Our Outlook for Tech & Communication Services Stocks
We strongly favor high-quality names in the current environment.
Quarter-End Insights
- Recent data points paint a mixed near-term demand picture.
- Firms with durable competitive advantages are better-positioned to weather economic downturns and competitive threats.
- The recent sell-off has expanded the opportunity set of high-quality businesses selling at attractive valuations.
Data points coming out of the technology and telecom sectors continue to paint a mixed, somewhat sluggish, near-term demand picture. Firms that operate within certain subindustries, such as analog chipmakers, semiconductor equipment manufacturers, and IT services firms seem cautiously optimistic about the second half of 2012, while telecom equipment providers and enterprise hardware firms have sounded a decidedly pessimistic tone. Cisco Systems (CSCO), Hewlett-Packard (HPQ), Dell , and NetApp (NTAP) all delivered tepid outlooks in their most recent reports, as weakening demand from Europe and a stingy public sector in the U.S. are weighing on results. Still, Oracle's (ORCL) relatively upbeat outlook provided in late June suggests that there is growing global demand for enterprise IT products and services, provided that the value proposition is compelling. At this point in time, it's difficult to tell if we're at the very front end of a protracted cyclical slowdown or if the hardware vendors are simply experiencing a slight pause in demand, coupled with various firm-specific issues.
If a rising tide lifts all boats, then, conversely, the current economic malaise provides an opportunity to better understand the competitive position and long-run earnings power of individual businesses. For example, Oracle's ability to deliver solid operating results in the current macroeconomic environment is a reflection of the high switching costs that its customers face, the value in Oracle's intellectual property, and the strength of its business model. While it is still too early to determine whether Oracle's strong software franchise will allow it to also capture significant hardware share with its proprietary integrated appliances, early results are encouraging.
On the other hand, Dell's recent weak outlook highlights the fact that the firm still has a long ways to go in its transformation from a PC manufacturer to an enterprise IT systems provider. Dell's fortunes are still largely tied to commodity PCs. As an assembler of other firms' intellectual property, Dell currently has limited ability to capture value, and its PC customers face limited switching costs. As an enterprise IT solutions provider, Dell would have more opportunities to create switching costs for its customers. The distinction is important, as technology firms whose customers face minimal switching costs can see previously healthy cash flows dry up quickly.
The diverging fortunes of Apple (AAPL) and Nokia (NOK) provide a contemporary case study. Nokia created no ties to its end customers with its traditional handsets, and the firm therefore had very limited ability to maintain its market share as competitors introduced better devices. On the other hand, we believe that Apple has embedded customer switching costs through its operating system, rich ecosystem of application developers, massive content library and increasing integration across multiple devices. Even if Apple misfires on a product cycle, we believe that these switching costs will pull users from one device generation to the next.
In our previous quarterly outlook, we observed that the technology sector, in aggregate, was trading at roughly fair value, and that the near-term spending environment was uncertain. Therefore, we recommended that investors seek out undervalued firms that possess economic moats. Since then, increasing macroeconomic uncertainty has caused the technology sector to sell off a bit, which in turn has pushed the sector into moderately undervalued territory. As a result, we see an expanded opportunity set of undervalued, high-quality names with solid balance sheets, consistently strong free cash flows, and durable competitive advantages. We list four such names at the conclusion of our industry level insights.
Industry-Level Insights
Telecom
Spectrum, device subsidies, and consolidation dominate the discussion within the U.S. wireless market. With AT&T (T) using the spectrum issue to defend its failed T-Mobile acquisition, many investors now wonder how the firm and its rivals plan to meet future capacity needs. In large part, spectrum is a matter of regulatory policy. U.S. regulators and lawmakers have taken some steps toward freeing up additional capacity, but a large-scale spectrum auction likely remains several years away. The treatment of Verizon Wireless' (VZ) (VOD) planned purchase of spectrum from a consortium of cable companies should provide insight into the Federal Communications Commission's current thinking around spectrum ownership. Refusal to approve the deal or conditions that require significant divestitures would be a boon for the industry's smaller players.
Rising smartphone subsidy costs have taken a bite out of wireless industry margins over the past couple years, and the carriers are looking to push back. AT&T management recently stated that it has done extensive studies with focus groups and that there has been no indication that consumers are willing to spend $500 or $600 for a phone, as prepaid carriers like Leap require for the iPhone, and that the reaction against high upfront phone costs remains strong. However, AT&T does believe that subsidies may decline as technology makes consumers more device-agnostic. The high speed and low latency that LTE technology provides enables more customer data, applications, and content to reside in the network than on customers' devices. In addition, the adoption of HTML 5, a vendor-neutral platform for building applications, promises to make applications ubiquitous across devices.
