Our Outlook for Technology Stocks

Quarter-End Insights: The technology landscape continues to be shaped by a few key mega-trends and companies

Grady Burkett, CFA 30 March, 2012 | 1:43PM
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Technology is the most popular investment sector right now, according to the latest global survey of professional money managers by BofA Merrill Lynch. The report reveals that fund managers around the world are piling into tech stocks. Specifically in the US, Europe and the UK, technology is the most popular sector.

Below, Morningstar outlines our forecasts for the various segments within the technology space, plus we pinpoint a few of our favourite technology stocks.

Overview:
• Large tech firms will put excess cash to work though 2012.
• A few key mega-trends are driving significant changes across multiple industries.
• We continue to favour larger firms that have the resources to easily weather any bumps in the global economic environment.

Apple's (AAPL) widely publicised dividend announcement is a recent, but not isolated, indication that technology firms are increasingly willing to chip away at excess cash accumulating on their balance sheets. Just one week prior to Apple's announcement, Dell (DELL) purchased network security vendor SonicWALL, while Cisco (CSCO) invested $5 billion of its overseas cash to acquire NDS, a software firm that specialises in pay-TV content security and management. This purchase comes on the heels of a 33% dividend increase from Cisco, and we expect tech firms will continue to utilise excess cash for strategic acquisitions, dividends, and share repurchases through 2012.

Although we see no clear indication that the demand environment will change materially in either direction over the next quarter, we recognise clear long-term trends across the various technology industries that will affect individual firms' financial results over the next few years. The mega-trends of cloud computing, mobility, and consumerisation march on, opening new profit pools and solidifying competitive advantages for certain firms and industries while forcing others to adapt quickly. These trends will continue to drive near-term spending, even if the demand environment weakens, and firms that are positively exposed to these secular forces will post solid operating results over the next few years.

The technology sector, in aggregate, is trading at roughly fair value. Given the lack of clear direction of the near-term spending environment and broadly uninspiring valuations, we would seek out individual firms that possess economic moats (which is a Warren Buffett-coined term that means that we are seeking firms that have a competitive advantage over their peers within their industry.) We are also seeking companies that are trading at reasonable margins of safety to intrinsic value. This is always a good strategy, but it seems particularly compelling at this current point in time.

Industry-Level Insights

Software
The cloud computing marathon continues to push forward as the large enterprise software giants prepare to compete head-to-head with the challengers.

Oracle (ORCL) expects to make its Fusion public cloud generally available for customers in the current quarter, with customer relationship management, human capital management, and financial management slated for launch. Oracle's flexible deployment model is a significant competitive advantage over software-as-a-service (SaaS) specialists such as Salesforce.com (CRM) and Workday, particularly in the large enterprise segment of the market. Large enterprises are likely to have hybrid (public plus private) clouds for a long time, with non-core applications moving to the public cloud while mission critical applications remain in on-premise data centers. Oracle's ownership of a broad suite of applications including mission critical and noncore applications, combined with customers' choice of deploying individual applications in on-premise data centers or in Oracle's cloud, gives it an attractive value proposition that the SaaS specialists simply cannot match. Of course, Oracle still needs to back its SaaS services with appropriate sales muscle, and we remain watchful on this front.

Germany's SAP (SAP) is also stepping up its cloud play with the acquisition of SuccessFactors. Lars Dalgaard, CEO of SuccessFactors, has taken over leadership of SAP's cloud efforts, while Peter Lorenz, who previously headed SAP's unsuccessful cloud efforts, has stepped down from his leadership role. We think this signals a renewed commitment to cloud sales for SAP, whose organic Business ByDesign cloud ERP solution had only 1,000 customers at the end of 2011.

Internet
While much of the investment community is anxiously awaiting the Facebook IPO (expected in May), we are anticipating strong growth in display advertising, driven not only by social companies such as Facebook and LinkedIn (LNKD), but also by Google (GOOG). While we do not expect Google to dominate the display advertising market in the same manner it has dominated the Internet search market, we believe the investment community is not fully appreciating the assets the firm has amassed through past acquisitions. Furthermore, we believe that performance-based advertising is providing measurable ROI (return-on-investment) for an increasing percentage of the display market, an important factor supporting continued growth for the entire industry.

On the competitive front, we look forward to seeing early results from the recently launched display partnership between Yahoo! (YHOO), Microsoft (MSFT), and AOL (AOL). We are initially skeptical about the success of this partnership, as we expect several technical hiccups that could prove challenging for advertisers in their efforts to fully control ad placement and pricing across multiple platforms. Advertisers will generally gravitate toward the content owners and networks that provide audience reach, targeting, and marketing analytics. We expect other platforms should prove superior in the near term.

Hardware
Apple appears to have flawlessly executed on its two recent product launches, the iPhone 4S and iPad 3, and we expect continued strong demand for the firm's smartphones and tablets through 2012 and beyond. As Apple's devices, along with Android-based mobile devices, proliferate, traditional handset and PC volumes will come under pressure. Handset makers such as Nokia (NOK) and Research in Motion (RIM) are already suffering as a result of this shift, while Dell and Hewlett-Packard (HPQ) continue to look to diversify away from the increasingly challenging PC industry.

