Five Tech Stocks to Watch

At Morningstar, we make no bones about being picky about valuation. We believe the price investors pay for a stock is one of the most critical factors in making a sound long-term investment. This is especially relevant in techland, where investors often bid up stock valuations on the basis of a given company's strong growth outlook. As a result, it's rare that the quality tech names we cover also pass our stringent valuation sniff tests. Indeed, of Morningstar's 43 total 5-star stocks as of December 7, only one of them was in the telecom, software, or technology hardware industries. And probably for good reason too, as the average stock in each of these industries is up 17%, 21%, and 22% respectively over the trailing three months.

Yet while 5-star tech stocks at Morningstar may be few and far between, there are plenty of technology companies we cover that we think would make great investments at the right price. The following is a list of five small to midsized tech stocks that fall into this camp; that is, they are smaller companies we think have a strong outlook but are not quite cheap enough to recommend.

 Adtran (ADTN)
Analyst: John Slack
Fair Value Estimate: $17; Buy Price $13.10
We believe Adtran is one of the best-positioned players in the telecom-equipment universe to benefit from increased demand for broadband-access products. Demand for access equipment is high due to the increasing penetration of high-speed Internet services like DSL, as telecom carriers need these products to connect their customers, whether consumers or large enterprises, over the last mile of the network. The company has carved out a unique niche as a low-cost supplier of network-access products, as its low cost structure allows it to price new products 40% to 50% below its competitors. Adtran does not sacrifice profitability either--it maintains operating margins above 20%, which is quite a feat in the telecom-equipment industry. We believe the company will be able to leverage its existing carrier relationships to gain share as the company's disruptive pricing strategy appeals to increasingly cash-conscious carriers. We expect revenues to be lumpy as carriers undergo a transition to the next-generation of DSL technology. We view potential weakness in the shares as an opportunity for investors to invest in the company.

 American Power Conversion  
Analyst: Eric Landry
Fair Value Estimate: $21; Buy Price: $16.20
American Power Conversion has a bright future for several reasons. First, the company is highly profitable in its largest market--uninterruptible power supplies for small systems. It enjoys immense brand power, unmatched distribution, and scale advantages afforded the market’s 800-pound gorilla. Second, the company’s impressive growth rate should endure for several years due to the introduction of its latest product: InfraStruXure. A disruptive technology in the data center market, it affords users substantial savings relative to competing products. Installations are accelerating, and we look for the product to gain share for several years. Lastly, management exudes the qualities we look for. They're strategic thinkers who excel in capital allocation. They've maintained a superb balance sheet. And with the top brass owning large equity stakes, their interests are well aligned with shareholders'.

 Avid Technology 
Analyst: Mike Trigg
Fair Value Estimate: $49; Buy Price: $37.80
An expensive stock price is all that keeps us from recommending Avid Technology. The company pioneered video editing in the late 1980s when it released the first product that allowed people to alter video and film using computers. Previously, the editing process was done by hand, which took a great deal of time. Avid performed well during much of the 1990s, but demand eventually slowed. This prompted the company to enter the audio market, in which the transition to digital editing was also taking place. In addition to its dominant video and audio businesses, we're enthusiastic about Avid because there are several significant growth opportunities that should drive the business for the foreseeable future. First, the growth of HD television is forcing broadcasters to make new investments in production equipment. Second, newsrooms have begun to convert from tape-based to digital systems. Finally, Avid is tackling the home studio audio market, which is experiencing growing demand. We think this is a company investors should keep on the radar.

 Cymer  
Analyst: Toan Tran
Fair Value Estimate: $25; Buy Price: $19.30
Cymer is one of our favorite names in the chip-equipment industry because of its dominant position in a market with high barriers to entry. The firm's light sources are used in the critical photolithography step of chip fabrication to transfer blueprints of circuits onto a silicon wafer. The ability to produce light of ever-smaller wavelengths is a crucial driver of "Moore's Law", which dictates the economics of the semiconductor industry. Cymer holds a significant technology lead over its smaller competitors and the investment of resources required to enter the light source market deters potential rivals. As a result, all three major lithography tool makers use Cymer light sources and the firm estimates that it supplied about 87% of the light sources installed by chipmakers in 2003. In addition, we are especially impressed with Cymer's shareholder-friendly attitude. Management's shareholder letters are candid, detail-filled, and articulate a clear strategy for the future. The board of directors also recently voted to terminate Cymer's poison pill provision. Cymer's technical expertise, market share dominance, and recurring revenue stream from its growing installed base make it a stock we would love to own at the right price.

 Silicon Labs  (SLAB)
Analyst: Jeremy Lopez, CFA
Fair Value Estimate: $42; Buy Price: $26.80
Silicon Labs earns about half of its sales by supplying components of cellular handsets, a market that has strong growth prospects given the global transition to more-advanced, data-enabled wireless networks. What sets the firm apart, however, is a key innovation in wireless transceivers, one of the critical components in a cell phone. Silicon Labs' Aero line of transceivers is designed on the CMOS manufacturing process, unlike most other transceivers that are designed on costlier, more exotic processes. Being able to overcome some complex technical barriers affords Silicon Labs with some key product advantages, such as significantly smaller size than competing products (a important selling point for handset makers). This innovation also highlights a competitive strength of Silicon Labs'. Despite its small size relative to behemoth rivals, such as  Texas Instruments (TXN), the firm has a highly regarded engineering team in a field in which experienced design engineers are very scarce. We think the firm will be able to leverage this talent quite well in the coming years, both in and outside of the wireless industry. Finally, we like Silicon Labs' business model of outsourcing product manufacturing, as it requires minimal capital investment and allows the firm to earn decent returns on capital on a relatively modest sales base, which was $325 million in 2003.