I was watching developments unfold at Motorola in recent months, it occurred to me that technology investors keep watching the same movie over and over again. The cast of characters changes, but these recovery stories all seem to share the same script. Ousting the C.E.O. is a key part of the each movie.

Each film starts the same way. A prominent company's products stumble in the marketplace. Market share slides and financial performance suffers. Shareholders begin to agitate. The board of directors loses patience and ousts the C.E.O. . The stock rallies in response, and then fades. A successor C.E.O. is named.

In his first financial conference call with investors, the new C.E.O. paints a despairing picture. The company's condition is messier than investors were previously led to believe-the hoped-for recovery will be delayed. The shares establish a new multi-year low before finally hitting bottom.

But under new leadership, the company gets un-stupid-taking action on several fronts over the next twelve months. Headcount is reduced. Manufacturing processes and inventory management are made more efficient. The stock price more than doubles from its lows.

Short answer: If investors buy the day that a reviled C.E.O. is ousted, or even the day a worthy successor is named they risk getting involved too early-just as the plot is about to thicken. Okay, that makes sense. But how does one know when a stock has actually bottomed?

Berman: There are certain signals in the script that suggest that a bottom is close. Horrible financial results, kitchen-sink guidance, or big write-offs that occur two to five months after the new C.E.O. comes on board are all clues that a bottom is near.

In our analysis of 34 different companies in which a C.E.O. left under duress and was replaced by an outsider (or at least not a longtime insider), share prices appreciated an average of 117 percent in the 12 months subsequent to the post-honeymoon low. With those kinds of returns, investors that purchased anywhere in the rough vicinity of a bottom did quite nicely. Assuming we can pick the bottom with any accuracy then, what's the best return an investor could have made after buying when a tech C.E.O. was shown the door?

Berman: Investors that purchased chip equipment makerLam Research in 1998-several months after the incompetent Roger Emerick had been thrown out and replaced by the extremely capable Jim Bagley (who had been one of the head honchos at Applied Materials) enjoyed stellar returns-with the stock appreciating seven-fold in the twelve months after the post-honeymoon low was put in.

But from my standpoint, I'd rather look at this framework in terms of the 'typical' or 'average' experience than by looking at the 'best' experience. The 117 percent average return I mentioned before is a robust statistic. In other words, the mean result is not wildly distorted by outliers that cause the "average" behavior to be very different than "typical" behavior. In only five of the 34 situations that we examined did shareholders not enjoy annual returns of at least 25 percent after the regime change low. Okay, but it can't always work. When did investors get completely burned when they bought in anticipation of some sort of turnaround?

Berman: Investors got badly burned in three of the 34 situations we examined: When Terry Semel replaced Tim Koogle at Yahoo in 2001, when Gil Amelio replaced Michael Spindler at Apple in 1996, and when Murray Goldman replaced Mark Allen at Transmeta in 2001. You point out that the greatest opportunity for upside in C.E.O. change is when the possibility of "revolutionary change" is on the table-when the C.E.O. was forced out and replaced by an outsider. Mark Hurd taking over from Carly Fiorina at Hewlett-Packard is the most obvious example of this. What are some other examples where this strategy delivered solid returns?

Berman: HP is the preeminent example this decade. In the 1990s, it was I.B.M.'s ouster of John Akers and his replacement by Nabisco's Lou Gerstner. Ironically, investors also enjoyed excellent returns after Carly Fiorina was hired by H.P. in 1999-and when Motorola's recently ousted C.E.O. Ed Zander was hired in January 2004. The opposite of your revolutionary change scenario is what you call "reshuffling of the deck chairs"-change without real change. What's the most egregious example of this you came across? And how badly did investors take it on the chin?

Berman: Almost precisely a year ago, Dell announced the resignation of Kevin Rollins as C.E.O. and his replacement by Michael Dell. Not only was Rollins replaced by an insider, but he was replaced by the company's founder and principal shareholder. At the time, a lot of investors attempted to compare Michael Dell's return as Dell's C.E.O. to Steve Jobs' return as Apple's C.E.O. But the circumstances could hardly be more different. Steve Jobs didn't work at Apple for twelve years. By contrast, Michael Dell has remained involved in Dell's day-to-day operations throughout his career. His return as C.E.O. didn't even require him to move his desk. You analyzed four different regime changes at Apple-from Steve Jobs to John Sculley to Michael Schindler to Gil Amelio and back to Steve Jobs again. Are we right in assuming the latest change offered the best returns? What of the others?

