Our Outlook for Technology Stocks
The credit crunch hits technology in the fourth quarter.
Quarter-End Insights
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In the last quarterly update, we wrote that technology would not be immune from the credit-starved and slowing economy. The fourth quarter bore out that prediction. So far in the fourth quarter, the technology-heavy Nasdaq Composite Index is down by roughly 25%. The common theme we are hearing is that customers are delaying orders because of a lack of access to credit. Unless and until the credit markets thaw, we do not expect technology spending to rebound in a material way. Let's review developments in the major technology sectors.
Hardware
After a robust third quarter, PC unit growth has slowed significantly in the fourth quarter. The good news is that unit growth is still in the midsingle digits. The bad news is that much of the growth is from low-end "netbooks," which are generally less profitable for the entire PC supply chain. Moreover, it is likely that unit growth will slow further. Michael Dell, the eponymous CEO of Dell , warned in September that conditions had slowed and recently mentioned that conditions remained in a depressed state. One PC maker we like at these prices is Apple (AAPL). The weak U.S. consumer will undoubtedly take its toll on Apple, but if you're a long-term investor (if such a person exists anymore in these markets) the Macintosh should continue take market share and the iPhone has all the markings of a blockbuster business.
Of course, the slowing PC market is terrible news for the hard disk drive makers like Seagate (STX) and Western Digital (WDC). To add to their difficulties, the massive glut of flash memory is helping solid state drives to become price competitive. The ongoing migration toward flash memory in consumer electronic devices like the iPod is also a major head wind.
Moving further back in the supply chain, companies that manufacture electronic components such as Amphenol (APH), Molex , and Tyco Electronics (TEL) all announced weak outlooks. These companies tend to be vanguards of demand trends as they serve a multitude of industries in and out of technology, so their announcements of an incremental 15%-20% fall in demand during the fourth quarter are not encouraging.
The one relatively bright spot in hardware is storage, but even this is starting to fade. Storage benefits from the natural demand growth as more information is created every day, so storage has tended to be easy high-return projects for IT departments that are looking to prioritize their budgets. However, as resilient as storage may be, it cannot sail untouched through the current economic storm. Industry giants like EMC and NetApp (NTAP) have become much more cautious about 2009 in recent months. Much of this pessimism has already been baked in by the market, given that both EMC and NetApp now trade at single-digit multiples of free cash flow. Enterprises may be able to delay storage investments, but not indefinitely. The growth of data is simply inexorable.
Software
Software giant SAP (SAP) sounded the alarm at the beginning of the fourth quarter with word that business conditions had deteriorated significantly at the end of the third quarter. The reason, of course, was the global credit crunch. While business with large enterprise customers held up, sales to small and medium-sized businesses were extremely weak as customers in this segment are generally more reliant on external financing to purchase SAP's products. As the quarter moved on, we saw many companies such as Autodesk (ADSK) begin to offer promotions and vendor financing in an attempt to alleviate the credit crunch and spur demand.
As we saw in the hardware space, IT departments are also prioritizing software spending toward small, quick, and high-return projects. Large, lengthy, and often unwieldy projects, such as enterprise resource planning implementations, will suffer disproportionately. In contrast to SAP's warning, Microsoft's enterprise software segment, which sells mostly stand-alone products, recorded 17% growth in the most recent quarter.
We expect the server virtualization trend to continue as it helps to cut costs by consolidating server capacity. VMWare has been a leader in virtualization software, but there will be an onslaught of competition from the likes of Microsoft (MSFT), Citrix , and Red Hat . VMWare clearly recognizes the commodity nature of the core virtualization software and has set itself on course to make money from software that manages virtual servers in the data center. If VMWare is able to successfully leverage its dominant position in virtualization to sell server management tools, the company could be an interesting growth play.
Semiconductors
The news from semiconductor land this quarter was uniformly bleak. Unlike the last semiconductor bust in 2001, which was primarily caused by excess inventory, inventories are now fairly lean in semiconductor supply chain. This means that the downturn is driven by a significant drop-off in end demand and it is unlikely that demand will return anytime soon. The world's largest semiconductor firm, Intel (INTC), warned that fourth-quarter revenue would fall by about 16% from last year. Another large chipmaker, Texas Instruments (TXN), reported sharp order decline starting in September and that fourth-quarter revenues would decline by an eyebrow-raising 30% sequentially.
As the outsourced manufacturers for much of the semiconductor industry, the two big chip foundries, TSMC (TSM) and UMC (UMC), are a good barometer to track. Unfortunately, both firms are reporting massive drops in monthly revenue and capacity utilization. TSMC's November revenue dropped by nearly a third from the October figure. UMC expects capacity utilization to drop from 80% in the third quarter to about 50% in the fourth quarter. Utilization rates that low are the harbinger of doom for such capital-intensive and high-fixed-cost businesses.