Even if AT&T dominates the cloud down the road, the firm's ability to reap the benefits will depend on the level of competition in the marketplace. The availability of low-cost yet powerful devices could provide a platform for the re-emergence of the prepaid carriers. The level of competition in the market will be determined in large part by the pace of industry consolidation, in our view. At this point, the potential for consolidation is highly uncertain. Sprint , which we believe should be a leader in consolidation, looks unwilling to make a move until its network-upgrade program is largely complete, likely 18 months or more from now. Deutsche Telekom (DTEGY) also needs to make a decision regarding the ownership structure of T-Mobile USA, but it seems to want to rebuild the unit's image and upgrade networks first.
In Europe, two events are currently shaking up the environment. First, America Movil (AMX) is invading the continent, building on its massive roots in Latin America. The firm has taken a large stake in Telekom Austria and made an all-cash offer for up to 28% of KPN (KKPNY). KPN believes America Movil's offer is too low and the firm is seeking strategic alternatives for its Belgian and German assets in an effort to boost its valuation. Second, the European debt crisis is hammering away at carriers with more questionable balance sheets. Telefonica (TEF), in particular, has come under pressure because of Spain's troubles and its own hefty debt load. In response, Telefonica has sold half its stake in China Unicom and is considering an IPO of its businesses in Germany or Latin America. Interestingly, actions at KPN and Telefonica could lead to the merger of their German businesses, a move we've long thought necessary for each to remain competitive. In any event, America Movil's entrance into Europe brings a strong balance sheet and management team into the mix, while highlighting the extremely cheap valuations we see among European telecom firms.
Looking directly at Latin America, spectrum and competition are also major issues. In Brazil, carriers collectively spent $1.3 billion at auction for spectrum intended to support new LTE networks. The industry aims to have these networks built in part within 10 months so that any kinks can be worked out before the country hosts the World Cup in 2014. Prices paid at auction were in line with our expectations, and we don't expect the result will have much impact on the intense competition for customers within Brazil. In Mexico, regulators have approved Televisa's bid to buy a stake in Iusacell, giving the media giant a position in the wireless market. This move could up the competitive aggression in Mexico. We continue to believe that America Movil is the best-positioned carrier to withstand the competitive pressures across Latin America thanks to its financial strength, high-quality networks, and scale.
Semiconductors
One of the major themes surrounding the semiconductor industry in recent months has been the shortages of cutting-edge, 28-nanometer (circuit size) production capacity at the foundries, particularly at leading foundry player Taiwan Semiconductor Manufacturing (TSM). The rising popularity of smartphones has been driving demand for state-of-the-art chips that are incorporated in these gadgets, with wireless chipmaker Qualcomm (QCOM) being a key beneficiary of that trend. However, Qualcomm does not have enough supply of its upcoming lines of mobile processors and baseband chips because of the limited 28-nm capacity at key foundry supplier TSMC. The capacity constraints are also affecting other fabless chipmakers with new 28-nm products, including FPGA (field programmable gate array) firm Altera , and PC graphics processor (GPU) suppliers Nvidia (NVDA) and Advanced Micro Devices (AMD). Nonetheless, we expect foundries to increase capital spending to boost their 28-nm production capabilities in the coming months, which should benefit semiconductor equipment firms such as KLA-Tencor (KLAC) and Applied Materials (AMAT).
In terms of near-term outlook, it appears that chipmakers as a group are seeing improving business conditions after the cyclical slowdown that hampered the semiconductor industry in late 2011. Analog chipmakers, such as Texas Instruments (TXN), Linear Technology , and Analog Devices (ADI), saw revenue declines in the second half of 2011 as a weak global economy caused many of their customers to draw down their chip inventory levels, rather than place new chip orders with the firm. Many of these broad-based chipmakers now see an end to the inventory drawdown and believe that their chip shipments to customers are better-aligned with true end-market demand. We continue to believe that many analog chipmakers are poised for a snapback in demand if and when macroeconomic conditions improve.
Internet
The Facebook (FB) IPO has come and gone, and its sell-off has brought heightened scrutiny to the question of "what's next" for companies dependent on Internet advertising. After pricing at $38, the stock fell below our fair value estimate within the first week. Aside from the unpredictable whims of short-term investors and traders, we believe the concerns about Facebook's slowing growth are not unique to Facebook. In our view, companies such as Zynga , Pandora and Yelp (YELP) face similar challenges in monetizing both social and mobile advertising in the coming quarters.
The potential of mobile advertising is not lost on us, but our cautious stance on near-term revenue growth leads us to favor companies that are investing in their economic moats, such as Apple and
Google (GOOG). These companies act as a gatekeeper between users and their activities with e-commerce stores, applications, and content. As long as third parties and users continue to garner benefits from Apple's IOS platform and Google's Android platform, we expect mobile revenue will eventually materialize in the form of advertising and e-commerce-related activity. Although near-term ad performance challenges may cause some cannibalization of desktop advertising and revenue-growth deceleration, Google's search and display businesses are alive and well. Furthermore, as ad technology and formats evolve to maximize advertising capabilities for mobile environments, we believe the mobile sector will become an area of growth over the medium and long term.
