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Quarter-End Insights

Our Outlook for Tech & Telecom Stocks

Technology companies put their cash to work.

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  • Large technology companies decided to put their substantial cash balances to work during the third quarter in a flurry of M&A and dividend announcements.
     
  • We expect M&A activity to continue as the large tech companies seek to round out their product portfolios in an ever more heated competitive environment.
     
  • In this quarterly outlook, we review a few potential acquisition candidates.

Large technology companies decided to put their substantial cash balances to work during the third quarter in a flurry of M&A and dividend announcements.  Hewlett-Packard (HPQ) and  Dell (DELL) engaged in a heated bidding war for high-end storage specialist  3Par (PAR). HP also took down security provider ArcSight (ARST) shortly after winning 3Par.

 Intel (INTC) made a bet on the potential of integrated hardware security with the acquisition of  McAfee (MFE) and then made a foray into wireless with the purchase of  Infineon's (IFNNY) wireless business a few days later.  IBM (IBM) sought to round out its data analytics business with an offer for data warehouse appliance maker  Netezza (NZ).

On the dividend and buyback front,  Cisco (CSCO) announced that it would target a 1% to 2% dividend yield for its shares next year.  Microsoft (MSFT) recently hiked its dividend by 23% from 13 cents to 16 cents per quarter. The software giant now sports a healthy 2.6% yield. In addition, the firm issued $4.75 billion of debt at record low rates to fund further stock buybacks. Semiconductor capital equipment maker  KLA-Tencor (KLAC) increased its dividend to $1.00 from $0.60 per share and now yields over 3%. We expect more dividend activity from the cash-rich technology sector as companies seek to capitalize on a secular shift in investor preferences toward income.

We also expect M&A activity to continue as the large tech companies seek to round out their product portfolios in an ever more heated competitive environment. In this quarterly outlook, we review a few potential acquisition candidates.

Increasing Competition Among Tech Giants Drives M&A
As overall sector growth has slowed from the strong pace of the past few decades, large technology companies are moving into adjacent markets in search of growth. Networking giant Cisco has moved into servers with its Unified Computing System initiative, which then spurred traditional server powerhouse HP to beef up its networking portfolio with the acquisition of 3Com.  Oracle (ORCL) moved far afield from its traditional database market into the hardware space with the purchase of Sun Microsystems.

As the technology giants compete more and more with each other, acquisitions will play an important role in rounding out technology portfolios. The field of potential acquisition candidates is rapidly diminishing, but there are still a number of smaller technology companies that may be of strategic value to the large players as they prepare for more intense competition. Moreover, the presence of a bidder like Dell, which has a large cash hoard and must find ways to further penetrate the enterprise IT market, may be a catalyst for increased deal activity. Below is a roundup of some possible acquisition targets.

Data Warehouse and Analytics:  Teradata (TDC)
After IBM's offer for Netezza and  EMC's (EMC) purchase of privately held Greenplum in July, Teradata is the last player standing in the data warehouse space. With a market capitalization of over $6 billion, Teradata would be a substantial acquisition for the likes of HP, Dell, or even Oracle, but the data computing market is heating up as enterprises try to extract information from mountains of data. For example, Oracle has stated that the pipeline for its Exadata product has grown from $1 billion to $1.5 billion sequentially over the past two quarters.

Semiconductor IP:  ARM Holdings (ARMH) and  MIPS Technologies (MIPS)
The explosive growth of smartphones and other Internet-connected devices, like  Apple's (AAPL) iPhone and iPad, have been manna from heaven for semiconductor intellectual property (IP) provider ARM Holdings. ARM licenses its chip designs to a wide variety of semiconductor firms, which then manufacture ARM-based chips that are used in nearly every mobile handset. ARM's shares have increased roughly 115% year-to-date and, in our opinion, currently price in a hefty acquisition premium. The strategic importance of ARM in the post-PC world clearly makes it an attractive asset, but financial and antitrust considerations raise substantial hurdles. With an enterprise value of nearly $8 billion and price/sales ratio of 15 times, ARM would be a pricey acquisition. Furthermore, if ARM is purchased by an acquirer like Apple, the company would likely lose significant revenue as Apple's competitors would attempt to find alternatives. An acquirer like Intel, which ARM clearly threatens, would face major antitrust issues, especially in Europe (ARM is a U.K. company) where American companies have faced scrutiny.