The semiconductor equipment industry remains in free-fall. The core chip equipment business at Applied Materials shrank by 38% this year and the company expects sales to fall a further 25% in 2009. Other chip equipment makers like KLA-Tencor (KLAC) and Lam Research (LRCX) have echoed Applied's outlook. One of the primary causes of the industry's woes is the massive overhang of DRAM (computer memory) and flash manufacturing capacity. DRAM and flash prices have been driven so low that three major suppliers, SanDisk , Micron (MU), and Qimonda (QI), actually reported negative gross margins. DRAM and flash is selling for less than it costs to manufacture. The overcapacity must be absorbed before there is to be any hope of an upturn.
Valuations by Industry
With the overall market off by such a large amount in the fourth quarter, it's not surprising that the price/fair value ratios came down significantly across all of the technology sector.
| Tech Valuations | |||
 | | | |
| Segment | Price/Fair Value* | Three Months Prior | Change (%) |
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| Audio/Video Equipment | 0.45 | 0.66 | -31% |
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| Business Applications | 0.63 | 0.79 | -21% |
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| Business/Online Services | 0.58 | 0.72 | -19% |
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| Components | 0.63 | 0.77 | -19% |
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| Computer Equipment | 0.58 | 0.77 | -25% |
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| Contract Manufacturers | 0.46 | 0.73 | -37% |
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| Development Tools | 0.78 | 0.93 | -17% |
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| Distributors | 0.67 | 0.83 | -19% |
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| Electric Equipment | 0.59 | 0.72 | -18% |
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| Entertainment/Edu Media | 0.48 | 0.83 | -42% |
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| Photography & Imaging | 0.54 | 0.70 | -23% |
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| Semiconductor Equipment | 0.52 | 0.74 | -30% |
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| Semiconductors | 0.62 | 0.73 | -15% |
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| Systems & Security | 0.65 | 0.87 | -25% |
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| Data as of 12-15-08. *Market-Weighted Harmonic Mean |
The economic picture is obviously bleak, but the key question to ask is how much despair is already baked into valuations. As you'll see below with our five picks for your radar screen, with many high-quality technology companies now trading at single-digit multiples, it's fair to say a lot of bad news has already been discounted. The problem, however, is the are few near-term catalysts to move stock prices up in technology.
Tech Stocks for Your Radar
Technology companies tend to hold mountains of cash and little to no debt on their balance sheets. When you look at a cash-heavy company, it makes sense to subtract the company's cash from its valuation. After all, if you were to pay $100 for a company with $50 of cash, your net outlay would be only $50. We call this figure a company's enterprise value (EV), or its market capitalization minus cash plus debt. As you can see in the last column of the chart below, many tech companies are now trading at single-digit EV/FCF (enterprise value/free cash flow) multiples.
| Stocks to Watch--Tech | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | EV/FCF |
| |||||
| EMC Corp |  | $18 | Narrow | Medium | 7.0 |
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| Applied Materials (AMAT) | | $22 | Wide | Medium | 6.0 |
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| Intel (INTC) | | $23 | Wide | Medium | 8.0 |
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| Autodesk (ADSK) | | $44 | Wide | Medium | 5.0 |
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| Texas Instruments (TXN) | | $39 | Narrow | Medium | 6.0 |
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| Data as of 12-18-2008. |
EMC Corporation
As businesses continue to digitize everything from correspondence to confidential customer information, management of the underlying data has become a critical business processes. A leader in enterprise storage solutions, we believe EMC is positioned to capitalize on emerging technology trends and explosive data growth in corporate data centers around the globe.
Applied Materials (AMAT)
Applied Materials is the behemoth of the semiconductor equipment industry, with its unmatched scale and broad product portfolio. The firm has steadily been establishing its solar equipment business, which we think could turn into a key growth driver for Applied. However, a severe cyclical slowdown in the chip equipment market has been hampering the firm.
Intel (INTC)
Intel has reasserted its dominance over Advanced Micro Devices (AMD) and once again reigns supreme in the microprocessor industry. We believe Intel holds long-term advantages over its smaller rival, which should keep the firm in the driver's seat of the processor market over the long run.
Autodesk (ADSK)
Autodesk will continue dominating the market for computer-aided design (CAD) software. The company has more than 8 million CAD users, making its products the de facto standard in digital design. The firm benefits from its customers' high switching costs: It takes time to learn a new design software application, and operational disruption and downtime costs discourage companies from changing CAD providers.
Texas Instruments (TXN)
Texas Instruments is a smart, well-run company that has managed to reinvent itself over and over again during its 78-year history. During this time, it has undergone many changes, and while some of the recent changes have prompted jitters in the stock market, we believe TI's positives far outweigh its minuses. Risks still remain, but we believe that investors would be well served by taking a closer look at this innovative firm.
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