Our outlook for tech & communication services stocks

Investors could still benefit by taking a closer look at some firms with strong positions in mobile computing.

Peter Wahlstrom 4 October, 2013 | 6:00PM
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Investors could still benefit by taking a closer look at some firms with strong positions in mobile computing.
What could happen when looking past Verizon's record bond offering.
Pay close attention to the exposures that mobile chip suppliers have to popular devices in the coming months.

The ongoing shift toward mobile computing continues to be the primary driving secular force in the technology and telecom sectors, with cloud computing steadily growing in importance. We expect global PC shipments will fall about 8% this year to 321 million units, as multiyear declines in developed-market un

it shipments are now being accompanied by moderate declines in emerging markets.

Smartphone and tablet shipments are more than filling the PC demand void, as the client/server computing era is steadily giving way to an emerging era centered around devices and massive, centralized data centres, or "clouds." We expect more than 2.6 billion total computing devices--including smartphones, tablets and PCs--will ship in 2017, more than double the total number of devices that shipped in 2012. Tech and telecom firms are acquiring assets to benefit from the shift toward mobile.   Verizon  VZ's acquisition of   Vodafone  VOD's stake in Verizon Wireless,   Microsoft  MSFT's acquisition of   Nokia  NOK's handset business and   Intel  INTC's heavy investment in producing microprocessors optimized for mobile devices suggest that the shift toward mobility is playing a key role in firms' investment decisions.

Interestingly, some of the more attractive buying opportunities can be found among firms that have strong hands to play in mobile computing, and we highlight four such names below (  Qualcomm  QCOM,   Apple  AAPL,   Broadcom  BRCM and   American Tower  AMT). Outsized profits and large, growing markets attract competition, and none of these firms is immune. However, these companies possess structural competitive advantages, and we expect each firm to generate substantial free cash flow and economic profits for many years. The combination of economic moats, reasonable valuations and strong exposure to mobile computing is compelling. We highlight these names as investment ideas to consider against a backdrop of moderate economic growth and generally uninspiring valuations.

Strategic wrangling across the U.S. wireless industry is finally nearing an end. Over the past quarter,   Sprint  S managed to shake free of   DISH Network  DISH, closing revised transactions with Softbank and Clearwire. Verizon finally landed Vodafone's 45% stake in Verizon Wireless, shelling out US$130 billion in cash, stock and other assets. A record US$49 billion bond offering and US$12 billion in bank debt will finance the deal. Even   AT&T  T got into the act, agreeing to acquire an increasingly desperate   Leap Wireless  LEAP.

As the dust settles, investor attention should shift toward operating performance. So far in 2013, the biggest surprise on this front has been   T-Mobile  TMUS's return to solid customer growth. The carrier added nearly 700,000 postpaid customers during the second quarter, a startling turnaround versus the 500,000 or so customers it had been losing each quarter over the past couple of years. Solid execution around its unique no-contract rate plans and the introduction of the iPhone have seemingly given T-Mobile new life. We aren't ready to celebrate the firm's return to health, though. We believe that T-Mobile still operates at a significant cost disadvantage versus larger rivals AT&T and Verizon Wireless. The firm needs to keep new customers satisfied while also boosting returns on capital to acceptable levels, which we believe will be difficult given its competitive position.

Amid the shakeup in wireless, DISH has remained on the outside looking in. We expect that DISH will continue seeking a partner to enter the wireless business, but we doubt it will find success. T-Mobile, the most natural remaining partner, is at a decent place to consider adding DISH to its long-term network plans. However, Deutsche Telekom owns 74% of T-Mobile's equity and has lent the firm US$11.2 billion via a series of bonds that mature between 2019 and 2023. It is unclear to us what interest DT would have in partnering with DISH. DISH has shown a proclivity for heavy debt leverage to finance its wireless ambitions. DT may not want to take on the risk that a highly leveraged transaction would impose on both its equity and debt holdings. DT also can't part with its equity stake until late 2014 per the MetroPCS merger agreement.

