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Quarter-End Insights

Our Outlook for Tech and Communication Services Stocks

We strongly favor high-quality names in the current environment.

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  • Last quarter's market rally pushed the tech and telecom sectors up toward fair value. 
  • The demand environment continues to look somewhat sluggish across most subsectors. 
  • We would stick with higher-quality names, given the current investment climate.

Last quarter we observed that while the demand environment looked somewhat sluggish, the technology sector was moderately undervalued. Although third-quarter data points continued to indicate tepid near-term demand across most subsectors, the recent market rally has pushed the technology and telecom sectors closer to fair value. Given the uncertain demand environment and limited margin of safety for most stocks we cover, our near-term sentiment on the tech and telecom sectors can best be characterized as cautiously pessimistic. In the current environment, we think investors should generally stick with higher-quality firms that possess strong balance sheets and consistently strong cash flows. While it is increasingly difficult to find firms that possess these characteristics and are also undervalued, we identify five ideas for investors to consider at the end of our industry-level outlooks.

Telecom
The quest for yield in today's low-interest-rate environment has led many investors to the U.S. telecom industry, sending shares of stalwarts  AT&T (T) and  Verizon Communications (VZ) to levels not seen in more than four years. Cable stocks have fared even better, with  Comcast (CMCSA) (CMCSK) shares nearing highs last reached during the late 1990s telecom bubble. Solid operating performance recently, especially in the wireless sector, has also lent support to the view that telecom provides a reliable stream of steady cash flow, making the sizable yields of the industry’s strongest players look all the more appealing. Both Verizon Wireless and AT&T's mobile business posted record margins during the second quarter, as the pace of phone upgrades among customers slowed to levels not seen in some time. However, any lingering hope that an elongated refresh cycle between iPhone models would keep consumers on the sidelines was dashed in early September with  Apple's (AAPL) announcement of the iPhone 5. Heavy sales of the new device will push phone subsidy costs up sharply during the second half of 2012, putting pressure on wireless margins.

We expect that margin volatility will remain a feature of the wireless industry as long as a single phone enjoys dominant market share. We have been looking for signs of willingness among carriers to push back against Apple's growing market power, but we've yet to see anything concrete. The iPhone 5 will sell at the same $200-$400 price points as its predecessor, indicating that subsidy levels will be comparable as well. The biggest challenge to Apple has been in Spain, where  Telefonica (TEF) announced that it would stop subsidizing handsets last March. Rivals  Vodafone Group (VOD) and Yoigo quickly followed suit, but  France Telecom (FTE) has held out. FT has handily outperformed the other carriers with respect to customer growth since these changes took effect, leading us to believe that carriers in other countries will remain reluctant to challenge Apple for now.

The threat that Apple's growing power poses to the telecom industry is one of several risks that leave us wary of chasing telecom stocks, regardless of valuation, in search of yield. The state of the carriers in Europe demonstrates that telecom is not immune to swings in the economy or the increase in competition that can accompany slowing growth. The fact that carriers in Spain were the first to take steps to reduce phone subsidies isn't a surprise, given the country's economic state. Several European carriers need to boost margins to better manage debt loads, as the European debt crisis has pushed borrowing costs up sharply during 2012. The rise in borrowing costs, coupled with regulatory and competitive pressure, has caused investors to punish European telecom stocks. Ironically, the result is that we see better value in Europe currently than we do in the United States, even after a rally in European stock prices following comments from European Central Bank president Mario Draghi regarding the bank's willingness to save the euro. France Telecom remains our top pick in Europe.

Many European carriers will continue to focus on debt reduction as long as the euro crisis lingers. In the current economic environment we agree with this focus, but we remain skeptical of the efficacy of asset sales to speed up the process. We believe there are few buyers for European telecom assets in the current environment and those that exist are looking for fire-sale prices.  KPN (KKPNY) has already scrapped plans to sell its Belgian business, awaiting better market conditions, and we think other operators will follow suit.

