Our Outlook for Tech & Communication Services Stocks
The technology and telecom landscapes continue to be shaped by a few key mega-trends, while business quality and valuation still trump other investment considerations.
Apple's (AAPL) widely publicized dividend announcement is a recent, but not isolated, indication that technology firms are increasingly willing to chip away at excess cash accumulating on their balance sheets. Just one week prior to Apple's announcement, Dell (DELL) purchased network security vendor SonicWALL, while Cisco (CSCO) invested $5 billion of its overseas cash to acquire NDS, a software firm that specializes in pay-TV content security and management. This purchase comes on the heels of a 33% dividend increase from Cisco, and we expect tech firms will continue to utilize excess cash for strategic acquisitions, dividends, and share repurchases through 2012.
Although we see no clear indication that the demand environment will change materially in either direction over the next quarter, we recognize clear long-term trends across the various technology industries that will affect individual firms' financial results over the next few years. The mega-trends of cloud computing, mobility, and consumerization march on, opening new profit pools and solidifying competitive advantages for certain firms and industries while forcing others to adapt quickly. These trends will continue to drive near-term spending, even if the demand environment weakens, and firms that are positively exposed to these secular forces will post solid operating results over the next few years.
The technology sector, in aggregate, is trading at roughly fair value. The telecom sector is trading at a slight discount, but this is primarily due to some severe mispricings in certain non-U.S. markets. Given the lack of clear direction of the near-term spending environment and broadly uninspiring valuations, we would seek out individual firms that possess economic moats and that are trading at reasonable margins of safety to intrinsic value. This is always a good strategy, but it seems particularly compelling at this current point in time.
The cloud computing marathon continues to push forward as the large enterprise software giants prepare to compete head to head with the challengers.
Oracle (ORCL) expects to make its Fusion public cloud generally available for customers in the current quarter, with customer relationship management, human capital management, and financial management slated for launch. Oracle's flexible deployment model is a significant competitive advantage over software-as-a-service (SaaS) specialists such as Salesforce.com (CRM) and Workday, particularly in the large enterprise segment of the market. Large enterprises are likely to have hybrid (public plus private) clouds for a long time, with noncore applications moving to the public cloud while mission critical applications remain in on-premise data centers. Oracle's ownership of a broad suite of applications including mission critical and noncore applications, combined with customers' choice of deploying individual applications in on-premise data centers or in Oracle's cloud, gives it an attractive value proposition that the SaaS specialists simply cannot match. Of course, Oracle still needs to back its SaaS services with appropriate sales muscle, and we remain watchful on this front.
SAP (SAP) is also stepping up its cloud play with the acquisition of SuccessFactors. Lars Dalgaard, CEO of SuccessFactors, has taken over leadership of SAP's cloud efforts, while Peter Lorenz, who previously headed SAP's unsuccessful cloud efforts, has stepped down from his leadership role. We think this signals a renewed commitment to cloud sales for SAP, whose organic Business ByDesign cloud ERP solution had only 1,000 customers at the end of 2011.
While much of the investment community is anxiously awaiting the Facebook IPO (expected in May), we are anticipating strong growth in display advertising, driven not only by social companies such as Facebook and LinkedIn (LNKD), but also by Google (GOOG). While we do not expect Google to dominate the display advertising market in the same manner it has dominated the Internet search market, we believe the investment community is not fully appreciating the assets the firm has amassed through past acquisitions. Furthermore, we believe that performance-based advertising is providing measurable ROI (return-on-investment) for an increasing percentage of the display market, an important factor supporting continued growth for the entire industry.
On the competitive front, we look forward to seeing early results from the recently launched display partnership between Yahoo (YHOO), Microsoft (MSFT), and AOL (AOL). We are initially skeptical about the success of this partnership, as we expect several technical hiccups that could prove challenging for advertisers in their efforts to fully control ad placement and pricing across multiple platforms. Advertisers will generally gravitate toward the content owners and networks that provide audience reach, targeting, and marketing analytics. We expect other platforms should prove superior in the near term.
Apple appears to have flawlessly executed on its two recent product launches, the iPhone 4S and iPad 3, and we expect continued strong demand for the firm's smartphones and tablets through 2012 and beyond. As Apple's devices, along with Android-based mobile devices, proliferate, traditional handset and PC volumes will come under pressure. Handset makers such as Nokia (NOK) and Research in Motion (RIM) are already suffering as a result of this shift, while Dell and Hewlett-Packard (HPQ) continue to look to diversify away from the increasingly challenging PC industry.
Dell's recent acquisition of network security vendor SonicWALL provides the firm with another building block for its strategy to become a one-stop provider of midrange enterprise IT infrastructure systems. Although Dell is still heavily reliant on its PC business, we think the firm's recent moves into storage, networking, and now network security have been shrewd, and we would not be surprised to see Dell successfully transition its business away from PCs over time. HP's current depressed market valuation implies an irreversible decline in profits, but we are a bit more sanguine. PCs account for less than one sixth of the firm's operating profits, and we think many of HP's wounds in services, printers, and enterprise hardware systems are self-inflicted and can be corrected over time.
Smartphones and tablets are natural outgrowths of the general push toward mobility that will continue to impact the enterprise hardware space in profound ways over the next several years. Enterprises are wrestling with the data storage, security, and user-experience challenges that mobility creates, and pure-play vendors that address these key issues will continue to capture increasing share of their customers' hardware spend. While EMC (EMC) in data storage, Aruba (ARUN) in wireless networking, and F5 (FFIV) in application delivery are three of our favorite businesses within their respective market segments, their current market valuations offer no margin of safety for investors.
