Our Outlook for Tech and Communication Services Stocks
Investment opportunities exist in unloved areas.
Quarter-End Insights
- The technology and telecom sectors are undervalued in aggregate, but investors should be selective.
- We see attractive buying opportunities in names that are currently out of favor with the market.
- We highlight five high quality names that generate strong free cash flows whose stocks are attractively priced.
The technology and telecom sectors each look moderately undervalued, based on a market-capitalization weighting of our price-to-fair value estimates. Still, we see a fair amount of dispersion among individual stocks in both sectors, and investors seem to be shunning any firm that faces uncertainty, regardless of the strength of the underlying business.
In the telecom sector, we are seeing this market sentiment manifest itself in a market valuation divergence between the sharply undervalued European telecoms and fully valued U.S. and Canadian telecom firms. Currently, investors are buying U.S. and Canadian firms for yield, while shunning European firms on the belief that current dividends, even where reduced, are unsustainable. Although many European service providers face a host of near-term pressures, the market has pushed down the valuations of generally strong companies, such as France Telecom (FTE), much lower than we believe is warranted on macroeconomic concerns.
In the technology sector, market sentiment surrounding the PC supply chain grew increasingly negative throughout the fourth quarter, and both Intel (INTC) and Microsoft (MSFT) sold off. Both businesses are now priced for long-term decline, despite the fact that each firm has pricing power in the PC supply chain and will generate substantial free cash flow even if the PC market shrinks further. Moreover, we expect Microsoft and Intel to experience strong growth from business segments unrelated to PCs, mitigating the long-term risks associated with the firms' PC exposures. We find each firm's stock attractive, as we think the market is overlooking the underlying competitive advantages that each firm possesses.
Interestingly, Apple's (AAPL) fourth-quarter sell-off has pushed the firm's stock into 5-star territory, as the market seems to believe that this business is also about to decline. In other words, the market is telling us that Intel and Microsoft, key beneficiaries of PC demand, face secular decline, and that Apple, a key beneficiary of smartphone and tablet demand, faces secular decline. We find it highly unlikely that none of these firms capitalizes on growing global demand for computing devices, whether desktop, notebook, tablets, smartphones, or some other form factor.
Telecom
Three major events of the past quarter promise to permanently remake the U.S. telecom landscape: T-Mobile USA's plan to merge with MetroPCS (PCS), Softbank's capital injection into Sprint , and the Federal Communications Commission's decision to remove restrictions on the wireless spectrum that DISH Network acquired in 2011. The first two moves are designed to improve competitive positioning versus industry giants AT&T (T) and Verizon (VZ). The T-Mobile deal is all about spectrum and synergies. MetroPCS and T-Mobile own spectrum portfolios that line up very well, which should enable a stronger LTE network deployment. The deal should also improve marketing and purchasing scale while duplicating network assets such as tower rent and backhaul costs. The Sprint agreement provides capital needed to fix the firm's balance sheet and provide ammunition to buy additional spectrum or make acquisitions.
The DISH spectrum action, on the other hand, adds additional uncertainty for DISH and the smaller wireless carriers. DISH's spectrum holdings had originally been designated for satellite use but will now be available for traditional terrestrial wireless services. The FCC also plans to move forward in 2013 with an auction for spectrum known as the H-block, which partially sits between DISH's holdings and the spectrum that Sprint is using to deploy its LTE network (the G-block). DISH has said that it will evaluate the new FCC rules and then decide how best to proceed. This decision could have a major impact on our view of DISH's valuation. As we've seen with Clearwire , a deep spectrum portfolio isn't worth much without a viable business plan.
Speaking of Clearwire, rumors continue to swirl around Sprint's intentions for the firm. Based on Sprint's past comments and the array of options in front of it, we believe the firm will take its time in moving forward with Clearwire. Sprint is clearly interested in adding the H-block to its spectrum holdings to directly augment the capacity of its LTE network. We believe this spectrum could cost Sprint up to $3 billion, a figure that likely has to figure into its broader strategic planning. Given the proximity of DISH's spectrum to Sprint's, we believe the firms likely remain engaged in discussions to form a partnership. A deal between the firms could allow DISH to meet build-out requirements far more cheaply and quickly than it could independently while easing the pressure on Sprint to acquire additional spectrum. Finally, Sprint also has to consider the potential benefits of a bid for MetroPCS prior to that firm's merger with T-Mobile USA. Ultimately, Sprint won't do anything in the near term that could interfere with progress on its own network initiatives. Sprint has also said that it would like to see how Clearwire's LTE network upgrade progresses before making a decision on the firm.
