Tech and telecom: M&A heats up, and the cloud changes the landscape

Mergers and acquisitions are ramping up (as are rumours), but with the sector slightly overvalued, we stick to fundamentals and seek firms with established economic moats.

Peter Wahlstrom 10 July, 2015 | 5:00PM

Despite a modest increase for the S&P 500 through the first half of 2015, it hasn't been a particularly smooth ride for investors. Performance for the technology sector in aggregate has been slightly stronger, up around 3%, but there were notable areas of strength and weakness. Global currency movements over the past two quarters have resulted in slightly elevated volatility across both the technology and communications-services sectors, but the overall tone from management teams has been fairly positive in terms of the macro environment. In aggregate, we view the tech sector as slightly overvalued and remain selective in our picks.

In our numerous discussions with clients about cloud-applications companies (also referred to as software-as-a-service, or SaaS, companies), we find a wide array of opinions about their long-term profit potential and ability to generate excess returns on capital. The lack of consensus is no surprise -- current GAAP operating margins for many firms are extremely low or negative, especially compared with successful on-premises software firms. Blind faith (or its enemy, dogmatic skepticism) has driven the bull (and bear) case for legacy software firms facing the disruptive forces of cloud computing and pure-play cloud providers recording strong revenue growth but paltry profits. We expect spending on cloud applications to grow nearly 20% annually to reach US$62 billion by 2019, paced by the customer relationship management segment, which should represent almost half of overall cloud spending.

Improving sales and marketing efficiency will drive significant operating leverage at many SaaS firms. Although they appear to be woeful on a GAAP basis, the cost of maintaining customers should be markedly cheaper than the cost of acquiring them. Even as growth has slowed, we anticipate that SaaS companies may be able to drive sales and marketing costs below 25% of sales in many instances. We also anticipate research and development leverage as products mature and cloud application companies realize the benefit of supporting only one version of each software product. These expenses are currently quite high, depressing cash flow and profitability, but growth in this expense category should slow as products mature and functionality becomes more fully featured. Similarly, SaaS providers with the highest switching costs are unlikely to suffer from price competition, and we expect pricing to increase, even when the industry matures. Currently, on-premises software firms have had the ability to increase pricing for maintenance and support services, and we expect cloud application pricing to follow a similar path. This pricing power is critical as we consider normalized financial models and returns on capital.

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Peter Wahlstrom

Peter Wahlstrom  Peter Wahlstrom, CFA, is director of technology, media, and telecom equity research for Morningstar.

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