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Technology’s Slim Pickings

Morningstar’s analysts see plenty of solid companies in the technology sector, but attractive valuations are much rarer.

Philip Guziec, 04/05/2012

The media has been talking all about tech in the past several months, from Apple’s big earnings to Facebook’s IPO and everything in between. I recently sat down with some of Morningstar’s tech analysts to see if there’s still investing opportunities in the area.

Philip Guziec: Since the market bottom in March 2009, we’ve seen the IPO market come back to life—lots of big tech names, some high-profile IPOs. You can’t turn on financial radio without hearing about a big IPO. What can we say about these?

Rick Summer: I think there is a dichotomy among the companies that have come out. Looking at the companies that we covered in 2011, there was only one company that came out that we felt pretty strongly about, that had good competitive advantages, and that was LinkedIn LNKD. And that traded extremely well, above its offering price. But the aftermarket trading for most of these companies has been pretty poor.

We’ve seen a little bit of a recovery here in 2012 for many of those companies, and certainly, the lineup of companies that are in a rush to go public has increased yet again. We’re seeing a big appetite from investors for investing in these. However, given that historical growth rates have been very tremendous, given the large appetite for IPO investment, and lastly, given the very large secondary market that’s taken place, where investors have been able to invest in advance of that IPO market, we’re not seeing a lot of attractive valuations. That being said, all eyes are on Facebook, a company we like that’s supposed to price sometime in the spring. It’s going to be a challenge, probably, to get around valuation once again. But it’s a company that we still think should be on investors’ radar screens just in case things end up trading south after the IPO. Many companies may not be worth participating in on day one or day two, but if they disappoint from an investor perspective and trade down, they could offer better long-term options for investment.

Guziec: You mentioned moaty names, LinkedIn being one of them. Are there any others?

Summer: In the IPO land, LinkedIn is the only one that we’d be excited about. Facebook, when it goes public, will be very interesting. I think that the growth rate for Facebook, while the market opportunity is fantastic, the stock will be decidedly choppy, from our early take on it. What that means is that a company with pretty distinct competitive advantages may end up being in a situation where it trades off, and investors could be able to get a crack at that. Right now, in terms of our coverage universe of companies that have recently gone public, those would be the two that we think could offer investors more of a core holding if the price was right.

Guziec: And other than that, we’d need a pretty deep valuation hit before we’d be interested in any of these other no-moat businesses?

Summer: Yeah, that’s our take on things, and it’s not surprising, when you have a robust IPO market. Sellers sell when prices are high, and that’s what insiders and venture capital firms are going to do.

Guziec: Aside from the recent hot IPO market, how do we see the technology landscape as the market has run up?

Michael Holt: Within technology, we’ve actually seen quite a strong runup in the last six months. For example, we saw a lot of value in enterprise hardware. We liked EMC EMC, and Cisco CSCO, and a lot of names out there, but their share prices have risen out of our 5-star territory. But these are still names that we still think have very entrenched competitive advantages when the right opportunity presents itself. The really hot topic in data center design, software, and hardware has been cloud computing. And this presents near-term tailwinds and long-term headwinds. So, it’s kind of an interesting concept to get around. But as people move their computing processes to the public cloud, that presents a threat to the guys who are selling the equipment and software to the on-premise places. We think that’s a decade-long transition, however, so in the meantime, people are investing a lot of money. Data center administrators and companies are investing a lot of money to bring the cloud into on-premise data centers. So, there’s a very beneficial trend for the EMCs and Ciscos, and we still do have one 5-star name in that area on the software side, which is Oracle. We think it has a very entrenched competitive advantage.

Guziec: How do we know when this starts to transition from a tailwind to a headwind, and the market starts to pick up on it?

Holt: That’s the million-dollar question. We know it’s not in the very near term, but it’s something we’re monitoring all the time. We think that we’ll see the technologies adapt to that public-cloud model, and so the vendors that are threatened by it are going to try to embrace it and come out on the other side as winners as well. But there’s a lot of ambiguity about how they’re going to accomplish that, at this point.

Guziec: Any other themes outside of the cloud transition that you might want to talk about?

Holt: I think we’re seeing a really interesting time in technology in general, how mobile devices have become such a dominant force, are upsetting the apple cart for PCs, and are changing how people think about operating systems. Where it’s playing out the most quickly is in the smartphone-handset market. Companies like Research in Motion RIMM have been behind the eight ball on this transition, and they’ve pretty much given away the market to the top two dogs, which are Apple AAPL and Android. Apple has certainly done phenomenal. It just had a blockbuster quarter, 37 million phones shipped. Android’s a strong second player, and they’re both positioned to do well.

Guziec: So, what do we think about Apple’s valuation, and at what price would we like it?

Holt: We actually have a fair value estimate of $560, so there is a bit of upside from where it’s at. But, we’ve changed the uncertainty rating to high, because to attain this valuation, you’re counting on a lot of things to happen over the next five-plus years to drive that value. There’s a lot of uncertainty about how Apple can sustain the current growth rate with current phone prices, for example. How do you get the next 200 million iPhone users? Guziec: We think it’s worth $560. So, in the $300s, mid-$300s, we’d start looking at it?

