Our Outlook for Tech & Communication Services Stocks
Though pockets of weakness have emerged, we expect well-positioned tech and telecom firms will continue to prosper.
The persistent stream of revenue and profit warnings from the semiconductor industry has been the strongest theme of the past several weeks. Giants Intel (INTC) and Texas Instruments (TXN) have both sharply lowered their outlooks for demand recently. While end-market demand has certainly weakened in certain areas, including several industrial segments, we believe the current chip downturn is more of a reflection on the deeply cyclical nature of the industry. In some cases, customers have drawn down inventories on fears that the current turbulence in the financial markets will hamper sales. In addition, a handful of one-time events have hurt demand. The flooding in Thailand, for example, has hampered hard disk drive production, disrupting the PC supply chain. The current weakness has pushed several semiconductor stocks well below our fair value estimates. We'd focus on well positioned firms such as Analog Devices (ADI).
Demand for tech hardware remains decent, especially among consumers. Smartphones and tablets have been the primary driver of demand, with Apple (AAPL) arguably the biggest beneficiary. We believe the next several months will prove critical as other firms attempt to build credibility in these markets. Given that these products are likely to build increasingly large customer switching costs over time, grabbing share today is critical. We think it will be tough for anyone to reach the type of scale Apple has achieved, especially in tablets, and the firm's shares remain among our best ideas.
The telecom industry also provides an example of the strong getting stronger, often at the expense of the weak. Several cable companies, including Comcast (CMCSA), recently inked a deal to sell wireless spectrum to Verizon Wireless. The firms have also agreed to resell each other's services, a move that pairs companies that have historically been mortal enemies. These agreements have removed a major pillar of support for Sprint (S) and its partner Clearwire (CLWR).
We continue to see better value among the smaller U.S. telecom players, but the gap in uncertainty between these firms and giants like Comcast, Verizon (VZ), and AT&T (T) has widened. For exposure to large, stable telecom firms, we prefer companies outside the U.S. at current valuations, including France Telecom (FTE).
The enterprise software giants have finally entered the cloud race. SAP's (SAP) proposed $3.4 billion acquisition of SuccessFactors (SFSF) marks an acceleration of the firm's cloud computing efforts. Although the deal is strategically interesting for the companies involved, the announcement came on the heels of Oracle's (ORCL) announced intention to acquire software-as-a-service (SaaS) customer service specialist RightNow Technologies (RNOW) and was quickly followed by IBM's (IBM) decision to acquire DemandTec (DMAN), a SaaS vendor that helps retailers set prices. We have long held that large-enterprise software vendors would have to embrace growing customer interest in public cloud computing, and this wave of acquisitions suggests that the enterprise software giants are now backing prior lip service to cloud services with actual financial commitment.
The recent cloud acquisitions could well be just the start of a wave of M&A activity in the industry as on-premise software vendors retool their product portfolios to remain relevant to their customers. The transition to cloud services will likely involve a mix of organic efforts (such as SAP's Business ByDesign suite for mid-market ERP) and acquisitions of vertical solutions such as the deals discussed above. SaaS specialists including NetSuite (N), Taleo (TLEO), Kenexa (KNXA) and privately held Workday could all be in play as the on-premise software giants seek to build out broad cloud portfolios. Salesforce.com (CRM) could also be a takeout candidate, but its relatively mature stage of development and significantly higher valuation makes it more likely to remain independent, in our view.
Assembling portfolios of cloud solutions is only half the battle; selling cloud solutions could well prove to be the tougher hill to climb. While SAP, Oracle, IBM, and others could use their balance sheets to bulk up on cloud solutions, it remains unclear whether their scale in on-premise enterprise software will enable them to sell cloud services at margins that are neutral or positive compared with their corporate average operating margins. SaaS specialists including pioneer Salesforce.com have struggled to generate material profits due to lower average selling prices (ASP) and higher customer churn. Although larger vendors' scale in distribution can significantly improve selling and marketing productivity, these acquisitors will have to be particularly resolute in selling cloud services even at the expense of near-term margin pressure. Failure to commit on the sales side of the equation will leave the door open for additional startups serving the same markets more effectively and could lead to further expensive acquisitions to consolidate market share down the road.
As we enter 2012, the rapid growth in smartphones and tablets is attracting competition that will help shape the market. Apple is no longer the only credible player in town, with alternatives quickly closing the functionality gap. Furthermore, lower price points are drawing in more customers and forcing firms to make tough choices about their positioning. The results of the holiday season will help define the trajectory of many of the major players.
Key indicators to keep an eye on during the next quarter include unit growth and share shifts within the smartphone market. Phones based on Google's (GOOG) Android operating system are outselling those based on Apple's iOS, but both have reached a sustainable mass of users. We believe user switching costs will grow higher in the future, so establishing a strong base in these early innings is critical. The two ecosystems are currently concentrated in different areas of the market, with iOS dominating the high-end (>$600) and Android selling best in the more affordable price ranges. However, Apple is clearly targeting a greater presence by moving down market, and Android device makers are competing against new threats from Nokia (NOK), Research in Motion (RIMM), and most importantly, each other. Material share-shifts are still possible.
