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Quarter-End Insights

Tech and Communication Services: Gravitate Toward the Moats

With these sectors trading above our fair value estimate, investors should seek firms with established economic moats to help them withstand near-term revenue and operating margin volatility. Plus, get our take on Apple Pay's impact and the ongoing wireless spectrum auction.

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  • Mid-October presented an opportunity for tech, but valuations have rebounded and there are only a handful of undervalued, albeit higher-uncertainty, stocks.
  • Apple Pay will have a ripple effect and the potential to disrupt the emerging mobile payments market.
  • The ongoing wireless spectrum auction has garnered bids in excess of $40 billion, far more than we had expected.

After a brief period in October when valuations across the technology sector corrected by 10%, stocks have rebounded, and the sector is once again slightly overvalued. The recent drop in oil prices and global currency movements have led to a bit more volatility across both the technology and communication services sectors, but there are currently no 5-star technology stocks and only a handful of 4-star names.

Below, we highlight a few companies that appear to be fundamentally undervalued, including one from the telecom sector. Taking a step back, with these two sectors trading at or above fair value, we would prefer a wider margin of safety and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility.

Apple Pay Should Be a Game-Changer
As if the presentation of two hot-selling iPhones and the introduction of Apple Watch were not enough,  Apple (AAPL) made another big splash with the recent launch of Apple Pay, a mobile payment platform built in cooperation with merchants, credit card issuers, and card networks. This solution should emerge as a game-changer in global commerce, and it's something that we're keeping a close eye on, as it has large implications for consumers, merchants, and the payment ecosystem alike.

First, iOS customers will benefit from Apple Pay by having a native application in their iPhones that is easy to set up and convenient to use, with a solid lineup of merchant partners, all while offering stronger security and privacy than the magnetic stripes on plastic credit cards today. Traditional cards still offer far greater merchant acceptance today, while the incremental convenience of a tap versus a card swipe might be minimal.

Second, merchants may prosper from Apple Pay in the long run by offering quicker payments for fast-service transactions, stronger point-of-sale security, and retaining control over transaction data, all while potentially benefiting from co-branding and enhanced customer engagement. When it launches, Apple Pay will boast an impressive roster of global retail and aggregator partners, including  Walgreen (WAG),  McDonald's (MCD), Subway, Groupon (GRPN), OpenTable, and, naturally, Apple's own retail locations.  Starbucks (SBUX),  Chipotle (CMG), and other players are also likely to join in late 2014 or 2015. In total, these partners represent 220,000 locations across the United States and--assuming these players are the natural partners for Apple Pay's international growth aspirations--potentially more than 50,000 more retail outlets outside the United States. Admittedly, these retailers represent only a fraction of the approximately 7 million–9 million retailers accepting credit cards in the United States, but we believe Apple has chosen its partners carefully to increase the likelihood of widespread consumer adoption.

Third, we think Apple Pay will initially have a modestly positive effect on the global business of payment networks, a modestly negative effect on card issuers, and a neutral effect on merchant acquirers. Partners will benefit from enhanced security features, reducing direct and indirect costs of fraud, and a small amount of incremental transaction volume is likely to shift from cash to electronic payments. However, Apple Pay is now competing for a piece of the existing payment pie and has the potential to muscle in on the network effects, brand value, and economic profits created by participants in the network paradigm. That said, we expect Apple Pay's global user base to exceed 100 million by 2017.

Two of the most common growth subsectors in technology are likely to have an impact on payment systems: cloud computing and mobility. Physical and online merchants have been developing nonpayment mobile applications for Android and iOS, primarily for marketing and loyalty programs. We believe this is training both merchants and consumers to use smartphones and embrace mobile payments, at least eventually.

Key Trends in Telecom
Consolidation, regulatory policy, and technology themes continue to converge in the U.S. telecom industry. The Federal Communications Commission has forcefully taken the position that existing competition needs protection, effectively killing any chance that  Sprint (S) and  T-Mobile (TMUS) would merge to better compete with giants  AT&T (T) and  Verizon (VZ). This action provides additional intrigue as regulators continue to consider the implications of significantly greater media concentration that the proposed acquisitions of  DirecTV (DTV) and  Time Warner Cable (TWC) would present.

