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Our Outlook for the Hardware Sector

We see opportunities in tech hardware.

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Up until now, the technology sector was considered an island of stability amid the turmoil affecting the larger economy. However, the indiscriminate selling that has swept the market has caused even this sector to decline from its summer highs. We are not surprised by this recent sell-off, given fears of softening spending among some large customers in the embattled financial sector. However, we think that such jitters are overblown, as the financial-services sector generally accounts for only 20% of tech spending, more than half of which comes from annuity-like obligations for software upgrades and services contracts.

Our view that the IT industry continues to mature has not changed, but we believe opportunities can be found among viable companies that are positioning their businesses to benefit from growth trends within certain segments of the IT industry. Storage is one of the few developed market segments that we expect to grow more quickly than the overall hardware market. In our opinion,  IBM (IBM),  Dell (DELL), and  EMC (EMC) are all well-positioned to capitalize on the growth and transformation in storage.

We also see value in fundamentally strong companies that have been successfully diversifying their revenues away from mature core businesses and reducing operating costs-- Texas Instruments (TXN) and  Tyco Electronics (TEL)--or firms whose story has been marred by events that have no bearing on their competitive advantage-- Maxim Integrated Products (MXIM). The market often mistakenly interprets such short-term bumps as long-term prospects, but this lack of foresight provides excellent buying opportunities for long-term investors.

Valuations by Industry
The average star rating equals 3 across the entire hardware sector, which suggests that the sector is fairly valued. However, we have identified an investment theme.

 Hardware Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
 
Change (%) 
Components 1.01 1.08 -6.5
Computer Equipment 1.01 1.07 -5.6
Contract Manufacturers 0.87 0.90 -3.3
Data Networking 0.86 0.98 -12.2
Optical Equipment 0.92 0.93 -1.1
Semiconductors 0.85 0.97 -12.4
Semiconductor Equipment 1.00 1.09 -8.3
Wireless Equipment 1.02 1.08 -5.6
Wireline Equipment 0.90 0.80 12.5
Data as of 11-27-2007.

In this environment, we think that companies will continue to invest in the storage and servers at the core of data centers, which are designed to function as application servers and repositories of critical companywide data. The need for storage continues to grow as firms expand their businesses and strive to meet legal, regulatory, security, and archival requirements. As storage needs grow, managing this growth has become a challenge, as IT infrastructure is often based on fragmented and ad-hoc storage systems built through business acquisitions or fragmented decision processes. Disparate servers have trouble communicating with one another, making it difficult to efficiently use storage capacity or transfer data throughout an entire enterprise. New investment is crucial to resolve these thorny problems.

Although there is a clear need for more storage, hardware vendors are also adapting their offerings to meet customers' primary need to reduce complexity and drive down costs. Industry watchers predict that escalating energy costs and space constraints in data centers will induce companies to modernize even facilities built just five years ago. Many companies are consolidating their sprawling infrastructures into more centralized facilities so that they can reduce costs and more easily manage and secure their data centers. Virtualization is a key technology that is enabling this consolidation, which reduces the amount of physical equipment required by using the existing equipment more efficiently. Additionally, these new facilities boast self-management capabilities, helping IT managers respond better to business needs and stay within budgets by reducing labor costs. We believe vendors that help their customers embrace this shift from "more" to "more efficient" will be well positioned for future growth.

Hardware Stocks for Your Radar

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

Theme

IBM                      $120 Wide Below Avg Growth
EMC         $22 Narrow Average Growth
Maxim                 $46 Wide Average Mix
Texas Instruments $46 Narrow Average Restructuring
Tyco Electronics $50 Narrow Average Restructuring
Data as of 12-07-2007.

