Wed, 30 Jan 2013
Although the tech sector hasn't had the best earnings season, Apple, Microsoft, and others still have solid long-term fundamentals and are trading at attractive discounts.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's been an eventful tech earnings season so far, and I'm here today with Grady Burkett; he is our director of technology research. We're going to look at some companies that have reported so far and where the best values are today.
Grady, thanks for talking with me.
Grady Burkett: Thanks for having me, Jeremy.
Glaser: So, I think we have to start with Apple. Certainly that's been the big news story so far. The stock has sold off pretty substantially since [reporting its] earnings and even before then. We talked to our Apple analyst, Brian Colello, about some of these specifics, but what else have we seen at Apple? Does it portend a broader decline in tech names?
Burkett: I think a lot of what we're seeing with Apple is a function of expectations kind of coming in for that particular company. So I don't know that you can necessarily extrapolate a trend across the entire sector. I will say that we took our fair value estimate down on Apple on the results. And essentially what happened is we lowered our long-run revenue projections and our long-run gross margin projections just a bit, but that flows through to free cash flow pretty substantially.
So, with Apple right now, we're expecting free cash flows to be roughly flattish over the next five years. So, that's kind of the bogey for investors to think about with that particular name. For investors, I think that the one key takeaway from our projections in the current stock price is that the market price implies decline and pretty substantial decline, and we think that's very unlikely for a company with such durable competitive advantages. It's a very well-run company still. It still has growing markets, and so $450 per share, $440, we think it's a very attractive company to look at right now.
Glaser: One area of Apple's quarter that that was weak was PCs, the Mac business. Some of that was [the result of] supply chain issues, but there has also been a broader weakness in PCs. How did that play out in, say, the results of Intel and Microsoft this quarter?
Burkett: Yeah, and that was interesting also. I mean, we had Intel post a little bit of a disappointment. It's interesting after all the gyrations of the quarter, we're still at about $21 per share on that particular name. So, we're had a pretty strong runup in the shares going into the middle of the year. I think investors got overly excited about Windows 8 and some of that would drive Intel. I think investors were really excited about what was going in the x86 server business as well. And when we saw some of that excitement kind of deflate. Again it's a situation where expectations came up maybe a little bit too aggressively, and now we're back at a slight undervalue, about a 20% discount to fair value. So, again it's a name with the 4% dividend yield that we find attractive right now.
Looking forward with Intel, we continue to think that story is about the growth of the x86 server microprocessor market, and then how the firm navigates, how they move into mobile, and then how the PC market fluctuates over time. So, we think the PC market is flattish, maybe has very sluggish growth globally, but we think Intel can continue to grow that server microprocessor business. So, we do like Intel.
Glaser: And how about Microsoft?
Burkett: And Microsoft, it's a very similar situation. I mean, I don't think there was lot of significant surprises in their quarter. I think that there are still some delays in waiting for some of the new product launches. Obviously we're going to have new Office products coming out. We're still waiting to understand what's going on with Office 365 and how much traction it will get there.
Microsoft is a little different in the sense that they're navigating the transition to cloud computing, so the competitive dynamics are a little bit different. But again, it's a situation where the stock is trading at a pretty meaningful discount, so it's another name that we like right now this quarter.
Glaser: How about corporate spending? Were there any signs that businesses are pulling back in any way, or is that still look fairly strong?
Burkett: Yeah. I think if you move outside of the PC supply chains, things look pretty positive. IBM's results were very strong. So, they had very strong results from their software portfolio; those are large capital investments for corporations to make. Now part of that is the fact that IBM is now fully ramped on its mainframe product cycle, and so we'll see a little bit of a pause next quarter, and then we should see a good second quarter and third quarter out of that company in terms of year-over-year growth. But the commentary out of IBM suggested there is no real reason for investors to be overly concerned about enterprise IT budgets going into 2013.
Glaser: There were some rumors that Dell was considering a private equity buyout. Do you think these are credible, and is this the sign of things to come--more tech leveraged buyouts?
Burkett: Right, it's really interesting because from a cash perspective, when we look at 10 of the largest tech firms, these companies have massive cash balances. And so if you look at the 10 large firms that we track in aggregate, they grew their cash balances 27% year over year to about $250 billion in total. So, there is certainly plenty of firepower. They're not earning much interest on that cash, and so there is certainly motivation for them to [partake in buyouts] from a financial perspective.
What we fail to see with the Microsoft/Dell rumors is the strategic rationale, and so we don't see anything that Dell has to offer Microsoft that Microsoft can't drive in some sort of partnership or some sort of form like that rather than taking on an ownership stake.
So, I would expect more acquisition activity in the tech space. We'll see on Dell; obviously the rumors continue to swirl. But I still think that most of these large tech firms will use the majority of their cash for smaller acquisitions, kind of tuck-ins, to augment their existing product portfolios, and then they will continue to accelerate share buybacks, accelerate dividends to return capital to shareholders, particularly as their revenue growth continues to moderate.
Glaser: So, let's take a look at valuation. When we talked last, the whole sector looked a little bit undervalued. Is that still the case? What does it look like on an aggregate level?
Burkett: Right, the market's moved up pretty quickly, at least the tech sector has. Right now we're sitting in aggregate about 7% overvalued. And interestingly if you look at valuations by market cap, companies below $20 billion market caps are in aggregate trading at about 11% overvalued. And if you look at it from risk, companies with very high or high fair value uncertainty ratings are trading about 11% over our analysts' valuations. And so that suggest that the market has run fairly quickly and is putting a bit of a premium value on risker assets.
So from our perspective, again and we said it last quarter and we think it's true again this quarter, stock selection is really important, and so we'd be very thoughtful about the names that we buy.
Glaser: That being said, what are some of your favorite ideas right now?
Burkett: Right, so last quarter we mentioned F5 Networks, Check Point, Cisco Systems, and Intel. For F5 and Cisco--the stocks have appreciated close to our fair value estimates. So, we think those are still very good businesses over the long run, but we would be a little bit thoughtful in terms of allocating new dollars to those names.
Check Point and Intel, they really haven't moved since we discussed them last quarter. Check Point, again, is a mid-cap name, a very high-quality name in network security. It has very strong profitability, trading at about a 20% discount to our fair value estimate. So, we do like Check Point. Intel, again, we discussed it earlier, it's the 4%-plus dividend yield that provides a lot of downside stability to the name. We continue to think that they have opportunities in servers. So, we like those two names still.
And then, I'm going to add Apple and Microsoft to that list. Apple is just too cheap right now. They generated $42 billion in free cash flow last year. They've got about $140 billion in net cash on the balance sheet. It's still a very, very quality name in a growing market, and so Apple, Microsoft, Intel, and Check Point are the four I am going to leave you with.
Glaser: Well, Grady, thanks so much for your thoughts today.
Burkett: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.