At the same time, the debate surrounding the "open Internet," or "net neutrality," continues to take shape, with President Barack Obama recently coming out in support of more strict industry regulation. As these issues are debated, there is a risk that the FCC or the Justice Department puts a hold on consolidation. Ultimately, we don't expect a major change to the competitive positioning of firms within the industry in the near term.

Of particular concern, the ongoing wireless spectrum auction has garnered bids in excess of $40 billion, far more than we had expected. AT&T and Verizon should be able to handle this expense without significantly eroding their financial strength, but we believe generating a return on this investment will prove difficult. We continue to expect Sprint and T-Mobile to struggle to generate acceptable profitability, placing a significant strain on their finances.

Consolidation is occurring in Europe, within countries and across national borders. Vodafone (VOD) recently bought Ono, the largest cable operator in Spain, while  Numericable (NUM), the largest cable operator in France, has acquired SFR, the second-largest phone company in the country. Importantly, European Union regulators approved  Telefonica Deutschland's (O2D) purchase of  KPN KPN German subsidiary E-Plus, and this deal has now closed.  Orange (ORAN) has agreed to acquire alternative carrier Jazztel in Spain. Additionally, European operators' connections to Brazil are influencing mergers and acquisitions there, with  Telefonica (TEF) agreeing to purchase GVT from  Vivendi (VIVHY), and Altice has entered exclusive negotiations to buy  Oi's (OIBR) Portuguese assets. Also,  America Movil (AMX) and Oi are discussing a bid for  Telecom Italia's (TI) Brazilian operation, TIM Brasil.

We anticipate additional M&A activity to continue around the world, which has pushed up the prices of many stocks. However, there are still pockets of value across the global telecom space. Most come with baggage, either in the form of lagging sales growth, higher legacy costs, or poor macroeconomic conditions, so we encourage investors to be highly selective.

Top Tech & Telecom Sector Picks

Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
IBM $196 Wide Medium $137.20
T-Mobile US $34 None High $20.40
Advanced Micro Devices $3.50 None Very High $1.75
Data as of Dec. 16, 2014

 International Business Machines (IBM)
IBM is one of the largest IT companies, with an array of offerings, including system hardware (14% of revenue), infrastructure software (25% of revenue), outsourcing, and systems integration services (60% of revenue when combined). The firm has operations in more than 175 countries and generates about 55% of revenue from abroad. We believe IBM is still in the early stages of a transition period that will last for a few more years. In our view, the ongoing secular shift to cloud-based environments has a very long tail and provides IBM some time to adapt and simplify its strategy in this market (a silver lining of sorts). However, alongside the anticipated medium-term profit growth that we expect to materialize from management's initiatives, we project elevated risk, more uncertainty, and added volatility.

 T-Mobile US (TMUS)
T-Mobile US, the fourth-largest wireless carrier in the United States, serves 53 million customers, including 26 million postpaid and 16 million prepaid customers. The firm's focus currently is on rapidly deploying LTE network technology to improve the customer experience while also aggressively marketing service plans, dubbed "Uncarrier" offerings, designed to play off of common customer frustrations, such as overage charges and contract termination fees. Despite recent solid performance, T-Mobile shares have sagged recently as a result of regulatory opposition to a proposed merger with Sprint, the nation's third-largest carrier, and fear that the firm has overspent on wireless spectrum at auction. If the firm does wildly overspend on spectrum, we will lower our fair value estimate. Shares today appear fundamentally undervalued, but we don't think T-Mobile benefits from an economic moat, and we reiterate our high uncertainty rating.

 Advanced Micro Devices (AMD)
Advanced Micro Devices designs and produces microprocessors and low-power processor solutions for the computer, communications, and consumer electronics industries. The majority of the firm's sales are in the computer market. AMD acquired graphics processor and chipset maker ATI in 2006 to improve its positioning in the PC food chain. In 2009, the firm spun out its manufacturing operations to form a foundry joint venture, GlobalFoundries. Although AMD will be facing some lumpiness in the near term and is a no-moat name, we continue to believe that the firm has been making the right strategic moves to diversify into new areas, such as semicustom processors, in order to reduce its dependence on the PC market.

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Peter Wahlstrom has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.