The other player in the semiconductor IP space, MIPS Technologies, looks much more intriguing. The shares trade at roughly 5 times sales, but MIPS' enterprise value is an easily digestible $325 million. MIPS traditional markets have been in enterprise networking with licensees  Cavium (CAVM) and  NetLogic (NETL) and the digital home (set-top boxes, Blu-ray players, etc.). The mobile market is a growth opportunity for MIPS, and the firm recently displaced ARM for mobile baseband and applications processors at an undisclosed Asian chip manufacturer. The company expects the first MIPS-powered Android smartphone to hit the market in early 2011. The strategic importance of MIPS as a counterweight to ARM is easy to ascertain, especially if an ARM acquisition does come to pass. Intel's current strategy is to extend its x86 instruction set to the mobile space with the Atom line of chips, but if Intel is unable to match ARM on power consumption, the acquisition of MIPS' inherently efficient and low-power chip architecture could help it fight off ARM on multiple fronts.

Security:  Check Point Software (CHKP), Fortinet (FTNT)
The acquisitions of McAfee and ArcSight by Intel and HP, respectively, highlight the importance of enterprise security. Both Check Point Software and Fortinet provide firewall and network security appliances. Check Point is the larger of the two with revenue of $1 billion and an enterprise value of over $6 billion, while Fortinet weighs in with revenue of $280 million and an enterprise value of $1.5 billion.

Given the pervasive importance of security, potential acquirers include the entire gamut of large technology companies from HP, Dell, IBM, Oracle, and Cisco to smaller players such as  Juniper Networks (JNPR) or  Symantec (SYMC). However, Check Point's founder, who still owns 15% of the company, is apparently reluctant to sell, and its location in Israel may raise political concerns. The U.S. government blocked Check Point's proposed acquisition of security firm SourceFire (FIRE) in 2006 for national security reasons.

Storage:  Isilon Systems (ISLN)
The bidding war for 3Par highlighted the importance of storage and the various niches within the storage industry. 3Par's particular niche is high-end storage, which is dominated by EMC, IBM, and  Hitachi (HIT). HP was a reseller of Hitachi's high-end storage systems, and Dell, a reseller of EMC in the mid-range storage market, was looking to move into the high-end market. The bidding war for 3Par was driven by the scarcity of high-end storage assets and the potential revenue acceleration from moving 3Par's products through HP's and Dell's much wider distribution channels. For example, Dell's acquisition of storage networking company EqualLogic in 2007 was done at a lofty valuation, but since then, Dell has been able to ramp EqualLogic's annual revenue run rate from $125 million to over $800 million.

Isilon Systems is a small storage company that could benefit greatly from the wider distribution available from an EMC or Dell. Isilon is a leader in the scale-out network storage space, and its systems perform well with large amounts of unstructured data such as video and images. Competitors include  NetApp (NTAP) (from its 2003 acquisition of Spinnaker), HP (from its acquisitions of IBRIX and PolyServe), and IBM with its SONAS product. Competitors such as Dell, EMC, or even Oracle looking to capitalize on the growth of clustered storage could be a suitor for Isilon. Isilon's stock, however, is up 265% year-to-date and at 11 times sales already prices in a healthy acquisition premium.

Application Delivery:  F5 Systems (FFIV),  Radware  (RDWR)
F5 and Radware both provide network hardware that helps optimize delivery of certain traffic, so that an employee's YouTube surfing does not interfere with mission-critical applications. F5 may be the less likely target given its hefty $7.7 billion enterprise value, but it is the clear leader in the space having beat back all rivals, including Cisco, for well over a decade.

Based in Israel, Radware is the more interesting proposition at a $600 million enterprise value, but the company's operating history has been spotty. Radware did score a big win in 2009 when it purchased Alteon from Nortel for a mere $18 million. Nortel had paid $7.8 billion to acquire Alteon during the tech bubble, and thus far, Radware seems to be extracting much more value from the Alteon assets than Nortel did in recent years. Potential acquirers could include HP or IBM as they seek to capture more value from their customers by offering Layer 4-7 switches rather than handing it over to F5.

Our Top Tech Picks
We generally believe the large capitalization technology companies such as HP and Cisco trade at very reasonable multiples given the strengths of their competitive advantages, solid balance sheets, and strong cash flows. After taking a hit from the resignation of CEO Mark Hurd, HP trades at a roughly 30% discount to our fair value estimate and less than 6 times enterprise value-to-EBITDA. We also want to highlight some interesting dividend-paying names in the semiconductor space:  Microchip (MCHP),  Maxim Integrated (MXIM), and KLA-Tencor, which sport yields of 4.7%, 5.0%, and 3.2%, respectively.

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

Dividend
Yield

Hewlett-Packard Company $55.00 Narrow Medium 0.8%
Cisco Systems $30.00 Wide Medium NA
Microchip Technology $28.00 Narrow Medium 4.7%
Maxim Integrated Products $24.00 Wide Medium 5.0%
KLA-Tencor Corporation $45.00 Wide Medium 3.2%
Data as of 09-20-10.

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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.