On the tablet front, after a series of flops (RIM's Playbook, HP's (HPQ) Touchpad, Motorola's (MSI) Xoom, Dell's (DELL) Streak), we finally have a serious challenger to Apple's iPad. Amazon's (AMZN) Kindle Fire is an Android derivative with a price of just $199 that is driving strong demand. The next few quarters will provide critical insight into just how much momentum Amazon is building. Apple's iPad still maintains a functionality lead in tablets, but this comes at a high cost ($499+) relative to the $199 Kindle Fire. We anticipate Apple will continue to do well, with the Kindle Fire expanding the market more than cannibalizing Apple's share. However, non-Apple device manufacturers will likely struggle to compete against the Kindle Fire. Samsung, HTC, and Research in Motion all lack the ability to copy Amazon's strategy of subsidizing the device in order to drive content sales.
The semiconductor industry as a whole remained mired in a cyclical downturn in the fourth quarter, though different dynamics are at play within each segment, with some pockets of strength benefiting select chipmakers. Chipmakers with exposure to the PC segment are being hampered by PC supply-chain disruptions, while weak end-market demand caused by global economic uncertainty is hampering semiconductor firms that supply into the wireless communications infrastructure and industrial segments. A notable area of strength is in smartphone chips, which continue to be a secular growth driver for the industry.
The recent flooding in Thailand has caused shortages of hard disk drives (HDDs) in the PC supply chain, as a significant portion of the HDD industry's manufacturing base is located in that country. Although end-market demand for PCs appears healthy, driven by emerging markets such as China and Brazil, the limited availability of HDDs has forced computer makers to lower their PC production levels, which in turn is causing them to temporarily reduce chip orders. This caused semiconductor behemoth Intel to recently lower its fourth-quarter forecast and will likely affect other chipmakers with PC exposure, such as Intersil (ISIL). Marvell (MRVL) has been directly affected by the HDD manufacturing problems, as the firm is a key supplier of chips that are used in HDDs and expects a 20%-30% sequential decline in storage-related chip sales this quarter. Nonetheless, the disruptions in the PC supply chain are only short term in nature, and it is expected that HDD output levels should recover in the first half of 2012, which should help drive a rebound in demand for PC-related chipmakers.
General macroeconomic uncertainty has also been hampering the semiconductor space, and the wireless communications infrastructure and industrial segments in particular have been pressured by weak end demand. Customers are continuing to draw down their chip inventory levels, in turn placing fewer new chip orders with a variety of firms. At some point, however, we expect these customers to replenish their inventory, which should result in a nice bounce back in chip demand for the industry. If the global macroeconomic environment improves, many broad-based chipmakers could be poised to benefit even further. That said, the timing and degree of any recovery remains to be seen. Microchip (MCHP) notably called a bottom to this latest downturn in November, but earnings warnings from Texas Instruments and Altera (ALTR) suggest that a bottom hasn't quite yet been formed.
The proliferation of smartphones has been a secular tailwind for the industry, and this opportunity continues to be a bright spot. We continue to believe that chip demand from the smartphone market will be more resilient than other tech sectors in the near term, especially as Apple's latest iPhone 4S release hits the market. Qualcomm (QCOM) expects robust revenue growth from its chip business in the near term, and Broadcom's (BRCM) revenue will attain the high end of its previously forecasted fourth-quarter range. Longer term, we don't see the secular shift in the handset industry away from basic handsets and toward high-end smartphones to slow down anytime soon. In turn, we believe that mobile processor makers, such as Qualcomm, will continue to prosper.
AT&T's pursuit of T-Mobile USA has come to an end, but the attempt continues to haunt the telecom sector. We've long held that smaller wireless firms, including Sprint, MetroPCS (PCS), Leap Wireless (LEAP), and T-Mobile, need to find ways to build sustainable competitive positions versus giants AT&T and Verizon. Doing so will likely require that these firms find ways to work together. However, each firm has struggled mightily throughout 2011, and finding agreement on the best way forward strategically will likely prove even more difficult at this point than it would have a year ago. In addition, these firms have drawn a skeptical eye from the capital markets. With the turmoil in the markets generally, raising addition funds is currently difficult.
Adding to the strain on smaller wireless carriers, Verizon Wireless found a very unexpected way to boost its competitive position during the fourth quarter. The firm announced plans to acquire wireless spectrum from a consortium of cable companies, including Comcast. The spectrum purchase will put Verizon Wireless well ahead of even AT&T in most major markets, giving it an advantage as demand for wireless data services grows. Also critical, Verizon Wireless and the cable companies have entered into an agreement to resell each other's services. Given the fact that Verizon and the cable companies compete fiercely in the fixed-line business, we're still skeptical about how well the firms' partnership will work. Still, this deal removes a major partner from Sprint, which has worked for years to collaborate with the cable companies, for at least the time being.
