Mon, 29 Oct 2012
Cyclical and economic concerns have hampered the tech sector but are also creating potential buying opportunities in large- and mid-cap names, according to Morningstar's Grady Burkett.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We are in the midst of tech earnings season, and we've had some misses that have raised concerns about both the enterprise and the consumer. I am here with Grady Burkett. He is the director of technology research at Morningstar, and we're going to get his take on these questions.
Grady, thanks for joining me today.
Grady Burkett: Thanks for having me, Jeremy.
Glaser: So, IBM kicked off earnings season on somewhat of a down note saying that they saw enterprise customers looking a little bit weaker than they had expected. Is that a trend you've seen throughout the tech earnings season, and what do you think is happening there?
Burkett: We have heard this commentary, this short-term commentary, around some uncertainty in enterprise budgets from other firms within the technology sector. So, there is certainly some credibility around what IBM is saying. We have this fiscal cliff that's emerging. We have some uncertainty around maybe what's going to happen in the fourth quarter. Normally, you'd expect to see a bit of a budget flush, maybe that doesn't come through in the fourth quarter for some of these vendors.
With IBM, specifically, you also had a couple of firm-specific issues at work. They are at the very front end of a mainframe product-refresh cycle, and they only ship the mainframe for 30 days out of the quarter. So, there is a sort of this trough phenomenon going there. You also have currency headwinds, and so they did cite that currency played a role about a 3-point roll in their 5% year-over-year decline in revenue.
Finally, in our view, there are some questions around the long-term secular trends in software. So, IBM has a very large software application consulting business and a very large software middleware business that supports traditional software enterprise applications. And as we move to kind of cloud-based applications like Workday for human resources or Salesforce.com for sales automation, that's when you might see some long-term pressure on IBM’s software business. They have to do some things, make some changes in the portfolio.
Glaser: So, when you look at these results and you say how much of them are really attributable to a product cycle--It's just that Windows 8 isn't out yet. It's just that the new mainframes are coming out--how much are really those long-term negative pressures in the business? Is there a way to quantify that?
Burkett: I think right now, we're primarily cyclical and product-cycle-driven, and for some of this uncertainty I think those are the primary pressures relating to this particular quarter. I think IBM has obviously done a fantastic job over years of transitioning its business from hardware to higher-value software to higher-value services, and they have a great merger and acquisition machine in place. So, I would expect them to continue navigate this, but certainly it's something worth watching. They did pay in August a fairly substantial premium for Kenexa, a human resource software application as a service company, and so it's just something to watch. Right now IBM's is trading roughly at our $193 fair value estimate. So, we would say there is not really a margin of safety. It's a great business, a wide-moat company. We'd just kind of wait before we committed new dollars to that particular name.
Glaser: Microsoft and Intel also seemed to have some disappointing results this quarter related to the PC industry. Is the PC in terminal decline? What do you think is going on there?
Burkett: So, certainly PCs are facing challenges, and in the third quarter according to Gartner, units fell 8% year over year. And if you look at the way that consumers are behaving, the PC might not be the center point of their computing device any longer. So, there is going to be a multitude of devices that the consumer accesses. That said, there is certainly a product-cycle components to this. There is certainly a cyclical component to this.
Again, we’re seeing this ramp of the adoption curve for iPhones and iPads, and so consumers are delaying their purchases on traditional PCs. At some point that's going to normalize. We have to keep in mind there is some positive trends that all computing devices benefit from. First of all in developed markets like the U.S., PC household penetration is greater than 100%. If you look out at Asia-Pacific, Eastern Europe, and some of these more developing regions, we saw penetration rates below 40%, so there is a tailwind.
Now if you look at Intel and Microsoft specifically, we think Intel is starting to look fairly attractive right now. It still [has a Morningstar Rating for stocks of 4 stars]. Our buy price is around $19, and we’re down at $21.50. But it is a name to watch. Keep in mind that Intel benefits from the transition toward cloud computing because it has a very strong growing dominant position in the server microprocessor industry. So, Intel is a company that has some hedges, and regardless we think that right now we've got more headline risk than underlying secular risk to PCs.
Glaser: So, certainly Microsoft had a big strategy shift or is going through this strategy shift in which they're actually producing their own PC at the surface. What do you think about that move? Does it make sense for Microsoft?
Burkett: It's an interesting strategy for Microsoft. They obviously need to capture more of the consumer dollars and also protect that core enterprise franchise that they have had such a strong position in for so long. We continue to model Microsoft's Windows franchise to be in secular decline over time, and so our fair value estimate already incorporates that. We think this could again delay that for some period of time, but not necessarily eliminate that decline. Microsoft's business has very strong franchises in Office and Server and Tools as well, so those are the businesses that are going to grow. Microsoft should also participate in cloud because it already owns the enterprise customers, so you've got some offsets there to PC, as well. But certainly this will be interesting to watch over the next year, how Microsoft can fit into the ecosystem that’s developing.
Glaser: Microsoft is also not only trying to push their operating system on tablets and PCs, but also with phones to compete against Apple and Google there. When you look at those three big ecosystems [Windows, Apple iOS, and Google Android] are you getting a sense that one is starting to win over another? Are we really getting into bit of a cold war in mobile?
Burkett: Microsoft is so obviously the new entrant in this kind of ecosystem. And I think right now we’ve still got two dominant leaders obviously, Android and Apple and Amazon now. And so I think that Microsoft has a very kind of steep slope to climb for it to really penetrate this market, but certainly Microsoft, with its cash flows and its position in the enterprise sector--and it’s clearly committed to continue to invest in the space it needs to--it's going to be a player eventually.
Glaser: Let's take a look at valuation then. When you look across the sector, do you see any big discounts?
Burkett: So, we see the sector as a whole about 10% undervalued. So as we discussed late last summer, we're still not seeing a real opportunity for investors to come in and invest in the sector as a whole. We would be thoughtful, and stock selection is very important here especially given all of the secular changes happening within the space and given some of the near-term uncertainty.
Glaser: So what are some of those individual companies that you think look attractive right now?
Burkett: Right now, obviously, we still like some of the large-cap names that look undervalued to us, that are exposed to some of these secular pressures. We do find some opportunity in Intel. We continue to think Cisco Systems is undervalued at this stage, but it's interesting because we've had some misses this quarter based on some of the uncertainty. So we're also finding some high-growth mid-cap names, very high-quality names that look attractive. If we look at F5 Networks with application-delivery controllers--it speeds of the performance of applications across the Web--that name is trading at about a 25% discount right now. It's narrow-moat company, with about a $6.5 billion market cap.
Another name that looks interesting to us, that hasn't for a while, that's been overvalued for a while, is Check Point Software. They make network security-device appliances. Again, it's a narrow-moat firm and very high-quality, trading at almost a 30% discount right now, and has about a $9 billion market cap. These two firms typically grow very quickly, but because of some of the uncertainty around enterprise budgets, we've had little bit of a pause in their growth. So, we think these are short-term issues, and we see growth reaccelerating next year.
Glaser: Grady, thanks for the update today.
Burkett: Thanks for having me, Jeremy.
Glaser: For Morningstar, I am Jeremy Glaser.