Dell's recent acquisition of network security vendor SonicWALL provides the firm with another building block for its strategy to become a one-stop provider of midrange enterprise IT infrastructure systems. Although Dell is still heavily reliant on its PC business, we think the firm's recent moves into storage, networking, and now network security have been shrewd, and we would not be surprised to see Dell successfully transition its business away from PCs over time. HP's current depressed market valuation implies an irreversible decline in profits, but we are a bit more sanguine. PCs account for less than one sixth of the firm's operating profits, and we think many of HP's wounds in services, printers, and enterprise hardware systems are self-inflicted and can be corrected over time.

Smartphones and tablets are natural outgrowths of the general push toward mobility that will continue to impact the enterprise hardware space in profound ways over the next several years. Enterprises are wrestling with the data storage, security, and user-experience challenges that mobility creates, and pure-play vendors that address these key issues will continue to capture increasing share of their customers' hardware spend. While EMC (EMC) in data storage, Aruba (ARUN) in wireless networking, and F5 (FFIV) in application delivery are three of our favourite businesses within their respective market segments, their current market valuations offer no margin of safety for investors.

The large enterprise hardware and software vendors, including Cisco, HP, Oracle, and IBM (IBM), are also looking to capitalise on these trends by selling pre-configured, integrated products in order to expand their footprints within their customers' data centers. These initiatives have increased the level of rivalry within the industry to levels not seen in at least a decade, if ever, and we believe the software vendors have the upper hand. Although we don't expect the competitive environment to improve for the large hardware vendors over the near term, we do believe that HP and Cisco possess durable competitive advantages that will allow each firm to navigate the current environment and maintain above-average returns on capital over time.

Semiconductors
The recent cyclical slowdown that hampered the semiconductor industry in the second half of 2011 appears to be bottoming, and we believe that business conditions should begin to improve for chipmakers in the coming months. The weak end-market customer demand caused by macroeconomic uncertainty that plagued broad-based chipmakers such as Texas Instruments (TXN), Analog Devices (ADI), and Linear Technology (LLTC) appears to be subsiding, as these firms provided positive outlooks during their latest earnings reports. While the recent hard disk drive (HDD) shortages caused by the flooding of a significant portion of the HDD manufacturing base in Thailand continues to hamper the PC supply chain and sales at chipmakers with significant PC exposure--including Intel (INTC) and Marvell (MRVL)--the issues are widely expected to be resolved by the middle of the year.

The smartphone adoption trend continues to be the biggest secular growth driver for the chip industry. Sales of chips used in smartphones have been strong and have defied the recent cyclical slowdown in the broader semiconductor space, thanks to the continued rapid proliferation of these devices. Qualcomm (QCOM) has been a major beneficiary of the trend, as the firm is not only benefitting from greater chip sales but also higher licensing revenue as the company receives a royalty on the price of virtually every smartphone. Qualcomm's position as a leading chip supplier into Apple's iPhone 4S should lead to healthy near-term sales growth as Apple gains share in the smartphone space. Meanwhile, a host of Nokia smartphones that will run Microsoft's Windows Mobile operating system all rely on Qualcomm's mobile processors and could give the company another sales boost. Some other interesting names to keep an eye on are Skyworks (SWKS), which supplies radio frequency chips, including those used in the Apple iPhone 4S, and Marvell, which has significant exposure to the growing smartphone opportunity in China.

Within the UK, two other interesting names that operate in this market are ARM Holdings (ARM) and Imagination Technologies (IMG). Both these companies create designs for microprocessor chips, that are used in mobile phones and smartphones around the world.

Our Top Technology Ideas
We generally favour financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The four firms below fit this criteria and are trading at attractive valuations, in our view.

Cisco Systems (CSCO)
Cisco continued to produce gross margin stability and showed no evidence of substantial market share deterioration in its core router and switch markets during its fiscal first quarter. Despite growing competition, the firm's dominant position in data networking equipment, its strong services business, and consistently strong free cash flow generation give us confidence that shares will recover from recent lows.

Oracle (ORCL)
Oracle is one of the highest-quality names in our tech coverage universe, and we expect the firm's 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 Oracle to drive additional software sales over time and further strengthen its competitive advantage over other firms.

France Telecom (FTE)
France Telecom is the dominant telecom operator in France and also has large operations in many other countries. In total it has 210 million subscribers, of which 150 million are wireless customers. This size allows it to keep the majority of its customers on its own network, which lifts profitability, provides it with a competitive advantage over competitors, and allows the firm to generate significant cash flow. This cash flow in turn allows France Telecom to pay a large dividend.

Google (GOOG)
With a wide economic moat (otherwise known as a strong competitive advantage), we have included Google as one of our favourites. Although we expect continued scrutiny from various global regulatory agencies, we do not expect potential changes to drastically alter the company's competitive advantages. Google has been an early and dominant company on the Web. The firm not only built a revolutionary Internet search engine, but it arguably pioneered performance-based advertising on a massive scale. Google has a formidable advantage in Internet search, which represents more than 75% of net revenue. Although growth is slowing in its core search market, we still expect annual growth in search revenue to exceed 15% during the next five years, supported by the firm's successful foray into mobile advertising.

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The original version of this article was published on our US sister site, Morningstar.com.

Read more about:
- Morningstar's Outlook for Equity Markets
- Morningstar's Outlook for Credit Markets
- Morningstar's Outlook for Different Sectors

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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About Author

Grady Burkett, CFA  Grady Burkett, CFA, is an associate director with Morningstar.