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Are Tech Stocks Overvalued?

The ongoing migration to cloud computing is having ramifications for dozens of stocks across Morningstar equity analysts' coverage

Brian Colello, CPA 18 July, 2017 | 2:54PM

Overall, Morningstar equity analysts view the technology 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 six months ago. Fair value is considered 1, and anything over that is overvalued. 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), 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 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.

Where are the Opportunities?

Across our coverage universe, some of the more attractively valued stocks include SaaS providers such as Salesforce.com (CRM), while former undervalued stocks ServiceNow (NOW), Microsoft, and Guidewire Software have all rallied 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 materialise. Meanwhile, we fear that the tremendous growth of their graphics chips used in video gaming will not last forever.

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

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Adobe Systems Inc184.15 USD0.99
Alphabet Inc A1,050.30 USD1.51
Amazon.com Inc1,139.49 USD1.17
Apple Inc173.14 USD1.86
Facebook Inc A181.86 USD1.75
Intel Corp44.94 USD0.72
Microsoft Corp83.72 USD1.44
Oracle Corp48.63 USD-0.80
Salesforce.com Inc108.80 USD1.33
About Author

Brian Colello, CPA  is a senior stock analyst with Morningstar.