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More Bargain Than Bubble

Use this screen to find undervalued tech companies poised to generate significant returns on their competitive advantages.

David Hirsch, 09/13/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

With the recent sizzling IPOs of LinkedIn LNKD and Yandex YNDX, as well as the highly anticipated offerings of Groupon and Facebook, many investors have begun to worry about the possibility of another bubble in the technology sector.

While they may have a point in questioning the rationale behind companies facing near-term loss projections trading at around 1,000 times earnings, this fear has also caused the market to shy away from well-established tech companies with formidable growth strategies. These companies are all industry leaders offering attractive margins of safety for investors.

Sector = Technology

We initiate the screen by narrowing it to technology companies. The Morningstar coverage universe extends to both foreign and domestic firms.

And Economic Moat = Narrow
Or Economic Moat = Wide

Because the technology sector is extremely competitive, these criteria focus on companies with already-defined economic moats. Having competitive advantages provides a degree of certainty in the company's ability to generate returns on investment above its cost of capital in a constantly changing environment.

And Morningstar Rating Overall > 4

In order to identify undervalued stocks, we focus on companies that are trading at severe discounts to Morningstar analysts' fair value estimates. We believe the market has significantly underestimated these companies' earnings potential and these equities will eventually converge to a much higher valuation.

And Forward PE Ratio < 10

To ensure we are not victim to a perceived bubble, we have selected companies that are currently priced at less than 10 times their expected future earnings. Even if these companies miss estimates, their trading multiple will still likely be less than the industry standard.

This screen, run in Morningstar Principia at the end of June, returned a handful of companies, all with major brands and unique business models.

Applied Materials AMAT
Applied Materials is the behemoth of the semiconductor equipment industry, with unmatched scale and a broad product portfolio.

Applied provides semiconductor fabrication tools to chipmakers. It is the dominant player in a fragmented industry and, with its broad product portfolio, competes in nearly every segment of the market, giving it a nearly ubiquitous presence in chip production. Applied is the closest thing to a one-stop shop for chip manufacturers, as competitors are usually specialists in their respective segments. In 2009, the firm had a commanding 15% share of a $17 billion market, according to Gartner.

While the semiconductor industry may experience some near-term headwinds as uncertainty regarding the economy lingers, we are bullish on the fundamental outlook for Applied. PAGEBREAK  

Cisco Systems CSCO
Cisco's dominance in data networking is clear. Its Ethernet switches, which move data along local computer networks, are ubiquitous in corporate data centers. Cisco's share of the switch market has remained near 70% in each of the past five years. Customer and channel partner switching costs are high, particularly in mission-critical switching applications, as IT managers are risk-averse, while Cisco certification remains the industry standard for network administrators. Moreover, Cisco's dominant market share provides scale advantages, and the company invests heavily in product development and customer and channel support to continually pressure its smaller competitors.

Although Cisco has diversified beyond switches and routers, these fundamental networking products remain the foundation of the firm's wide economic moat. Meaningful customer and reseller switching costs, R&D scale advantages, and a global sales and marketing force nearly 25,000 strong should allow Cisco to maintain its lead in enterprise-class switches and high-end routers well into the future.

Hewlett-Packard HPQ
H-P has aggressively expanded its services offering in pursuit of the successful IBM model in recent years. Services for H-P are not simply a stand-alone offering but rather a complementary segment to the other technology offerings; H-P continues to raise customer switching costs by increasing its customers' reliance on the firm.

Although competition is heating up among the data center giants, we believe H-P will be able to leverage its market-leading position in servers to capitalize on recent improvements to its storage and networking portfolio, delivering integrated hardware stacks.

Overall, we believe H-P's global reach and well-run logistics will continue to provide an efficient platform to assimilate and distribute new technologies.

Intel INTC
Intel is the dominant force in the roughly $30 billion computer processor market. It has benefited tremendously from the proliferation of personal computers in the past few decades. Intel holds long-term advantages over smaller rival Advanced Micro Devices AMD in the microprocessor industry.

The mass proliferation of tablets provides immense growth opportunities for Intel. The emergence of tablets is part of the trend toward cloud computing, where computing tasks are offloaded onto the "cloud" and users gain access to the cloud with an interface such as a tablet. As adoption of tablets and other devices rises, it will require substantial server build-outs to create the infrastructure necessary for the cloud. This will provide significant long-term tailwinds for the growth of Intel's server processor segment, which is the firm's most lucrative business.

Microsoft MSFT
Cloud computing is a double-edge sword for Microsoft. Microsoft's server and business application software products are well positioned to ride the cloud-computing wave even as the Windows PC OS franchise bears the brunt of the incoming tide.

The switching costs that form the moat around the Windows PC OS franchise are declining as cloud-based services sever the historical ties between applications and operating systems and lower the barriers for switching among computing platforms. This will likely result in reduced revenue and economic profit opportunities for the Windows PC franchise.

Cloud computing also threatens Microsoft's predominantly desktop-based Office franchise, but we expect the firm to move this business to a new cloud-based model. Microsoft's ownership of broad suites of integrated products should help the company win competitive battles and maintain its market share even as the business model evolves.

One business' bane is another's boon. Application developers need software platforms to develop and deploy cloud applications, and Microsoft's Azure is poised to emerge as one of the largest platforms for cloud computing.

While the transition to cloud computing will affect Microsoft's business over a long period, the firm's near-term financial performance will be driven by demand for its current products. Windows 7 is enjoying a strong cycle following tepid customer interest in Windows Vista, and Office 2010 appears to be off to a solid start. The server and tools business continues to grow as SQL Server gains market share and demand for Windows Server remains robust.

David Hirsch is a research analyst with Morningstar.

is a guest author

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