Hardware
As we head into the second half of the year, the most recent earnings announcements from hardware firms have been filled with outlooks that at best, lack enthusiasm, and at worst portend a significant headwind in IT spending during the back half of the year. Broadly speaking, the squeamish guidance can be traced to macroeconomic uncertainty in Europe and across the global public sector. However, for some firms, the weakness is revealing underlying weakness in their business models.
For much of the first half of the year, hardware firms have been projecting an uptick in spending during the back half of 2012. The deterioration in confidence has been abrupt, with the negative sentiment appearing in the firms that report results off-cycle (for the quarter ended in late April instead of March 31). Cisco, Dell, NetApp and Hewlett-Packard all fit this bill, and we've been treated with uninspiring midquarter updates from Nokia and Research in Motion (RIMM). Although most of the hardware stocks have retreated on the negative outlooks, we see companies that are in three different positions. First, with Cisco, NetApp, and Hewlett-Packard, we believe that the economic uncertainty is a temporary headwind that is not revealing any unexpected challenges to companies that have struggled, these firms remain fundamentally sound. Second, with Dell, we believe the sobering outlook has reminded investors that more than half of the firm's revenue is still tied to commodity PCs. We are starting to see value in Dell. But it is a name that requires grounded expectations, and the firm's recent results have demonstrated that its transition to enterprise solutions and services will continue to be time-consuming and expensive. Finally, with RIM and Nokia, we see almost no impact from the economic situation because the underlying business models are deteriorating so rapidly.
With hardware stocks beaten down, investors must determine if there is value in the technology sector, or simply value traps? Our advice for investors is to focus on quality businesses, specifically those with economic moats that represent sustainable competitive advantages that will last beyond the current uncertainty. In some cases, such as Research in Motion, we hold out little hope for a turnaround. In others, such as Nokia, we expect the firm to survive in a permanently crippled competitive state. In contrast, with Cisco and Hewlett-Packard, we see firms with lasting business models that aren't receiving the credit they deserve from the market.
IT Services
IT and BPO service providers witnessed a slow start to 2012, but most of the indicators point to a gradual pickup in demand in the near term. Historically, we had seen some volatility in the first quarter, especially in an uncertain macroeconomic environment, as companies try to work with their budgets. The pace of spending picks up as the year goes on, and so far we haven't seen anything that says otherwise. Additionally, most of the service providers reported strong first-quarter bookings, indicating that near-term growth prospects look good. Despite its recent struggles, Europe continues to be a bright spot for IT service providers, and growth here was mainly driven by increased adoption of outsourcing by European companies. On the contrary, the United States, despite economic improvements, continues to be cautious on IT services spending. We expect this trend to persist in this quarter, as well. On the U.S. public sector side, budget cuts continue to be a drag on federal IT spending.
We expect currency movements to play a significant role in the second quarter. All the top-tier service providers have a global footprint, and the recent appreciation of the U.S. dollar against almost all currencies will be a drag on reported revenue. However, we expect these currency movements to have a positive impact on the margins. Most of the service providers have a large presence in India, and the appreciation of the U.S. dollar against the Indian rupee should support their operating margins, in our view. Across companies, each 1% change in the rupee affects operating margins by 30-50 basis points. Additionally, companies are also expected to benefit from the recent fall in wage inflation and employee-attrition levels.
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 four firms below fit these criteria, and are trading at attractive valuations, in our view.
| Top Tech & Communication Services Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price / Fair Value | |
 | |||||
| Applied Materials |  | $19.00 | Wide | Medium | 0.59 |
| |||||
| Oracle |  | $38.00 | Wide | Medium | 0.73 |
| |||||
| Qualcomm | | $70.00 | Wide | Medium | 0.78 |
| |||||
| | $780.00 | Wide | High | 0.72 | |
| |||||
| Data as of 06-25-12. |
Applied Materials (AMAT)
Applied is the behemoth of the semiconductor equipment industry, with unmatched scale and a broad product portfolio, making it the closest thing to a one-stop shop for chip manufacturers. Although the firm's foray into the solar-equipment industry has weighed on financial results, the stock has been overly punished, in our view. As semiconductor circuit sizes continue to shrink, demand for Applied's complex tools and services will continue to grow.
Oracle (ORCL)
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 it will enable Oracle to drive additional software sales over time and further strengthen its wide economic moat.
Qualcomm (QCOM)
We like Qualcomm's position as the developer of CDMA network technology, which enables the firm to collect royalties on every 3G device sold. The firm is a prime beneficiary of the secular shift from basic handsets to smartphones, which will lead to higher-priced phones and, thus, greater royalty revenue over time. Qualcomm's chips also power many of today's most popular handsets and tablets, such as Apple's latest iPhones and iPads. Meanwhile, the firm has a pristine balance sheet, and recent investments in mobile-display technology Mirasol and the acquisition of Atheros could provide new avenues of growth for Qualcomm down the line.
Google (GOOG)
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 also 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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