 IBM's (IBM) ability to deliver best-of-breed solutions across hardware, software, and services is the key to its competitive advantage. We believe the company's hardware lineup will get a significant boost by systems built around its new microprocessor architecture, Power6. The new processor boasts significantly better performance and energy efficiency, a crucial requirement for data center operations. In fact, IBM's largest supercomputers, based upon its Power architecture, captured 26 out of the top 27 spots in terms of energy efficiency. IBM also has a growing partnership with  Network Appliance (NTAP), a leading network storage company. NetApp is a key player in the fast-growing distributed storage market, and its impressive software and hardware assets are a nice addition to the menu for IBM's global services group. Together these firms continue to marry ease of use and innovative storage technology that allow for advanced storage management, provisioning, and security. As storage records proliferate, customers look to these vendors to control costs by managing complexity. In addition, IBM is working on the next stage in autonomic computing--the self-managing capabilities--to provide operational intelligence for data centers.

In our opinion,  EMC (EMC) is the company that will best capitalize on the growth and transformation in storage. EMC has successfully evolved from a company providing leading-edge storage "islands" to a full-service company helping customers expand their storage capabilities while helping them simplify the resulting complexity. Historically, companies flocked to major storage vendors such as EMC simply because they needed more storage to hold their spawning files of data. Over time, larger storage networks and new business requirements (e.g., regulatory compliance) created a need to build intelligent software on top of the storage hardware to manage this complexity. Most notably, the sales partnership with Dell has helped EMC reach double-digit growth in its midrange storage segment. We believe that EMC's ability to build and support total storage offerings (including hardware, software, and services) will solidify its hold on customers' IT spending. Through its ownership of  VMWare (VMW), EMC is benefiting from the virtualization trend that is spreading across data centers in order to expand physical limitations of facilities and reduce operating costs.

We're also big fans of Tyco Electronics and Texas Instruments, which are undergoing restructurings, and Maxim, whose good name has been tarnished by a delisting from Nasdaq. All three have an economic moat and are offered at very attractive valuations.

 Maxim Integrated Products (MXIM) remains one of our favorites for long-term investment. We believe Nasdaq exchange delisting has obscured the true picture of Maxim--a highly skilled analog chipmaker with a clear profit growth roadmap. The company specializes in designing high-performance analog chips, with a margin profile that rivals the most profitable software firms. We like Maxim's differentiated chip designs, extensive product portfolio, and team of talented engineers, which are in short supply in the industry. By leveraging its extensive design library and continuously improving operational efficiency, Maxim has positioned itself well to capture growth opportunities across many end markets and to generate excess returns for years to come. We think these competitive advantages should enable the firm to continue earning outsized returns and creating value for shareholders in the long run.

Although many know  Texas Instruments (TXN) because of its steady-Eddie calculator business, the lion's share of its revenues are generated through the sales of semiconductors. For many years, TI's bread-and-butter business was selling digital signal processors (DSPs) to  Nokia (NOK) for use in mobile phones. Although this is still a large percentage of its business, TI has realized that as the DSP market has matured, it has become harder to differentiate itself and generate healthy profits by selling these chips. Instead, it has shifted the focus of its mobile phone market strategy toward application processors (the chips that run programs in "smartphones" and multifunction devices). We believe that as hybrid communication/computing devices become more ubiquitous, TI will be well-positioned to profit from the trend. It is also steadily working to diversify its mobile phone client list to include other large handset makers, such as  Motorola (MOT) and  Ericsson (ERIC), so as to reduce dependence on Nokia.

Newly independent  Tyco Electronics (TEL) is poised to exploit its advantages in electronic components. Tyco's primary source of competitive advantage comes from customer switching costs. Once its components are designed into new products, customers are reluctant to switch vendors during the product life cycle. However, we do not believe Tyco Electronics was being managed optimally to exploit its competitive advantages before the spin-off. Its competitors, such as  Molex (MOLX) and  Amphenol (APH), have been expanding capacity through aggressive acquisition strategies, but Tyco has not invested as much in its manufacturing capacity or global customer base. As a result, its sales and operating profit growth significantly underperformed these competitors' over the past two years. However, we expect the company to increase its investment, both internally and through opportunistic acquisitions, now that it is independent. The company is also moving quickly to restructure its global operations to take advantage of lower-cost opportunities, which we believe will help improve its operating margins.

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