M&A Will Continue in Tech and Telecom
As firms seek to better position themselves for growth and utilize excess cash, look for competition to intensify.
Multi-billion-dollar acquisition announcements in the second quarter from Texas Instruments (TXN), CenturyLink (CTL), Applied Materials (AMAT), and Microsoft (MSFT) suggest that large-cap tech and telecom firms are still willing to absorb large targets in order to improve competitive positions and fuel growth. Although none of the respective targets--National Semiconductor, Savvis, Varian, and Skype--are being acquired at attractive valuations in our opinion, all of the deals appear strategically sound. We expect a continuation of this theme throughout the remainder of the year as large, cash-rich tech firms will be willing to pay up for companies with strong competitive positions in growing markets that are strategic to existing operations.
This increased level of mergers and acquisitions activity also underscores the point that large tech and telecom firms will seek to capture a greater share of the enterprise customer's IT spend throughout the year. For example, Microsoft will most likely leverage Skype's technology to bolster its enterprise-class video-conferencing offerings and improve its competitive position relative to Cisco Systems (CSCO) in the unified communications market. We expect competition among enterprise-focused tech firms to remain intense throughout the remainder of 2011, as the major U.S.-based vendors-- Oracle (ORCL), Hewlett-Packard (HPQ), International Business Machines (IBM), Dell (DELL), and Cisco--continue to encroach on one another's markets. In our view, Oracle, IBM, and Microsoft are well-positioned to compete in a consolidating landscape, while the hardware-centric vendors face an uphill battle.
Microsoft's acquisition of Skype also demonstrates the continued affect mobile computing will have on corporate strategy and operating performance across a large swath of tech and telecom firms. Microsoft has thus far been uncompetitive in the smartphone and tablet platform race, and the software giant plans to integrate Skype into its Windows Phone platform as it searches for a competitive response to Apple (AAPL) and Google (GOOG). Like Microsoft, most participants in the traditional PC and handset value chains are developing new products and services to adapt to the changing landscape, and many new smartphones, tablets, and related services should come to market in the second half of the year. However, we see little in the near term to alter the current competitive landscape, and we expect Apple and Google to extend their platform dominance throughout 2011, while Nokia (NOK) and Research In Motion (RIMM) continue to struggle.
Industry Level Insights
AT&T's (T) planned acquisition of T-Mobile USA--and the fallout surrounding it--continues to dominate developments in the U.S. telecom industry. AT&T has repeatedly pressed its view that this deal is the best route to meeting future wireless data demand and a clear path to future innovation, garnering widespread support from the tech community, including the likes of Oracle and Microsoft. Consumer groups and rivals, notably Sprint (S), have been equally vocal on the opposite side, claiming that AT&T will gain an unfair advantage once T-Mobile is taken out, creating a wireless duopoly that hurts consumers. We believe there is a strong case against this merger given the already-growing dominance of AT&T and Verizon Wireless and the other options available to meet AT&T's capacity needs. It's tough to count AT&T out, though, given its regulatory savvy. Judging what issues will sway the Federal Communications Commission and Justice Department one way or the other is ultimately an impossible task.
In any case, the T-Mobile deal is going to reshuffle the U.S. wireless industry, and bottom-tier carriers from Sprint on down have been scrambling for position. Sprint continues to work with partner Clearwire (CLWR) on its next-generation wireless strategy, but it is also allegedly holding talks with start-up LightSquared on a spectrum- and infrastructure-sharing agreement. Cable operator Cox Communications recently decided to shut down and sell off its wireless operation, using a wholesale agreement with Sprint to serve customers instead. Smaller players U.S. Cellular (USM), Leap Wireless (LEAP), and MetroPCS (PCS) have gotten involved, as well. U.S. Cellular announced plans to accelerate its next-generation network build-out, Leap has signed a deal with LightSquared, and MetroPCS is rumored to have bid on TerreStar, a bankrupt company that holds a large chunk of spectrum.
At this point, it looks like DISH Network (DISH) could emerge as the biggest wireless surprise of 2011. It looks like DISH will emerge the winner in the TerreStar auction, building on spectrum it acquired earlier in the year. DISH could end up with a highly valuable resource that could quickly add wireless data capacity, but the firm has stated that it won't do anything without an experienced partner. At this point, Sprint is likely the best, if not the only, option. With numerous cable companies and spectrum owners vying to work with Sprint, we continue to believe that the firm is in the best position of any besides AT&T and Verizon Wireless. Pulling a wide variety of competing interests together will likely prove to be a considerable challenge, however.