Despite the economic headwinds in Europe, carriers there also continue to push forward with network enhancements. On Dec. 6, Deutsche Telekom (DTEGY) announced plans to spend EUR 4 billion over the next three years to speed up deployment of fiber-to-the-curb (FTTC) and LTE technology. DT has been in a multiyear spat with European regulators, resulting in one of the slowest fiber rollouts in Europe. However, Neelie Kroes, the European telecom commissioner, has stated the need to produce durable regulatory guidance after previously commenting that the EU would allow much greater flexibility on the pricing of wholesale fiber sales. With these pronouncements, DT is ready to build FTTC to cover 65% of the German population once the regulations are formally approved. In the past three years, particularly since Liberty Global (LBTYA) acquired UnityMedia, cable operators have pressed their network advantage to gain broadband customers. An easing regulatory burden is a big positive for DT as it combats these rivals.
DT has joined another trend seen across Europe: In order to help pay for the additional network spending, the firm followed fellow European incumbents Telefonica (TEF), Telecom Italia (TI), France Telecom, and KPN (KKPNY) in reducing its dividend, cutting it to EUR 0.50 per share for 2013 and 2014 from EUR 0.70 per share.
Elsewhere, France Telecom announced plans to deploy LTE technology more quickly in an attempt to distinguish its network, especially relative to new entrant Iliad. FT's roaming agreement with Iliad doesn't include LTE service, and FT's management has stated it doesn't plan to add it. FT originally stated the same thing regarding 3G roaming; we suspect the French government, which still owns 26.7% of FT, pressured the firm to sign a deal. In our opinion, the political climate has since changed. With a new French president that is more concerned with layoffs, which the other French telecom operators have announced recently, we don't expect much government pressure to sign another deal. We believe the government wants Iliad to increase its own capital expenditures, which will add jobs and also hinder its ability to offer exceptionally low prices.
After adding stakes in KPN and Telekom Austria during the second quarter, America Movil (AMX) now says it has no imminent plans to further increase its European exposure. Instead, the firm will turn its focus back to Latin America. In Brazil, changes in the regulatory framework have definitely bled into the competitive landscape, as carriers have been a bit less aggressive with their SIM card promotional offerings of late. That's good news as margins have been declining across the board. Mobile termination rate cuts, a choppy economic backdrop, and aggressive promotional activity have all conspired to weaken the industry's profitability. We believe, however, that margins should turn around in 2013 as firms restructure their commission frameworks and realize cost savings from their respective mergers.
In Mexico, competition is definitely heating up as marketing expenses have been on the rise thanks to greater subsidies on smartphones. Through the first nine months of the year, America Movil's EBITDA margin in Mexico was down 320 basis points year over year (to 45.6%). The near-term prospects don't look much better, with NII Holdings recently making its long-awaited 3G launch, and Iusacell now receiving cash injections from its new deep-pocketed parent Televisa (TV). Thankfully, America Movil's scale economies allow it to hold its margins stable amid a turbulent operational backdrop.
Semiconductors
The semiconductor market has continued to slow in the past couple of months, as softening macroeconomic conditions have damped global chip demand. The weakness has been fairly broad and includes the industrial, automotive, and consumer segments, though chipmakers exposed to the PC market have had to endure a particularly tough business environment.
Semiconductor behemoth Intel is one of the chipmakers that has been affected by the PC slowdown, which we believe is partly secular and partly cyclical. While PC sales in developed countries are being pressured by the popularity of tablets, the situation in emerging markets appears to have more to do with uncertain economic conditions. Over the long term, we think that PC chipmakers can still see some growth, as PC demand recovers in emerging countries (such as China), though overall PC unit growth in the future will certainly fall short of historical rates. As for Intel, we believe the firm has growth opportunities outside of its core PC microprocessor business, particularly in server processors. The firm also continues to make headway on smartphone and tablet processor opportunities.