 America Movil (AMX) is one firm that remains interested in Europe, though it remains price conscious. After boosting its European exposure in the second quarter through stakes in KPN and Telekom Austria, America Movil is reportedly now taking a hard look at Poland. According to reports, the firm is considering acquiring both Play, the country's smallest cellular carrier, and Hawe, a Polish fiber network wholesaler. Regardless of whether these specific reports pan out, it's clear that since America Movil has run out of merger and acquisition opportunities in Latin America, it is more than willing to diversify and expand its footprint through inexpensive acquisitions in Europe.

Back in its core market of Latin America, America Movil has had to deal with more regulatory heat. After the mobile termination rate cuts in Brazil in February, Anatel, the Brazilian telecommunications regulator, has struck again. In July, Anatel suspended America Movil's Brazilian subsidiary Claro and two rivals ( Oi (OIBR) and  TIM Brasil (TSU)) from selling new contracts in certain regions in an effort to improve Brazil's network quality. Anatel gave the firms one month to create plans to solve their infrastructure inadequacies. While Anatel ended up lifting the ban two weeks later, it's clear that the regulator is turning up the heat on the carriers as it braces itself for what is projected to be an overwhelming amount of data traffic demand when it hosts the 2014 World Cup and 2016 Summer Olympics. This comes in the wake of telecom minister Paulo Bernardo's mandate in May that the carriers raise their investment spending more than 40%.

Semiconductors
The outlook for the overall semiconductor industry has become increasingly uncertain in recent weeks. While many chipmakers saw improving business trends in the second quarter, the group has since become more cautious about the threat of weakening near-term semiconductor demand caused by a challenging global economic environment. In early September,  Intel (INTC) lowered its third-quarter revenue outlook to $12.9 billion-$13.5 billion from the outlook of $13.8 billion-$14.8 billion provided in July. The firm attributed the reduced forecast to weaker-than-expected processor demand, as computer manufacturers manage chip inventories in the PC supply chain in response to macroeconomic conditions. More recently, broad-based analog chipmaker  Texas Instruments (TXN) noted during its midquarter update for the third quarter that overall demand for its products have tracked slightly below expectations.

Nonetheless, the recent launch of Apple's iPhone 5 should provide some tailwinds for chip suppliers with exposure to the new gadget, as preorder activity for the device has been strong. In particular, a number of firms, including  Qualcomm (QCOM),  Broadcom (BRCM), and  Skyworks Solutions (SWKS), should have chips incorporated into the iPhone 5 and should benefit from the popularity of the gadget. Although the smartphone and tablet phenomenon has provided a positive secular trend for the semiconductor industry as a whole, not all chipmakers have benefited equally.  Marvell Technology Group (MRVL) continues to see its mobile and wireless chip business decline as key customer  Research in Motion (RIMM) loses its competitiveness in the smartphone market.

Internet
We expect a reasonably benign fourth quarter for our Internet coverage list as macroeconomic concerns in Europe persist, while modestly improving metrics in mobile advertising should be anecdotal at best. As the tides of fear can rise and fall (along with the stock price), stock prices may enter into periods of increased volatility. 

For the upcoming quarter, we do not expect the recent launch of Apple's iPhone 5 to lead to massive market losses for Android, the mobile operating system that is largely controlled by  Google (GOOG). Importantly, if Android is able to maintain or increase its share of mobile shipments during the quarter, we believe Google's wide economic moat will be stronger than ever in the mobile sector. We balance our long-term optimism with our short-term belief that a nascent mobile advertising market and generally cheaper pricing for mobile ad units may restrain investors' enthusiasm for the company. Still, even after Google's solid stock performance in the third quarter, we believe the shares remain modestly undervalued.

 Facebook (FB) and  Yahoo (YHOO) are facing company-specific issues during the quarter, and we would only highlight Facebook at this time as a company to consider as an investment. During the fourth quarter, there is a significant lockup expiration of Facebook shares with nearly 1.5 billion shares from investors and employees becoming available for sale. This additional stock may lead to short-term price declines as the market absorbs the new inventory. We believe Facebook stock is extremely compelling under $19 and suggest that investors put the stock on a watch list. We are less enthusiastic about Yahoo. We are anxiously waiting for more clarity regarding its turnaround strategy. The firm recently announced an additional $3 billion share buyback after closing on a partial liquidation of a holding in Alibaba Group, a private Chinese company. The company has more than $3 billion in cash and equivalents on the balance sheet, and we expect an increase in acquisitions by the firm. We continue to not recommend a purchase of Yahoo shares until we learn more about the company's turnaround and capital allocation plans.

