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Our Outlook for Technology Stocks

The end of inventory destocking.

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The technology supply chain is showing some very faint signs of life, and the technology heavy NASDAQ has rallied markedly since the early March lows. However, a slightly less negative information flow speaks more to the fact that few pits are actually bottomless rather than to any fundamental uptick in end demand. The good news is that much of the technology supply chain, from chips to hard drives, has done an admirable job of taking out production capacity in the last few months. As a result, inventory destocking, or the process of working off excess inventory, has run its course for now.

Most of the evidence pointing toward the end of destocking comes from the semiconductor industry. The largest outsourced semiconductor manufacturer,  TSMC (TSM), saw its capacity utilization rate drop from 100% to 40% over the past three quarters as customers cut back on production. In recent weeks, however, customers have come to TSMC with rush orders for new chips as their inventories have run low. TSMC raised its first-quarter 2009 revenue guidance by 10% and expects a double-digit sequential increase in second-quarter orders. Moving further out on the supply chain,  Microchip Technology (MCHP), the leading maker of chips that control everything from remote controls to refrigerators, also noted an increase in rush orders. Management stated, "We are seeing a high level of expedited requests from our customers, despite relatively short lead times on all of our products. We believe this indicates that customer inventories are depleted and that customer order patterns are now trying to catch up to actual demand." (Watch our recent video report on Microchip.)

Another bright spot for the semiconductor industry has been the 3G wireless build-out in China.  Altera (ALTR) and  Xilinx (XLNX), the two programmable logic leaders, both were able to slightly increase their first-quarter 2009 sales expectations because of improved demand from China. Other companies, such as  Analog Devices (ADI) and  STMicro (STM), should also benefit from Chinese 3G demand.

Valuations by Industry
There is a lot of noise in some of the numbers below, especially in industries where there are only a handful of companies such as Audio/Video Equipment. Looking at the larger industries, however, such as Semiconductors, we see that the gap between price and fair value has shrunk over the past three months. These companies were in free fall three month ago as production ground to halt, but as inventory destocking has ended, the incremental news has turned slightly more optimistic. For example, the change in sentiment has helped TSMC shares rally nearly 30% since the last quarterly update.

 Technology Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%)

Uncertainty
Percentile**

Audio/Video Equipment 3.0 0.94 0.45 108.0% 8.7
Business Applications 4.6 0.60 0.63 -4.8% 3.9
Business/Online Services 3.9 0.66 0.58 13.7% 66.9
Components 4.0 0.63 0.63 0.0% 51.2
Computer Equipment 4.7 0.67 0.58 15.5% 7.1
Contract Manufacturers 4.4 0.37 0.46 -19.6% 93.7
Development Tools 3.5 0.84 0.78 7.6% 36.2
Distributors 4.3 0.73 0.67 8.9% 26.8
Electric Equipment 4.0 0.69 0.59 16.9% 47.2
Entertainment/Education Media 3.9 0.73 0.48 52.0% 40.2
Photography & Imaging 3.0 0.86 0.54 59.2% 98.4
Semiconductor Equipment 4.4 0.50 0.52 -3.9% 52.8
Semiconductors 4.0 0.71 0.62 14.5% 48.8
Systems & Security 4.5 0.67 0.65 3.0% 32.3
Data as of 03-13-09. *Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

The continuing theme in technology is that high-quality companies still look cheap. Despite a substantial rebound in stock prices, the market is still offering up many cash-rich companies with solid competitive advantages and good growth opportunities at single-digit multiples.

Our Top Tech Picks
Some of our favorite technology names have rallied significantly in recent weeks. Some, like  NetApp (NTAP) and  Adobe Systems (ADBE), are no longer rated 5 stars. We feel both companies should be kept on the radar screen, however, because there may yet be opportunities to buy them at great prices.

 Top Tech Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Gain From
52-week Low

Apple  $169.00 Narrow Medium 29.9%
NetApp   $20.00 Narrow Medium 50.7%
KLA-Tencor $45.00 Wide Medium 39.1%
Symantec $22.00 Narrow Medium 41.0%
Adobe Systems   $26.00 Wide Medium 35.2%
Data as of 03-19-2009.

 Apple (AAPL)
We believe Apple has ample growth opportunities. We think the company can continue taking market share with it Macintosh lineup in the United States, which stands at less than 10%. The new 3G iPhone also has enormous headroom for growth and will be available in more than 70 markets before the end of 2008. We believe the strategy to open up the iPhone to third-party software developers will help increase demand for the new platform.

 NetApp (NTAP)
NetApp established itself as one of the fastest-growing companies in networked storage by offering high-end features on midrange storage systems. We think NetApp is positioned to continue capturing market share by taking advantage of emerging IT trends.

 KLA-Tencor (KLAC)
KLA-Tencor occupies a sweet spot in the chip equipment industry because of its dominant position in the process diagnostic and control market. Given KLA's wide moat and appealing exposure to technology advances by chipmakers, we think the firm has a bright future.

 Symantec (SYMC)
Symantec's scale advantages over smaller security software competitors should enable the company to maintain its leadership in mature security software products. The explosive growth in the use of electronic data has created opportunities for several niche players to target specific emerging threats to data security and integrity. However, such companies generally lack the scale to compete effectively in the enterprise segment, and we expect ongoing consolidation as larger players, such as Symantec and  McAfee (MFE), expand into growing markets.

 Adobe Systems (ADBE)
Adobe is situated at the epicenter of several strong growth trends. The emergence of next-generation Web applications bodes well for Flash and Acrobat as tools to create and share media-rich content. In addition, the growing popularity of digital photography and video should drive sales of products such as Photoshop and Premiere.

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Toan Tran does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.