Wed, 1 Aug 2012
Morningstar's Grady Burkett highlights the new dynamics in an increasingly mobile-driven sector, the effect of Europe woes on key players, the hallmarks of durability among social media names, and more.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Tech has been a relative bright spot over the last few years, but will that trend continue? Here to explore this is Grady Burkett. He's the director of technology research at Morningstar.
Grady, thanks for joining me.
Grady Burkett: Jeremy, thanks for having me.
Glaser: So, let's start by taking a look at some of the earnings that we just got from this quarter. What did we see in tech? Has it held up?
Burkett: I think the big-picture message from earnings so far is that we're in an environment where really you can start to evaluate individual business models. So, when we were moving into the quarter, to be honest, I was feeling a little cautious coming into this quarter. We saw preannouncements from Seagate in hard drives. We saw preannouncements from AMD and Applied Materials. A lot of these hardware companies started to preannounce. The question was is this going to follow through to the service companies, the software firms, some of the Internet sector, and what we saw as we moved through the quarter is that a lot of the enterprise software names and some of the more resilient names actually had very strong quarters. Oracle had very solid software license revenue growth; application license sales grew 23% year on year. SAP reported strong results. Generally, when you flow through and move down to some of the enterprise hardware names like EMC, the ones that are better-positioned in data storage, VMware also, they had really good results. And so I think where we're at right now is a place where if you've got a really good business exposed to decent secular trends, you're doing OK. If you've got some headwinds facing you, you're having some challenges, particularly with top-line growth.
Glaser: But even after these decent earnings, tech stocks have sold off some during the last couple of months. Where do you think valuation levels are right now?
Burkett: Right, so if you just look back in late March when this sector really started to get hot and really peaked--even some of the old tech names, such as Microsoft and Intel, looked like they were really on a tear for some period of time--the sector as a whole, using the NASDAQ as a proxy, has sold off about 10% from the peak in late March until the July 31 market close. If you look at our valuations, in March we viewed the sector as fairly valued. Really the price/fair value ratio was 1. So it was really interesting. Right now we see the sector is about 10% undervalued. Now I wouldn't go out and buy the QQQs based on that; that's not a sector call. There's still not a huge margin of safety around tech generally speaking, but there are pockets in the sector where you can find some buying opportunities.
Glaser: Looking forward if you think about some of the big trends that are going to shape the industry in the years to come, let's start with Microsoft, obviously the firm is the behemoth. It has a new operating system coming out. In the past we talked about how a new operating system from Microsoft could kind of drive the rest of the industry as people upgraded their computers. Do you see that happening with Windows 8?
Burkett: It's interesting. It's a little different now obviously because of the way mobile computing has really taken hold globally, and I don't think you can really point to a PC upgrade cycle to really drive a lot of growth throughout the industry. I think Windows 8 is interesting from Microsoft's perspective. Our long-run view is still that Microsoft's Windows businesses is in secular decline and will slowly decline over time, though some of what the firm has done with the new user interface could maybe stave this off temporarily.
I think that the more interesting dynamic now to look at honestly is Apple, its iPhone-release cycle, and what's happened in mobile in general. So I would be watching for that, the iPhone 5 and how that flows through and affects the different players in tech. For instance, we saw Qualcomm kind of report a sluggish quarter relative to what you'd hope for. Not sluggish, but sluggish by Qualcomm's standards. I think part of that is just based on waiting for this next iteration of iPhone.
Glaser: How about Europe? Certainly it seems to be in the news almost on a daily basis. Have we seen any impact in tech from the worries in Europe?
Burkett: To me it's interesting because you look at some of the companies that are most exposed to tech, and obviously when you look at enterprise tech as a whole, you can look at upper-teen exposure. So, these companies will have anywhere between 15% and 20% of revenue going to Europe and the European region, and a lot of those names are undervalued to us. You look at Oracle, Cisco, and Google with large revenue exposure to Europe, and you're getting very attractive valuations in some cases. For us, yes, Europe will definitely have some modest impact to revenue growth, but if anything that creates a buying opportunity for a lot of these higher-quality names.
Glaser: If we think about an area of tech that has been under almost microscopic focus, it has been social-networking. It has been Facebook, Zynga, and the Groupons of the world taking a lot of space up in newspaper column inches at least but seem to be having some disappointing results certainly this quarter. Do we see any value in that sector? Is this really just a fly-by-night kind of idea, or will there be some value there in long term?
Burkett: First of all I think there are a couple lessons here. I think Facebook comes to mind, specifically. The first thing is that as an individual investor a lot of times you're really at a disadvantage with these IPOs. If you're buying on the first day, it's kind of buyer beware, and so my first takeaway as an individual investor is just to avoid them. Just let some things settle out, get the public information out there, let the lockup periods expire, and then take a look and see where there's value.
Specific to these businesses that have recently IPO’d, so looking at Facebook, LinkedIn, Pandora, Groupon, and Zynga, I would try to piece apart which companies have benefitted from network economics and network effects and switching costs. So, I think you can separate the bucket and look at Facebook and LinkedIn as two companies that have very durable business models, very durable competitive advantages. We rate them both as wide moats, and those companies can build long-term businesses and platforms, and then really be a little more careful when you are looking at some of the other businesses like a Groupon or Pandora where you really can't generate switching costs or create switching costs around your services.
That's one thing to look at. In terms of where we see some value, I mean we are almost there on Facebook. Rick Summer, who is our Internet analyst, sees $20 as a place to really start getting interested in Facebook, and I think we're at $21 to $21.50 right now. So, investors shouldn't ignore this segment regardless because these companies are changing a lot of what's happening throughout the tech industry. Even if you look at how Facebook builds its infrastructure and how it looks to push its suppliers to deliver products and services they aren’t used to supplying for data center products, you're seeing a lot of change happen based on the Facebooks, the Googles, et. cetera. So that's the way I think about this kind of group. Pay attention to them. Watch Facebook and watch LinkedIn for some buying opportunities if they come. They're not here yet, and then just kind of separate the wheat from the chaff, if you will.
Glaser: Certainly those companies are very focused on consumers, but how about firms that are more focused on enterprises? Is there a big divide in performance between kind of consumer-facing firms and enterprise-facing firms, or are we not really seeing that?
Burkett: Yes, within tech generally, I think if you separate it out [between] consumer and enterprise, you really are again thinking about what kind of customer-switching costs can a business create, and I think that's really important. I think that when you look at some of the wide-moat companies in tech and their ability to kind of navigate some of the business cycles and also still be able to create value over the long term, the enterprise tech companies have the ability to lock in and create switching costs. So, when I think of companies like Oracle, Cisco, Microsoft, EMC, and these types of companies, you are not as beholden to product cycles or swings in the economy. Those are the places I'd be looking right now. They have very strong balance sheets and cash flows, and they are very locked in to their customer environments. With some of the consumer names I think you have to be a little more cautious.
Glaser: Grady, thanks so much for the update today.
Burkett: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.