Ultimately, DISH's best option may be to sell off its spectrum holdings. AT&T would be a natural buyer for DISH's holdings in the 700 MHz band, but the bulk of DISH's portfolio rests in the newly created AWS-4 band. The U.S. Federal Communications Commission placed stringent network build-out requirements on this spectrum, which any buyer of the spectrum could use against DISH in negotiating a purchase price. Ultimately, we are still cautious on DISH's prospects in the U.S. wireless business.

Hardware: Bifurcation in the marketplace, separating the haves and the have-nots

The smartphone and tablet industries continue to capture mind and wallet share within the consumer tech space, and Apple and Samsung remain at the head of the pack, gaining share from struggling competitors like HTC,   Blackberry  BBRY and Nokia. Apple's stellar integration of hardware, software and services into easy-to-use devices has driven the firm's strong revenue growth and profitability in recent years. We project decent, but not exponential, iPhone growth over the next few years, although we recognize that pricing pressure and gross margin deterioration may occur on future iPhone sales. Meanwhile, we anticipate strong tablet adoption over the next few years, both for larger iPads and lower-priced iPad Minis. As long as Apple can continue to build on its success (and we see little evidence to the contrary thus far), we think the company will remain a leader in the premium smartphone and tablet markets for years to come.

Meanwhile, Samsung continues to take advantage of gaps in Apple's product portfolio, as well as windows of opportunity between iPhone refresh cycles. Samsung's larger screen Galaxy S4 sold more than 10 million units in its first month, while the company's Galaxy Note phone/tablets, or "phablets," fill a niche within the industry for even-larger-screen devices. We believe that much of Apple's skyrocketing growth in the past five years came from a first-mover advantage with little competition in the smartphone space, but Samsung has now clearly emerged as a major threat to Apple in high-end devices.

Finally, both Nokia and BlackBerry are making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apple's iOS and   Google  GOOG's Android. Nokia's Windows-based Lumia phones haven't gained much traction so far, spurring Microsoft to bid for Nokia's handset business in an attempt to better align the Windows Phone ecosystem and emerge as a viable third operating system.

BlackBerry appears to be on life support, as devices running the firm's new BlackBerry 10 operating system have flopped, selling only 2.7 million units in the May 2013 quarter. BlackBerry will likely never recapture its former glory among smartphones, but it appears increasingly unlikely that the firm will be able to reinvent itself as a niche player, either. The firm's decision to look for strategic alternatives may result in a breakup of the firm, and rumours swirl that even the company's remaining loyal enterprise customers are holding off on upgrades until they receive clarity about the firm's future.

On the enterprise hardware front, we expect large suppliers like   IBM  IBM,   Hewlett-Packard  HPQ,   Cisco  CSCO and   EMC  EMC will continue to post fairly tepid results through the remainder of 2013. Enterprise IT managers are unlikely to alter existing budgets given the current macroeconomic environments, and government budgets will likely remain constrained. Additionally, an ongoing shift toward cloud computing and increasing commoditization of the hardware components used to support IT operations is unlikely to abate. Suppliers are being forced to adjust. We consider the juxtaposition of Cisco's decision to lay off 4,000 employees with the firm's US$2.7 billion acquisition of network security vendor Sourcefire. Cisco's actions last quarter highlight the shift that legacy vendors must make as IT delivery and consumption models evolve. In 2014,   Dell  DELL will most likely be private, HP's balance sheet should be strong enough to support new acquisitions, and Cisco will likely have fully integrated flash storage into its data centre computing systems. These three facts alone point to heightened competition in the server, storage and networking space over the next 12 to 18 months.

Pay close attention to the exposures that mobile chip suppliers have to popular devices in the coming months

The business environment in the semiconductor industry has improved significantly since the cyclical slowdown that hampered the space in the second half of 2012. While mobility remains the major growth driver for the industry, chipmakers that are diversified across numerous end markets, such as   Texas Instruments  TXN and   Microchip Technology  MCHP, have seen across-the-board improvements in business conditions in recent quarters.

