Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud

• Foreign exchange headwinds persist and are likely to have an impact in 2016, but we haven't seen it affect the tech spending environment all that much. The sector looks 3% undervalued, and we'd be selective.
• We think a near-term cyclical peak in analog semiconductors has arrived, and downturns tend to provide long-term, patient investors with buying opportunities.
• Cloud remains in focus and the market is growing, but not all players will benefit equally; improving sales and marketing efficiency will drive significant operating leverage at many software-as-a-service firms.
• A new European Union antitrust chief is taking a harder stance as consolidation slows.

The S&P 500 is in negative territory for the year following the late August sell-off, and we expect additional volatility in the remaining three months. Performance for the technology sector in aggregate has been stronger, but there are notable areas of strength and weakness.

Global currency movements over the past three quarters have resulted in slightly elevated volatility across both the technology and communications-services sectors, but the overall tone from management teams has remained modestly positive in terms of the macro environment. Still, with hedges rolling off and foreign exchange headwinds persisting, this may result in another year of challenging growth and profitability at some firms. In aggregate, we view the tech sector as slightly undervalued and remain selective in our picks.

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 in some form or another, a factor that investors will want to keep a close eye on because we don't explicitly offer currency forecasts, although they are baked into our uncertainty ratings. 

Taking a step back, although these three subsectors (technology, media, and telecom) are trading just below their respective fair values, we would still seek a wider margin of safety in many 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.

Don't Fear the Fast-Paced Chip Space: Analog Moats Are Relatively Safe
Although the broader semiconductor industry is characterized by rapid technological change and swift movements in market share on the digital side, we find relative safety and sustainable competitive advantages in analog that make this $46 billion-plus segment of the chip industry downright sleepy by comparison. 

Valuations have been stretched for many analog names for quite some time, but recent market concerns about Greece and China have pulled most of our list back into 3-star territory. We think a near-term cyclical peak has arrived, and downturns tend to provide long-term, patient investors with buying opportunities.

First, leading analog chipmakers have valuable intangible assets associated with proprietary designs that span multiple decades. Second, as analog semiconductors often make up a tiny portion of a product's bill of material, and design wins are based on performance rather than price, analog firms are able to prosper from long product lives and high customer switching costs. Third, because analog semiconductors are required to handle real-world signals that digital parts (with their series of 0's and 1's) simply can't process, we see no imminent substitutes for analog chips on the horizon. Finally, in analog, we find a fragmented marketplace where several firms can earn outsize economic profits over the course of the cycle.

In recent years, analog chipmakers have profited from favorable business conditions in the end markets they serve, such as industrial growth as global GDP recovered from the aftermath of the credit crisis, as well as telecom infrastructure associated with the smartphone boom. Yet the strongest growth driver for firms under our coverage over the past few years has been the automotive space, and we expect the good times to continue. In fact, we are even more bullish than general consensus on the automotive chip opportunity, as we think the automotive sector represents a sizable tailwind that can drive normalized top-line growth in excess of 10% from automotive customers for the next several years.

March to Cloud Continues While We Monitor Underlying Mix Shift
As in past quarters, enterprise adoption of cloud-based products will be top of mind for both legacy and cloud software providers. In particular, we expect revenue growth for companies with pure-play cloud exposure to slow, and any perceived shortfall in results or outlook is likely to cause a sell-off in the underlying stock, in our view. However, cloud is the right strategic position to be in and while many of these names trade close to our fair value estimates, we highlight several names that we would look to in a sell-off, including  Salesforce (CRM),  Workday (WDAY),  Blackbaud (BLKB), and  Ultimate Software . In our view, the moats and underlying businesses for these companies are high quality, but there is meaningful uncertainty about the long-term growth opportunity (and trajectory) for many of these firms as legacy competitors inevitably respond. 

As the revenue mix for legacy software providers begins to tilt more heavily toward cloud offerings, we expect segment results to provide a greater degree of comparison. Today, it's somewhat opaque, and disclosures aren't like-for-like across companies. In general, for providers with strong competitive positioning (for example,  Oracle (ORCL) and  Microsoft (MSFT)), we expect strong double-digit growth in cloud and deferred revenue. Any near-term weakness in the cloud segments should be buttressed by performance in on-premises revenue (looking at a combination of maintenance and new license streams). However, legacy tech firms are not equals, as reflected in our economic moat and trend ratings. While many of these players have growing cloud exposure, they are entering into a new area of the market while likely cannibalizing their core/foundational/legacy businesses over the medium to long term.

U.S. Telecom Sees Mixed Results on Regulatory Front, but Consolidation Is Still a Key Theme
 AT&T (T) closed its acquisition of DirecTV in July, ironically agreeing to upgrade its fixed-line networks serving 12.5 million homes to win regulatory approval. We believe AT&T’s upgrade will add only modest incremental competitive pressure for the nation's cable companies--it will touch only about 10% of the country--and that cable will remain the strongest network available to the majority of consumers.
What's more, AT&T picks up DirecTV as concerns surrounding the traditional pay-television business--DirecTV's sole operation--have mounted. While we've long taken a negative view of the traditional linear television business, the fact that the number of pay-television subscriptions nationwide has started to shrink for the first time in 2015 seems to have caught many off guard. We believe this decline will accelerate over the coming years, shifting the competitive balance even more in favor of cable companies, which can provide high-quality Internet access at relatively low cost. 

