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Quarter-End Insights

Our Outlook for Tech & Communication Services Stocks

With the tech and telecom sectors becoming more fully valued, it's time for investors to be selective.

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  • The technology and telecom sectors are moving closer to fair value, and investors should be selective.
  • We see attractive buying opportunities in names that are currently out of favor with the market.
  • We highlight five high-quality names that generate strong free cash flows and whose stocks are attractively priced. 

 

Price/fair value ratios within the technology and telecom sectors have generally moved higher, and we see fewer attractive buying opportunities now relative to last quarter. Still, we continue to find value in a handful of quality firms that face near-to-intermediate term uncertainty as the secular trends of cloud and mobile computing force these firms to evolve. Some investors may be tempted to chase overpriced stocks favorably exposed to these trends. However, we are finding the best investment opportunities in cash-rich firms that are trading at reasonable discounts to fair value because the market is undervaluing their structural competitive advantages. We highlight five ideas that fit this description beneath our industry level insights.

Industry-Level Insights

Telecom
Among those potential partners, Deutsche Telekom's (DTEGY) T-Mobile USA is inching closer to closing its merger with  MetroPCS (PCS). We had thought that Sprint might step in with a bid for Metro, but at this point, that seems unlikely. T-Mobile is laying plans to aggressively shake up the wireless industry following the merger, with new branding and a set of rate plans that seeks to separate the cost of service from phone subsidies. Despite these moves, we believe that T-Mobile and MetroPCS face an uphill battle as they fight against  AT&T (T) and Verizon Wireless.

The reshuffling among the smaller players within the U.S. telecom industry continues to slowly move forward. With fresh capital from Softbank, Sprint Nextel (S) has pounced on Clearwire (CLWR), looking to bring its on-again-off-again partner under direct control. It appears that Sprint has spurned any partnership with  DISH Network (DISH), as DISH has launched a rival bid for Clearwire. We believe that Sprint remains the strongest of the small wireless carriers and that it will succeed in its pursuit of Clearwire. That leaves a major question mark around DISH and the chunk of the wireless spectrum it acquired in 2011. While many investors have ascribed huge value to DISH's spectrum asset, we continue to believe that the firm is in a challenging position, facing network build-out requirements and a group of would-be partners that are currently busy with other initiatives.

The future of Verizon Wireless has also come into question recently, with rumors of a deal between its parents, Verizon (VZ) and Vodafone (VOD), circulating. Verizon has long indicated that it would like full ownership of Verizon Wireless, and Vodafone appears to be a willing seller. However, we believe the status quo is the most likely outcome here, as disagreements over valuation, tax implications, and other managerial complexities remain hurdles to any deal.    

Deleveraging continues to be a major focus among European telecom firms, which has led many companies to cut their dividends. Most recently,  Koninklijke KPN NV (KKPNY) once again cut its dividend to increase its free cash flow available for debt reduction. The firm's dividend has now dropped from EUR 0.72 for the 2011 year (partially paid in 2012) to EUR 0.03 announced to be paid in 2013. Deutsche Telekom also announced that while it will maintain a EUR0 0.70 dividend for 2012 (payable in 2013), it will reduce its payout for the next two years to EUR 0.50. Even BT Group (BT) and Vodafone, which increased their dividends, have continued to pay down debt.

Semiconductors
The semiconductor market is showing some signs of a recovery following the cyclical slowdown that hampered the space in the past couple of quarters. Major chipmakers that serve a broad array of end markets, such as  Texas Instruments (TXN)Linear Technology (LLTC), and  Analog Devices (ADI), have seen a pickup in order activity to kick off the year, following the more cautious business environment that pervaded the industry in the second half of 2012. With chip inventories across the electronics supply chain at relatively lean levels, we would expect overall global semiconductor demand to strengthen quickly if the economy were to pick up steam.

