Our Outlook for Tech Stocks
Several high-quality technology giants are currently available at attractive valuations.
Quarter-End Insights
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- Bellwether Cisco spooked technology investors by providing conservative commentary and a lower-than-expected forecast for its fiscal second-quarter revenue.
- Other technology heavyweights, including Oracle and HP, delivered a more optimistic outlook, implying Cisco's concerns were not widely shared in the industry.
- We believe technology spending will remain solid heading into 2011 and that several high-quality technology giants are currently available at attractive valuations.
Cisco Spooks Market by Offering Sharply Lower Guidance
During its first-quarter earnings call, Cisco (CSCO) warned that revenue growth will likely slow dramatically during its fiscal second quarter, which ends in January 2011. The firm blamed two specific parts of the business: the public sector, primarily in Europe, and its cable set-top box unit.
Europe has been a soft spot for some technology firms in recent quarters, and the headlines coming out of Europe lend credence to Cisco's claim that government spending there is weak. Weakness in the set-top box business also isn't surprising. U.S. cable companies have been reporting soft subscriber growth throughout 2010 and somewhat lower customer churn as well. Churn is an important factor behind cable box demand, because a customer move or cancellation is the most common reason for the disposal of an old cable box and the purchase of a new one.
Although we believe the weaknesses Cisco has cited are understandable and not indicative of a broader trend, the firm has a reputation for spotting changes in IT spending a quarter or two in advance. As a result, its revenue warning spooked the broad market and has weighed on the technology sector generally. However, since Cisco's warning, several other important technology firms have provided fresh evidence that fears of a widespread technology downturn over the near term are overblown.
Strong Outlook from Other Tech Titans
Oracle's (ORCL) latest results provide perhaps the strongest evidence that IT spending will remain strong heading into 2011. With broad exposure to software and hardware markets across the globe, Oracle's performance is a barometer for a wide range of technology spending. The firm posted a 47% gain in sales from the prior-year period, or about 17% after adjusting for the acquisition of Sun's hardware business. Results were solid across the board, with double-digit revenue growth in all geographies and product categories. For the current quarter, management's guidance range for new license revenue and total revenue imply double-digit growth rates, suggesting further growth acceleration. While the positive outlook reflects Oracle-specific momentum, partially driven by the strong performance of the new hardware business, it also indicates the business spending environment is steadily improving.
HP's (HPQ) solid fourth-quarter results and increased fiscal 2011 guidance from the levels previously set out in September provided another vote of confidence for the sector. Corporate spending--accounting for 75% of HP's total revenue--was notably stronger than consumer spending during the quarter. This was especially evident in the PC segment, where consumer revenue declined 10% year-over-year while commercial revenue increased 20%. Looking ahead, HP raised the midpoint of its fiscal 2011 revenue guidance to $133 billion, implying year-over-year growth will be above 5%.
The Public Sector Isn't That Bad� At Least in the U.S.
The positive outlook for IT spending has extended to smaller industry players as well. One of the most interesting takeaways from NetApp's (NTAP) quarter was the firm's take on public sector spending. In contrast to the negative commentary from technology bellwether Cisco, the public sector was one of the strongest areas of growth for NetApp. Specifically, the U.S. public sector, which accounts for approximately 20% of NetApp's revenue, grew 59% year over year during the quarter. However, this is not a simple matter of NetApp executing better than Cisco. Rather, there are clear differences between the two firms' public sector exposures--these results reflect NetApp's U.S.-centric market share and larger proportion of federal business relative to state and local contracts. Cisco's struggles appeared to center more around Europe and the cash-strapped lower levels of the U.S. government.
Play the Wide Moats Over the Near Term
In combination with strong calendar third-quarter results and positive company outlooks, we see no signs that technology investment is withering as we enter 2011. The industry appears to be sustaining its momentum through the fourth quarter with the traditional year-end budget flush re-emerging. As we wrote last quarter, the titans of the technology industry continue to scramble to position themselves as providers of all-in-one solutions. These moves create some uncertainty around market share shifts, but it will take time for these battles to play out. In the near term, we believe technology giants with economic moats--including Cisco, Oracle, HP, and IBM (IBM)--are well positioned to take advantage of the current IT spending environment.
We are less sanguine about the prospects for the large no-moat tech firms, and those that are unfavorably positioned in consumer markets. Nokia (NOK) and Research in Motion (RIMM) are two firms that stand out along these lines. While Nokia's new CEO provides some hope that the firm's smartphone strategy will shift in the right direction, we expect Apple's (AAPL) iPhone and the Android ecosystem will continue to expand their lead relative to the former handset king in 2011. This same trend threatens RIM. Though the firm recently posted blistering revenue growth during its fiscal third quarter, we believe its product line lags far behind the iPhone and that this disparity will cut into the firm's increasingly consumer-focused business over the near term.
Our Top Tech Picks
Given our positive near-term outlook for IT spending generally, we believe several interesting opportunities have emerged for investors to own high-quality tech firms at reasonable prices. Most of our top picks are high-quality names with economic moats that are positioned to benefit from continued strength in technology spending.
| 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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| Cisco Systems |  | $30.00 | Wide | Medium | 0.65 |
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| Hewlett-Packard |  | $55.00 | Narrow | Medium | 0.76 |
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| Applied Materials | | $22.00 | Wide | Medium | 0.62 |
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| Advanced Micro Devices | | $15.00 | None | High | 0.54 |
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| ATMI | | $27.00 | Narrow | Medium | 0.77 |
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| Data as of 12-17-10. |
We believe Cisco's story will be particularly interesting to watch during the next quarter because of its contrarian and cautious outlook. In our view, the market's reaction to Cisco's warning wasn't about European public sector spending or cable boxes. Instead, we think that management's forecast provided a focal point for festering concerns that Cisco's voracious appetite for growth, which continues to drive the firm to attack new markets, is diverting attention from markets that may be smaller, but more central, to Cisco's core business and long-term competitive advantages.
However, the firm's switching and routing businesses continue to do well, and Cisco has recently executed a highly successful refresh of its core router business. While some may be disappointed to see firms like F5 (FFIV) and Aruba Networks growing so quickly at Cisco's expense, we do not believe that the market share losses that Cisco is willingly suffering as it chases larger opportunities (like UCS) are significant to its valuation.
We think the market has severely overreacted to Cisco's weak forecast and that this could be a good opportunity for investors to pick up a blue-chip name at a very attractive price. Cisco is trading at an enterprise value-to-EBITDA multiple of less than 8 times on a trailing-12-month basis. Looking forward, the firm is trading at a bit more than 7 times our estimate for 2011 EBITDA. The cheapest we've seen the shares in recent memory is about 6.1 times forward EBITDA, back in March 2009, when the shares hit $14.33 and the S&P closed below 700, during the depths of the financial crisis.
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