The large enterprise hardware and software vendors, including Cisco, HP, Oracle, and IBM (IBM), are also looking to capitalize on these trends by selling pre-configured, integrated products in order to expand their footprints within their customers' data centers. These initiatives have increased the level of rivalry within the industry to levels not seen in at least a decade, if ever, and we believe the software vendors have the upper hand. Although we don't expect the competitive environment to improve for the large hardware vendors over the near term, we do believe that HP and Cisco possess durable competitive advantages that will allow each firm to navigate the current environment and maintain above-average returns on capital over time.
The recent cyclical slowdown that hampered the semiconductor industry in the second half of 2011 appears to be bottoming, and we believe that business conditions should begin to improve for chipmakers in the coming months. The weak end-market customer demand caused by macroeconomic uncertainty that plagued broad-based chipmakers such as Texas Instruments (TXN), Analog Devices (ADI), and Linear Technology (LLTC) appears to be subsiding, as these firms provided positive outlooks during their latest earnings reports. While the recent hard disk drive (HDD) shortages caused by the flooding of a significant portion of the HDD manufacturing base in Thailand continues to hamper the PC supply chain and sales at chipmakers with significant PC exposure--including Intel (INTC) and Marvell (MRVL)--the issues are widely expected to be resolved by the middle of the year.
The smartphone adoption trend continues to be the biggest secular growth driver for the chip industry. Sales of chips used in smartphones have been strong and have defied the recent cyclical slowdown in the broader semiconductor space, thanks to the continued rapid proliferation of these devices. Qualcomm (QCOM) has been a major beneficiary of the trend, as the firm is not only benefitting from greater chip sales but also higher licensing revenue as the company receives a royalty on the price of virtually every smartphone. Qualcomm's position as a leading chip supplier into Apple's iPhone 4S should lead to healthy near-term sales growth as Apple gains share in the smartphone space. Meanwhile, a host of Nokia smartphones that will run Microsoft's Windows Mobile operating system all rely on Qualcomm's mobile processors and could give the company another sales boost. Some other interesting names to keep an eye on are Skyworks (SWKS), which supplies radio frequency chips, including those used in the Apple iPhone 4S, and Marvell, which has significant exposure to the growing smartphone opportunity in China.
The bottom tier of the U.S. wireless industry is starting to shift. We've long held that any carrier not named AT&T (T) or Verizon Wireless needs to examine its long-term place in the industry and take appropriate strategic action. However, AT&T's attempted acquisition of T-Mobile USA a year ago largely paralyzed the industry as regulators debated the deal. In addition, LightSquared's plans to enter the market and DISH Network's (DISH) recent spectrum acquisitions have convoluted the landscape for much of the past 12 months. Each of these issues has been settled, at least for now, courtesy of the Justice Department and the FCC. Of course, the AT&T/T-Mobile deal died at the hands of the DoJ. Similarly, the FCC pulled the plug on LightSquared's network plans, citing unavoidable interference with GPS services, and denied DISH's request to remove restrictions on the usage of its spectrum, subject to future hearings. LightSquared appears all but dead, and DISH will now have to plow ahead with the FCC to gain the approvals needed to make good use of its spectrum, substantially delaying its entrance into the wireless business.
With LightSquared and DISH sidelined, the rest of the industry is starting to move forward. The biggest beneficiary could be fledgling Clearwire (CLWR). Sprint (S), Clearwire's majority owner and largest customer, formally ended its network sharing relationship with LightSquared. The move further increases Sprint's commitment to Clearwire and the LTE network it plans to build. Clearwire also signed Leap Wireless (LEAP) as an LTE wholesale customer, marking a big step forward for both firms. We believe that Clearwire needs additional partners beyond Sprint to remain viable. While Leap isn't a large nationwide carrier, it adds some scale to Clearwire's LTE effort. Leap could provide an important strategic piece to the broader Sprint/Clearwire ecosystem. We view both Leap and MetroPCS (PCS) as solid acquisition targets for Sprint, but Sprint has clearly indicated that it isn't currently in a position to take on a major deal. The firm reportedly recently walked away from an agreement to acquire MetroPCS, choosing instead to focus on the Network Vision upgrade as it attempts to rebuild investor confidence. Leap's decision to partner with Clearwire for LTE capacity builds on its earlier roaming agreement with Sprint, keeps Leap's network strategy in line with Sprint's, and potentially sets the stage for consolidation down the road. Similarly, we believe an agreement between MetroPCS and Clearwire would also make logical sense at this point.
T-Mobile USA has largely remained out of the spotlight thus far in 2012. The firm has reportedly held talks with Sprint regarding a network sharing arrangement, but nothing has materialized. Instead, the firm is moving forward with a $4 billion network upgrade plan that includes the move to LTE technology. However, this initiative won't address the firm's size disadvantage, and T-Mobile's spectrum position is spotty in some markets, like New York, meaning that it may need to partner with someone for additional capacity. The firm could hold out hope that DISH emerges as a viable alternative, but this path is risky. In addition to the potential for a long delay, DISH could choose to sell its spectrum--or the entire company--to another, such as oft-rumored suitor AT&T.
Our Top Tech & Communication Services Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The four firms below fit this criteria and are trading at attractive valuations, in our view.
|Top Tech & Communication Services Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
| Price / |
|Data as of 03-23-12.|
Cisco Systems (CSCO)
Cisco continued to produce gross margin stability and showed no evidence of substantial market share deterioration in its core router and switch markets during its fiscal first quarter. Despite growing competition, 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 it will enable Oracle to drive additional software sales over time and further strengthen its wide economic moat.
France Telecom (FTE)
France Telecom is the dominant telecom operator in France and 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, and allows the firm to generate significant cash flow. This cash flow in turn allows France Telecom to pay a large dividend.
With 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 firm 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.
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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.