One segment of the chip space that continues to show signs of weakness is the PC-related chip market. The popularity of tablets continues to pressure PC demand, which has created some headwinds for chipmakers exposed to that area, such as Marvell Technology (MRVL), and Intersil (ISIL). The trend has also affected semiconductor behemoth  Intel (INTC), the world's biggest supplier of PC microprocessors. Nonetheless, we think Intel can still grow over time, thanks to its server processor segment. We expect the firm to see significant sales growth in server chips in the coming years, driven by the continued build-out of the cloud infrastructure.

Finally, one of the more interesting announcements in the past few months came from Intel and programmable chipmaker Altera (ALTR). Intel will provide manufacturing services based on next-generation 14-nanometer tri-gate transistor process technology for future programmable logic devices from Altera. The move certainly furthers Intel's foray into the foundry business, as the firm currently provides manufacturing services for a handful of chip startups. For the time being, we believe Intel will remain selective with any additional foundry tie-ups and will partner with customers with similar profiles to Altera--a highly profitable chipmaker that doesn't compete with Intel, yet can take advantage of Intel's cutting-edge manufacturing capabilities. As a result, for now we don't anticipate Intel's providing foundry services for chips based on designs from ARM (ARMH) including  Apple's (AAPL) A-series processors for iPhones and iPads. While the Altera deal will have little impact on Intel's financials, the firm's interest in the foundry business is something worth keeping an eye on.

Internet
Fear has subsided for now in the Internet sector, as investors have pushed up stock prices for much of our coverage list. We think investors maintain exposure to the sector, although we see little new opportunity for investment.

Strong growth in digital advertising spending should continue, although robust expectations and well-placed faith in competitive advantages have resulted in fully valued stocks in most instances. For the leader of the pack, Google (GOOG), we believe revenue growth from desktop-based Internet search will begin a modest slowdown, and advertising revenues coming from DoubleClick and mobile advertising will continue to grow in importance. These businesses have lower structural operating margins. As Google's advertising reach broadens, the company will be forced to share revenues with a greater number of partners, including handset manufacturers, content owners, and developers. Although the company is actively pruning its product portfolio, we do not expect to see a measurable improvement in the overall cost structure.

Notably, we believe  Facebook (FB) is a more attractive investment opportunity at this time, although we believe near-term expectations are not overly conservative. At the other end of the spectrum, we find  LinkedIn's (LNKD) valuation difficult to justify, and we strongly encourage investors to avoid this investment based on our view that there is considerable downside risk at the current stock price.

Software
In the software sector, we continue to believe Oracle (ORCL) is a largely underappreciated story, and last quarter's earnings disappointment and subsequent sell-off have created a more attractive buying opportunity for patient investors. As the market focuses on new trends in cloud-based software and "big data" solutions, we note that Oracle's position as an incumbent technology provider is as important as ever. These technologies have been disruptive to some, yet companies with economic moats such as Oracle (and similarly  IBM (IBM)) will be able to defend their turf. As a result, thanks to an overly cheap valuation, Oracle is one of the most attractive names in our software universe.

With the early numbers ranging from inconclusive to disappointing,  Microsoft's (MSFT) Windows 8, Surface tablet, Windows phone, and Office 365 launches are the headline catalysts for the year. The firm did not release numbers for the Surface RT Tablet in last quarter's results, which likely points to disappointing launch results for the holiday quarter. However, the recent launch of the more robust Surface Pro tablet is meant to appeal to corporate users and will give a better indication of early Windows tablet adoption. Because Windows 8 is optimized for mobile devices, the Windows phone represents a lower cost opportunity for consumers to adopt the new OS, but it competes with popular offerings from iOS, Android, and a resurgent  Research in Motion (BBRY). We believe the recent success of Android's and Apple's iOS phones and tablets represents a clear threat to Microsoft's Windows franchise, and Microsoft's OS strategy focuses on these opportunities. On the PC side, Windows 8 adoption lags Windows 7 adoption in the comparable period, but with significant changes in user interface and limited hardware options early on, we are not surprised at the slow uptake. The recent launch of Office 365 gives Microsoft a presence in the software-as-a-service productivity application market, while refreshing a crucial business for the firm. We remain cautiously optimistic that Microsoft can establish beachheads in the mobile and tablet segments, while reinvigorating its Office franchise, which should help slow the decline in Windows market share.

