(By Grady Burkett, CFA)
- Current near-term economic uncertainty is presenting a buying opportunity in higher-quality names.
- In an environment of tightening corporate IT budgets, we would look to invest in attractively valued firms that sell mission-critical products with recurring revenue streams attached. The software industry is a natural hunting ground for firms with these characteristics.
- Cloud-based services and mobile computing will continue to be major disruptive forces within IT. Hardware firms will be forced to adapt in a rapidly shifting landscape.
The Nasdaq fell nearly 13% from the end of the second quarter through Sept. 22, as macroeconomic uncertainty and disappointing outlooks from a number of hardware and semiconductor firms weighed on market sentiment.
Weakness from large firms like Dell (DELL) and HP (HPQ) are to be expected given secular headwinds for PCs and ongoing pressure on public sector budgets. However, even smaller, higher-growth companies with exposure to prominent secular trends, like Cavium (CAVM), Riverbed (RVBD), F5 (FFIV), and Juniper (JNPR), provided a muted outlook relative to previous expectations.
Software and services firms have yet to show signs of weakness, with Oracle's (ORCL) reasonably solid results serving as our most salient data point. However, Oracle's software business is benefiting from firm-specific strengths, and it is too early to extrapolate the company's results into broader resiliency. At this point, it is beginning to feel like we are experiencing a typical cyclical slowdown in tech--weakness in semiconductor firms and hardware companies first, with software vendors and services firms following later.
This near-term uncertainty has created a number of buying opportunities across our coverage, and we are currently finding the most value among large-cap firms with durable competitive advantages. Given the current uncertain macroeconomic outlook, we see little reason to look beyond these high-quality, attractively valued large-cap firms; and we highlight five of our favorite ideas below.
Industry Level Insights
Ongoing economic weakness in Europe and North America could impact third-quarter performance of many software companies if clients delay capital expenditures in the face of uncertainty. The impact of the slowdown could be felt in the enterprise as well as consumer markets: Sales of big-ticket enterprise software of the type sold by SAP (SAP) could be at risk, and recent PC sales forecast reductions by research firms Gartner and IDC suggest that consumer PC purchases in developed markets have been weaker than earlier expectations. Investors should be on the lookout for buying opportunities in high-quality, moaty software companies if stocks sell off on weak third-quarter performance.
While a capital spending slowdown could impact most software companies, not all software companies are equally susceptible to revenue declines, and others could actually benefit. Revenues of security software companies such as Symantec (SYMC) and Check Point (CHKP) tend to be more resilient than most, as customers typically cannot cut or ignore security spending as long as they remain in business. Meanwhile, macroeconomic clouds favor continued shifts in enterprise application software market share toward subscription-based software-as-a-service (SaaS) providers from traditional on-premise software vendors. Salesforce.com's (CRM) management appears to be particularly committed to aggressively investing in growing the business regardless of economic conditions, and we think this is the right strategy, as the firm's solid value proposition to customers is further strengthened when IT budgets are tight.
As we enter the fourth quarter, concerns about demand from the public sector and European markets have taken a toll on enterprise hardware stocks, creating opportunities to pick up high-quality names at steep discounts. Investors must be selective, however, and take care to differentiate between economic issues and some of the secular changes occurring in the hardware industry.
Virtualization and cloud computing are changing the way data centers are architected. When faced with these types of disruptive forces, determining if the firm has established an economic moat is paramount. In hardware, this often means looking for those firms that bridge the gap between one generation of devices and the next with software and related services. For example, Cisco's (CSCO) technology advantages are largely driven by its software, and HP is pushing into the more software-centric portions of the hardware space, including storage and networking. We view these software-centric segments to be more durable than PCs, x86 servers, and other hardware segments where the hardware vendor is merely assembling other firms' intellectual property.
We see similar trends occurring on the consumer front. Apple (AAPL) is succeeding not just because it has the best device currently on the market. Instead, Apple is using software to connect the user to not just a single device, but an ecosystem of applications and content spanning multiple devices and creating a relationship that survives the useful life of any single device.
The overall semiconductor industry has seen business conditions slow in recent months after benefiting from a robust upturn in global chip sales over the past couple of years. Although the slowdown was first triggered by excess semiconductor inventories in the electronics supply chain, the weakness has persisted in the space as chip demand has softened across a broad array of end markets.
In recent weeks, a handful of chipmakers have lowered their outlooks, including Intersil (ISIL), Texas Instruments (TXN), Xilinx (XLNX) and Altera (ALTR). All in all, we expect most chipmakers to see revenues decline by mid- to high-single digits in the third quarter. In particular, the consumer electronics, industrial and automotive, and communications infrastructure end markets appear weak, while the wireless device chip segment seems to be doing better.
In addition, trends and commentary in the computer-related chip space have been mixed. Business conditions at Intel (INTC) and Advanced Micro Devices (AMD) appear to be holding up. Despite weakness in the consumer PC market in developed countries, the firms have been seeing healthy server processor demand, as well as solid PC microprocessor sales in emerging markets. On the other hand, chipmakers such as Intersil, Maxim (MXIM), and Micron (MU) have blamed some of their recent woes on a soft computer end market.
