Tech & Telecoms: Opportunities in Apple and Microsoft

While the tech sector looks fairly valued, there may be opportunities in smartphone and cloud software-related providers

Brian Colello, CPA 1 July, 2016 | 10:44AM
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Firms with exposure to the smartphone market have faced some tough times in recent quarters, as Apple (AAPL) iPhone demand has not lived up to prior expectations and the company reported its first year-over-year quarterly revenue decline since 2003.

Meanwhile, the rest of the smartphone market hasn't fared much better; we've seen some company-specific market share shifts across the Android ecosystem, but in total, smartphone unit sales will fail to achieve double-digit growth in 2016 for the first time this decade. In turn, a host of components suppliers have sold off accordingly.

Despite this near-term sluggishness, we remain confident that the strong secular shift away from feature phones and toward more advanced smartphones is still intact. Although we no longer foresee exponential iPhone growth for Apple, we think that customer switching costs will drive most iPhone customers today to buy future iPhones tomorrow, thus supporting the company's unmatched free cash flow generation.

Microsoft's Evolution Will Yield Long-Term Success

In the software space in particular, we have seen several firms navigate the challenges of moving from a legacy, on-premises world to the new world of cloud computing. Adobe (ADBE) has been especially adept at this transformation, while Oracle's (ORCL) shift remains to be seen. We now view Microsoft (MSFT) on the more favourable end of this spectrum and showcase the company's transformation from a dominant legacy software vendor to a more nimble and user-friendly business.

Following the lead of new CEO Satya Nadella, Microsoft has embraced changes that we think will leave the firm better positioned for long-term, sustained success. Microsoft has quickly emerged as one of the most important cloud computing firms in the world. Azure, the firm's public cloud service, has established itself as the number-two player in the space behind Amazon (AMZN), and the platform should continue to garner significant user growth as Microsoft leverages Azure-hosted software such as Office 365 and Dynamics.

Public cloud represents a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud, and the firm has curated a rich set of software and tools that will help keep developers in the ecosystem. The rise of Azure should help make up for the Windows Server OS, which is flagging against the continued meteoric rise of Linux, and it should also offset declines in other segments.

Top Tech Picks

Apple
Star Rating: 4 Stars

We believe that near-term weakness and a broadly sluggish smartphone market have provided investors with an attractive margin of safety in narrow-moat Apple as compared with our $133 fair value estimate. By our calculations, Apple appears to be priced as if iPhone sales have peaked and will face a long, secular decline from here on out. Although we no longer foresee exponential growth for the iPhone, we think that future sales will be more resilient than what the market has priced into the stock.

Ultimately, we think that, for a host of reasons, including software and services like iCloud, FaceTime, and iMessage, as well as the need to repurchase apps and subscriptions, and a loss of compatibility with other Apple products. iPhone users today will continue to buy iPhones well into the future. Meanwhile, we think the market is giving Apple little credit on the innovation front, either in new software, native applications, new services such as a streaming TV service, or new products – potentially Apple Car.

Microsoft
Star Rating: 4 Stars

Microsoft has emerged as one of the most important cloud computing firms in the world, and we believe the market is undervaluing its long-term opportunities as a cloud leader. Azure, the firm's public cloud service, has established itself as the number-two player in the space behind Amazon, and the platform should continue to garner significant user growth as Microsoft leverages Azure-hosted software such as Office 365 and Dynamics.

Public cloud represents a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud, and the firm has curated a rich set of software and developer tools that will help keep developers in the ecosystem. We believe Azure will help offset declines in some of Microsoft's legacy businesses, solidifying the firm's wide moat and stabilizing the moat trend.

Although we think Microsoft will be subject to some lumpiness over the next several quarters as the revenue mix continues to shift toward cloud-based services, we are confident that management can guide the company into its next era of widespread success as a dominant cloud vendor spanning Internet as a service, platform as a service, and software as a service.

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.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Adobe Inc547.05 USD-0.16Rating
Apple Inc247.77 USD0.41Rating
Microsoft Corp443.33 USD-0.60Rating
Oracle Corp177.74 USD-6.67Rating

About Author

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

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