Although smartphone and tablet adoption continues to provide tailwinds for chipmakers that have products incorporated into these devices, some of these firms will fare better than others in the coming quarters. During its second-quarter earnings conference call in late July, leading foundry   Taiwan Semiconductor  TSM indicated that there are signs that chip inventories are building up in the electronics supply chain, caused by lower-than-expected sales of some smartphone models, as well as PCs, which will require inventory adjustments and in turn hamper foundry demand in the fourth quarter. As a result, investors should pay attention to the exposures that mobile chip suppliers have to popular devices in the coming months, such as Apple's iPhone 5S and 5C. Nonetheless, we view Qualcomm as a firm that will benefit from the mobility trend and as a name that depends less on specific design wins, as the firm is designed into most popular smartphones today and generates tremendous cash flow from royalties associated with 3G and 4G wireless technologies.

Strong performance by Internet heavyweights; Twitter looks to take advantage of the recent market upswing

In the third quarter, privately held Twitter's announcement of a confidential S1 filing capped off a quarter of strong stock performance, particularly from   Facebook  FB, a stock that we noted was undervalued at the end of the second quarter. Although we have yet to see Twitter's financial statements, we look forward to gaining a stronger understanding of the economics of this significant Internet company. On our coverage list, continued strong performance from Facebook,   LinkedIn  LNKD and Google highlighted the advantages of these wide-moat firms as industry spending is consolidating around these market leaders. By contrast,   Yahoo  YHOO continues to lose market share, although its stock has been propped up by increased optimism with respect to a potential for an IPO of Alibaba Group (a portion of which is owned by Yahoo) by the end of 2014.

Strong growth in digital advertising spending should continue, and Google, Facebook and LinkedIn are all well positioned to capitalize on this growth. For Google, the market leader, we believe revenue growth from desktop-based Internet search will begin a modest slowdown, and advertising revenue coming from DoubleClick and mobile advertising will continue to grow in importance. Furthermore, we believe a focus on the lack of attractive economics of the Motorola handset business may begin to take on greater importance. These businesses have lower structural operating margins. As Google's advertising reach broadens, the company will be forced to share revenue with a greater number of partners, including handset manufacturers, content owners and developers. Although the company is actively pruning its product portfolio, we do not expect to see a measurable improvement in the overall cost structure.

Software: Slow and steady can still win the "Big Data" race

In the software sector, we still believe   Oracle  ORCL is an underappreciated story that represents an attractive buying opportunity for patient investors. As the market focuses on new trends in cloud-based software and "big data" solutions, we note that Oracle's position as an incumbent technology provider is as important as ever. Companies with economic moats such as Oracle (and similarly IBM) will be able to defend their turf even as these technologies disrupt others. As a result, thanks to an inexpensive valuation, Oracle remains one of the most attractive names in our software universe.

Tepid results for the Windows 8 and Surface tablet launches combined with a shorter-version release cycle means that Windows 8.1 and a refreshed Surface lineup will hit the market this fall with the hopes of addressing user concerns and spurring Windows OS sales. The company's recent acquisition of Nokia's handset business signals Microsoft's commitment to the smartphone market. With a mild refresh in both software and hardware this fall, we think the headline issues will remain the adoption of Windows 8.1 and any incremental gains Microsoft may make in the tablet and smartphone markets. Revenue run-rate milestones for Office 365 and Windows Azure point to early signs of success for Microsoft's software-as-a-service productivity application and cloud strategy. We remain cautiously optimistic that Microsoft can build on its still small market share in the tablet and smartphone markets to help slow the declines of its flagship Windows OS while driving additional sales of its Office franchise.

