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By Jeremy Glaser and Grady Burkett, CFA | 08-01-2012 01:00 PM

What to Watch in Tech Today

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.

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