In short, the strong have gotten stronger in the U.S. telecom market over the past year. This puts even more pressure on the industry's smaller carriers to make something happen strategically in 2012. Sprint should be in the best place to drive future strategy, but recent blunders have hit the firm especially hard. The company has struggled to communicate effectively with investors regarding the impact of Apple's iPhone on its business and its expected capital needs as it undertakes a major network upgrade. With Sprint now in a place of financial weakness, we believe uncertainty has ratcheted higher for all of the smaller U.S. carriers.
Internationally, as the fourth quarter comes to a close, we are getting close to the entrance of Iliad into the French wireless market. The firm recently reached the 20% coverage milestone needed to begin offering service. Despite the prospect of increased competition, France remains one of our favorite wireless markets globally, and incumbent France Telecom remains one of our favorite telecom stocks. As in the U.S., we believe the strength of the largest wireless players in the French market will allow these firms to remain dominant over the long term. Iliad is late in entering what is already a very mature market, its network is inferior, and it lacks widespread distribution. We think that after an initial aggressive push, it will realize that it needs to charge higher prices to cover network costs, which will mute its impact on the market. We also expect Iliad will be more disruptive with lower-value prepaid subscribers than among contract customers, which provide the most value to FT. We believe that the market has overly punished FT's shares, making them a compelling value.
While 2011 has been a year marked by hype surrounding IPOs that were even loosely associated with social networking (including LinkedIn (LNKD), Pandora (P), Groupon (GRPN), and Zynga (ZNGA)), we expect that companies without economic moats will need to show both growth and profitability in 2012 or risk potentially dramatic sell-offs. On the other end of the spectrum, we believe the market will once again recognize that Google, the juggernaut of the Internet industry, has formidable advantages versus a new crop of upstarts.
Digging deeper into the online advertising industry, we expect continued fragmentation in the market for display advertising. We believe that continued weakness at Yahoo (YHOO) and AOL (AOL) will bode well for Google, Facebook, and other content companies. Importantly, we will be watching for signs that display advertising is taking market share away from traditional offline channels, a key factor in our long-term investment thesis for the sector. Investors should also take heed that because most display advertising is impression based and not performance based, this segment is also the most vulnerable to any macroeconomic weakness.
We expect IT services budgets to remain largely flat or increase modestly at best in the near term. Most companies around the world have kept a tight leash on IT spending in the past few years, with minimal discretionary spending. So, despite an uncertain global environment, we think it will be tougher for companies to further slash their IT service budgets. However, with offshore outsourcing continuing to gain traction worldwide, we expect service providers with an established offshore network to notch up market share gains. We believe Accenture (ACN), IBM, and larger offshore IT firms such as TCS, Infosys (INFY), Cognizant (CTSH), and Wipro (WIT) should gain from this trend.
The deteriorating economic environment in Europe is a cause for concern, but so far the downtrend in IT spending is limited to peripheral regions in the eurozone. We haven't seen any visible changes in spending pattern in countries like France, Germany, and the United Kingdom, which are the major outsourcing buyers from the region.
On the U.S public sector side, budget cuts and continuing resolutions will likely keep demand in check in the near term, and the situation may turn for the worse if sequestration kicks in and is followed to the letter. Except for a few, most of the companies we cover have limited exposure to the federal IT space. Computer Sciences Corporation (CSC), CACI International (CACI), and CGI Group (GIB) count the U.S government as their largest client, but all of them have reported good bookings/book-to-bill ratios in recent quarters, indicating that their near-term growth prospects aren't under threat.
Our Top Tech & Communication Services Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The five firms below fit this criteria and are trading at attractive valuations, in our view.
|Top Tech & Communication Services Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
| Price / |
|Data as of 12-16-11.|
Cisco Systems (CSCO)
Cisco continued to produce gross margin stability and showed no evidence of substantial market share deterioration in its core router and switch markets during its fiscal first quarter. Despite growing competition, 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.
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. 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.
)Oracle is one of the highest-quality names in our tech coverage universe, and we expect the firm's core software business (which accounts for 68% of revenue) will continue to perform well in the near term. Although Oracle's hardware segment could generate underwhelming results in the next few quarters, we believe this business has solid long-term prospects and will enable Oracle to drive additional software sales over time and further strengthen its wide economic moat.
France Telecom (FTE)
France Telecom is the dominant telecom operator in France and 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, and allows the firm to generate significant cash flow. This cash flow in turn allows the firm to pay a large dividend.
With a wide economic moat, we have included Google as one of our favorites. Although we expect continued scrutiny from various global regulatory agencies, we do not expect potential changes to drastically alter the company's competitive advantages. Google has been an early and dominant company on the Web. The firm not only built a revolutionary Internet search engine, but it arguably pioneered performance-based advertising on a massive scale. Google has a formidable moat in Internet search, which represents more than 75% of net revenue. Although growth is slowing in its core search market, we still expect annual growth in search revenue to exceed 15% during the next five years, supported by the firm's successful foray into mobile advertising.
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Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.