Technology: Valuations Painting Overly Rosy Scenarios
Semiconductor equipment appears overvalued as booming near-term orders won't last forever, while some value remains in SaaS vendors.
Overall, we view the tech sector as overvalued today at a market cap weighted price/fair value of 1.09 as of the end of August, versus 1.13 as of the end of May and 1.06 at the end of February. The Nasdaq index rose about 4% from the end of May to the end of August.
Semiconductor business conditions have been downright stellar in recent months, with robust demand from the automotive and industrial sectors and optimism for a rush of new Apple (AAPL) iPhone sales in the fall. Enterprise software and IT Services are still interesting growth sectors to us, and we still see a handful of undervalued names in these spaces. Tech bellwethers Apple, Facebook (FB), Oracle (ORCL), Taiwan Semiconductor (TSM), and Intel (INTC) all appear modestly overvalued to us. Alphabet (GOOGL) (Google) appears fairly valued, while we see a decent margin of safety in Microsoft (MSFT).
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) appears significantly overvalued to us.
In our view, the single most important trend in technology remains 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-premises IT hardware and software, are shifting more and more workloads to infrastructure-as-a-service (IaaS) vendors, such as Amazon's Web Services, Microsoft Azure and Google.
In turn, IaaS vendors, along with software-as-a-service (SaaS) vendors are seeing tremendous growth while legacy IT vendors face ongoing headwinds. In SaaS, 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, in our view, albeit with some signs of optimism at times.
Across our coverage universe, we still see some value in SaaS providers like Salesforce.com (CRM), ServiceNow (NOW), and Workday (WDAY). These firms 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 future operating leverage in these business models is still being discounted, as companies in this space are 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 shift to customer retention, which is far less costly than customer acquisition spending today. In turn, we foresee many SaaS vendors benefiting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.
On the other hand, semiconductor equipment makers are some of the most overvalued names within the tech sector. Business conditions have been terrific in recent quarters, predominantly as memory chipmakers expand capacity and leading foundries invest in new manufacturing technologies such as extreme ultraviolet (EUV) lithography. Yet we don't expect these good times to last forever and view leaders in the sector like ASML (ASML), Lam Research (LRCX), Tokyo Electron (8035), and Applied Materials (AMAT) as fundamentally overvalued.
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $83.00
Fair Value Uncertainty: Medium
5-Star Price: $58.10
We recently raised our fair value estimate for Microsoft to $83 per share, a reflection of our rosier outlook for the firm's two flagship cloud properties: Office 365 and Microsoft Azure. In the case of the former, we believe Microsoft has mitigated a substantial amount of migration risk in its enterprise customer base by building a comprehensive set of cloud services under the Office 365 umbrella. We believe this franchise will follow a similar path to Adobe's Creative Cloud franchise, which experienced substantial revenue uplift by adopting a subscription-based selling model.
In the case of Azure, we believe Microsoft has solidified itself as one of two long-term strategic public cloud vendors (alongside Amazon Web Services) that enterprises will look to for their infrastructure needs. We ultimately believe these two franchises will drive the majority of revenue and profits for the consolidated entity by the end of our explicit forecast period, a level of growth that we believe the market continues to discount.
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $68.00
Fair Value Uncertainty: High
5-Star Price: $40.80
Qualcomm remains a best idea as we continue to see an adequate margin of safety in this narrow-moat chip leader. Allegations levied against the firm by South Korea, the United States, and Apple have caused the firm's licensing business to be called into question. As a result, Qualcomm's stock fell considerably and continues to trade in 4-star territory.
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 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 lawsuit against Qualcomm and dual-sourcing endeavors. Along with an increasing trend of smartphone original equipment manufacturers 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 expect 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 11 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.