Software
 Microsoft (MSFT) takes top billing in our software outlook, with the imminent and ever-important launch of Windows 8. This new operating system not only incorporates a radical change in the user interface for desktop users, but also it is the foundation of a combined operating system for PCs, tablets, and mobile phones. On the PC side, we expect little immediate uplift as enterprises have become more deliberate about staging new software investments than in past upgrade cycles. For our purposes, we are wholly focused on the early results of tablets (the Microsoft Surface) and mobile phones (leading with a flagship  Nokia (NOK) phone). We believe the recent success of Android phones and Apple's iOS phones and tablets represent a clear and present threat to Microsoft's Windows franchise. We are cautiously optimistic that the company can become relevant in the mobile and tablet segments.

On the enterprise software side, we believe Workday's upcoming initial public offering will be met with breathless anticipation. The founders of Workday have made no secret of their intention to steal market share from  SAP (SAP) and  Oracle (ORCL), and the company's recent S-1 filing shows that these enterprise giants have reason to be fearful. Workday provides human capital management software to help employers manage their workers, but delivers the solution in a software-as-a-service model, saving customers significant amounts of money in up-front costs and ongoing support. Although customers may lose the ability to customize their solutions, Workday's rapid growth proves the offering is resonating with the market. Workday also provides a financial application in direct competition with Oracle's suite of enterprise applications. While the switching costs are notable for Oracle customers, we are bullish that Workday will find new customers and convince others that have been disgruntled by Oracle's aggressive pricing to switch providers. We expect that investors will take note of  Salesforce.com's (CRM) meteoric rise since its IPO and reward Workday with a very optimistic price on its offering date.

Hardware
The financial performance gap continues to widen between the stronger players like Apple and Samsung and their direct and indirect competitors, including PC-focused firms  Hewlett-Packard (HPQ) and  Dell (DELL) and lagging handset vendors RIM and Nokia. If valuation didn't matter, the investment decision would be simple. Apple is riding the wave of smartphone and tablet adoption that it has largely created, and it is also the only company in the aforementioned list that owns the most valuable intellectual property embedded in its devices. As a result, we expect Apple to generate above-average growth and economic profits for quite some time. 

However, valuation does matter, and Apple's stock price is now above our fair value estimate, while Dell's stock looks too cheap to ignore. We believe Dell's lackluster financial results and weak share price already reflect its current challenging competitive environment. On the other hand, Apple's financial results have yet to reflect the increasing level of competition that will eventually have an effect. The high-profile patent battle between Apple and Samsung highlights the fierce competitive environment. While the trial outcome may have been a superficial near-term win for Apple, it also highlighted an increasing lack of significant differentiation between the vendors' offerings. While we continue to be impressed by Apple's operational and financial performance, the valuation is not compelling and we would look elsewhere at this time. 

The mobile computing era that Apple helped usher in is also having wide-ranging affects on the enterprise IT landscape. The spillover of smartphones and tablets into business environments is characterized by the IT community as "bring your own device," and this phenomenon is representative of a broader push toward the consumerization of enterprise IT. As the workforce becomes increasingly mobile and as the lines continue to blur between one's work life and personal life, workers are seeking out new tools to perform their jobs more effectively while away from the office. Services that aren't necessarily enterprise-hardened, such as Dropbox for file synchronization, Twitter for marketing, and Apple's Facetime for video conferencing, are forcing corporate IT departments to evolve legacy security policies and architectures, upgrade connectivity infrastructure, and in many cases rethink their data center designs. 

While the impact that consumerization is having and will continue to have on the enterprise IT landscape affects a broad swath of vendors, we currently see a handful of longer-term investment opportunities in the sub-sector that are tied to this trend. Focused firms like  Check Point Software Technologies (CHKP) in network security,  Acme Packet (APKT) in voice-over-IP security, and  Riverbed Technology (RVBD) in application delivery stand to benefit from consumerization over the longer term, and each firm's stock is currently trading in 4-star territory.