Charter's (CHTR) planned acquisition of  Time Warner Cable  has gained support in recent months, with  Netflix (NFLX)--a major opponent of  Comcast's (CMCSA) failed attempt to buy TWC--praising the deal. We expect Charter's attempt to buy TWC to be successful, creating a cable company with scale to near rival Comcast. We suspect the Federal Communications Commission would love to see Comcast and Charter/TWC eventually acquire or build their way into the wireless industry. Such a move could create two additional financially solid, diversified telecom operators to challenge  Verizon (VZ) and AT&T nationally.

The financial performance of  Sprint and  T-Mobile (TMUS) continues to cast doubt on their long-term ability to compete. Sprint, in particular, faces a dire near-term situation as it burns cash at an alarming rate while trailing Verizon, AT&T, and T-Mobile on nearly every measure of customer retention, growth, and network quality. Sprint management has been hinting for some time at a new network strategy and corporate reorganization, with Softbank, which owns about 80% of the carrier, committing to secure additional financing. At this point, we view Sprint as a highly speculative investment, as each passing quarter places minority shareholders increasingly at Softbank’s mercy. If Sprint fails to improve its standing with customers, we wouldn't be surprised to see Softbank walk away, likely leaving the firm to restructure via bankruptcy, a move that would make it a far more attractive acquisition target for one of the cable guys. 

EU Competition Commissioner Continues to Take Hard Stance in Telecom
As we discussed last quarter, one of our concerns regarding continued mergers and acquisitions in European telecom was Margrethe Vestager, the new European Union competition commissioner. She followed up her rhetoric from March with tough negotiations with  Telenor (TELNY) and  TeliaSonera (TLSN) regarding their proposal to merge their respective Danish operations into a joint venture. On Sept. 11, the two firms called off the merger because of their inability to reach a settlement with the regulators that would still bring the benefits of a merger. 

We had expected this deal to be approved as Denmark has a small population. Where we had anticipated trouble was in the large countries of the United Kingdom and Italy. In the U.K., 3 U.K., part of CK Hutchison, has agreed to acquire O2 U.K. from  Telefonica (TEF). While in Italy, 3 Italia, another division of CK Hutchison, has agreed to merge with  VimpelCom's (VIP) Wind subsidiary. We think the likelihood of these deals going through is now even lower than before. However, Telefonica needs the cash to reduce its overleveraged balance sheet, so it may agree to more stringent terms in order to receive approval. In order to fund such concessions, it may have to accept a lower price than was originally agreed. At a minimum, we expect greater concessions to be accepted by the firms than were required for previous mergers that consolidated wireless operators in a country from four to three. 

One of the drivers of European M&A remains the overarching movement to converged services of fixed-line telecom, broadband, and pay television with wireless telephony. We still believe convergence will be a major theme going forward and will enable the lead operators to increase margins and free cash flow. In general, however, anticipation surrounding global mergers and acquisitions across the telecom industry 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 Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Twenty-First Century Fox		$38.00	Wide	Medium	$26.60
Time Warner		$99.00	Wide	Medium	$69.30
Grupo Televisa SAB		$40.00	Wide	Medium	$28.00
Data as of 09-24-2015

 Twenty-First Century Fox
Twenty-First Century Fox is a media conglomerate with a wide range of assets: a film studio, which creates television programs and movies; broadcast television, including the Fox broadcast network and local TV stations in the U.S.; cable networks, which comprise over 300 channels around the world; and direct-broadcast satellite TV in the form of SKY, a satellite pay-TV provider in Europe. We acknowledge that the streaming service and skinny bundles will disturb the traditional pay-TV bundle in the near future. However, the timing and magnitude of the disruption remains unclear, and too much pessimism appears baked into the share price at current levels.

 Time Warner
Time Warner is a pure-play entertainment company that owns several television networks, including HBO, CNN, TNT, and the CW. The filmed entertainment segment creates and distributes movies and television programming for both internal and external distribution outlets. Warner Bros. and New Line Cinema combine to form the largest filmmaker in the world. The company owns a deep and valuable content library that includes popular movie franchises such as DC Comics and Harry Potter and television programs such as Friends and The Big Bang Theory. We acknowledge that the streaming service and skinny bundles will disturb the traditional pay-TV bundle in the near future. However, the timing and magnitude of the disruption remains unclear, and too much pessimism appears baked into the share price at current levels.

 Grupo Televisa (TV)
Grupo Televisa is the largest media company in the Spanish-speaking world. Besides operating broadcast channels in Mexico, the company produces pay-television channels whose content reaches subscribers in North America, Asia, Europe, and Latin America. Televisa also owns interests in satellite television, cable TV, terrestrial radio, magazine publishing, Mexican bingo parlors, and three of Mexico's professional soccer teams. We remain focused on the regulatory front, but management appears focused on strengthening its core businesses. The firm continues to seek out balance between growth, investment (margin preservation), and navigating the regulatory environment.

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Basic Materials: U.S. Construction Activity Provides Shelter From the Storm
• Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: Re-Analyzing Banking Systems and Bank Moats
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Industrials: High-Quality Industrials Are on Sale
• Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive
• Utilities: Low Rates Keep the Sector's Lovefest Raging