Our outlook for tech & communication services stocks

Investors should remain selective amid a generally uninspiring marketplace, while keeping an eye on secular themes.

Peter Wahlstrom 29 June, 2013 | 3:11AM
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Investors should remain selective amid a generally uninspiring marketplace, while keeping an eye on secular themes
A revised U.S. telecom landscape continues to take shape, but plenty of uncertainty remains.
The smartphone and tablet industries continue to thrive, and Apple and Samsung remain at the head of the pack, gaining share.

Second-quarter results across the technology and telecom sectors were generally muted if not unremarkable, as a relatively benign, if somewhat sluggish global macroeconomic environment provided a reasonably good backdrop for evaluating firms' "mid-cycle" earnings power. Key secular themes of pervasive mobility, social Internet and cloud computing continue to drive change throughout the technology and telecom sectors, while emerging trends such as big data and machine-to-machine computing will become increasingly important over time. As firms across the sector shift their portfolios to benefit from these trends, we believe that companies with the strongest competitive advantages -- wide and narrow moats -- are best positioned to capitalize on change over the longer term.

We see no clear rebound with respect to short-term demand, as fairly healthy activity from U.S. enterprise, commercial and consumer customers will likely continue to be offset by tepid U.S. federal spending and continued weakness from Europe. In the current environment, we expect business customers to remain fairly stingy with their technology investments and for consumers to continue to allocate their technology spending toward mobile devices such as smartphones and tablets and away from fixed devices such as PCs and televisions. Moreover, aggregate sector price/fair value estimate ratios are uninspiring. The average price/fair value estimate ratio for the technology sector remains slightly above 1, with discounts found only on a stock-by-stock basis. The telecom sector looks moderately undervalued owing to continued uncertainty surrounding European operators, and long-term yield-oriented investors may want to look for opportunities in Europe ahead of the U.S., in our view.

In the current environment, we think investors should remain selective. We find the most attractive investment opportunities among higher-quality, cash-rich firms that the market is shunning, based on heightened near-term uncertainty. We list five such firms below our industry-level discussions.

Plenty of uncertainty remains in U.S. telecom landscape

T-Mobile US TMUS completed its merger with MetroPCS in early May, but only after T-Mobile parent Deutsche Telekom agreed to reduce the amount of debt placed on the combined company. While T-Mobile has a modestly better balance sheet as a result of this change, we still believe the firm faces a difficult future as it attempts to keep pace with larger rivals AT&T T and Verizon Wireless VZ. T-Mobile will likely see some near-term improvement in its postpaid business thanks to the introduction of the iPhone and some buzz around its rate plans, which include less expensive pricing for customers who don't want a phone subsidy. But we expect the iPhone lift will be short lived and that competitors will respond quickly if T-Mobile's rate plan structure catches on with consumers. Longer-term, we believe the firm will be challenged to smoothly integrate MetroPCS' networks into its own while also investing in data network coverage and capacity.

The saga around Sprint S has finally reached an end. Softbank's latest bid for Sprint carried the day versus DISH Network's DISH competing offer. However, we were disappointed that Softbank chose to reduce the amount of capital it will infuse in Sprint to instead send more cash to Sprint shareholders. Sprint and Softbank also finally resolved the fate of Clearwire CLWR, with Sprint boosting its all-cash offer to again trump a competing bid from DISH. We believe Sprint should have considered calling DISH's bluff, selling its Clearwire stake to DISH or used Sprint equity to fund a portion of its bid for Clearwire. Sprint is in only a slightly better position than T-Mobile, in our view, and we believe it needs all of the financial firepower it can get as it looks to stabilize its competitive position in the market.

We recently attended a meeting with AT&T executives to discuss the current state of the firm's business. While wireless spectrum and phone subsidies remain major topics, AT&T's intentions in Europe were a focal point of discussion. The firm sees a lot of potential in Europe given current valuations and the potential for rapid wireless data growth, but it hasn't found many willing sellers in the market. This view lines up nicely with our overarching take on European telecom valuations, though we're quick to note that we don't anticipate a quick operational turnaround in the region, which could be an overhang. While AT&T faces constraints in its ability to buy European carriers outright, we believe investors have numerous opportunities to buy shares on the cheap. France Telecom FTE is one name that appears to be pricing in overly bearish long-term operating assumptions, and shares trade well below our fair value estimate. While its shares aren't as inexpensive, Vodafone VOD brings diversified operations across Europe, with additional exposure to the best U.S. wireless asset -- Verizon Wireless -- and emerging market growth.

Smartphone and tablet industries continue to thrive

The smartphone and tablet industries continue to thrive, and Apple AAPL and Samsung remain at the head of the pack, gaining share from struggling competitors such as HTC, BlackBerry BBRYand Nokia NOK. 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, though 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, across both the larger iPad and lower-priced iPad Mini product lines. 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 phablets (phone/tablets) fill a niche within the industry as demand for even-larger-screen devices has increased sharply. 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.

Meanwhile, both Nokia and BlackBerry are making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apple's iOS and Google's GOOGAndroid. Nokia's Windows-based Lumia phones haven't gained much traction thus far, and we remain concerned that even if Windows phones gain tremendous adoption, other smartphone makers, and perhaps Microsoft MSFT itself, will build Windows-based phones that may outsell Nokia.

BlackBerry announced its BlackBerry 10 operating system in January 2013. The firm saw only minimal sales of its Z10 touch-screen handset in its first month, and although the company's Q10 device with BlackBerry's beloved physical keyboard has hit the market more recently, we still don't see BlackBerry recapturing its former glory in the smartphone space. We also continue to be concerned about BlackBerry's ability to generate high-margin services revenue on both BB10 device sales and its existing BlackBerry 7 and prior subscriber base. Ultimately, we view BlackBerry as relegated to the role of niche supplier of smartphones into the enterprise and in certain countries worldwide where the firm still has some loyal users and decent brand recognition.