Holt: Absolutely. Below $400, we’re very excited about Apple.

Summer: The smartphone ecosystem’s incredibly important. And while Apple has the pre-eminent high-margin, smaller-market strategy, Google GOOG has really embraced a more open, mass-market strategy at the same time. It segments out the markets quite nicely, and it’s not a one-winner market, from our perspective. All of the success that Apple has is with an integrated hardware, software, and content platform; Google is approaching it in a mostly open way. It’s mostly open, because it’s open to hardware providers, and it’s open to many different content providers, but it’s also attempting to have Google services be the glue behind it and, most important, tie advertising to that.

Our perspective on Google is that an open platform is a lot more powerful for a company that’s already a giant, as Google is, in terms of locking in consumers and providing value to advertisers at the same time. So, while the discrete mobile business for Google is certainly worth less than the mobile business for Apple, it is meaningful in terms of driving valuation and its economic moat.

We still look at that being as one of the pillars of Google’s strategy going forward, not only to protect and extend its moat out, its wide moat out, but also in providing growth. Still, at today’s prices, we have a fair value of $744 for Google. It’s trading in the low $600s right now. We were a lot more excited when it was trading right below $500 last summer. But it still is a pretty attractive core holding for a lot of investors, even at these levels.

Guziec: Any other themes?

Brian Collelo: To go along with Mike and the discussion of Apple and the smartphones, some of the wireless chip makers, in particular, saw some real resiliency in the second half of this year, even though the economy was down and the industry as a whole was in a bit of a downturn. Qualcomm QCOM just reported a terrific fourth quarter, a record number of chip shipments. And the other part of the business, the part that we really like, is royalty revenue. It basically invented the 3G network, and it gets royalties based on the price of every smartphone. You’re seeing more and more higher-priced Apple smartphones being sold, a strong shift away from basic handsets toward smartphones, which lifts average selling prices for the entire industry. Both of these things are benefiting Qualcomm.

What we like about the company as well is that it is exposed to the rest of the handset space as well. It sells chips for Android-based phones. It’s the sole chip supplier today in the upcoming Nokia phones running Microsoft Windows Mobile. So, we really like that company for its broad exposure to the smartphone boom.

Guziec: What do we think Qualcomm is worth? Where would we like to buy it?

Collelo: Right now, we think it’s worth $62, and it’s trading at about $62. We liked it a lot more probably three months and 20% ago.

Guziec: What’s the uncertainty on that? Collelo: It’s a medium uncertainty rating. It’s a wide-moat stock.

Guziec: So, we’d get excited in the mid-$40s, to pick this up?

Collelo: Absolutely. We don’t have very many wide-moat chipmaker stocks, so, from that perspective, anytime we see weakness, we get excited.

Andy Ng: As Mike touched upon earlier, the smartphone trend is also driving the cloud. And when you look at a company like Intel, when you build up the cloud, you need a lot of server chips. And Intel has really been benefiting from that in the past year or two. We think that’s a trend that will continue.

We think the server-processor business of Intel INTC can grow in the midteens in the next several years, just because as you build up the Internet, and cloud infrastructure, you’ll drive demand for server chips.

Guziec: What do we think Intel is worth? Ng: It’s worth $26 per share, and it’s trading at $27 right now. So, once again, six months ago, it was much cheaper. It was trading at around $20.

Guziec: Once it breaks through $20, we get excited, right?

Ng: Yes. But it’s one of the few wide-moat names in the chip space, so it’s definitely one we keep an eye on.

I’m going to shift gears to the semiconductor equipment industry—the companies that make manufacturing equipment that chipmakers buy to produce semiconductors. With all these applications, smartphones, cloud, you need cutting-edge chips, so you need new semiconductor-manufacturing processes. Major chipmakers like Intel and Taiwan Semiconductor Manufacturing TSM are investing pretty heavily to advance their manufacturing technologies. That’s driving demand for new types of manufacturing gear from these equipment suppliers. Right now, we like Applied Materials AMAT. Our fair value is $19 per share, and it’s trading at about $13 right now. It has a wide moat. It is the world’s largest chip-equipment supplier, so we think it will benefit from these trends. A lot of the other names have run up recently, but Applied is still attractively valued, in our opinion.

Guziec: What has kept the valuation down on Applied?

Ng: Applied isn’t only in chip equipment. They’re also in flat-panel-display manufacturing equipment and solar equipment as well, and those two segments have been weighing on the firm in recent quarters. Applied has been pretty focused on the solar-equipment opportunity in the past couple of years, and they’ve actually lost some market share in its main semiconductor-equipment business.

But all the signs are pointing toward Applied starting to regain share, and it seems well positioned to gain share in 2012 and in the next couple of years. Refocusing back into their main business should benefit the firm.

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