High-quality large caps offer the most compelling valuations.
--Current near-term economic uncertainty is presenting a buying opportunity in higher-quality names.
--In an environment of tightening corporate IT budgets, we would look to invest in attractively valued firms that sell mission-critical products with recurring revenue streams attached. The software industry is a natural hunting ground for firms with these characteristics.
--Cloud-based services and mobile computing will continue to be major disruptive forces within IT. Hardware firms will be forced to adapt in a rapidly shifting landscape.
The Nasdaq fell nearly 13% from the end of the second quarter through Sept. 22, as macroeconomic uncertainty and disappointing outlooks from a number of hardware and semiconductor firms weighed on market sentiment.
Weakness from large firms like Dell
Software and services firms have yet to show signs of weakness, with Oracle's
This near-term uncertainty has created a number of buying opportunities across our coverage, and we are currently finding the most value among large-cap firms with durable competitive advantages. Given the current uncertain macroeconomic outlook, we see little reason to look beyond these high-quality, attractively valued large-cap firms; and we highlight five of our favorite ideas below.
Industry Level Insights
Ongoing economic weakness in Europe and North America could impact third-quarter performance of many software companies if clients delay capital expenditures in the face of uncertainty. The impact of the slowdown could be felt in the enterprise as well as consumer markets: Sales of big-ticket enterprise software of the type sold by SAP
While a capital spending slowdown could impact most software companies, not all software companies are equally susceptible to revenue declines, and others could actually benefit. Revenues of security software companies such as Symantec
As we enter the fourth quarter, concerns about demand from the public sector and European markets have taken a toll on enterprise hardware stocks, creating opportunities to pick up high-quality names at steep discounts. Investors must be selective, however, and take care to differentiate between economic issues and some of the secular changes occurring in the hardware industry.
Virtualization and cloud computing are changing the way data centers are architected. When faced with these types of disruptive forces, determining if the firm has established an economic moat is paramount. In hardware, this often means looking for those firms that bridge the gap between one generation of devices and the next with software and related services. For example, Cisco's
We see similar trends occurring on the consumer front. Apple
The overall semiconductor industry has seen business conditions slow in recent months after benefiting from a robust upturn in global chip sales over the past couple of years. Although the slowdown was first triggered by excess semiconductor inventories in the electronics supply chain, the weakness has persisted in the space as chip demand has softened across a broad array of end markets.
In recent weeks, a handful of chipmakers have lowered their outlooks, including Intersil
In addition, trends and commentary in the computer-related chip space have been mixed. Business conditions at Intel
We believe that the latest industry downturn has begun to present buying opportunities for some analog chipmakers, such as Analog Devices
The U.S. telecom industry has been placed in a holding pattern thanks to the Department of Justice's decision to challenge AT&T's
We've lowered our fair value estimates on Sprint, Leap, and MetroPCS, but we believe the market has severely overreacted to the firms' recent earnings troubles. We believe the sell-off in these stocks has created an opportunity to own assets that will eventually form a critical piece of the U.S. telecom infrastructure. We also lowered our Deutsche Telekom fair value estimate as a result of the DOJ's legal challenge to AT&T. If the deal is ultimately killed, we think the lost time and distraction will have left T-Mobile USA in worse shape than it was before. It hasn't developed any kind of next-generation network strategy of its own, likely forcing it into the hands of another operator. Teaming up with Sprint would make the most sense over the long term, but the prospects for such a merger will depend on the language regulators use in blocking the AT&T agreement--the DOJ's original statement was vague on this front, in our view.
Within Europe itself, France continues to garner the most attention. Competition continues to increase in the country as carriers prepare for Iliad's entrance into the wireless business. Recently France Telecom
Our Top Tech Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The five firms below fit this criteria and are trading at attractive valuations, in our view.
With a compelling valuation and a wide economic moat, we have included Google as one of our favorites. Although we expect continued scrutiny from various global regulatory agencies, we do not expect potential changes to drastically alter the company's competitive advantages. Google has been an early and dominant company on the Web. The company not only built a revolutionary Internet search engine, but it arguably pioneered performance-based advertising on a massive scale. Google has a formidable moat in Internet search, which represents more than 75% of net revenue. Although growth is slowing in its core search market, we still expect annual growth in search revenue to exceed 15% during the next five years, supported by the firm's successful foray into mobile advertising. Additionally, we expect initiatives in display advertising and video website YouTube to represent multi-billion-dollar revenue opportunities.
Oracle is one of the highest-quality names in our tech coverage universe, and we expect the firm's core software business (which accounts for 68% of revenue) will continue to perform well in the near term. Although Oracle's hardware segment could generate underwhelming results in the next few quarters, we believe this business has solid long-term prospects and will enable Oracle to drive additional software sales over time and further strengthen its wide economic moat.
France Telecom is the dominant telecom operator in France. It also has large operations in many other countries. In total it has 210 million subscribers, of which 150 million are wireless customers. This size allows it to keep the majority of its customers on its own network, which lifts profitability, provides it with a narrow moat in our opinion, and allows the firm to generate significant cash flow. France Telecom has generated more than EUR 8 billion in free cash flow in each of the past several years and expects to do so again in 2011. This cash flow in turn allows the firm to pay a large dividend (current gross yield is 9%), reduce debt, and make additional acquisitions, primarily in emerging markets.