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Stock Strategist

Our Outlook for the Hardware Sector

There are still opportunities to be found in tech hardware.

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Longtime technology investors will likely be familiar with what is often termed the "summer doldrums" for tech hardware shares. Historically, the summer months have seen a seasonal slowdown that has been particularly tough for many tech hardware subsectors as IT spending takes a summer pause, and share prices follow suit. We wouldn't be surprised to see weakness in the shares of many hardware companies should they not live up to the heightened expectations that are implied in the valuations of many firms. However, as long-term investors, we believe that the market's often myopic view of the short-term prospects of sectors and companies can provide investors with some attractive bargain-hunting opportunities.

Our overall views for technology hardware remain largely unchanged over the past quarter. With the underlying IT market maturing, our outlook for much of the sector remains subdued. Although there are niches of explosive growth--such as areas of storage and networking--valuations of many of the companies in these industries are currently unattractive. We believe opportunities can be found where large-cap incumbent players are undergoing restructurings while also working to align their businesses along attractive niches of growth--such as telecom equipment spending related to access networks.

Valuations by Industry
The median price/fair-value ratio equals about 1.14 across the entire hardware sector, which suggests that, on average, the sector is overvalued by about 14%, in our opinion. However, by looking at the table below, we can see that certain subsectors--most notably, optical equipment and contract manufacturers--remain slightly undervalued, while others are more overvalued--most notably, semiconductor equipment and components.

 Hardware Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Components 1.78 1.35 9
Computer Equipment 2.74 1.04 27
Contract Manufacturers 3.67 0.83 9
Data Networking 2.50 1.05 10
Optical Equipment 2.80 0.98 5
Semiconductors 2.82 1.17 58
Semiconductor Equipment 2.03 1.32 30
Wireless Equipment 2.90 1.04 10
Wireline Equipment 3.00 1.04 15
Data as of 06-15-07.

Based on our valuations, the hardware sector bottomed in July 2006 and rallied strongly with the broader market into the first quarter of 2007. Despite this rally, many of the hardware segments exposed to the communications equipment food chain--optical equipment, wireless and wireline equipment, data networking, and some pockets of communication semiconductors--have in large part missed out on much of the broader market rally due to spending slowdowns associated with both carrier and vendor consolidation.

We expect both telecom-service providers and corporations to continue to invest in their networks as the volume and variety of traffic traversing these networks continue to grow, and we believe that firms with exposure to the telecom equipment food chain should benefit during the next few years. We expect carriers to return to fiber build-out investments to better compete with cable companies, and beneficiaries should include  Alcatel-Lucent ,  Tellabs , and  ADC . Data-networking vendors such as  Cisco (CSCO) and  Juniper (JNPR) should benefit not only from carrier demand, but also as greater network complexity drives increased network equipment spending as a percentage of total IT budgets.

There is, however, a caveat to this picture of improving demand that we have been repeating for some time now: Telecom service provider consolidation has led to high revenue concentration for most telecom equipment vendors. This leads to limited visibility and extremely volatile sales cycles for vendors and their shares.

Hardware Stocks for Your Radar
Despite a significant reduction in the number of 5-star names in the hardware sector over the past quarter, there are still a handful of companies we believe investors should keep on their radar screens. Two common themes underlie these investment opportunities: exposure to the telecom equipment food chain, and companies in the midst of restructuring programs that should improve margins.

 Stocks to Watch--Hardware
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Alcatel-Lucent $18 Narrow Average 0.77
Motorola $25 Narrow Average 0.71
Radware $20 None Average 0.72
Vimicro International $10 None Above Avg 0.57
Data as of 06-26-07.

We are bullish on Alcatel-Lucent's prospects. With the closing of the largest cross-border technology merger ever, Alcatel-Lucent's broad product portfolio and geographic diversification should better position the combined company in the communications equipment industry. We believe that the combined firm will reap considerable cost savings that should improve returns to investors, but it will likely take the company several years to realize these improvements. After spending the first half of 2007 rationalizing its product lines, we expect the company's sales momentum to improve in the second half of 2007. 

 Motorola (MOT) is another company in the midst of restructuring that we believe is poised for improving fortunes in the second half of 2007. Although the company rode the success of its RAZR handset in 2004-05, an over-reliance on the RAZR and weak follow-on offerings have led to lost market share throughout the first half of 2007. We believe a refreshed handset lineup in the second half of 2007 and an improving outlook for the company's networks business, coupled with a series of cost-cutting measures (which represent upward of 10% of 2006 operating expenses), should provide for greater operating leverage as the company's handset business improves. 

We are also bullish on two small-cap opportunities in the hardware sector:  Radware (RDWR) and  Vimicro VIMC. Neither of these companies have a moat, and Vimicro carries an above-average risk rating, but for investors who can stomach the risk, we like the growth opportunities they offer at very attractive valuations.

Radware has suffered from a number of problems with its U.S. salesforce that have prevented it from taking part in the industry's growth, despite its focus on providing hardware and software for application switching, a hot area in the networking industry. However, we think these problems have brought the stock down to a level where the potential reward from investing in this Israeli-based technology firm outweighs the risk that the firm will not get its salesforce in order. Radware has recently hired an industry veteran to help get its North American salesforce back on track in the second half of 2007.

Vimicro is a leading chip-design company in China. Inventory buildups of PC-related semiconductor devices have slowed demand for the firm's webcam processor chips. But now that  Microsoft's (MSFT) Windows Vista has launched, we expect Vimicro to see a steady recovery in demand throughout the next year. We are excited about the long-term prospects of this company, as it diversifies into the mobile phone multimedia chip market. With China's rapidly emerging semiconductor industry as a backdrop, we believe that Vimicro has some bright opportunities ahead

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John Slack does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.