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Our Outlook for Technology Stocks

The cloud and the mass commoditization of datacenter hardware.

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We believe cloud computing will be a hugely disruptive trend for the entire enterprise IT market. Massive cloud datacenters, like those being built by  Microsoft (MSFT) and  Google (GOOG), offer enterprises the opportunity to outsource a portion of their datacenter needs. The cloud allows enterprises to purchase computing power on a pay-as-you-go basis, and this elasticity leads to potentially large cost savings. Enterprises can avoid large up-front capital investments in computing infrastructure, and instead pay for only the computing power consumed. In addition, enterprises no longer have to provision for peak usage and thus will not have wasted excess capacity during nonpeak times. Enterprises can scale their computing power up or down as business needs dictate.

The providers of the cloud can reap massive economies of scale with their datacenters. According to estimates from  Amazon's (AMZN) James Hamilton, a very large datacenter (50,000 servers) enjoys a 5 to 7 times reduction in networking, storage, and IT administration costs versus a medium-sized datacenter (1,000 servers). The current generation cloud datacenters are built on an even larger scale. One significant source of these cost savings comes from the use of commodity hardware components by the cloud providers. For example, instead of purchasing servers from  Hewlett-Packard (HPQ) or  IBM (IBM), or networking equipment from  Cisco (CSCO), or storage arrays from  EMC (EMC), Google builds its own servers, network switches, and storage systems from off-the-shelf commodity parts. The magic that makes Google's datacenters hum is the custom software the company has developed to distribute computing tasks and storage among its giant army of commodity servers.

This, of course, begs the question that if the cloud providers use commodity hardware and enterprises reduce their hardware spending because they shift more computing needs to the cloud, where does that leave enterprise IT vendors like HP,  Dell (DELL), Cisco, EMC, and  NetApp (NTAP)? We believe adoption of the cloud will be a head wind for the traditional enterprise IT hardware vendors. We are fairly confident that Google is unlikely to purchase storage from EMC because Google does not want to pay the price premium that allows EMC to earn 50% gross margins. We are hard-pressed to understand what, if any, value the traditional enterprise IT vendors will bring to the cloud providers.

An additional head wind may come from enterprise customers following the cloud providers into the commodity hardware promised land. One example is Facebook, which recently moved its storage of user photos from NetApp hardware to a custom-built system made from off-the-shelf commodity parts. Facebook stores 60 billion user photos in 1.5 petabytes of storage, with 25 terabytes added each week. At this scale, storage is a material expense that Facebook is now addressing by running its own custom software on commodity hardware (Facebook's engineering blog has the details). This is lost revenue for NetApp.

Although we are likely a few years away, if enterprises begin to make use of cloud computing, we expect that to come at the expense of internal datacenter hardware spending. This will shift the mix of IT spending from proprietary hardware to commodity hardware, which will be a head wind for the traditional hardware vendors. Mark Templeton, the CEO of  Citrix Systems (CTXS), stated on the company's recent earnings conference call: "Capital spending on IT peaked out at about 22% of all capital spending. And it's coming down. It's the largest capital spending category that exists. And so it's kind of collapsing under that weight." We tend to agree with that statement, and the cloud represents a way for companies to reduce IT capital spending. Beyond a shift to cloud computing, open-source implementations of the custom software developed by firms like Google could enable enterprises to implement commodity hardware solutions in internal datacenters (for example, Hadoop is an open-source version of Google's MapReduce distributed computing framework).

Valuations by Industry
The broad market rally has continued to help bring many technology stocks close to fair value. As you can see in the table below, the price/fair value ratios in each of the four major technology industries have increased significantly.

 Technology Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%)

Uncertainty Percentile**

Application Software 3.51 0.85 0.62 37% 14.8%
Computer Hardware 2.95 1.00 0.65 54% 28.4%
Electronics & Computer Distribution 2.44 1.21 0.74 64% 51.1%
Semiconductors 3.38 0.84 0.67 25% 60.2%
Data as of 06-12-09.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of each industry's underlying stocks.

While there are still pockets of undervalued technology stocks, we think it will be difficult for most technology stocks, especially the lower-quality names that have led this rally, to appreciate much further. A substantial and lasting economic rebound appears to be have been priced in by Mr. Market, and if such a scenario fails to materialize, the recent rally could easily reverse. As evidenced by the price/fair value ratios, current prices offer very little margin of safety.

Our Top Tech Picks
Our five top picks from the last quarterly outlook have performed well.  Apple (AAPL) is up 34% since March 19,  Adobe (ADBE) is up 35%, NetApp is up 20%,  KLA-Tencor (KLAC) is up 22%, and  Symantec (SYMC) is up 11%. Unfortunately, our stable of high-quality 5-star technology stocks offers much fewer choices this time around.

 Top Tech Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

 

Intel $23.00 Wide Medium
KLA-Tencor $45.00 Wide Medium
IMS Health $26.00 Wide Medium
Analog Devices $35.00 Narrow Medium
Computer Associates $28.00 Narrow Medium
Data as of 06-19-09.

 Intel (INTC)
We believe the greatest obstacle on the horizon for Intel is the global economic slowdown. Nonetheless, its work on cutting costs and opportunities for more market share gains from an embattled AMD should help Intel hold up better in an economic downturn than most technology firms.

 KLA-Tencor (KLAC)
KLA-Tencor occupies a sweet spot in the chip equipment industry because of its dominant position in the process diagnostic and control market. Given KLA's wide moat and appealing exposure to technology advances by chipmakers, we think the firm has a bright future.

 IMS Health (RX)
IMS Health's long-term prospects remain bright. Despite the ongoing salesforce restructuring of drug companies and regulatory risks, which are hurting IMS in the near term,we believe the company's core value remains intact, in part because of drug companies' reliance on IMS' global information repository of prescription and over-the-counter drug sales to measure and maximize the performance of investments in new drugs.

 Analog Devices (ADI)
Analog Devices is well-positioned to expand in promising markets, such as consumer electronics and automotive, and we expect it to improve return on investment by weeding out unprofitable businesses and raising operating efficiency.

 Computer Associates (CA)
We believe the worst is behind CA, and a new management team and new strategic vision give it a fresh start. However, the company faces ongoing competition and slow growth in maturing markets.

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