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Quarter-End Insights

Tech: Overvalued Overall, but Opportunities Remain

Valuations in general are painting overly rosy scenarios, but we still see pockets of value in areas such as enterprise software and IT services.

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  • Overall, we view the tech sector as slightly overvalued at a market cap weighted price/fair value of 1.06.
  • We see a tectonic shift toward enterprise cloud computing.
  • The  Intel (INTC) and  Mobileye (MBLY) merger highlights the fight for automotive chip leadership, although valuations in semis more than exceed the hype.

 

Overall, we view the tech sector as modestly overvalued today at a market-cap-weighted price/fair value of 1.06, versus a ratio of 0.98 last quarter. Large-market-cap contributors like  Apple (AAPL) reported strong fourth-quarter results that contributed to a rise in valuation toward our fair value. Meanwhile, several key semiconductor firms still see bright business conditions, while software vendors are bouncing back nicely as well.

In general, we still believe that valuations across tech are painting overly rosy scenarios in new and emerging technologies around artificial intelligence, for example. Some growth prospects, like rising demand from the automotive sector, are properly being considered by the market, in our view. We still see some pockets of value in tech, such as enterprise software and IT services.

Perhaps the single most important trend in technology is the ongoing shift toward cloud computing, which we think is having ramifications on dozens of stocks across our coverage. In short, both startups and enterprises, in efforts to reduce the high fixed costs associated with running on-premise IT hardware and software, are shifting more and more workloads to infrastructure-as-a-service, or IaaS, vendors, such as  Amazon's (AMZN) Web Services,  Microsoft (MSFT) Azure, and Google (GOOGL). In turn, IaaS vendors, along with software-as-a-service (SaaS) vendors, are seeing tremendous growth, while legacy IT vendors face ongoing headwinds.  Adobe (ADBE) and Microsoft have been especially adept at transitioning to the SaaS model, as selling subscription software, rather than charging for upfront licenses, have expanded their customer bases.  Oracle (ORCL), for one, has been relatively slower to pivot, in our view, although it has shown recent signs of optimism.

Across our coverage universe, some of our most undervalued names are SaaS providers like  Salesforce.com (CRM) and  ServiceNow (NOW). Both firms are good examples of software vendors that should continue to gain market share and see outsized revenue growth over the next decade as they continue to ride SaaS and cloud tailwinds. Yet we think that future operating leverage in both business models is being discounted. Both firms are generating minimal profits today as they continue to spend on customer acquisition in a land grab. As we look further out, beyond the next one or two years, future spending by SaaS leaders should lead to customer retention, which is far less costly than customer acquisition spending today. In turn, we foresee many SaaS vendors like Salesforce.com and ServiceNow benefitting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.

On the other hand, semiconductors are some of the most overvalued names within the tech sector, albeit for different reasons. We remain fond of the growth opportunities for semis within the automotive sector, in particular, as cars are adding more and more electronic features around infotainment systems, electric drivetrains, and advanced driver assistance systems, or ADAS, which require processors and other types of chip content.

Intel's $15 billion acquisition of Mobileye is the latest big move by a chip leader to stake a claim in the car. Yet we think that semiconductor valuations have already priced in strong growth in the automotive sector, while ignoring cyclicality within the industry and less-rosy prospects in other end markets. For example, stocks like  Nvidia (NVDA) and  AMD (AMD) are significantly overvalued, in our view, as the hype around their graphics chips used in artificial intelligence far exceeds our expectations for how revenue growth will truly materialize. In analog semis, we view high-quality, wide-moat leaders in this space as roughly 10%-20% overvalued. Automotive and industrial chip demand remains bright, but their growth prospects in smartphones and telecom infrastructure are muted, in our view.

All the while, semis are priced as if revenue and margins will grow in a straight line and recent strong quarterly results will last forever. Yet whenever there is any sort of macroeconomic turbulence or slowdown in end-market demand beyond chipmakers' control, we often see sharper cuts in chip orders that lead to industry downturns. We typically like buying high-quality names during selloffs and industry downturns, but simply see the inverse of this situation today.

Top Picks

 Cognizant Technology Solutions (CTSH)  
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $70.00
Fair Value Uncertainty: Medium
5-Star Price: $49.00

We view Cognizant as a leader in the IT services market. The company has a track 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 the company to appear as either a U.S. or Indian firm, as circumstances dictate.

We believe that 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. Finally, we also believe that Cognizant has relatively less exposure within Europe, a region where we don't foresee tremendous growth in the near term.