Berman: Absolutely, the latest change-which occurred over 10 years ago now-was the best. When Gil Amelio was fired after about 500 days on the job in July 1997, Apple was at $3.42. When Steve Jobs agreed to return on a temporary basis that September, the stock was $5.48. But Apple shares declined to $3.23 by December 1997. Over the next year, the stock had tripled. Oddly, the next best experience came after Jobs was ousted in 1985. Investors lost money with Amelio and had a mixed experience with Spindler. By your analysis, recent changes at Motorola hold promise for investors. Not only was Ed Zander pretty much shown the door, but his replacement Greg Brown, although an insider, is not so much a long-time Motorola employee. What about the fact that these jokers haven't had a success since the Razr? Doesn't that count for something?

Berman: Companies like Cisco, Microsoft, Oracle, Google, Apple, I.B.M., Hewlett-Packard, E.M.C., Sun Microsystems, Intel, Texas Instruments, Qualcomm, Applied Materials, and Corning have helped turn the technology sector into one of America's strongest export industries. Motorola has been the long-standing exception to the rule. There's little denying that Motorola is a national embarrassment.

In 2006, Motorola had the hottest handsets in the industry. Just two years later, its handset market share has fallen from 22 percent to less than 12 percent. The company's global competitiveness has deteriorated so much that it's a wonder that they have not moved headquarters from Schaumberg, Illinois to Detroit. The stock probably hit bottom at $10.01 when Brown offered kitchen-sink financial guidance in his first conference call with investors in January. Over the next 12 months, investors will probably assign a higher probability to an eventual turnaround than they are now. If I'd been listening to you, I wouldn't have bought Yahoo when they booted Terry Semel for Jerry Yang. After all, Yang was pretty much as inside as you can get as one of the company's founders. Then Microsoft makes a bid, and the stock rises 48 percent. What good are you to me here?

Berman: To date, the changes under Yang's leadership can be placed into two categories: the gradual and the imperceptible. Microsoft's ill-advised offer to buy Yahoo would have come regardless of who was sitting in the C.E.O. seat. Admittedly, if you had been using my framework you would not have been looking to plow your life savings into Yahoo in the wake of Semel's departure. But regime change at Yahoo had nothing to do with the hostile bid Microsoft has put on the table. The offer came despite Yang-not because of him. What now? It's an M&A game. The only way that investors that buy Yahoo here are likely to look smart is if Microsoft is dumb - choosing to compound its mistake by bidding against itself and raising its offer. While we're at it, didn't Steve Jobs found Apple? How was his return revolutionary?

Berman: Steve Jobs did not work at Apple from 1985 to 1997. That's long enough to say that he was clearly no longer an insider. Unlike his predecessors, Jobs has a great sense of design, aesthetics, and timing.

What's more, he's had three tailwinds at his back that have helped him tremendously. First, the emergence of the Internet made the P.C. less of a personal productivity platform than a communications platform. A huge portion of the market that had been locked into Wintel solutions-or scared off by the relatively small number of software titles for the Mac-could suddenly look to Apple as a viable alternative.

Second, Microsoft increased the appetite for an alternative as Windows became less secure due to the spread of viruses. And third, the digital media revolution opened up an entirely new market opportunity. Jobs negotiated groundbreaking agreements with the technophobes that run the Hollywood studios and the recording industry. The cooperation of the content players has been as crucial to Apple's success as anything they've done on the design and engineering fronts. Only someone as cool as Steve Jobs could have gotten that done. In your report, you make analogies to buying the "I.P.O." of the United States not on July 4, 1776, but when the stock hit bottom in the fall of 1777, when the British surrendered. That, you argue, would have been a great investment. You also mention that France's stock would have "bottomed" around the death of Robespierre. Cute, but not really that instructive. Shouldn't an analyst be spending more time looking at earnings per share than reading history books?

Berman: Duff, your Canadian roots are showing. The British didn't surrender until 1783. But the tide turned in 1777. In September '77, the prospects for achieving independence from the crown appeared dim. But the Battle of Saratoga proved decisive. The capture of an entire British army secured the northern American states from attacks out of Canada. The victory helped convince the French to join the battle against British tyranny.

My historic point was that revolutionary change is rarely pretty. If nations traded on the stock exchange, few would hit bottom in the immediate wake of a coup d'etat. Revolutionary change operates similarly at the corporate level. New leaders typically encounter plenty of tough slogging in the early going. Fear, uncertainty and doubt are only replaced by optimism once new leadership can prove some measure of success.

And what do you have against reading history books? Analysts should first and foremost be highly inquisitive people. Just like any good historian, I am fascinated by pattern recognition-and using past patterns to predict likely outcomes. History never repeats itself exactly, but it sure can rhyme.

Visit for the latest business news and opinion, executive profiles and careers.© 2007 Condé Nast Inc. All rights reserved.