Market Outlook: Tech Stocks

Technology stock valuations are painting overly rosy scenarios, but Morningstar equity analysts still see pockets of value in areas such as enterprise software and IT services

Brian Colello, CPA 12 April, 2017 | 2:40PM
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Overall, we view the tech sector as modestly overvalued today at a market-cap-weighted price/fair value of 1.06, versus a ratio of 0.98 last quarter. Large-market-cap contributors like Apple (AAPL) reported strong fourth-quarter results that contributed to a rise in valuation toward our fair value.

Meanwhile, several key semiconductor firms still see bright business conditions, while software vendors are bouncing back nicely as well. In general, we still believe that valuations across tech are painting overly rosy scenarios in new and emerging technologies around artificial intelligence, for example.

Some growth prospects, like rising demand from the automotive sector, are properly being considered by the market, in our view. We still see some pockets of value in tech, such as enterprise software and IT services.

Perhaps the single most important trend in technology is the ongoing shift toward cloud computing, which we think is having ramifications on dozens of stocks across our coverage. In short, both start-ups and enterprises, in efforts to reduce the high fixed costs associated with running on-premise IT hardware and software, are shifting more and more workloads to infrastructure-as-a-service, or IaaS.

Vendors such as Amazon’s (AMZN) Web Services, Microsoft (MSFT) Azure, and Google (GOOG). In turn, IaaS vendors, along with software-as-a-service (SaaS) vendors, are seeing tremendous growth, while legacy IT vendors face ongoing headwinds.

Who Has Made the Transition?

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 (ORCL), for one, has been relatively slower to pivot, in our view, although it has shown recent signs of progress.

Across our coverage universe, some of our most undervalued names are SaaS providers like Salesforce.com CRM and ServiceNow (NOW). Both firms are good examples of software vendors that should continue to gain market share and see outsized revenue growth over the next decade as they continue to ride SaaS and cloud tailwinds.

Yet we think that future operating leverage in both business models is being discounted. Both firms are generating minimal profits today as they continue to spend on customer acquisition in a land grab. As we look further out, beyond the next one or 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 and ServiceNow benefitting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.

Which Stocks are Overvalued?

On the other hand, semiconductors are some of the most overvalued names within the tech sector, albeit for different reasons. We remain fond of the growth opportunities for semis within the automotive sector, in particular, as cars are adding more and more electronic features around infotainment systems, electric drivetrains, and advanced driver assistance systems, or ADAS, which require processors and other types of chip content.

Intel’s $15 billion acquisition of Mobileye is the latest big move by a chip leader to stake a claim in the car. Yet we think that semiconductor valuations have already priced in strong growth in the automotive sector, while ignoring cyclicality within the industry and less-rosy prospects in other end markets. For example, stocks like Nvidia (NVDA) and AMD (AMD) are significantly overvalued, in our view, as the hype around their graphics chips used in artificial intelligence far exceeds our expectations for how revenue growth will truly materialise.

In analogue semis, we view high-quality, wide-moat leaders in this space as roughly 10%–20% overvalued. Automotive and industrial chip demand remains bright, but their growth prospects in smartphones and telecom infrastructure are muted, in our view.

All the while, semis are priced as if revenue and margins will grow in a straight line and recent strong quarterly results will last forever. Yet whenever there is any sort of macroeconomic turbulence or slowdown in end-market demand beyond chipmakers’ control, we often see sharper cuts in chip orders that lead to industry downturns. We typically like buying high-quality names during selloffs and industry downturns, but simply see the inverse of this situation today.

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 Inc399.09 USD1.19Rating
Advanced Micro Devices Inc93.50 USD-3.28Rating
Alphabet Inc Class C2,186.26 USD-1.29Rating
Amazon.com Inc2,151.82 USD0.25Rating
Apple Inc137.59 USD0.17Rating
Microsoft Corp252.56 USD-0.23Rating
Oracle Corp68.63 USD2.37Rating
ServiceNow Inc433.03 USD1.47Rating

About Author

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