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Quarter-End Insights

Our Outlook for Tech Stocks

Japan's crisis introduces near-term uncertainty.

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  • Japan's crisis will create short-term disruption for the technology supply chain and add a near-term layer of uncertainty across most industries.
     
  • Regardless of near-term fallout from Japan, high-quality technology firms with global reach will generate significant free cash flows in 2011. As cash balances grow, we expect M&A activity to remain fairly high.
     
  • Given the geopolitical uncertainties and generally full valuations, we prefer financially strong firms with solid competitive positions.

Crisis in Japan Creates Supply-Chain Disruption and Lingering Uncertainty
The earthquake in Japan will have macroeconomic effects that will hamper chip demand in the country and impact near-term financial results for many firms across the technology sector. Japan is one of the bigger consumers of semiconductors and is home to many electronic device makers, including  Sony  (SNE) and Nikon.

Aside from fewer near-term purchases of electronics and other goods that contain chips--such as PCs, smartphones, automobiles, and industrial equipment--in the country, Japanese electronics makers experienced manufacturing stoppages. Further, many chipmakers, especially analog firms, are suppliers to Japan's automobile industry, and these customers also had production stoppages. As a result, chipmakers across the board--from analog and microcontroller firms to microprocessor and memory companies--will be affected by lower near-term demand. For example, analog chipmakers  Linear Technology (LLTC) and  Analog Devices  (ADI) generate about 15% of their sales in Japan, while roughly 10% of  Intel's  (INTC) revenue comes from the country.

Given that Japan is home to many semiconductor firms and chip fabrication plants, a number of companies have had operations disrupted.  Texas Instruments  (TXN) saw damage to a digital light projector plant in Miho that contributes about 10% of its total revenue, while Japan's largest microcontroller producer, Renesas, was forced to shut down five fabrication plants and two chip packaging facilities. There have also been disruptions to production of computer memory (DRAM) and NAND flash memory chips in Japan, which have already materially affected the supply and pricing in both of these markets.  SanDisk  (SNDK) and Toshiba, which have joint venture NAND flash memory manufacturing plants in the country, reported that both of their NAND fabs were shut down for a short period of time last Friday because of the earthquake. Although operations have resumed, any disruptions to a fab, even small ones, can have significant effects on output and flash memory prices.

The effects of these disruptions will be felt to varying degrees across multiple industries and companies within technology, from PC manufacturers to telecom equipment vendors to software firms. IDC estimates that Japan has accounted for just over 4% of worldwide PC unit demand in recent quarters. Given recent concerns over sluggish PC demand and excess hard drive inventory, even slight weakness from Japan could be problematic for both industries over the near term. More important for the PC manufacturers, however, is that we are likely to see price increases and possibly shortages in some components required for PC production. For example, Japan is a major player in the lithium battery supply chain, accounting for over 50% of the global lithium battery materials' production value. Price increases in certain components should reverse a recent trend where favorable component pricing has led to surprisingly strong PC margins. 

Telecom equipment vendors are also exposed, as weakened end-market demand coupled with higher component prices could put near-term pressure on both revenue and gross margin.  Juniper  (JNPR) has a significant distribution relationship with NEC in Japan, while  Cisco (CSCO) generated roughly 4% of 2010 revenues in the country. Given Juniper's rich valuation and Cisco's recent gross margin pressures, any near-term earnings disappointment could weigh on shares. Even  IBM  (IBM) isn't immune in the short run, with 11% of revenue generated in Japan. In short, we expect most technology firms with global exposure to be affected in some way by this unfortunate disaster.

M&A Will Remain in Focus
Despite the potential for modest weakness over the next couple of quarters, large, high-quality technology and telecom firms will generate significant free cash flow throughout 2011, and we expect to see more acquisitions over the near term.  AT&T's (T) $39 billion bid for T-Mobile provided a late-quarter reminder that well-positioned, financially strong companies are unlikely to reverse course on strategic acquisitions, regardless of broader economic and geopolitical concerns. Should this deal pass regulators' scrutiny and go through at the proposed offer price, AT&T would pick up an additional 34 million wireless subscribers and distance itself from Verizon Wireless in terms of total wireless subscribers by a large margin.  

