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Quarter-End Insights

Tech: A Tectonic Shift Toward Enterprise Cloud Computing

The ongoing migration to cloud computing is having ramifications for dozens of stocks across our coverage.

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  • Overall, we view the tech sector as notably overvalued at a market-cap-weighted price/fair value of 1.13.
  • We still see a tectonic shift toward enterprise cloud computing.
  • Semiconductors appear overvalued due to the hype around artificial intelligence.

Overall, we view the tech sector as notably overvalued today at a market-cap-weighted price/fair value of 1.13 as of the end of May, versus 1.06 at the end of February and 0.98 two quarters ago. The Nasdaq index has risen about 6% from the end of February to the end of May.

Semiconductor business conditions have been downright stellar in recent months, perhaps to the point of warnings that a cyclical peak is emerging. Former best ideas within the enterprise software and IT Services sectors have appreciated in recent months, although we still see a handful of undervalued names in these spaces.

Tech bellwethers Apple (AAPL), Alphabet (GOOGL) (Google), Facebook (FB), Oracle (ORCL), and Intel (INTC) all appear modestly overvalued to us. In general, we still believe that valuations across tech are painting overly rosy scenarios in new and emerging technologies around artificial intelligence, for example, where Nvidia (NVDA) and Advanced Micro Devices (AMD) appear significantly overvalued. In our view, some growth prospects, like rising demand from the automotive sector, are properly being considered by the market.

We think the single most important trend in technology remains the ongoing shift toward cloud computing, which is having ramifications for dozens of stocks across our coverage. Both startups and enterprises, in efforts to reduce the high fixed costs associated with running on-premises IT hardware and software, are shifting more and more workloads to infrastructure-as-a-service vendors, such as  Amazon's (AMZN) Web Services,  Microsoft's (MSFT) Azure, and Google. In turn, IaaS vendors, along with software-as-a-service 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, has expanded their customer bases. Oracle, for one, has been relatively slower to pivot, although has shown recent signs of optimism.

Across our coverage universe, some of our best ideas include SaaS providers such as  Salesforce.com (CRM), while former best ideas like ServiceNow (NOW), Microsoft, and Guidewire Software (GWRE) have all had nice runups in recent months.

Salesforce.com remains a leading example of a software vendor that should continue to gain market share and see outsize revenue growth over the next decade as it rides SaaS and cloud tailwinds. Yet we think future operating leverage in the Salesforce business model is still being discounted, as the company is forsaking profits today in order to spend on customer acquisition in a land grab.

As we look beyond the next one to 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 benefiting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.

On the other hand, semiconductors remain among the most overvalued names within the tech sector, albeit for different reasons. Chipmakers tied to artificial intelligence, such as Nvidia and AMD, are significantly overvalued, in our view, as the hype around their graphics chips used in artificial intelligence far exceeds our views regarding how revenue growth will truly materialize. Meanwhile, we fear that the tremendous growth of their graphics chips used in video gaming won't last forever.

We also see a handful of overvalued stocks tied to the upcoming launch of Apple's iPhone 8, as the rumored addition of 3D-sensing capabilities like facial recognition will lead to new component opportunities for firms such as STMicroelectronics (STM) and Lumentum Holdings (LITE), although we think the growth potential of these opportunities will not meet the hype.

Top Picks

Infosys (INFY)
Star Rating: 3 Stars

Economic Moat: Narrow
Fair Value Uncertainty: High
Fair Value Estimate: $17.70
5-Star Price: $10.62

Infosys has launched several initiatives to improve its performance, and a number of signs are promising, with revenue growth, client mining, and employee attrition improving. We think the appointment of well-respected CEO Vishal Sikka has also reinvigorated the company's morale and strategic direction. Sikka's appointment signifies a greater emphasis on proprietary software product development and a shift away from increasingly commodified outsourcing services.

To that end, revenue from new software and software-related services such as Mana, Edge, Panaya, and Skava are growing rapidly (42% year over year in fiscal 2017), and Infosys will look to break out these strategically important and rapidly growing business lines in the first quarter of fiscal 2018.

Over the long term, we think the growth and margin profile of these newer services will change the complexion of Infosys' traditional labor arbitrage-type business model. On U.S.-based work visas, which we believe is a primary concern for investors today, Infosys has stated the current uncertainty and that it has no clear understanding of what is likely to eventuate. In any case, the company is expanding its onshore development center capacity to help mitigate any future pressure. As we have previously published, we do not expect this issue to be a major hindrance to our base-case valuation on Infosys. Additionally, management commented that it would relentlessly focus on higher offshoring and onsite role mix optimization, and that it benefits from automation to minimize any impact on operating margins.

Salesforce.com (CRM)
Star Rating: 3 Stars
Economic Moat: Wide
Fair Value Uncertainty: High
Fair Value Estimate: $103.00
5-Star Price: $61.80

Salesforce.com remains one of best ideas, as we believe the shares of this wide- moat software firm have meaningful upside to our $103 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 cloud-native 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.

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

Qualcomm remains one of our best ideas, as we continue to 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 have caused the firm's licensing business to be called into question. As a result, Qualcomm's stock has fallen considerably and now trades in 4-star territory.

We believe the litigation process will be a lengthy one, 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 2018 price/adjusted earnings ratio of 15 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 modestly for fiscal 2017. We think licensing revenue will fall in the low single digits in fiscal 2017, as Apple has withheld payments in recent quarters, and we surmise it will continue to do so over the rest of the fiscal year. However, we expect Qualcomm to receive catch-up payments over the next few years to offset these shortfalls once the litigation is resolved.

Regarding the pending tie-up with NXP Semiconductors (NXPI), we expect revenue synergies to take 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 13 times our adjusted fiscal 2018 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.