Tech, Telecom, and Media: Long-Term Opportunities Amid Software's Storm

• The tech sector looks modestly undervalued to us at a price/fair value estimate ratio of 0.92, but we’d be selective across investment ideas.
• We see long-term opportunities as we sift through software's storm
• We still see the programmatic advertising wave surging.
• Even with the evolution of the television bundle, there's still plenty of profit in couch potatoes for wide-moat media firms.
• Telecom merger rumors continue to swirl in Europe, but don't get excited.

The S&P 500 is down slightly to date, but it has been a rocky ride for the index, down as much as 11.4% in the first month and a half of the New Year before recovering a bit. In line with the broader market, technology stocks faced a sharp sell-off, and margins of safety began to arise within several sub-sectors of tech, only to almost fully recover. As of mid-March 2016, we view the tech sector as modestly undervalued at a price/fair value estimate ratio of 0.92.

Despite some choppiness across the global macroeconomic landscape, many management teams have remained upbeat and relatively optimistic about their operations and opportunities heading into 2016. Many large tech firms are struggling to reinvent themselves and drive organic growth from new avenues (funded through existing cash flow), while other fast-growing niche players are hoping to disrupt the hierarchy by taking advantage of adoption in analytics, cloud, and engagement (social-media advertising).

Companies leveraged to a single product, like Tableau (DATA), have crashed, but those with broad product and customer exposure have held up quite well. Firms with exposure to the smartphone market have faced some tough times, as Apple (AAPL) iPhone demand has not lived up to prior expectations, but many companies are anticipating a nice bounceback in the sector later this year. Finally, persistent foreign exchange headwinds may result in another year of challenging growth and profitability at some firms; however, the underlying tech spend is still projected to grow. In aggregate, we view the tech sector as modestly undervalued, and we would remain selective in our picks.

We See Long-Term Opportunities as We Sift Through Software's Storm
Software shares have taken a beating this quarter, catalyzed by subpar earnings from a number of high-flying stocks, most notably Tableau and ServiceNow (NOW). Although these stocks have suffered the steepest declines, we believe several high-quality names have been thrown out with the bathwater as well, creating investment opportunities. In particular, wide-moat software names Adobe (ADBE) and Guidewire (GWRE) are trading at meaningful discounts to our respective fair value estimates. Although we expect volatility to persist in the near term, we believe these names look attractive.

In our view, Adobe's successful transition to the cloud and subsequent investment in its marketing cloud platform will yield significant growth opportunities in markets where we believe the firm holds a competitive advantage. Guidewire has become the premier vendor for legacy software replacements among property and casualty insurers, having inked deals with nearly half of the world's largest insurance companies. Guidewire's solutions are mission-critical to the policy life cycle, and the firm has the ability to increase lifetime customer value through cross-selling to additional business lines and upselling add-on applications.

We Still See the Programmatic Advertising Wave Surging
As we highlighted last quarter, we still think that investors should pay attention to a massive shift in the digital advertising industry toward programmatic advertising (the automated buying and selling of advertising inventory), a trend that we believe highlights the distinct competitive advantages of Alphabet (GOOGL) and Facebook (FB), while underscoring the wasting assets at traditional web media properties such as Yahoo (YHOO). This algorithmic placing of ads represents nearly half of the $30 billion display market in the United States.

These new technologies are detrimental to companies such as Yahoo because marketers now have the ability to target audiences in a more precise, identifiable, and efficient way across multiple web properties. Quite simply, technology has leveled the playing field by providing marketers with reach, obviating the value of Yahoo's generic traffic, where little is known about the users. In our view, the rich customer data that Google and Facebook possess is even more valuable in a programmatic world, particularly as these companies seem to be operating walled gardens. We also believe that wide-moat firms such as Oracle (ORCL), Salesforce (CRM), and Adobe are selling rich marketing technology products that will help marketers maximize their data assets and adapt to a world where they are marketing across multiple devices and multiple channels. These products will have switching costs similar to their broader software offerings, in our view.

The Evolution of the Television Bundle: There's Still Plenty of Profit in Couch Potatoes for Wide-Moat Media Firms
The television ecosystem is constantly evolving, and the traditional bundle model has come under pressure recently, but we believe investors have over-reacted to fears that a sudden shift in consumer behavior is about to occur. In our view, the changes taking place today are a continuation of the fragmentation that has been occurring over the past several decades. Penetration of traditional television service has steadily eroded, following a peak somewhere around the end of the past decade. Perhaps counterintuitively, the industry's growth accelerated sharply during the worst of the financial crisis and has steadily deteriorated since. We ascribe this blip to the limited video alternatives available at the time, aggressive price promotion among several providers aiming to protect their customer bases (especially the phone and satellite companies), and the fact that television service is inexpensive relative to other forms of entertainment.

But the market is different today than it was just a few years ago. We find that younger age cohorts are driving the majority of the decline in traditional television penetration. Younger consumers are increasingly viewing traditional content in nontraditional ways, but we still believe younger consumers simply don't value the traditional television bundle as much as prior generations have.