IT Services
There hasn't been much change in our business outlook for IT and business process outsourcing service providers since our last update. The demand environment remains mixed, with trends varying among industry verticals and geographic regions. Banking, financial services, and insurance continues to be a dominant vertical for most of the IT service providers, and the recent slowdown in IT services spending by these firms remains an area of concern. Demand rebounded in the second quarter, albeit modestly. With discretionary spending still tight for many financial services firms, we think it will be a while before we see any notable improvement in performance from the BFSI vertical. This has turned the focus on emerging verticals including retail, health care, and manufacturing, where the demand situation remains favorable. In terms of geography, America continues to hold up better than Europe. Additionally, European performance depends on currency movements, which isn't working in favor of service providers so far. Despite the near-term challenges, we expect continental Europe to be a key growth market for the offshore IT service providers over the long term, primarily because of low adoption rates.

Most of the IT services firms that we cover ended the first half with a healthy pipeline, which bodes well in the near term. In a normal demand environment, it is safe to assume that pipelines always translate to projects. However, conversion rates were hampered by macroeconomic factors in the past, and we are keeping a close eye on this metric these days. So far, all the commentary from management indicates that the pace of conversion has remained steady over the past few months.

On the cost side, service providers with a large Indian presence are benefiting from a weak Indian rupee and a combination of low wage inflation and employee attrition. We expect this trend to persist in the near term, which should provide a cushion for companies to protect their margins if growth were to turn south.

Our Top Tech and Communication Services 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 these criteria and are trading at attractive valuations, in our view. 

Top Tech & Communication Services Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Price /
Fair Value
Applied Materials $17.00 Wide Medium 0.69
Oracle $38.00 Wide Medium 0.87
Autodesk $37.00 Wide Medium 0.90
Check Point $61.00 Narrow Medium 0.77
Cisco Systems $24.00 Wide Medium 0.79
Data as of 09-18-12.

 Applied Materials (AMAT)  
Applied is the behemoth of the semiconductor equipment industry, with unmatched scale and a broad product portfolio, making it the closest thing to a one-stop shop for chip manufacturers. Although the firm's foray into the solar equipment industry has weighed on financial results, the stock has been overly punished, in our view. As semiconductor circuit sizes continue to shrink, demand for Applied's complex tools and services will continue to grow. 

 Oracle (ORCL)
Oracle is one of the highest-quality names in our tech coverage universe, and we expect its 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 the firm to drive additional software sales over time and further strengthen its wide economic moat.

 Autodesk (ADSK)
Autodesk continues to be the de facto standard in digital design because of its early presence in the computer-aided design industry, the largest client base of about 9 million CAD end users, and its wide range of industry-specific solutions. High switching costs help support Autodesk's wide moat. Engineers and designers are trained on AutoCAD in college, and employers don't want to incur the costs to retrain them on different software. Although the firm is working through some salesforce execution issues and a transition to mobile delivery platforms, we think these shorter-term hiccups have created a reasonably attractive entry point for patient investors.

 Check Point (CHKP)
Check Point is a leading provider of network security solutions. The network firewall market is a slow-growth area, but we expect the company's appliance strategy and software blade architecture will enable it to grow faster than the core firewall market. High switching costs and risks make Check Point's network security solutions very sticky, enabling the firm to deliver high operating profitability. Although upstarts like Palo Alto Networks pose a legitimate threat, we expect Check Point's market price to rise toward fair value as investors realize that the firm's competitive advantages are intact.

 Cisco Systems (CSCO)
We have included wide-moat Cisco as one of our favorites. Although we expect fierce competition to continue across portions of Cisco's switch and router businesses, we think the firm has largely put product transitions behind it with its massive installed base intact. Additionally, Cisco's growing services business should provide greater earnings stability during the next economic downturn. Management has increasingly demonstrated more shareholder-friendly behavior through dividend increases, greater focus on core businesses, and a disciplined acquisition strategy.

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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.