 Salesforce.com (CRM)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $99.00
Fair Value Uncertainty: High
5-Star Price: $59.40

We believe the shares of this wide-moat software firm have meaningful upside to our $99 fair value estimate. Salesforce is the world's leading software-as-a-service provider, and although it has had extraordinary success since its launch in 1999, we believe the market is underappreciating the broad opportunity that awaits Salesforce as the enterprise cloud migration still has plenty of runway left.

Salesforce's primary customer relationship management suite is the most cloud-ready, scalable offering on the market, in our view. Although Salesforce has built its suite via a mix of internally developed technology and acquisitions, the company has been highly selective in how it builds and integrates software products (in particular, limiting itself to purchases of cloudnative application vendors such as ExactTarget), allowing it to build a complete, end-to-end customer relationship management platform. The firm’s flagship salesforce automation is the largest and most mature product, but the company is seeing more than 20% revenue growth across its other major product categories, including Service Cloud, Marketing Cloud, and App Cloud, the last of which is one of the most promising offerings in the rapidly broadening platform-as-a-service market. Further, as the firm's billing mix tilts more toward renewals versus new business, Salesforce should generate significant operating leverage via sales and marketing and research-and-development spending, yielding consistent margin expansion for several years.

 Guidewire Software (GWRE)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $67.00
Fair Value Uncertainty: High
5-Star Price: $40.20

Although Guidewire Software has appreciated considerably from its late-February lows near $42 per share, we see meaningful upside today compared with our $67 fair value estimate.

Guidewire is the runaway leader in property and casualty insurance software, holding relationships with roughly half of the world's Tier 1 insurance companies. Over the past several quarters, the company has broadened its product portfolio to include add-on services around predictive analytics and digital portals to improve operational efficiency and customer experience for insurance companies, providing further avenues for revenue growth and increasing its customers' switching costs.

We think investors have become too hung up on Guidewire's somewhat surprising reversal into investment mode, but we believe this reversal signals a long-term positive for the business. A significant amount of the incremental investment Guidewire is undertaking in fiscal 2017 revolves around a digital greenfield opportunity with a large insurance company.

This particular deal spans Guidewire's entire core insurance suite in addition to several add-on products and cloud-based delivery, the latter of which remains a rare choice for large property and casualty insurers. While we believe large insurers will choose to deploy Guidewire's software on-premises for the foreseeable future, we believe this project will give the company a strong reference for providing a multifaceted, cloud-based solution for large insurers that will lead to larger wins and faster implementations.

Although the nature of this project could create lumpiness in Guidewire's quarterly results in the near term, we expect the firm will maintain GAAP profitability this year. We expect the digital greenfield project will begin making revenue contributions by the end of fiscal 2017, and the company will probably return to consistent gains in operating leverage in fiscal 2018 and beyond amid a backdrop of shifting revenue mix toward high-margin license revenue and away from low-margin services revenue, a shift that is being aided by a growing list of system integration partners, including the addition of Accenture in EMEA earlier this year. This particular addition is notable, as Accenture came on board after selling a majority stake in Guidewire's chief North American competitor, Duck Creek, which we believe underscores the strength of Guidewire's offering and market position.

 Qualcomm (QCOM)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $68.00
Fair Value Uncertainty: High
Consider Buying: $40.80

We see an adequate margin of safety in this narrow-moat chip leader. Recent allegations levied against the firm by South Korea, the U.S., and  Apple (AAPL) have caused the firm's licensing business to be called into question. As a result, Qualcomm's stock has fallen considerably. We believe the litigation process will be lengthy, particularly as it occurs on multiple fronts with regulatory agencies and major customers alike. Additionally, we surmise the financial fallout will be fines on the order of $1 billion from the regulatory lawsuits, a considerable sum, but not debilitating for Qualcomm. Nonetheless, we expect our fundamental thesis on Qualcomm, as it pertains to its ability to collect fair and reasonable royalties on its essential patent portfolio, to be upheld. Our fair value estimate is $68 per share, and implies a fiscal 2017 price/adjusted earnings ratio of 14 times.

On the chip side, we forecast a steeper decline in modem business from Apple, given its recent suit against Qualcomm and dual-sourcing endeavors. Along with an increasing trend of smartphone OEMs to use internally developed chips, we expect chip sales to be down 6% for fiscal 2017. We think licensing revenue will rise in the low single digits in fiscal 2017 via a combination of better China collections and less-than-expected declines in smartphone average selling prices. Regarding the pending tie-up with NXP Semiconductors, we expect revenue synergies to take into effect a few years after the close (projected by the end of calendar 2017). Our valuation incorporates our preliminary view on potential revenue and cost synergies, particularly with respect to the automotive and Internet of Things end-markets. With shares currently trading at 11 times our adjusted fiscal 2017 earnings estimate, we believe prospective investors should find this an attractive entry point.

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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.