Our top picks in tech and communication services

With the impressive step-like gains experienced in the U.S. stock market (the S&P 500 is up 20% year to date), we peg the average price/fair value ratio for our technology and telecom coverage at 1.14 and 0.95, respectively. It's important to note that just three months ago, technology was fairly valued and telecom traded at a 10% discount to today's levels. There are still a few undervalued names in European telecom, but most carry at least some macro or political risk, and with limited visibility on an economic recovery in the region, our theses could take several years to play out. As for the technology sector, there is a wide dispersion of under-/overvalued names, but in general the group has had an impressive run lately. We would prefer a wider margin of safety and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility.

In general, we like companies possessing a combination of scale, switching costs and pricing power in categories where perceived differentiation matters, and strong dividend-growth potential.

Top Tech & Communication Services Sector Picks
Star Rating Fair Value
Fair Value
Oracle $38.00 Wide Medium $26.60
Apple $600.00 Narrow High $360.00
American Tower $100.00 Narrow Medium $70.00
Qualcomm $75.00 Wide Medium $52.50
Broadcom $35.00 Narrow High $21.00
Data as of 9-16-13

  Oracle  ORCL
Oracle is one of the highest-quality names in our tech coverage universe, and we expect that its core software business (which accounts for 68% of revenue) will continue to perform well in the near term. Although Oracle's hardware segment could generate underwhelming results in the next few quarters, we believe this business has solid long-term prospects, and it will enable the firm to drive additional software sales and strengthen its wide economic moat.

  Apple  AAPL
Although Apple's current market price implies maturity, we forecast continued growth. Smartphones still account for less than 50% of total handset shipments, and we expect this penetration rate to continue to grow. Additionally, Apple still retains a dominant position in the tablet market, which should grow quickly during the next several years. Apple's success in tablets and smartphones has helped the firm drive strong sales of its Macs, even as the overall PC market shrinks. As Apple sells more devices to its customers, it can increase customer switching costs around its software and services.

  American Tower  AMT
While some investors might fear that American Tower's recent REIT conversion will handcuff the share price, we continue to believe that plenty of upside remains. There is no shortage of fundamental growth drivers on the horizon, with the number of smartphone users likely to double over the next three years, all the U.S. carriers deploying 4G networks, and AMT expanding internationally. Ultimately, the REIT conversion can be accretive to shareholders since it allows the firm to save on taxes without compromising its growth profile. Even during an economic downturn, carriers cannot afford to let the health of their networks erode, and while many often worry about carrier consolidation, the T-Mobile/MetroPCS merger will affect revenue by less than 1%. The tower firms are a major beneficiary of this phenomenon, and American Tower remains the best-run company of the peer group.

  Qualcomm  QCOM
We like Qualcomm's position as the developer of CDMA network technology, which enables the firm to collect royalties on every 3G device sold. The firm is a prime beneficiary of the secular shift from basic handsets to smartphones, which will lead to higher-priced phones and thus greater royalty revenue. Qualcomm's chips also power many of today's most popular handsets and tablets, such as Apple's latest iPhones and iPads. Qualcomm will have to continually invest in cutting-edge chips in order to outpace the competition, but we think it has the size and wherewithal to fend off its rivals. Meanwhile, the firm has a pristine balance sheet, and expansion into nonwireless markets via the acquisition of Atheros could provide new avenues of growth for Qualcomm.

  Broadcom  BRCM
Broadcom is the market share leader in providing chips for technologies such as enterprise networking, set-top boxes and mobile connectivity functions. Both consumer demand and technological innovation are pushing converged devices, such as smartphones and tablets. Broadcom has demonstrated proficiency for integrating various functions onto a single chip, which ultimately enables the development of these devices. Broadcom's extensive research and development staff, and deep expertise in networking and mobile chips, should allow the firm to maintain a leadership position for years to come.

Please see our detailed take on each sector in the reports that follow.

  •  Our outlook for the U.S. economy
  •  Our outlook for the U.S. stock market
  •  Consumer cyclical
  •  Basic Material
  •  Energy
  •  Consumer defensive
  •  Health Care
  •  Financials
  •  Industrials
  •  Utilities

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About Author

Peter Wahlstrom

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

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