Technology: Sector Appears Overvalued Despite Birth of First Trillion-Dollar-Market-Cap Stock in Apple

• We view the technology sector as overvalued overall at a market-cap-weighted price/fair value of 1.075.
• Enterprise cloud computing remains the most important story in tech.
• The U.S.-China trade war continues to add risk to tech investments.
• Semis and software are still sectors to watch on the M&A front.

We view the technology sector as slightly overvalued overall at a market-cap-weighted price/fair value of 1.075 as of Aug. 31, versus 1.02 at the end of May, 1.05 at the end of February, and 1.08 at the end of November 2017. The Nasdaq index has risen about 3% from mid-June to mid-September and is up about 16% year to date as of mid-September. We can’t look at market capitalizations in technology without noting the birth of the first trillion-dollar-market-cap company as Apple crossed the barrier this quarter.

The single most important trend in technology remains the ongoing shift toward cloud computing, as enterprises move their computing workloads to pay-as-you-go business models that lead to greater flexibility, security, and cost savings. The shift has ramifications for dozens of stocks across our coverage. Although the tech sector is overvalued today, we see a couple of undervalued names that are strong beneficiaries of cloud computing, such as  Salesforce.com (CRM) and  ServiceNow (NOW). Independent of valuation, we still see winners among infrastructure-as-a-service vendors, such as  Amazon.com (AMZN) Web Services,  Microsoft (MSFT) Azure, and  Google (GOOG). Software-as-a-service vendors are seeing tremendous growth while legacy IT vendors face ongoing headwinds. In SaaS,  Adobe Systems (ADBE) and Microsoft have been especially adept at transitioning to the SaaS model, as selling subscription software, rather than charging for up-front licenses, has expanded their customer bases.  Oracle (ORCL) has been relatively slower to pivot, in our view, albeit with some signs of optimism at times.

The U.S.-China trade war continues to add risk to technology investments; although companies have not been hit hard by tariffs just yet, we see many tech leaders assessing the current political situation and hoping for a satisfactory outcome.  Apple's (AAPL) popular gadgets, such as the iPhone and Apple Watch, are believed to be exempt from the trade war for now, which we suspect is a relief to the technology supply chain as the vast majority of Apple's devices are assembled in China. Any tariffs slapped on Apple products could have negative ramifications for dozens of technology stocks under our coverage, as lower demand for iPhones could weigh on revenue from many component suppliers that count on the smartphone titan as a large customer.

We continue to see M&A as a key theme in technology. We see no signs of enterprise software deals slowing, with deals such as Adobe-Magento, Microsoft-GitHub, and Salesforce-MuleSoft occurring in 2018. Adobe-Marketo was also recently rumored among large-cap software names. We anticipate more software deals in the years ahead, as leading vendors like Adobe, Microsoft, Salesforce, Oracle,  Workday (WDAY), and others branch out from their core product lines and tack on adjacent opportunities. Similarly, nontraditional software vendors like  Cisco Systems (CSCO) and Amazon may make software-related deals as well, as software is becoming a more important portion of their enterprise offerings.

We might be in the later stages of a wave of semiconductor M&A, but we still think deals will occur in the months and years ahead, the latest of which is Renesas' bid for Integrated Device Technology. 2018 deals include  Microchip Technology's (MCHP) bid for Microsemi,  Marvell Technology's (MRVL) acquisition of Cavium, and  KLA-Tencor's (KLAC) deal for Orbotech. We still anticipate consolidation in the semiconductor industry as larger players seek scale and diversification while being able to strip out excess costs and drive operating leverage.

Top Picks

 Intel (INTC)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $65
Fair Value Uncertainty: Medium
5-Star Price: $45.50

Wide-moat Intel trades at an attractive discount to our $65 fair value estimate. The chip titan's comprehensive product portfolio tailored to computers from the data center to the edge gives us confidence in the company's long-term growth prospects, despite a declining PC market. We applaud Intel's scattershot approach to address challenges in computing (artificial intelligence and cloud), connectivity (5G), and memory (3D NAND and 3D XPoint). This data-centric strategy is rooted in a swath of products that attempt to support data creation, transfer, storage, and analysis. Intel's string of acquisitions (Altera, Mobileye, Nervana, and Movidius) has unlocked new growth vectors to tackle while augmenting the capabilities of its old guard in client computing and data centers. One of the chipmaker's most recent large acquisitions, Mobileye, benefits from incumbency in countless advanced driver-assistance systems programs and a robust pipeline of design wins. Now coupled with Intel's technological and financial resources, the combination will be a formidable player in the race to self-driving cars, in our opinion. Additionally, we view Mobileye’s approach to autonomous driving very favorably, as it looks to incrementally build upon existing products to enable full autonomy. We estimate a $7 billion 2025 opportunity for Intel's autonomous platform solution, with the company capturing a meaningful portion of this addressable market.

 Microchip Technology (MCHP)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $112
Fair Value Uncertainty: Medium
5-Star Price: $78.40

We view wide-moat Microchip Technology as one of the highest-quality companies under our semiconductor coverage. Microchip remains a leading supplier of the "brains" needed for a variety of smart devices categorized as the Internet of Things. We find Microchip under the hood (figuratively and often literally) of the latest cars with the most advanced electronics and think it is poised to profit from rising chip content per vehicle. We're confident in Microchip's wide moat rating, thanks to high customer switching costs associated with electronics redesigns, intangible assets associated with the company's proprietary chip designs, and decades of expertise and reliability. Revenue growth is understandably decelerating after a stellar 2017 for Microchip and others, but we see business conditions in 2018 reverting toward the mean of what we consider a normalized growth environment in the mid- to high-single-digit range. Longer term, Microchip's exemplary management team has made shrewd mergers in the past and believes its recent acquisition of Microsemi will be another hit. We think Microchip's profitability targets with Microsemi are mildly conservative, and we can foresee even greater upside. With this and the company hitting its long-term target of 7%-9% organic revenue growth, we see a healthy amount of upside for investors.

 Broadcom (AVGO)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $300
Fair Value Uncertainty: Medium
5-Star Price: $210.00

Broadcom is the product of a bevy of mergers and acquisitions in the semiconductor space. Most prominent is the combination of Avago Technologies and Broadcom, which was consummated in 2016. The company's latest deal to acquire CA Technologies led to an overly punitive sell-off by the market, which we see as a potential buying opportunity for long-term investors. While CA's growth profile is admittedly unappealing, we remain positive on the financial benefits of the deal (modest premium, high profitability, and solid cash generation). As we look at Broadcom's core semiconductor businesses, the former Avago's expertise in radio frequency filters for smartphones and legacy Broadcom's dominance in networking, broadband, and wireless connectivity have created a broad and profitable semiconductor behemoth. Longer term, we think Broadcom is part of the heavyweight class of chip leaders and boasts intangible assets around the design of products that go into a multitude of end markets. Near term, healthy spending by cloud vendors and enterprise IT should drive growth in wired and storage. Broadcom has been aiding cloud providers to design custom chips for offloading compute applications, such as Google's TPU for artificial intelligence inferencing tasks. Consequently, this subsegment of wired has outgrown the broader wired business and should persist as demand for these types of chips increases. We remain positive on Broadcom's powerhouse networking, RF filter, and connectivity portfolios and believe the inclusion of CA's mission-critical products should bolster the company's cash generation potential to fuel future accretive acquisitions.