Tech and Communication Services: Gravitate Toward the Moats

• Mid-October presented an opportunity for tech, but valuations have rebounded and there are only a handful of undervalued, albeit higher-uncertainty, stocks.
• Apple Pay will have a ripple effect and the potential to disrupt the emerging mobile payments market.
• The ongoing wireless spectrum auction has garnered bids in excess of $40 billion, far more than we had expected.

After a brief period in October when valuations across the technology sector corrected by 10%, stocks have rebounded, and the sector is once again slightly overvalued. The recent drop in oil prices and global currency movements have led to a bit more volatility across both the technology and communication services sectors, but there are currently no 5-star technology stocks and only a handful of 4-star names.

Below, we highlight a few companies that appear to be fundamentally undervalued, including one from the telecom sector. Taking a step back, with these two sectors trading at or above fair value, we would prefer a wider margin of safety and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility.

Apple Pay Should Be a Game-Changer

As if the presentation of two hot-selling iPhones and the introduction of Apple Watch were not enough,

First, iOS customers will benefit from Apple Pay by having a native application in their iPhones that is easy to set up and convenient to use, with a solid lineup of merchant partners, all while offering stronger security and privacy than the magnetic stripes on plastic credit cards today. Traditional cards still offer far greater merchant acceptance today, while the incremental convenience of a tap versus a card swipe might be minimal.

Second, merchants may prosper from Apple Pay in the long run by offering quicker payments for fast-service transactions, stronger point-of-sale security, and retaining control over transaction data, all while potentially benefiting from co-branding and enhanced customer engagement. When it launches, Apple Pay will boast an impressive roster of global retail and aggregator partners, including

Third, we think Apple Pay will initially have a modestly positive effect on the global business of payment networks, a modestly negative effect on card issuers, and a neutral effect on merchant acquirers. Partners will benefit from enhanced security features, reducing direct and indirect costs of fraud, and a small amount of incremental transaction volume is likely to shift from cash to electronic payments. However, Apple Pay is now competing for a piece of the existing payment pie and has the potential to muscle in on the network effects, brand value, and economic profits created by participants in the network paradigm. That said, we expect Apple Pay's global user base to exceed 100 million by 2017.

Two of the most common growth subsectors in technology are likely to have an impact on payment systems: cloud computing and mobility. Physical and online merchants have been developing nonpayment mobile applications for Android and iOS, primarily for marketing and loyalty programs. We believe this is training both merchants and consumers to use smartphones and embrace mobile payments, at least eventually.

Key Trends in Telecom

Consolidation, regulatory policy, and technology themes continue to converge in the U.S. telecom industry. The Federal Communications Commission has forcefully taken the position that existing competition needs protection, effectively killing any chance that

At the same time, the debate surrounding the "open Internet," or "net neutrality," continues to take shape, with President Barack Obama recently coming out in support of more strict industry regulation. As these issues are debated, there is a risk that the FCC or the Justice Department puts a hold on consolidation. Ultimately, we don't expect a major change to the competitive positioning of firms within the industry in the near term.

Of particular concern, the ongoing wireless spectrum auction has garnered bids in excess of $40 billion, far more than we had expected. AT&T and Verizon should be able to handle this expense without significantly eroding their financial strength, but we believe generating a return on this investment will prove difficult. We continue to expect Sprint and T-Mobile to struggle to generate acceptable profitability, placing a significant strain on their finances.

Consolidation is occurring in Europe, within countries and across national borders.

), the largest cable operator in France, has acquired SFR, the second-largest phone company in the country. Importantly, European Union regulators approved

's (

) purchase of

German subsidiary E-Plus, and this deal has now closed.

We anticipate additional M&A activity to continue around the world, which has pushed up the prices of many stocks. However, there are still pockets of value across the global telecom space. Most come with baggage, either in the form of lagging sales growth, higher legacy costs, or poor macroeconomic conditions, so we encourage investors to be highly selective.

International Business Machines

IBM

IBM is one of the largest IT companies, with an array of offerings, including system hardware (14% of revenue), infrastructure software (25% of revenue), outsourcing, and systems integration services (60% of revenue when combined). The firm has operations in more than 175 countries and generates about 55% of revenue from abroad. We believe IBM is still in the early stages of a transition period that will last for a few more years. In our view, the ongoing secular shift to cloud-based environments has a very long tail and provides IBM some time to adapt and simplify its strategy in this market (a silver lining of sorts). However, alongside the anticipated medium-term profit growth that we expect to materialize from management's initiatives, we project elevated risk, more uncertainty, and added volatility.

T-Mobile US

TMUS

T-Mobile US, the fourth-largest wireless carrier in the United States, serves 53 million customers, including 26 million postpaid and 16 million prepaid customers. The firm's focus currently is on rapidly deploying LTE network technology to improve the customer experience while also aggressively marketing service plans, dubbed "Uncarrier" offerings, designed to play off of common customer frustrations, such as overage charges and contract termination fees. Despite recent solid performance, T-Mobile shares have sagged recently as a result of regulatory opposition to a proposed merger with Sprint, the nation's third-largest carrier, and fear that the firm has overspent on wireless spectrum at auction. If the firm does wildly overspend on spectrum, we will lower our fair value estimate. Shares today appear fundamentally undervalued, but we don't think T-Mobile benefits from an economic moat, and we reiterate our high uncertainty rating.

Advanced Micro Devices

AMD

Advanced Micro Devices designs and produces microprocessors and low-power processor solutions for the computer, communications, and consumer electronics industries. The majority of the firm's sales are in the computer market. AMD acquired graphics processor and chipset maker ATI in 2006 to improve its positioning in the PC food chain. In 2009, the firm spun out its manufacturing operations to form a foundry joint venture, GlobalFoundries. Although AMD will be facing some lumpiness in the near term and is a no-moat name, we continue to believe that the firm has been making the right strategic moves to diversify into new areas, such as semicustom processors, in order to reduce its dependence on the PC market.

More Quarter-End Insights

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• Economic Outlook: Stop Watching the Fed, Start Following the Consumer
• Credit Market Outlook: Tailwind From Declining Interest Rates Has Likely Run Its Course
• Basic Materials: Iron Prices Swoon on Weaker China--Copper Is Next
• Consumer Cyclical: 4 New Realities for Retailers
• Consumer Defensive: Only a Handful of Values Left
• Energy: Oil Price Collapse Takes Center Stage
• Financial Services: Bargains Still Hard to Find
• Health Care: A Strong Run, but Some Stocks Still Look Undervalued
• Industrials: Macroeconomic Tailwinds Lift Market Valuations
• REITs: Tread Carefully in This Low Interest Rate Environment
• Utilities: Repeating a Stellar 2014 Performance Will Be Tough