How to analyze tech stocks - 7 factors that must be considered

There are a number of measures that are especially pertinent to tech stocks. Do you know what they are and how to interpret them?

Earnings season is in full swing. This post will attempt to provide a few guidelines for drawing your own conclusions when reading tech stock results. This is not to say that standard measures of revenue and income are not important; they are. The point of this post is that there are areas to examine that will allow you obtain a deeper understanding of a tech company's results. And hopefully, will allow you to do a better job trading tech stocks.

The seven factors to consider --

• Year-over-year comparisons versus sequential quarterly results: It is important to always examine y-o-y revenue and earnings. It may not be obvious that tech sales have a seasonal component but they do. Enterprise software companies, for example, are affected by the budgeting cycles of large corporations which are generally on an annual calendar-based cycle with projects often ramping up as the new year begins and budgets are defined. Hardware component companies that are players in consumer electronics often have bigger sales in the summer and fall as they supply parts to the companies that are focused on building products for the holiday selling season. This is why we have recently heard some of the semiconductor companies like Intel (INTC) and SanDisk (SNDK) talking about a "return to seasonal trends".
• Gross Margin: theoretically, this term is not really specific to tech companies as any company can be evaluated on this metric. Simply put, Gross profit margin = (Revenue - Cost of Goods Sold) divided by Revenue. Investors track this carefully for tech stocks because it provides a quick way of identifying if costs are under control. There are two more factors that play into this analysis: scale and factory or fab utilization. Usually, when production systems are more fully utilized, cost per unit is reduced which helps to reduce the overall cost of goods sold (COGS). Similarly, efficiencies of scale will tend to drive down unit costs. When you are looking at hardware companies that are cranking out electronic components, unit costs can be a huge driver for overall profitability. Declining margins, therefore, are often a sign prompting investors to stay away from a stock, a situation we saw in the recent earnings report from AMD.
• Average Selling Price (ASP): this term is most often used with respect to semiconductor companies. It can be used to describe a specific product line of chips or it can be a consolidated number for several different product lines. Declining ASPs are often a red flag for tech investors. On the other hand, there may be a "sweet spot" where a product is cheap enough to gain wide acceptance but expensive enough to provide good profit to the manufacturer. It is important to know where in that lifecycle a company's flagship products are. Where ASPs are high and the products tend to be cutting edge, like the microprocessors sold by Intel (INTC), ASPs are highly scrutinized and commented upon. We saw this when Intel began reporting higher shipments of their lower cost Atom chips for netbooks.
• New license revenue: For software companies, comparing new license revenue versus maintenance revenue is a critical evaluation. In tough times, these companies are supported by maintenance revenue but if you are looking for growth, it is important to see new licenses being sold in order to increase the user base. This is always a major topic when Oracle (ORCL) or SAP, for example, report earnings.
• Debt: most tech companies have modest amounts of debt and strong balance sheets. This is one reason they have gained in popularity during this recession. Beware tech companies with loads of debt. Be sure cash flow covers debt payments. Use a ratio like debt-to-equity to evaluate the debt load. A large company like Cisco Systems (CSCO) can accommodate a lot more debt than a small company like Skyworks (SWKS). Ratios help you make an apples-to-apples comparison across companies.
• R&D: beware tech companies with R&D expenses that are falling significantly on a sequential basis. This could be a sign that they are milking current product lines while ignoring the future. It is true that during an economic downturn like we have today, companies will tend to reduce R&D somewhat but an investor needs to assured that the company is continuing to invest in its future.
• Customer base: It is not uncommon for small-cap tech companies to have just a few large customers. This is especially true of companies like Big Band Networks (BBND) that sell into the telecom sector. This sector tends to be dominated by a few huge service providers in each country, thus limiting the potential customer base that is available. Over time, however, the customer base should expand as the company develops more products or extends its international footprint. Beware the companies where this hasn't occurred or where a large customer is suddenly lost.

Try using these seven factors to evaluate the next tech stock you are interested in and see if they don't provide a much clearer picture of the company's true worth.

If there are factors you use that I have not listed here, please leave a comment!