Fri, 3 May 2013
This quarter's distributions to shareholders are not a flash in the pan, says Morningstar's Grady Burkett.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. First-quarter tech earnings have been coming in fairly soft. I'm here today with Grady Burkett; he is our tech strategist at Morningstar. We're going to look at some of the drivers of this weakness and his best picks in the sector. Grady, thanks for joining me.
Grady Burkett: Thanks for having me, Jeremy.
Glaser: So let's start with the kind of two big things: capital allocation and PC sales. Let's start with capital allocation. The big announcement is from Apple, this $100 billion plan to return cash to shareholders in the next couple of years. Is this a trend across a lot of different tech companies, or is this more idiosyncratic and related to issues that happened at Apple?
Burkett: This is one of the more interesting stories in tech this quarter, and we discussed it last quarter, you and I did, about these cash balances these tech firms are maintaining. The cash balances continue to grow. The largest tech firms that we cover had about $280 billion in cash this quarter on the balance sheet, net cash. So we've seen a lot of these companies start to redistribute that cash to shareholders in the form of buybacks and dividends. Apple is obviously the most visible example, but we've seen it across the sector.
If you look at companies like Corning, they authorized a new share-repurchase program and raised their dividend. IBM just announced a new $5 billion share-repurchase authorization; they increased their dividend. Cisco Systems increased their dividend 21%. So really what we're seeing from these companies is their revenue growth is slowing and their cash balances continue to grow because they're very competitively well-positioned to generate lots of cash. They're increasingly distributing that to shareholders.
It's certainly something specific to the quarter where we're seeing this. We think there's legs to this trend, because the payout ratios are so low for a lot of these large companies and the cash balances are still really high. So we think that this can continue for multiple years, not just multiple quarters.
Glaser: We look at these cash balances--a lot of analysts have said, well, a lot of it is overseas; it's difficult to bring back, because you'd have to pay taxes on it. Apple is getting around this by borrowing at some very attractive rates. What do you think about companies kind of levering up their balance sheets a little bit? Is that something you think we're going to see across the industry?
Burkett: Well, I think what Apple's doing makes sense. The yield on its 3-year notes, for example, I think they're less than 50 basis points. So when you look at that type of cost of debt and how that affects your weighted average cost of capital, it's a pretty attractive option, particularly when your cash balance is just too high. So I think that as long as these companies with good recurring streams of cash flows and really strong balance sheets--as long as they can get these really attractive rates on the debt, it makes sense for them to go out and issue the debt and return that to shareholders in some form or fashion, or maybe reinvest in their business. But generally it'd be a return of capital. So, yeah, I would expect--it wouldn't be surprising at all for me to see companies continue to go out and tap the debt markets. We're seeing a lot of it's rolling over old maturities, but I think we'll continue to see that going forward.
Glaser: How about that reinvestment, though? Are these companies basically saying they don't have enough opportunities to invest in their businesses and they're kind of mature, or is it just that they have so much cash that they're able to both invest and give this cash back?
Burkett: I think the reinvestment isn't happening right now. Obviously, these large companies, it's very hard to grow the top line anyway. I think the companies have plenty of cash to reinvest internally; a lot of their overseas cash can actually be used to buy overseas companies, and we're seeing a lot of these companies do that. Cisco has made a lot of overseas acquisitions. In fact, in 2013, all of its acquisitions have been overseas companies. So that's one way to kind of whittle down that overseas cash. Obviously, tech is global, and so the R&D opportunities are global, the distribution channels are global. So there are opportunities overseas. I think with these bond issuances it will be about returning capital to U.S. shareholders.
Glaser: Let's turn to the other big story in the quarter, which was plummeting PC sales. It was down big--the first quarter's industry data said almost as much as 15%. What's driving that big decrease and how is it affecting results?
Burkett: Well, first I have to go back and take my own forecasting lumps here, because I think I mentioned that we were looking at PC sales to be kind of flattish globally a few quarters ago, and obviously it's deteriorated worse than we expected. The drivers are that the smartphone and tablet penetration rates are still very low, and consumer preferences are shifting to those types of devices over a traditional desktop or notebook-based PC. So right now we're kind of in just the middle of that particular shift.