Hardware
The smartphone and tablet industries continue to thrive, and Apple and Samsung remain at the head of the pack, gaining share from struggling competitors such as HTC, BlackBerry, and  Nokia (NOK). Apple's stellar integration of hardware, software, and services into easy-to-use devices has driven the firm's strong revenue growth and profitability in recent years. We project healthy iPhone growth over the next few years, especially in China, although we recognize that pricing pressure and gross margin deterioration may occur on future iPhone sales. Meanwhile, we anticipate strong tablet adoption over the next few years, both for larger iPads and lower-priced iPad Minis. As long as Apple can continue to build upon its success (and we see little evidence to the contrary thus far), we think the company will remain a leader in the premium smartphone and tablet markets for years to come.

Meanwhile, Samsung took advantage of a window of opportunity between iPhone refresh cycles, delivering strong sales of its Galaxy S III smartphone in the summer of 2012 that incorporated 4G LTE compatibility and larger screen sizes than the smaller, 3G-only iPhone 4S. We suspect that Samsung may repeat this effort with its recently announced Galaxy S4, again carrying a larger screen size and new features versus the iPhone 5.

Meanwhile, both Nokia and BlackBerry are making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apple's iOS and Google's Android. Nokia's Windows-based Lumia phones haven't gained much traction thus far, and we remain concerned that, even if Windows phones were to gain tremendous adoption, other smartphone makers, and perhaps Microsoft itself, will build Windows-based phones that may outsell Nokia.

BlackBerry announced its BlackBerry 10 operating system and Z10 touch-screen handset in late January, and although initial sales figures haven't been released, we're skeptical that these products are taking the industry by storm. We also remain concerned about BlackBerry's ability to generate high-margin services revenue on BB10 device sales as well as its current BlackBerry 7 and prior subscriber base. Ultimately, we view BlackBerry emerging as a niche supplier of smartphones into the enterprise and in certain countries worldwide where the firm still has some loyal users and decent brand recognition.

Top Tech & Communication Services Sector Picks
  Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Applied Materials $17.00 Wide Medium $11.90
Oracle  $39.00 Wide Medium $27.30
Apple $600.00 Narrow Medium $420.00
Check Point Software
$61.00 Narrow Medium $42.70
Intel $26.00 Wide Medium $18.20
Data as of 03-21-13.

 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.

 Apple (AAPL)   
Although Apple's current market price implies maturity, we expect continued growth. Smartphones still account for less than 50% of total handset shipments, and we expect this penetration rate to continue to grow. Additionally, Apple still retains a dominant position in the tablet market, which should grow quickly during the next several years. Apple's success in tablets and smartphones has helped the firm drive strong sales of its Macs, even as the overall PC market shrinks. As Apple sells more devices to its customers, it can increase customer switching costs around its software and services.

 Check Point Software Technologies (CHKP) 
Check Point is a leading provider of network security solutions. The network firewall market is a slow-growth area, but we expect that 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 such as Palo Alto Networks pose a legitimate threat, we expect Check Point's market price to rise toward fair value as investors realize the firm's competitive advantages are intact.

 Intel (INTC) 
Concerns over the demise of the PC are exaggerated, in our view. Regardless, Intel still has a strong growth driver in its server microprocessor business, where the firm is dominant, and has opportunities to break into smartphones and tablets with its low-power Atom chips. With a 4.4% dividend yield, rock-solid balance sheet, and one of the most durable competitive advantages in the technology sector, we think Intel's stock is attractive.

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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.