On the enterprise hardware side, investor sentiment continued to improve throughout the second quarter. Enterprise technology suppliers demonstrated an ability to generate strong free cash flow despite demand weakness from Europe and the federal government and ongoing commoditization of legacy technologies. The group is now about fairly valued, with discounts limited to smaller firms undergoing business model transitions or increasing product commoditization risk.

The biggest driver of improving investor sentiment, perhaps, is that management teams of maturing tech firms are increasingly distributing cash to shareholders. In the second quarter, NetApp NTAP and EMC EMC announced their first-ever dividend programs, while Cisco CSCO, IBM IBM and HP HPQ all increased their dividend payouts.

Dividend growth at IBM and HP is unlikely to exceed a mid-single-digit pace over the next several years, in our view, as these companies don't maintain excess cash balances and will likely spend a significant portion of free cash flow to modernize their product and service portfolios through acquisitions and internal development. Cisco, EMC and NetApp, on the other hand, can expand their dividends at a much faster rate as these firms maintain significant excess cash balances, have relatively low current payout ratios, and are unlikely to deviate significantly from their existing financial and strategic models for the foreseeable future.

Chip industry continues to improve

Business conditions in the chip industry continue to improve, as the sector recovers from the cyclical slowdown that was seen in the second half of 2012. Chipmakers that supply a broad array of end markets, such as Texas Instruments TXNand Microchip Technology MCHP, have continued to see a pickup in order activity in recent months.

Mobility remains the key theme in the space, as smartphone and tablet proliferation drive demand for chips used in those devices. We think firms such as Qualcomm QCOM and Skyworks Solutions SWKS are positioned to benefit from the trend. While ARM Holdings ARMH remains an incumbent player in the segment, as pretty much all processors used in mobile devices are based on designs from the firm, we think investors should keep a close eye on Intel INTC. The semiconductor behemoth recently scored its first major tablet design win in the 10.1" version of Samsung's Galaxy Tab 3. In addition, Intel will release a refresh of its smartphone and tablet Atom chips, which will be based on the new "Silvermont" architecture, by the end of the year. We think the move could make the firm more competitive in this fast-growing market opportunity.

Internet firms on acquisition spree

In the second quarter, Internet firms demonstrated their willingness to pay up to acquire new services in order to preserve competitive advantages. Google, Facebook FB, Yahoo YHOO and LinkedIn LNKD announced a combined 14 acquisitions last quarter, with Yahoo's $1.1 billion offer for blogging site Tumblr and Google's $1.1 billion bid for social mapping provider Waze among the largest. Investors seem to be taking these acquisitions in stride. Shares of Yahoo and Google, by far the most acquisitive firms of the group, have drifted above intrinsic value, while Facebook -- arguably the most prudent acquirer last quarter -- saw its stock price fall despite turning in a solid earnings result. We believe Facebook's shares are attractively priced, while the remainder of our Internet coverage (on average) appears overvalued.

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 revenues coming from DoubleClick and mobile advertising will continue to grow in importance. These businesses have lower structural operating margins. As Google's advertising reach broadens, the company will be forced to share revenues 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: Focus on wide-moat incumbents amid cloud and 'big data' trends

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. These technologies have been disruptive to some, yet companies with economic moats such as Oracle (and similarly IBM) will be able to defend their turf. As a result, thanks to an inexpensive valuation, Oracle is one of the most attractive names in our software universe.

Tepid results for the Windows 8 launch combined with a shorter-version release cycle means that Windows 8.1 will hit the market this fall with the hopes of addressing user concerns. With upcoming hardware releases incorporating new form factors and Intel's new Haswell chip, we think the headline issues will remain the adoption of Windows 8/8.1 and any incremental gains Microsoft may make in the tablet and smartphone markets. Recent revenue run-rate milestones for Office 365 and Windows Azure point to early signs of success for both Microsoft's software-as-a-service productivity application market and cloud strategies. We remain cautiously optimistic that Microsoft can establish beachheads in the mobile and tablet segments, while reinvigorating its Office franchise, which should help slow the decline in Windows market share.

Our top tech & communication services picks

After a choppy yet impressive ride (the S&P 500 is up double digits year to date), we peg the average price/fair value ratio for our technology and telecom coverage universes as 1.06 and 0.88, respectively. 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, we would become more interested if the market were to trade down another 10% or so, but we're 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 where there is strong dividend-growth potential.

Top Tech & Communication Services Sector Picks
Star Rating Fair Value
Fair Value
Oracle $39.00 Wide Medium $27.30
Facebook $34.00 Wide High $20.40
Apple $600.00 Narrow High $360.00
American Tower $100.00 Narrow Medium $52.50
Qualcomm $75.00 Wide Medium $52.50
Data as of 6-19-13

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 over time and further strengthen its wide economic moat.

Facebook FB
With the world's largest social network standing at more than 1 billion monthly users, Facebook members have built their "social graph," using their new habits in the way they communicate with friends and acquaintances while sharing applications and content. Nearly 60% of members use Facebook every day, attracting more than $4 billion in advertising revenue during 2012 and an additional $800 million in e-commerce-related revenue. We anticipate continued improvements in analytic methods for measuring the return on investment for ad spending, which should support continued revenue growth. Facebook is capturing data and online/user activity in a comprehensive way that competitors can only dream about. We expect the company to capture a massive share of the online advertising market.

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 revenues 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 over time. 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 non-wireless markets via the acquisition of Atheros could provide new avenues of growth for Qualcomm down the line.

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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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