Oracle's integrated appliance strategy has sparked a wave of consolidation in the information technology industry as large vendors aim to position themselves as single-stop shops for enterprise customers. For software vendors, business analytics has emerged as a fierce battleground as Oracle's Exadata appliances have rapidly gained customer acceptance. To combat the growing threat from Oracle, companies such as SAP (SAP) and Microsoft are partnering increasingly more closely with hardware vendors such as HP and IBM to bring competitive integrated business analytics appliances to market. SAP has launched its HANA appliance in partnership with IBM, HP, and other vendors, and Microsoft has partnered with HP for its Enterprise Data Warehouse Appliance. In addition to partnering with software companies, hardware vendors like HP and IBM are also investing in developing proprietary integrated solutions as evidenced by both IBM's acquisition of Netezza, which is an Exadata competitor, and HP's acquisition of Vertica, a provider of business analytics software solutions.
Integrated appliances are poised to benefit from private cloud (on-premise datacenter) investments during the next three to five years, and we expect such solutions to gain acceptance in additional areas. Oracle's Exalogic and IBM's Workload Deployer appliances have targeted the application server space, and Microsoft has partnered with HP to bring Exchange appliances to market. In the longer term, we expect public cloud computing to offer compelling alternatives for customers seeking rapid deployment of a broader range of enterprise solutions. However, on-premise appliances remain well-positioned to gain widespread adoption in the interim.
The proliferation of smartphones continues to be a key theme for the semiconductor industry, with chipmakers such as ARM Holdings (ARMH) and Qualcomm (QCOM) being major beneficiaries of the trend. However, not all wireless chipmakers have been winners, particularly those with significant ties to Nokia and Research in Motion--two handset makers that have been losing market share to the Apple and Google Android smartphone platforms.
Texas Instruments lowered the range of its second-quarter outlook during the firm's recent midquarter update call, as Nokia's struggles hurt demand for TI's baseband chips. However, this should have limited long-term effects on TI, as the firm has been winding down its baseband unit anyway. At the same time, the erosion of RIM's competitive position has weighed on chipmaker Marvell (MRVL), a prominent RIM supplier. Fortunately for Marvell, the firm has been focused on developing mobile processors for the 3G TD-SCDMA standard in China and is beginning to benefit from product ramps of handsets that incorporate these chips, which should help offset the revenue declines resulting from RIM's recent failures.
The tablet revolution will continue to disrupt PC markets. But wholesale substitution is unlikely and the traditional PC form factor will not disappear. Demand for tablets has exceeded our expectations for consumers in developed markets, but we still do not view them as a replacement for PCs tasked with content creation. This limits the cannibalization effect on PCs in corporate use and in emerging markets where the single-PC household is still the norm (increasing the sensitivity to price and utility). With robust PC demand still anticipated in emerging markets that now account for 52% of PC shipments, we expect to see unit shipments continue climbing for the foreseeable future. Several industry analysts cut their 2011 PC outlook (units) recently, but we were already expecting a lower growth rate and are sticking with our 4% forecast.
The handset industry had a very interesting quarter, as two long-time industry leaders--Nokia and Research in Motion--suffered significant strategic setbacks.
Nokia's second-quarter earnings warning didn't come as a big surprise, as the company is in the middle of a transition from its legacy mobile operating systems to Microsoft's Windows Phone 7 OS. With both Symbian and MeeGo being phased out, handsets running on those operating systems are less attractive, and with Nokia's first Windows phones at least five months away, we'd expect weakness to continue through the third quarter and (depending on whether its first Windows phones launch in time for the holiday season) perhaps into the fourth quarter. In our view, the reception of Nokia's first Windows phones will be critical to the long-term survival of the firm. If they flop, Nokia doesn't have an attractive Plan B, having already scrapped its own proprietary operating systems. However, we think that Microsoft is committed to having a successful mobile operating system (if only to protect its desktop assets), and as Nokia has already burned its boats, we think that both firms are going to throw everything they have into making the partnership successful.
