Our Outlook for Tech & Telecom Stocks
Smartphones stay hot; flash capacity gets tight.
Quarter-End Insights
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- The rapid growth of the smartphone market continues to be a defining trend in the technology industry. Microsoft (MSFT) plots a mobile comeback with Windows Phone 7.
- The growth of smartphones, along with increased solid-state drive adoption, will likely strain available flash memory production capacity.
- Tight flash capacity may catalyze a semiconductor equipment investment cycle, which would benefit KLA-Tencor (KLAC) and Applied Materials (AMAT).
The smartphone market remains hot. According to Gartner Research, while the global handset market remained flat at roughly 1.2 billion units in 2009, smartphone unit shipments surged 24% to 172 million. While Nokia's (NOK) Symbian platform is the putative smartphone share leader, the market is rapidly moving away from Nokia and toward devices like Apple's (AAPL) iPhone, Research in Motion's (RIMM) Blackberry, and Google's (GOOG) Android.
Along with Symbian, Microsoft's Windows Mobile also lost market share in 2009. However, unlike Nokia, Microsoft appears to have at least plotted a course toward relevance in the new smartphone world with the announcement of its Windows Phone 7 (WP7) operating system.
We believe the iPhone juggernaut is unstoppable at this point and will capture a significant portion of the smartphone market. The market will likely be large enough to support several major platforms, and WP7 gives Microsoft a fighting chance against the Android ecosystem. Google's critical mistakes with Android include fragmented hardware and a lack of support for potential developers. Google's first attempt to unify Android hardware with the Nexus One phone has been a flop so far. The even larger mistake, however, is the lack of support for potential third-party software developers. Google has no means by which a developer can directly contact the Android team for code support, in contrast to Microsoft and Apple, which both provide access to company developers and help with debugging code. Microsoft and Apple both have a long history of dealing with outside developers and understand that helping those developers and helping them make money are two foundational requirements of a successful platform. Google appears to have left some room for WP7 to outflank Android.
We think Microsoft is making some smart strategic decisions with WP7. Microsoft has minimum hardware requirements for WP7 phones that include an 800x480 pixel multitouch screen, five specific hardware buttons, and a Qualcomm (QCOM) Snapdragon processor. The importance of these requirements is that they guide developers to build applications for a known quantum of hardware. This is the strength of the iPhone ecosystem with its singular device and the weakness of the Android ecosystem with its fragmented hardware.
Microsoft's most important asset and strongest competitive advantage is its legion of loyal third-party developers. To build out WP7 with applications that will attract users to the platform, Microsoft made the correct move to break compatibility with previous Windows Mobile releases and center WP7 development on the company's Silverlight and XNA frameworks. The advantage is that developers are already familiar with these frameworks and Microsoft is providing additional tools to speed up WP7 application development.
Microsoft has a long climb ahead, but WP7 appears to be, by far, the company's most credible effort in the mobile space. The Android OS is free, so Microsoft not only has to convince handset manufacturers that WP7 is better than Android, but better by a sufficient margin to justify the WP7 license fee. If Microsoft can channel its developers to create WP7 applications, the virtuous cycle of users begetting more applications begetting more users may be ignited. Given the shortcomings of the Android platform, Microsoft may yet be able to secure a meaningful portion of the non-iPhone smartphone market.
Industry-Level Insights
Smartphones consume significantly more flash memory than traditional handsets, and the market's rapid growth has started to strain the available flash memory production capacity. We estimate that industry flash memory capacity utilization is currently at 100%, and we expect demand growth, driven by smartphones and solid-state drives, to outstrip capacity additions during the next two years. The 12-month lead time to bring a new chip fab online means that no new plants will be opened in 2010 because flash producers retreated into a bunker during the credit crisis. The only officially announced new flash memory fab is being built by Toshiba, but it will not come on line until 2011.
The upshot is that the industry is headed into a flash shortage situation, and flash prices will likely increase for the next few quarters. The most direct play on flash memory prices is SanDisk . Although SanDisk is entering a sweet spot of the flash cycle where price increases drop directly to the bottom line, playing the stock requires the appropriate timing.
A better and less volatile play is to purchase our two favorite wide-moat semiconductor equipment companies: KLA-Tencor and Applied Materials. Both stocks are rated 5 stars and trade at single-digit multiples of prior peak free cash flow. We expect Toshiba's recently announced $9 billion flash memory fab to be one of many new capacity additions. These new fabs will result in new orders for KLA-Tencor and Applied Materials, and we expect investors will begin to price in another semiconductor equipment investment cycle.
Our Top Tech Picks
| Top Tech Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Fair Value | |
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| Qualcomm |  | $49.00 | Wide | Medium | 0.82 |
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| France Telecom |  | $37.00 | Narrow | Medium | 0.64 |
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| Applied Materials | | $22.00 | Wide | Medium | 0.60 |
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| KLA-Tencor | | $45.00 | Wide | Medium | 0.69 |
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| ATMI | | $27.00 | Narrow | Medium | 0.70 |
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| Data as of 03-24-10. |
Qualcomm (QCOM): We believe Qualcomm is a wide-moat play on the continuing global adoption of 3G wireless technologies.
France Telecom (FTE): FT should continue to generate significant free cash flow each year for the next five years, which can be used to pay down debt and further increase the dividend.
Applied Materials (AMAT): Applied is the chip equipment industry's standard-bearer. The firm has the broadest product portfolio and offers customers the closest thing to a one-stop shop.
KLA-Tencor (KLAC): KLA occupies a sweet spot in the chip-equipment industry because of its dominant position in the process diagnostic and control market.
ATMI : Because of its many advantages, chip manufacturers have adopted ATMI's technology as the industry standard for gas storage and delivery.
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