Technology: Most Bellwethers Are Overvalued

• We view the tech sector as overvalued at a market cap-weighted price/fair value of 1.08.
• We see a tectonic shift toward enterprise cloud computing.
• M&A abounds.

Overall, we view the technology sector as overvalued at a market cap-weighted price/fair value of 1.08 as of the end of November versus 1.09 at the end of August and 1.13 at the end of May.

As of mid-December, the Nasdaq Composite has risen about 7% from mid-September and is up about 28% year to date.

Although we think iPhone unit sales (split this year among the iPhone 8 series and the high-end iPhone X) will be relatively flat versus the holiday season a year ago, higher prices associated with the iPhone X should drive nice revenue growth for Apple. Technological advancements in the iPhone have lifted the semiconductor space and companies such as

), and

Semiconductor business conditions have remained strong in recent months, with robust demand from the automotive and industrial sectors in addition to demand from Apple. Enterprise software and IT services are interesting growth sectors to us, and we see a handful of undervalued names there.

Tech bellwethers Apple,

In general, we believe valuations across tech are painting overly rosy scenarios for new and emerging technologies around artificial intelligence.

In our view, the single most important trend in technology is the shift toward cloud computing, which we think has ramifications for dozens of stocks across our coverage. Both startups and enterprises, in an effort to reduce the high fixed costs associated with running on-premises IT hardware and software, are shifting more of their workloads to infrastructure-as-a-service vendors such as

IaaS vendors, along with software-as-a-service vendors, are seeing tremendous growth, while legacy IT vendors face headwinds.

Another trend in technology remains mergers and acquisitions, with Broadcom making an industry-altering attempt to buy

Enterprise software has always been an area where vendors pair up to offer more-robust services to their customers.

Across our coverage universe, we still see some value in SaaS providers such as

Yet future operating leverage in these business models is still being discounted, as companies are forsaking profits today in order to spend on customer acquisition in a land grab. As we look beyond the next one to two years, future spending by SaaS leaders should be for customer retention, which is far less costly than customer acquisition. We foresee many SaaS vendors benefiting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.

On the other hand, semiconductor equipment makers are some of the most overvalued names in the tech sector. Business conditions have been terrific in recent quarters, predominantly as memory chipmakers expand capacity and leading foundries invest in new manufacturing technologies such as extreme ultraviolet lithography. However, we don't expect these good times to last forever, and we view leaders in the sector such as

), and

Top Picks

Synaptics

SYNA

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $64.00

Fair Value Uncertainty: Very High

5-Star Price: $32.00

This leading-edge smartphone component provider's touch, display, and fingerprint solutions are ubiquitous across premium mobile devices, including the Apple iPhone and Samsung Galaxy. We expect greater adoption of organic light-emitting diode displays, integration of touch and display, and fingerprint sensors to drive average revenue growth in the midsingle digits for Synaptics.

Integrating touch and display functions is the surest path to technological relevance for Synaptics, in our opinion. The company is considered the market leader in touch and display driver integration but is not expected to reap material financial benefits from the technology until 2018 and beyond. Advantages of TDDI include a simplified design process with manufacturing, cost, and supply chain benefits in addition to a slimmer form factor with better display and battery performance. The OLED variant of TDDI is expected to be available in 2018, and we believe Synaptics remains the leader in this technology.

However, major customers such as Apple and Samsung have sought to develop their own internal solutions to replace those provided by the likes of Synaptics. Given this, the recent deceleration in smartphone growth, and the cutthroat nature of the smartphone component supply chain, we assign no-moat Synaptics a very high uncertainty rating. With the shares trading at around a 35% discount to our $64 fair value estimate, we believe the current risk/reward balance favors investors with a long-term horizon.

Guidewire Software

GWRE

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $95.00

Fair Value Uncertainty: Medium

5-Star Price: $66.50

Guidewire's recent investments to improve its positioning as a cloud vendor solidify our belief that the company will continue to win substantial share in the property and casualty insurance software market. We believe Guidewire's holistic platform and proven excellence at the top of the insurance market, coupled with the mission-critical nature of its core application offerings, yield a wide economic moat.

While these solutions have been primarily deployed on premises historically, the company's latest release of InsuranceSuite is fully standardized on Amazon Web Services, and Guidewire recently struck a partnership with Salesforce to integrate its applications with Salesforce's best-of-breed customer relationship management platform. These moves should provide further inroads into the Tier 1 and 2 insurance market, where we believe the bulk of addressable market opportunity resides. We believe Guidewire can easily consume upward of 30% share in this market over the next 10 years, yielding more than $1.5 billion in annual software revenue by the end of our explicit forecast period.

Criteo

CRTO

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $35.00

Fair Value Uncertainty: Very High

Consider Buying: $17.50

Criteo, one of the leading ad-tech companies in the growing digital ad market, is currently trading well below our fair value estimate, creating an attractive buying opportunity, in our view.

While significant changes in the retail industry, possible increasing competition from the two dominating firms in digital advertising, and various data-tracking changes brought about by companies such as Apple have increased the risks faced by Criteo, we believe they are more than priced in to the stock.

In our view, given the disruption in the overall retail environment, the firm is taking the right steps in investing in new product development to attract more retail ad and marketing dollars. Criteo is now further integrating its Criteo engine with its clients' CRM systems to gather more consumer purchasing behavior data. Such data can be utilized for more timely and higher-yielding online retargeting and multi-channel marketing campaigns.

We also think Criteo is well aware of possible threats from its friends/enemies Google and Facebook, which is why it continues to invest in new offerings and in expanding its services into new geographic regions. Also, we have taken such competition from the two behemoths into account as we continue to give Criteo a negative moat trend rating.

Quarter-End Insights

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