We'll start to lap easier comps in the upcoming quarters, so we'll see if that's--we don't think this is a complete shift. We think that consumer households, businesses will continue to have some sort of larger PC form factor in their house for better processing, better screen size, printing, to kind of be the hub of their computing experience. But certainly we still have a ways to go before that trend works through. So we'll probably see a pretty challenging quarter next quarter, and then maybe we start to lap some easier comps.
Glaser: So is this hitting just the manufacturers or the chipmakers? Where are we seeing the weakness?
Burkett: Well, that's what's really interesting. I mean, we haven't seen big numbers from HP or Dell. They're still yet to report. We'll obviously see that show up in their PC results; for HP specifically, which I cover, that's a very small part of their overall operating income, so it's not going to be--that's not going to be the big driver of how their stock performs in this quarter's results, assuming more about how they do in the enterprise technology side and the services side. But this is what I think is interesting is how well Intel and particularly Microsoft are managing this.
I mean, if you look at Microsoft's year-over-year net income, it grew 19%. That's not per share. That's the net income grew 19%, and if you look at their individual businesses and the divisions within it--Microsoft Business Division, the productivity suites, and their servers and tools business, the database software and the operating systems for enterprise data centers--they had really good performance. So I think that with companies who own their intellectual property and are able to kind of drive their own fortunes rather than just be manufacturers to other companies' IP, I think they're still pretty well positioned. I don't think Microsoft and Intel are companies that necessarily--their fortunes aren't necessarily completely tied to PC units.
Glaser: So we see weakness in PCs, we see weakness in mainframe and other hardware products. Are companies like IBM or HP, like you mentioned earlier, going to be able to make this transition from selling a lot of hardware to being software services businesses and be able to make that trade-off?
Burkett: Obviously, IBM is kind of the classic study of a company that started that transition back in the early to mid-90s, when it started to see its mainframe threatened by client/server computing and distributed computing. This quarter is kind of like a microcosm of this longer-term trend, where software and services continue to capture more of the value in the enterprise. I think when you look at this quarter, we look at hardware performance, hardware year over year for the enterprise vendors was down 6%, and so we are seeing a decline in hardware revenue. On the flip side of that, software revenue for these companies, large companies--Oracle and IBM and SAP, et cetera, EMC--it was up 6%. So these companies are making that shift.
I would note that this quarter, there is probably some economic uncertainty or some end market demand uncertainty that's driving hardware. Hardware is transactional; software tends to be more recurring in nature. So if we look at the tightening federal budgets, we look at what's going on in Europe, there probably is a little bit of a depressed result in the transactional hardware stuff. But, yeah, it's a long-term trend that these companies are all trying to navigate. I think in terms of who's best positioned, it's who is most entrenched in its customers, who is most strategic to its customers. So I would look at companies like Oracle, IBM, EMC over companies like HP or Dell, for example.
Glaser: Let's take a look at valuations. Does the sector look attractive right now?
Burkett: On aggregate, it's about 2% overvalued, and really last quarter we noted that some of the small-cap and higher-uncertainty names were a little bit more overvalued than some of the larger-cap names. This quarter's pretty broad-based. It just looks fairly valued to slightly overvalued. So no, there's not really any kind of way that you can slice that up. But yeah, not a big margin of safety. But also, you can't say that this is a sector to avoid at this point in time.
Glaser: So what are some of your best ideas?
Burkett: Last quarter we mentioned Check Point, Intel, Microsoft, and Apple as four top names. Intel and Microsoft, we still view those as good core holdings. They're very good dividends, very strong companies, strong growing cash flows, but they have kind of appreciated off of the last earnings, so Intel is up 13% and Microsoft is up 16% since last quarter. So I'd be a little bit thoughtful about allocating new dollars to those two names. Nevertheless, good long-term core holdings. Apple, it's still kind of flattish, down a little bit since we recommended it last quarter, so we continue to like Apple. Obviously, the increased repurchase authorization and the dividend reinforces that recommendation.
We also continue to like Check Point. Then we're going to add back F5 to that. This is a very good mid-cap, high-quality mid-cap company--again, very recurring revenue base, very entrenched in data centers. So F5 is a name we like. Then we're adding Qualcomm. Qualcomm sold off a little bit after the quarter. There was little bit of a disappointment in ASP in terms of how the average selling prices are trending for their chips. Qualcomm is just a great business tied to mobile; they earn 3%-5% royalties on every single smartphone that's sold. So we think that's a great long-term holding to consider.
Glaser: Grady, thanks for the update today.
Burkett: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.