Just two weeks prior to AT&T's announcement, the data storage industry turned in two large strategic deals with  NetApp's  (NTAP) $480 million bid for LSI's (LSI) external storage business and  Western Digital's  (WDC) $4.3 billion offer for  Hitachi's (HIT) hard drive business. Although Western Digital and NetApp have markedly different growth profiles, both firms had accumulated a significant amount of cash and were looking to fill a gap within their product portfolios to strengthen their competitive positions. Western Digital's proposed acquisition, like AT&T's, would also provide the firm with significant cost savings opportunities while consolidating a mature industry.

2011 will also provide investors an opportunity to assess the track records of acquisitive technology giants.  Dell (DELL), for example, is widely known for its propensity to overpay as it attempts to diversify beyond PCs and x86 servers. Although we've been skeptical of rich valuations in certain deals, Dell's surprisingly strong fourth-quarter gross margin suggests that the company is indeed beginning to benefit from the billions of dollars it has spent to move into higher-margin businesses.

 HP  (HPQ)  raised some investor concerns over the lofty premiums it paid for data networking firm 3Com and storage systems vendor 3PAR in order to gain a larger footprint within its customers' data centers. However, positive results from HP's enterprise hardware business in its recent quarter suggest that these acquisitions are bearing fruit. In contrast, Cisco's 2009 acquisition track record has proven mixed, with disappointing results from web-based e-mail provider PostPath and video-camera maker Pure Digital. We do, however, expect better results from the firm's more recent acquisitions of Starent and Tandberg, as both complement Cisco's core businesses and should benefit the firm throughout 2011.

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
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Price /       Fair Value

Cisco Systems $30.00 Wide Medium 0.58
Hewlett-Packard $55.00 Narrow Medium 0.77
Applied Materials $22.00 Wide Medium 0.69
France Telecom $34.00 Narrow Medium 0.65
Rogers Communications $45.00 Narrow Medium 0.79
Data as of 3-24-2011.

 Cisco  (CSCO)
Margin pressure and weakness in Cisco's core switch business led to the company's third consecutive disappointing quarter and a sharp sell-off in February. Despite growing competition and lingering questions around Cisco's consumer efforts, the firm's dominant position in data networking equipment, strong services business, and consistently strong free cash flow generation give us confidence that shares will recover from recent lows.

 Hewlett-Packard  (HPQ)
Weak PC demand and disappointing revenue from services led Hewlett-Packard to trim its 2011 revenue guidance, creating a second chance for investors to own a high-quality name at an attractive discount. Despite the recent strategy summit that left many questions unanswered about the firm's plans for software and cloud computing, we believe the company's leading position in services, enterprise hardware, and printing create more than enough value to support our fair value estimate.

 Applied Materials  (AMAT)
Applied Materials is the largest semiconductor equipment firm in the world. It has unmatched scale and the broadest product portfolio in the industry, which give the firm a leg up over its smaller competitors. In recent quarters, Applied and the rest of the semiconductor equipment industry have been benefiting from a business upturn, as chipmakers have an increased demand for manufacturing tools. We expect the robust business environment, as well as market share gains, to help propel Applied's top and bottom lines in the upcoming quarters.

 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 boosts profitability, provides it with a narrow moat in our opinion, and allows the firm to generate significant cash flow. France Telecom has generated over 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.

 Rogers Communications  (RCI)
Despite the recent spike in competitive intensity (due to pricing pressure from smaller new entrants), Canada remains one of the most attractive wireless sectors because of its low penetration rates and high economic efficiency. We continue to believe Rogers Communications is the best investment opportunity in that sector because of its superior customer base, leading smartphone share, and the fact that it has more wireless exposure than its fellow integrated peers  Bell Canada (BCE) and  Telus (TU). Ironically it's that very point (having more relative exposure to the increasingly competitive wireless subsector) that has handcuffed the shares of late, offering investors an attractive risk/reward entry point.

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