The one bright spot in the semiconductor space continues to be in smartphones. Qualcomm (QCOM), the leading wireless chipmaker and licensor of key 3G and 4G technologies, has been a major beneficiary of the smartphone phenomenon. Not only does the firm have a number of marquee chip design wins, such as in Apple's iPhone 5, but the shift to more advanced wireless technologies, such as 4G LTE, is enabling Qualcomm to collect higher average selling prices per chip. ARM Holdings , Broadcom , and Skyworks Solutions (SWKS) all appear poised to profit handsomely from the secular shift toward smartphones and tablets, which require additional chip content per device than basic flip phones, in the years ahead.
Internet
In the Internet sector, we believe that headline risk around regulatory issues should be ignored in favor of larger, more fundamental trends toward increased programmatic buying and selling of digital advertising.
As advertising spending continues to move toward where users are, our optimism around growth in digital advertising remains steadfast. In our view, we still believe that Facebook (FB) and Google (GOOG) are two giants that will continue to help advertisers target their audience, and we believe the maturity of the Google platform may be underappreciated. Google has continued to integrate its advertising technology assets into its DoubleClick product, allowing buyers and sellers to purchase multiple ad formats, prices, and channels (including mobile and desktop) with a simplified process. In order to replicate Google's path, we would expect Facebook to acquire technology capabilities to eventually become a broader clearinghouse for advertising. While we believe Facebook's recent stock price appreciation has been driven by advertising success within the Facebook walled garden, our long-term thesis depends on its ability to catch up to Google's mature advertising platform, offering advertisers an alternative way to reach their audience.
On the mobile front, we believe investors are overly focused on the smartphone wars without understanding the key assets that companies need to hold onto their competitive advantages. Google's relaunch of Google Maps for Apple's iOS platform is a great reminder that Google will be successful wherever users access its applications, and that squashing Apple is not in its best interests, at least over the near term. We also look to Yahoo to invest more heavily in core products such as Flickr and Yahoo Fantasy Sports in an attempt to drive greater adoption on smartphones and tablets. Although some of these investments in mobile applications may not immediately drive massive revenue growth, we are more optimistic about the longer-dated revenue opportunities and the protection of these firms' economic moats.
Software
In the world of enterprise software, we continue to like Oracle (ORCL), even in the face of the potential threats of software-as-a-service (SaaS) companies in the applications segment and of in-memory databases from competitors such as SAP (SAP) in the database segment. Currently, our investment thesis for Oracle depends on its ability to hold onto its customer base while continuing to flex its muscle and protect its pricing and operating margins. While we expect revenues to grow at a modest low- to mid-single CAGR over a longer-time frame, we expect the market to continue to focus on companies such as SAP and Workday (WDAY) that it believes are disrupting Oracle's moat. We believe these fears are overstated, and we continue to rate Oracle's moat as wide with a stable moat trend.
Microsoft's launches of Windows 8, Surface tablet, and Windows phone are the headline catalysts this year. Windows 8 incorporates a significant change in the user interface for desktop users and is also the foundation of a combined operating system for PCs, tablets, and mobile phones. On the PC side, we expect little immediate uplift as enterprises have become more deliberate about staging new software investments than in past upgrade cycles. We are focused on the early results of Windows 8, Microsoft Surface tablets, and Windows phone sales. We believe the recent success of Android phones and Apple's iOS phones and tablets represent a clear threat to Microsoft's Windows franchise. We are cautiously optimistic that the company can establish beachheads in the mobile and tablet segments, which should help slow the recent decline in Windows market share.
Hardware
Despite a global macroeconomic malaise, the smartphone and tablet industries continue to thrive, and Apple and Samsung remain at the head of the pack, gaining share from struggling competitors like RIM (RIMM), Nokia (NOK), and HTC. Apple's stellar integration of hardware, software, and services into easy-to-use devices has driven the firm's strong revenue growth and profitability in recent years. As long as Apple can continue to build upon its success (and we see little evidence to the contrary thus far), we think the company will remain a leader in the premium smartphone market for years to come.
Meanwhile, Samsung took advantage of a window of opportunity between iPhone refresh cycles, delivering strong sales of its Galaxy S III smartphone in the summer of 2012 that incorporated 4G LTE compatibility and larger screen sizes than the smaller, 3G-only iPhone 4S. Apple’s larger 4G iPhone 5 is back on par with Samsung in terms of technical specifications, and we're interested to see what Samsung can do for an encore in 2013 with its next generation of smartphones.
