Tech and Telecom Sectors: Time to Be Selective
Given the tech sector's higher recent volatility and overvaluation, we're seeking wider margins of safety and established economic moats.
Despite flat stock returns for the S&P 500 through the first quarter, it hasn't been a particularly smooth ride for investors. The technology sector as a whole has lagged the market but there were notable areas of strength and weakness, often hinging on a firm's quarterly execution and management's initial 2015 outlook. The drop in oil prices and global currency movements over the past two quarters have resulted in slightly elevated volatility levels across both the technology and communication services sectors, and today we remain selective. In aggregate, we view the tech sector as slightly overvalued.
In the table below, we highlight a few companies in technology, media, and telecom that appear to be fundamentally undervalued. All three have significant international exposure, so this is a factor that investors will want to keep a close eye on, as we don't explicitly offer currency forecasts, though they are baked into our uncertainty ratings. Taking a step back, with these three sectors trading above their respective fair values, we would prefer a wider margin of safety in most cases. We are quick to gravitate toward firms with established economic moats, those with strategic assets, and those that are well-positioned in key growth areas. We believe firms with this combination should be in a better relative position to withstand near-term revenue and operating margin volatility, while offering long-term free cash flow growth potential.
Advertising on social, mobile, and video platforms will continue to drive the highest revenue growth as the overall online advertising market begins to slow. We expect spending across all three categories to grow more than 30% this year, as mature segments such as desktop-based advertising grow less than 10%. These emerging segments highlight companies that have valuable mobile properties, powerful video platforms, and deep customer datasets, such as Facebook (FB). In particular, applications (such as messaging, social newsfeeds, and mobile video) and developer platforms (such as Google Play (GOOG) and Apple's (AAPL) App Store) can afford companies short-term growth and long-term defensibility.
Over the long run, we still expect search advertising to be the most significant form of digital advertising. In spite of slowing growth, we expect this segment to grow in the low teens for 2015. Furthermore, the Internet search market will capture the largest segment of the digital advertising pie for years to come, in our view. We believe investors are overstating the threat that social, mobile, and video advertising may be having on legacy online business models, particularly Google.
Consolidation, regulatory policy, and technology themes continue to converge in the U.S. telecom industry. The FCC remains active across the industry, recently adopting new regulation and rules with the intention of ensuring an open Internet. These rules, which impose more stringent regulation on Internet access services, are unlikely to radically reshape the economics of the U.S. telecom industry. We caution investors, however, that regulatory risk is nearly always present with the telecom sector given the view among many regulators and politicians that Internet access and phone services constitute essential public goods. In addition, regulators continue to consider the implications of significantly greater media concentration that the proposed acquisitions of DirecTV (DTV) and Time Warner Cable (TWC) would present. We believe there is a risk that the FCC or the Justice Department puts a hold on consolidation.
The conclusion of the AWS-3 wireless spectrum auction also promises to remake the telecom landscape. The auction garnered $45 billion in gross winning bids, far more than we had expected. We believe AT&T's (T) insistence on gaining 20 MHz of new spectrum nationwide and DISH Network's (DISH) desire to acquire significant spectrum while demonstrating the value of its existing spectrum holdings drove bids beyond any reasonable estimate of fair value. Verizon showed more discipline at auction, in our view, but it still bid heavily on a handful of licenses that it deemed strategically important. The net result is that returns on capital across the wireless industry, already mediocre, will suffer. Any escalation of price competition would only make matters worse.
Consolidation is occurring in Europe, within countries and across national borders. Vodafone bought Ono, the largest cable operator in Spain, while Numericable (NUM), the largest cable operator in France, has acquired SFR, the second-largest phone company in the country. EU regulators approved Telefonica Deutschland's (O2D) purchase of KPN's (KPN) German subsidiary E-Plus, and this deal has now closed. Recently announced deals include BT Group (BT) agreeing to acquire EE (the U.K. joint venture of Orange (ORAN) and Deutsche Telekom (DTEGY)) and Three UK coming to terms to buy Telefonica's (TEF) U.K. operations. One potential damper on the European M&A front comes from Margrethe Vestager, Europe's new antitrust chief. We had expected the new European Commission to be more lenient toward mergers, but on March 8 Vestager spoke in favor of low prices and against mergers, which we think puts some of the proposed deals at greater jeopardy of not being allowed.
In general, however, we anticipate global M&A activity across telecom to continue, and this is reflected in higher stock prices in many cases. There are still pockets of value across the global telecom space, but most come with baggage, in the form of lagging sales growth, higher legacy costs, or poor macroeconomic conditions, so we encourage investors to be highly selective.
|Top Tech & Telecom Sector Picks|
| ||Star Rating|| Fair Value |
| Economic |
| Fair Value |
| Consider |
|Oi Sa||$3.20||None||Very High||$1.60|
|Data as of 3-26-2015|
Oi SA (OIBR)
In Brazil, Oi now has nearly 18 million lines in service, making it the largest fixed-line provider in Brazil. Its wireless operation, Oi Movel, controls more than 50 million wireless customers and is Brazil's fourth-largest cellular provider, with 18% market share. The firm has roughly 75 million revenue-generating units among its corporate, telephony, broadband, and television subscribers. The 2014 merger with PT adds an extra 27 million RGUs, bringing the total for the combined entity to more than 101 million. The company carries a lot of risk owing to its leverage, but the firm still has a few things going for it. Industry consolidation in whatever form should help all the players, plus data and converged services are beginning to take off and provide significant long-term growth opportunities for Oi.
Millicom is a telephone company that mostly operates in smaller, less congested markets or in less developed countries with lots of opportunities for subscriber and revenue growth. It operates in three regions--Central America, which accounts for about 38% of revenue; South America, which accounts for 46%; and Africa, which accounts for 16%. In Africa it is primarily a wireless-only operator, but increasingly in Latin America it offers a converged package that may include fixed-line telephony, broadband, and pay television services. We think the stock has sold off due to near-term concerns regarding emerging markets, currency risks and the departure of its CEO. In comparison with other European telecom stocks that we cover, Millicom's stock trades at one of the lowest EV/EBITDA multiples (4.7 times 2015 estimate) and with an average yield (3.7%) despite significantly faster (above a 7% five-year CAGR, excluding acquisitions) revenue growth prospects.
Ingram Micro (IM)
Ingram Micro is the largest global IT distributor, with approximately $43 billion in revenue in 2013. It distributes products from about 1,400 suppliers to more than 200,000 customers in 170 countries. Ingram's product revenue comprises IT peripherals (35%), systems (30%), software (12%), networking (12%), and mobility (11%). Ingram also offers value-added services (less than 10% of total revenue) that range from technical support and systems configuration to logistics management and supply-chain management. IT budgets can fluctuate with economic conditions and materially affect sales. We think that this, in part with the underlying shift toward cloud (and the role of the traditional distributor) is driving market uncertainty.
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Peter Wahlstrom has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.