We believe that the latest industry downturn has begun to present buying opportunities for some analog chipmakers, such as Analog Devices (ADI). Stocks in the semiconductor space tend to fluctuate with industry cycles, and a number of these names are now trading at discounts to our fair value estimates. We like the analog space in particular, because it contains a number of high-quality firms with economic moats that generate healthy free cash flows and offer nice dividend payouts. Other analog names to keep an eye on in the downturn are TI, Linear Technology (LLTC), and Maxim, as well as Microchip (MCHP), a microcontroller chipmaker that has characteristics similar to those of high-quality analog firms.
The U.S. telecom industry has been placed in a holding pattern thanks to the Department of Justice's decision to challenge AT&T's (T) acquisition of Deutsche Telekom's (DTEGY) T-Mobile USA unit. We continue to believe that smaller players in the industry, including Sprint (S), Leap Wireless (LEAP), and MetroPCS (PCS), need to join forces, but these firms are certainly waiting to see what comes of T-Mobile USA and its assets. However, the three aforementioned firms posted weak second-quarter earnings, prompting both the equity and credit markets to shun each of them. A deal sooner rather than later is in the interest of the group, in our view, to maximize the odds of gaining financing needed to roll debt maturities and ensure financial flexibility. The firms will need financial flexibility to invest in next-generation network technology, adding data network capacity to keep pace with AT&T and Verizon Wireless. Sprint also appears set to offer Apple's (AAPL) iPhone, a move that will enable it to better win and retain customers, but also likely cause the firm to burn cash initially. Sprint plans to announce its next-generation network strategy in early October, but we're most hopeful that it puts a multiyear financing plan in place.
We've lowered our fair value estimates on Sprint, Leap, and MetroPCS, but we believe the market has severely overreacted to the firms' recent earnings troubles. We believe the sell-off in these stocks has created an opportunity to own assets that will eventually form a critical piece of the U.S. telecom infrastructure. We also lowered our Deutsche Telekom fair value estimate as a result of the DOJ's legal challenge to AT&T. If the deal is ultimately killed, we think the lost time and distraction will have left T-Mobile USA in worse shape than it was before. It hasn't developed any kind of next-generation network strategy of its own, likely forcing it into the hands of another operator. Teaming up with Sprint would make the most sense over the long term, but the prospects for such a merger will depend on the language regulators use in blocking the AT&T agreement--the DOJ's original statement was vague on this front, in our view.
Within Europe itself, France continues to garner the most attention. Competition continues to increase in the country as carriers prepare for Iliad's entrance into the wireless business. Recently France Telecom (FTE) created a new low-end brand dubbed Sosh designed for the 18-35-year-old demographic. The offering includes various voice and data tiers, all with unlimited texting. We think this service is aimed directly at the customers Iliad will be going after. We expect more offerings from all the operators over the next several months in an effort to pre-empt Iliad. We think all three existing French wireless carriers--France Telecom, Vivendi (VIV), and Bouygues (EN)--are cheap. All three are in 5-star territory and France Telecom remains one of our favorite telecom ideas.
Our Top Tech Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The five firms below fit this criteria and are trading at attractive valuations, in our view.
| Top Tech Sector Picks|
Price / Fair Value
Data as of 09-23-11
With a compelling valuation and a wide economic moat, we have included Google as one of our favorites. Although we expect continued scrutiny from various global regulatory agencies, we do not expect potential changes to drastically alter the company's competitive advantages. Google has been an early and dominant company on the Web. The company not only built a revolutionary Internet search engine, but it arguably pioneered performance-based advertising on a massive scale. Google has a formidable moat in Internet search, which represents more than 75% of net revenue. Although growth is slowing in its core search market, we still expect annual growth in search revenue to exceed 15% during the next five years, supported by the firm's successful foray into mobile advertising. Additionally, we expect initiatives in display advertising and video website YouTube to represent multi-billion-dollar revenue opportunities.
Cisco Systems (CSCO)
Cisco's fiscal fourth-quarter results showed signs of gross margin stability and no evidence of substantial market share deterioration in its core router and switch markets. Despite growing competition and lingering questions around Cisco's restructuring efforts, the firm's dominant position in data networking equipment, its strong services business, and consistently strong free cash flow generation give us confidence that shares will recover from recent lows.
Oracle is one of the highest-quality names in our tech coverage universe, and we expect the firm's core software business (which accounts for 68% of revenue) will continue to perform well in the near term. Although Oracle's hardware segment could generate underwhelming results in the next few quarters, we believe this business has solid long-term prospects and will enable Oracle to drive additional software sales over time and further strengthen its wide economic moat.
Apple's three primary growth engines--the iPad, iPhone, and PCs--should allow the firm to deliver strong top-line growth during the next few years. Moreover, we think that Apple is increasing customer-switching costs--a rare feat for a consumer-focused tech firm--by delivering a seamless user experience across various devices. Although increasing competition from Google and Steve Jobs' recent departure from operations present risk, we see no clear impediment to near-term growth and believe investors are currently presented with a rare opportunity to buy a high-quality growth firm.
France Telecom (FTE)
France Telecom is the dominant telecom operator in France. It also has large operations in many other countries. In total it has 210 million subscribers, of which 150 million are wireless customers. This size allows it to keep the majority of its customers on its own network, which lifts profitability, provides it with a narrow moat in our opinion, and allows the firm to generate significant cash flow. France Telecom has generated more than EUR 8 billion in free cash flow in each of the past several years and expects to do so again in 2011. This cash flow in turn allows the firm to pay a large dividend (current gross yield is 9%), reduce debt, and make additional acquisitions, primarily in emerging markets.