Meanwhile, both Nokia and RIM are making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apple's iOS and Google's Android. Nokia's Windows-based Lumia phones show some promise, but given Nokia's former dominance in the handset industry, the company will have to sell tens of millions of devices in the coming months in order to bring its struggling smartphone business back to profitability.
RIM will arrive late to the smartphone operating system party, as its long-anticipated Blackberry 10 o/s will be launched in January with devices to be sold in the first quarter of 2013, thus missing out on the 2012 holiday season, where so many other hardware vendors are focused. However, RIM's loyal subscriber base in certain countries and with certain enterprise customers could allow the firm to see some decent BB10 acceptance. We remain skeptical that either Nokia or RIM will set the smartphone world on fire in the coming months, and their stocks are currently valued as such. Thus, either company could see a nice bounce-back if near-term smartphone sales deliver better-than-expected results.
IT Services
The fourth quarter is typically a mixed bag for IT services firms, as they have to work with numerous holidays and year-end furloughs. In the past, service providers were able to more than offset this with budget flush as companies rushed to spend unspent budget dollars by the end of the calendar year. In recent years, budget flush has been quieter, and so far all signs point to a continuation of this trend in 2012. Additionally, quite a few companies made cautious statements warning that Hurricane Sandy has made things slightly more difficult during the quarter.
At a higher level, we would characterize the current demand environment as choppy with some sectors/geographies showing signs of growth and others showing signs of near-term weakness. Rebound in demand from the banking, financial services and insurance (BFSI) vertical is a positive development as BFSI remains the major vertical for most offshore IT service providers. On the other hand, IT spending by health-care institutions has slowed in recent quarters, and recent bookings indicate that the demand will likely remain anemic in the near term. Despite its recent struggles, Europe continues to be a bright spot for offshore IT service providers, and growth here was mainly driven by increased adoption of outsourcing by European companies. On the contrary, the U.S, despite economic improvements, continues to be cautious on IT services spending.
On the margin front, we don't expect to see any major divergence from historical ranges. With demand remaining relatively light, we think wage inflation and employee attrition will be a non-factor in the near term. Additionally, employee utilization rates continue to remain at the low end of the historical range for most of the companies, offering some cushion if demand were to unexpectedly spike. Variations in the exchange rate of the Indian rupee against the U.S dollar, British pound, and euro also impact margins. However, companies use currency hedges to nullify the effect. Rupee depreciation positively impacts operating margins (a 1% downward move leads to a 30-40 bps expansion in margins) for the offshore IT service providers. However, since most of the service providers hedge against exchange-rate movements, any benefits from rupee depreciation at the operating income level will be largely offset by hedging losses reported in other income.
Our Top Tech and 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 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 |  | $17.00 | Wide | Medium | 0.66 |
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| Oracle |  | $39.00 | Wide | Medium | 0.84 |
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| Apple | | $770.00 | Narrow | Medium | 0.69 |
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| Check Point | | $61.00 | Narrow | Medium | 0.77 |
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| Intel | | $27.00 | Wide | Medium | 0.77 |
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| Data as of 12-18-12. |
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 its 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 the firm to drive additional software sales over time and further strengthen its wide economic moat.
Apple (AAPL)
Although Apple's current market price implies maturity, we expect continued growth. Smartphones still account for less than 40% of total handset shipments, and we expect this penetration rate to continue to grow. Additionally, Apple still retains a dominant position in the tablet market, which should grow quickly over the next several years. Apple's success in tablets and smartphones has helped the firm drive strong sales of its Macs, even as the overall PC market shrinks. As Apple sells more devices to its customers, it can increase customer switching costs around its software and services.
Check Point (CHKP)
Check Point is a leading provider of network security solutions. The network firewall market is a slow-growth area, but we expect the company's appliance strategy and software blade architecture will enable it to grow faster than the core firewall market. High switching costs and risks make Check Point's network security solutions very sticky, enabling the firm to deliver high operating profitability. Although upstarts like Palo Alto Networks pose a legitimate threat, we expect Check Point's market price to rise toward fair value as investors realize that the firm's competitive advantages are intact.
Intel (INTC)
Concerns over the demise of the PC are exaggerated, in our view. Regardless, Intel still has a strong growth driver in its server microprocessor business, where the firm is dominant, and has opportunities to break into smartphones and tablets with its low-power Atom chips. With a 4.4% dividend yield, rock-solid balance sheet and one of the most durable competitive advantages in the technology sector, we think Intel's stock is attractive.
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