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Quarter-End Insights

Tech & Telecom: Opportunities in Smartphones and IT Services

The tech sector looks overvalued overall, but investors can find some value in smartphone-related vendors and IT services leaders.

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  • Overall, we view the tech sector as overvalued at a market-cap-weighted price/fair value of 1.02, while telecom is fairly valued at 1.00.
  • We continue to see opportunities in smartphone-related vendors.
  • Commissioning a digital and cloud strategy? Best to consult with moaty IT services leaders.

 

We Continue to See Opportunities in Smartphone-Related Vendors
Firms with exposure to the smartphone market have faced some tough times in recent quarters, as  Apple (AAPL) iPhone demand has not lived up to prior expectations and the company reported its first year-over-year quarterly revenue decline since 2003. The rest of the smartphone market hasn't fared much better; we've seen some company-specific market share shifts across the Android ecosystem, but in total, smartphone unit sales will fail to achieve double-digit growth in 2016 for the first time this decade. A host of component suppliers have sold off accordingly.

Despite this near-term sluggishness, we remain confident that the strong secular shift away from feature phones and toward more-advanced smartphones is still intact. Although we no longer foresee exponential iPhone growth for Apple, we think customer switching costs will drive most iPhone customers today to buy future iPhones tomorrow, thus supporting the company's unmatched free cash flow generation.

Commissioning a Digital and Cloud Strategy?
Best to Consult With Moaty IT Services Leaders

In the technology sector, investors often unfairly gloss over the large, fragmented world of IT services, focusing instead on product development surrounding the latest hardware and software innovations. However, we believe the services market provides fertile ground for economic moats to proliferate.

As the industry evolves, we think there are pockets in the market that are undergoing significant, often misunderstood structural changes. For instance, digital readiness and cloud computing are reshaping client demand, legacy services, and vendor go-to-market. As these forces resonate through the industry, we think some vendors, such as  Accenture (ACN),  Capgemini (CAP),  Cognizant Technology Solutions (CTSH), and  IBM (IBM), are better positioned than others to adjust. Of the 10 companies we cover, our top investment idea is Cognizant, as it offers investors a quality, well-positioned vendor that trades at a significant discount to our $69 fair value estimate.

Top Picks

 Apple (AAPL)
Star Rating: 3 Stars
Economic Moat: Narrow
Fair Value Estimate: $133.00
Fair Value Uncertainty: High
Consider Buying: $79.80

We believe near-term weakness and a broadly sluggish smartphone market have recently provided investors with an attractive margin of safety in narrow-moat Apple as compared with our $133 fair value estimate. Although we no longer foresee exponential growth for the iPhone, we think future sales will be more resilient than what the market has priced into the stock. Near-term sales of the iPhone 7 are uncertain today but could surprise the market. Ultimately, we think that for a host of reasons (such as software and services like iCloud, FaceTime, and iMessage; the need to repurchase apps and subscriptions; and a loss of compatibility with other Apple products), iPhone users today will continue to buy the latest iPhones well into the future. Meanwhile, we think the market is giving Apple little credit on the innovation front, either in new hardware, software, native applications, services (perhaps a streaming TV service), or new products (AirPods, potentially Apple Car).

 Skyworks Solutions (SWKS)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $92.00
Fair Value Uncertainty: High
Consider Buying: $55.20

We foresee growth at a reasonable price and an adequate margin of safety in narrow-moat radio frequency chipmaker Skyworks Solutions. Given the need for far higher RF chip content per 4G LTE smartphone, the ongoing complexity around LTE networks, and the rapid expansion of these networks in developed and emerging markets over the next few years, we foresee tailwinds for RF chip suppliers such as Skyworks over the next couple of years. We have some concerns about long-term RF pricing trends, but we believe these are accounted for in our $92 fair value estimate, as we model Skyworks' long-term growth at a slower pace than the firm's forecast.

 Cognizant Technology Solutions (CTSH)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $69.00
Fair Value Uncertainty: Medium
Consider Buying: $48.30

We view Cognizant as a leader in the IT services market. The company has a proven record of providing differentiated industry-relevant solutions that have led to significant client intimacy and recurring sticky business, as evidenced by our narrow economic moat rating. The firm has a fine balance between the consulting-centric incumbent operating model and the offshore industrial model that relies on lower-cost delivery, allowing it to appear as either a U.S. or Indian firm as circumstances dictate. We believe Cognizant's level of reinvestment has been a key to its above-industry growth performance and, while the firm does not pay a dividend, we think its focused capital allocation has led to differentiated intellectual property and particularly strong positions in the healthcare and financial services industries. In our opinion, Cognizant is also well positioned to address the burgeoning digital and cloud agendas of clients, which will be an area of long-term growth for the company. As a result, we expect Cognizant to sustain its long-term leadership in the IT services market. Also, Cognizant has relatively less exposure in Europe, a region where we don't foresee tremendous growth in the near term.

 Micron Technology (MU)
Star Rating: 3 Stars
Economic Moat: None
Fair Value Estimate: $22.00
Fair Value Uncertainty: Very High
Consider Buying: $11.00

We see an adequate margin of safety in no-moat memory supplier Micron. As end-market demand for PCs waned considerably in 2015 after a strong showing in 2014, DRAM oversupply caused relevant average selling prices to decline and Micron's stock price to fall even more precipitously, down 60% for the year. Compounding this headwind was the firm's new technology ramps in 3-D NAND and 20-nanometer DRAM. The persistence of these two factors over the past few quarters has reduced Micron's gross margins to the high teens in 2016. We think the market is pricing Micron as if these low margins are the new normal for the firm, whereas we believe a healthier product mix with more advanced NAND than DRAM will lead to more stability in gross margins. Our $22 fair value estimate implies a rebound toward the 30% range. Also, Micron has been steadily diversifying its end markets from PC-centric to mobile devices and servers, with one of the key catalysts for NAND being the secular shift toward solid-state drives used in PCs and servers from the prior incumbent hard disk drives. Furthermore, Micron's joint venture with Intel has yielded a new memory technology called 3D XPoint, which we view as a potential disrupter to the memory space, although the product is still in the early stages of development.

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