Although RIM is looking at a 2011 that is financially stronger than Nokia's, we still think that RIM is in a worse strategic position. We've spent the better part of the year talking about how RIM's aging BlackBerry OS was lagging far behind iOS and Android, and we now think it is probably that RIM's year-over-year sales will turn negative by the end of the calendar year--which would be a first for the firm. In our view, management hasn't articulated a viable turnaround plan and seems to believe that incremental improvements to the BlackBerry OS will make the firm competitive. The company's product roadmap is to release the BlackBerry 7 operating system later in the year and then sometime in 2012 switch all of its products to QNX (the OS that runs the PlayBook tablet). That leaves Android and iOS a lot of time to widen their leads, and gives the Nokia/Microsoft partnership a lot of time to catch up.
In March, we lowered the majority of our fair value estimates across the solar sector given our belief that solar supply and demand had become imbalanced and the stage was set for an industry downturn. Results and deteriorating industry conditions (such as falling pricing, inventory buildups, and extension of payment terms) have confirmed that this in fact is occurring, and our solar coverage list names have experienced material share-price declines. However, we still believe solar stocks will fall further from here. Although a challenging near-term is starting to be priced in, solar shares trade largely on near-term results, and we believe the market is placing too much faith in a second-half rebound and the industry cycle bottoming out in the second quarter.
Without question, global installation activity will undoubtedly increase in the coming months. But the fact remains there simply is not enough demand for the industry to both reduce inventory levels and keep factories running at high-utilization rates. The rumblings from the recent Intersolar conference (the solar industry's largest) suggest that though demand is slowly improving, it is nowhere near enough to stop further pricing declines. In our opinion, global demand needs to be at least 23 gigawatts in order to keep pricing levels near where they are today (about $1.40 per-watt for solar modules). We are forecasting 18.3 GW of installations will occur this year, which if accurate means the industry's troubles are far from over. As SunPower (SPWRA) CEO Tom Werner said when his company recently cut its 2011 forecast, the problems solar is facing are structural in nature. We don't believe these headwinds can be solved in one quarter. We continue to view Renewable Energy and Suntech (STP) as overvalued names with near-term downside.
Despite our very bearish near-term view, the fact remains that solar still has a very promising long-term future. Eventually, industry fundamentals will improve as supply and demand rebalance. Once share prices approach their bottoms, we think investors should be targeting well-run companies with leading cost structures and strong balance sheets. The two companies that clearly fit such a description are First Solar (FSLR) and Trina Solar (TSL). Although share prices for both companies have materially declined, we believe the near-term industry headwinds are severe enough that more attractive entry points are likely to present themselves before shares bottom out.
Our Top Tech Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The four firms below fit this criteria and are trading at attractive valuations, in our view.
|Top Tech Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
Price / Fair Value
|Data as of 6-14-2011|
Cisco Systems (CSCO)
Margin pressure and weakness in Cisco's core switch business led to the company's fourth consecutive disappointing quarter, placing further pressure on shares. Despite growing competition and lingering questions around Cisco's restructuring efforts, the firm's dominant position in data networking equipment, its strong services business, and consistently strong free cash flow generation give us confidence that shares will recover from recent lows.
Weak PC demand and disappointing revenue from services led Hewlett-Packard to trim its 2011 revenue outlook, creating a second chance for investors to own a high-quality name at an attractive discount. Despite the firm's disappointing quarterly forecast and near-term uncertainty surrounding consumer PC demand, we believe the company's strong position in enterprise hardware, services, and printing create more than enough value to support our fair value estimate.
Apple's three primary growth engines--the iPad, iPhone, and PCs--should allow the firm to deliver strong top-line growth during the next few years. Moreover, we think that Apple is increasing customer-switching costs--a rare feat for a consumer-focused tech firm--by delivering a seamless user experience across various devices. Although increasing competition from Google and Steve Jobs' health present long-term risks, we see no clear impediment to near-term growth and believe investors are currently presented with a rare opportunity to buy a high-quality growth firm.
France Telecom (FTE)
France Telecom is the dominant telecom operator in France. It also has large operations in many other countries. In total it has 210 million subscribers, of which 150 million are wireless customers. This size allows it to keep the majority of its customers on its own network, which lifts profitability, provides it with a narrow moat in our opinion, and allows the firm to generate significant cash flow. France Telecom has generated more than EUR 8 billion in free cash flow in each of the past several years and expects to do so again in 2011. This cash flow in turn allows the firm to pay a large dividend (current gross yield is 9%), reduce debt, and make additional acquisitions, primarily in emerging markets.
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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.