Technology: Data Security and Privacy Remain on the Forefront

• Overall, we view the tech sector as modestly overvalued at a market cap weighted price/fair value of 1.02.
• Enterprise cloud computing remains the most important story in tech.
• Data security and privacy remain at the forefront of technology.
• We still see a hot M&A sector, particularly in semis and software.

Overall, we view the Tech sector as slightly overvalued today at a market cap weighted price/fair value of 1.02 as of May 31, versus 1.05 as of the end of February and 1.08 at the end of November. The Nasdaq index has risen about 4% from mid-March to mid-June and is up about 11% year to date in 2018 as of mid-June.

In our view, the single most important trend in technology remains the ongoing shift toward cloud computing, which we think is having ramifications on dozens of stocks across our coverage. We continue to see several undervalued names with healthy cloud computing exposure, such as  Microsoft (MSFT) and  Salesforce.com (CRM). In short, both startups and enterprises, in efforts to reduce the high fixed costs associated with running on-premises IT hardware and software, are shifting more and more workloads to infrastructure-as-a-service, or IaaS, vendors, such as  Amazon's (AMZN) Web Services, Microsoft Azure and  Google (GOOGL). In turn, IaaS vendors, along with software-as-a-service (SaaS) vendors are seeing tremendous growth while legacy IT vendors face ongoing headwinds. In SaaS,  Adobe (ADBE) and Microsoft have been especially adept at transitioning to the SaaS model, as selling subscription software, rather than charging for upfront licenses, have expanded their customer bases.  Oracle (ORCL), for one, has been relatively slower to pivot, in our view, albeit with some signs of optimism at times.

Perhaps the most newsworthy items in technology over the past few months have been Facebook's privacy, data security, and regulatory struggles. Cambridge Analytica gained access to data on a reported 87 million  Facebook (FB) users, casting a spotlight on the details of data captured, maintained, and shared by the social network, along with how Facebook uses such data to monetize its business. Separately, Europe recently passed its General Data Protection Regulation, which strives to standardize data capture, privacy, and distribution requirements for businesses as well as set guidelines to enable citizens to better understand their rights associated with user data. Finally, as part of the debate around Facebook's user policies,  Apple (AAPL)'s Worldwide Developer Conference highlighted several new features embedded within its Safari browser and iOS operating system that will strive to protect user data, restrict browser tracking, and allow users to set limits to their screen time and interactions in certain applications. While we anticipate that Facebook will weather the storm around increased near-term data scrutiny, and note that the stock has bounced back in recent weeks after a Cambridge-related dip, data security and privacy will continue to be hot topics for debate among several tech titans.

Another ongoing trend within technology remains M&A. In the second quarter, two notable deal announcements were Adobe's bid to enter into commerce by acquiring Magento and Microsoft's $7.5 billion valuation of developer community Github. We anticipate more and more software deals in the years ahead, as leading vendors like Adobe, Microsoft, Salesforce, Oracle,  Workday (WDAY) and others continue to branch out from their core product lines and tack on adjacent opportunities. Similarly, non-traditional software vendors, like  Cisco (CSCO) and Amazon, may make software-related deals as well, as software is becoming a more important portion of their enterprise offerings. We believe that the ability to provide customers with additional software offerings leads to a stickier customer base and raises customer switching costs, which underpins our moat ratings for many software leaders.

We have not seen a sizable merger in the semiconductor space in the past couple of months, but this sector remains a hot one. Recent deals include  Microchip (MCHP)’s bid for Microsemi,  Marvell (MRVL)’s acquisition of  Cavium , and  KLA-Tencor (KLAC)’s deal for  Orbotech . We still anticipate consolidation in the semiconductor industry as larger players seek scale and diversification while still being able to strip out excess costs and drive operating leverage.

Top Picks

 Synaptics (SYNA)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Uncertainty: Very High
Consider Buying: $32.00

Synaptics is a leading-edge smartphone component provider whose 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. Despite its current technology lead, major customers such as Apple and  Samsung (SSNGY) have sought to develop their own internal solutions to replace those provided by the likes of Synaptics. Combined with the recent deceleration in smartphone growth and cutthroat nature of the smartphone component supply chain, we assign no-moat Synaptics a very high uncertainty rating. With the shares trading at a wide discount to our fair value estimate, we believe the current risk/reward balance favors investors with a long-term horizon.

 Criteo (CRTO)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Uncertainty: Very High
Consider Buying: $18.50

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 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.

 Microsoft (MSFT
)Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Uncertainty: Medium
Consider Buying: $85.40

We view Microsoft as one of two top-flight public cloud infrastructure- and platform-as-a-service vendors in the world alongside Amazon, and we think it is poised to amass greater market share. We think the market opportunity for IaaS and PaaS numbers in the hundreds of billions, as large public cloud vendors will consolidate IT spending that was once allocated to disparate vendors around a small handful of strategic providers. We view Microsoft as one of those strategic providers, and we believe its Azure offering will grow at a 31% compound annual growth rate over the next 10 years, eventually contributing north of 35% of total revenue by the end of our explicit forecast period compared with an estimated 9% in fiscal 2018. We also view the opportunity around Office 365 as one of the most important long-term growth stories for the firm. Office 365 is now larger than the legacy Office business, and we expect Microsoft to enjoy the natural uplift in lifetime customer value that comes with a migration to a high-retention subscription model. We think the firm provides a better value to consumers across applications and storage, reflected in the firm’s 30-million-plus consumer subscribers. Microsoft remains one of the highest-quality operators in enterprise software today, and we believe the business is starting to pick up steam as it works through declines in its legacy businesses. Finally, shareholders can also reap the benefits of a robust capital return program that has returned more than $70 billion to shareholders in the past three years by way of dividends and share repurchases.

Quarter-End Insights

Communication Services: Undervalued With a Case of Merger Fever
U.S. telecom consolidation is in the works with a T-Mobile-Sprint merger.

Basic Materials: Overpriced, With Significant Downside Ahead for Commodities
Few basic materials stocks currently offer risk-adjusted return potential amid our negative outlook for commodity prices.

Financial Services: A Positive Outlook for U.S. Banks, More Consolidation to Come for Asset Managers
While tightening of financial regulations is uneven across the globe, rising deposit costs are nearly universal.