Looking ahead, the key question is how the media industry can evolve to combat the challenges currently facing the traditional television business. We expect consumer purchase decisions will fragment into network choices, where cable companies such as Comcast (CMCSA) are positioned to dominate content selection. We also believe content owners should work aggressively to accelerate this shift, encouraging new entrants to innovate the manner in which consumers interact with content and compete away excess profits that exist in the content distribution business today to make content more affordable to consumers. In so doing, we see a clear path to maintaining and enhancing the broad appeal that the traditional bundle has enjoyed for most of the past couple of decades.

As new firms continue to come into the television market, we expect that video on demand and subscription video on demand will steadily grow in importance as these entrants innovate around television distribution. We have introduced a new four-pillar framework through which we evaluate each company’s positioning amid the changing media landscape. The four criteria are: known brands and studios; access to a strong library of content; lower dependence on traditional advertising; and higher international exposure.

We prefer media firms with strong production studios in both film and television, along with a deep content library. As the bundle evolves, we expect the most-watched networks to survive and even flourish. Their content and sports rights provide a leg up in discovery, as consumers already watch and monitor their channels.

In addition, we are looking for companies with lower exposure to one of the traditional sources of revenue: advertising. We expect that new television platforms will prioritize the customer experience over ad loads, putting pressure on traditional ad revenue. Also, advertisers are steadily shifting budgets to digital formats that are more easily measured.

Finally, strong companies should have exposure to the faster-growing international markets where high-quality Internet access is less pervasive, providing a longer runway for traditional distribution models.

We believe five companies--Comcast, Walt Disney (DIS), CBS (CBS), Twenty-First Century Fox (FOXA), and Time Warner (TWX)--have the networks necessary to remain in any relevant bundle. From a content production and library standpoint, Disney, Fox, Time Warner, and Comcast are best situated to anticipate and react to potential outcomes from the transition away from traditional distribution channels. Three companies pass all four pillars of our wide-moat framework for media firms: Walt Disney, Time Warner, and Twenty-First Century Fox. These firms stand out as possessing both a wide moat and the ability to sustain their moats in the face of the ongoing changes across the pay-television landscape. We believe the investor reaction to fears surrounding the pay-television business has created an opportunity to buy all three at attractive prices.

Telecom Merger Rumors Continue to Swirl in Europe, but Don't Get Excited
Telecom merger rumors continue to swirl in Europe, but we don’t place much credence in many of them. Vivendi (VIVHY) has slowly built up a 24.9% stake in Telecom Italia (TI), which we continue to think is strange after it just went through the process of selling its telecom assets. We believe it will hold at this level as Italian law requires an offer for the entire firm if a company acquires more than 25% of another company. Rumors have been flying that Vivendi wants to arrange a merger of Orange (ORAN) and Telecom Italia, but we don't see this happening, in line with comments from Telecom Italia's management.

However, Orange has entered talks to acquire Bouygues (EN). Orange believes such a deal would be reviewed by the French telecom regulator rather than by EU regulators because of both companies having greater than two thirds of their European revenue in France. If it is reviewed in France it might get through, as the French government is concerned about unemployment. Bouygues and Numericable-SFR (NUM) have both laid off lots of employees since Iliad entered the market in 2012, and such a merger would likely bring more stability to the sector as well as employment. However, if the deal goes to the EU, we continue to believe it doesn't have a chance. We expect the rumor mill to continue to churn, but we’d encourage investors to maintain an eye on underlying fundamentals and not get caught up in market speculation.

We are moving into crunch time on the EU regulator's ruling for the proposed acquisition of Telefonica (TEF)'s O2 division in the United Kingdom by CK Hutchison Holdings's (00001) 3 U.K. unit, which is expected in the second half of April. A decision on its Italian unit's proposed merger with VimpelCom (VIP)'s Wind unit is still several months away. Until those rulings are out, we don't expect any more in-country merger proposals.

Although we expect more rumors between now and then, we believe the likelihood of any official merger announcements in Europe before then to be quite low. In general, 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.

Walt Disney (DIS)
Although Disney is a media conglomerate, we view the company as two distinct yet complementary businesses: media networks, which include ESPN and ABC, and Disney-branded businesses, including parks, filmed entertainment, and consumer products. The crown jewel of Disney's media networks segment is ESPN. It dominates domestic sports television with its 24-hour programming and profits from the highest affiliate fees per subscriber of any cable channel. The Disney Channel also benefits from attractive economics, as its programming consists of internally generated hits with Disney's vast library of feature films and animated characters. We expect the unique content on ESPN and Disney Channel will provide the firm with a softer landing than its peers as viewing transfers to an over-the-top (OTT) world over the next decade.

Viacom (VIAB)
Viacom holds a valuable portfolio of cable networks with worldwide carriage, a large production studio, and a deep content library. In our view, two of the company’s networks, Nickelodeon and MTV, particularly benefit from strong brands. Despite increased competition, we think Nickelodeon will continue to thrive as a major player in the children's TV segment, given its scale and reputation. MTV also faces more competition than ever from other entertainment options for teenagers and young adults, including social media, short-form Internet videos, and OTT streaming. However, MTV still enjoys a positive worldwide brand with teens and young adults.

Discovery Communications (DISCA)
Discovery Communications produces and owns unique content with proven appeal to audiences across cultures and languages. This transnational appeal provides the company with the ability to repurpose the content across multiple platforms and international borders. Discovery is leveraged to benefit from increased pay-TV penetration internationally as it already generates 50% of its revenue and 45% of its EBITDA outside the U.S.

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