The Investment Outlook for Technology

PERSPECTIVES: Tech specialist and fund manager Ben Rogoff provides his investment outlook for the technology sector

Ben Rogoff, 27 July, 2012 | 1:30PM
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From time to time, Morningstar publishes articles from third-party contributors under out "Perspectives" banner. Below, Polar Capital's Ben Rogoff outlines his thoughts on the future of technology.

Technology Review
Technology shares materially outperformed the broader market over the year, with the Dow Jones World Technology Index rising 8.3% in Sterling terms. While some of the sector’s relative strength was passive (reflecting the significant outperformance of US equities and a somewhat stronger Dollar), stellar performances from a number of large-cap technology stocks contributed materially to the sector’s relative returns. This was especially evident in the US where Apple (+72%) (AAPL), IBM (+25%) (IBM) and Microsoft (+27%) (MSFT) helped large caps (as measured by the Russell 1000 Technology Index) gain c.15% in Sterling terms during the year. While Apple’s performance was all the more remarkable given the death of CEO Steve Jobs in October, the stock’s ascent essentially mirrored its earnings progress.

In contrast, the strong performance of both IBM and Microsoft reflected their appeal as inexpensive ‘stores of wealth’ epitomised by the revelation in November that Warren Buffett’s Berkshire Hathaway (BRK.B) had built up a 5.4% stake in IBM, having previously eschewed the technology sector. The combination of Apple’s strength and the allure of inexpensive large-caps resulted in a ‘crowding out’ of riskier assets; small caps trailing their large-cap peers by more than 22% as measured by the difference between the Russell 1000 and 2000 Technology Indices.

The magnitude of large-cap outperformance helped obfuscate the implosion of a number of incumbents such as Hewlett Packard (-20%) (HPQ), Nokia (-60%) (NOK1V) and Research in Motion (-70%) (RIM) as tablet and smartphone growth began to negatively impact both the personal computer (PC) and traditional handset markets.

In addition to those incumbents plainly impacted by the new cycle, there were a number of ‘tell tale’ acquisitions of next-generation companies by legacy vendors. While the £6.7 billion purchase of Autonomy by HP for a 79% premium in August was undoubtedly the most dramatic attempt at reinvention during the year, there were a number of M&A transactions, particularly in the Software-as-a-Service (SaaS) space. IBM, Oracle (ORCL) and SAP (SAP) each acquired next-generation companies.

The semiconductor space also saw further consolidation following the acquisitions of equipment suppliers Novellus Systems and Varian Semiconductor by Lam Research (LRCX) and Applied Materials (AMAT), respectively. However, the largest transaction of the year saw Google pay $12.5 billion for Motorola Mobility in order to bolster the intellectual property (IP) position of its Android operating system.

At the sector level, late cycle areas such as software and IT services outperformed while earlier cycle stocks trailed. Weakest performance was reserved for networking stocks (primarily due to a hiatus in service provider spending) and the alternative energy sector due to the persistence of oversupply conditions.

Technology Outlook
Assuming that worst case outcomes are avoided, subtrend global growth should continue to provide a relatively positive backdrop for the technology sector by driving greater focus on productivity. However, the combination of slower economic growth and the deflationary impact of a new technology cycle is continuing to dampen global technology spending. IT experts Gartner are forecasting growth of just 2.5% in current US Dollars and a 5.3% compound annual growth rate (CAGR) between 2011 and 2016. Unfortunately for IT managers, muted budget growth is entirely at odds with computing needs that are increasing inexorably. According to IDC, the ‘digital universe’ (every electronically stored piece of data) is doubling every two years while IP traffic is expected to grow at a 29% CAGR over the next five years. This mismatch is continuing to force a significant reallocation of IT budgets in favour of new technologies and vendors that help bridge this gap. We expect this dynamic to accelerate over the coming year as a number of key, disruptive themes (in particular, Cloud and tablet-based computing) appear to have achieved levels of penetration often associated with rapid subsequent adoption. This is likely to auger a more pernicious period resulting in significantly more uneven value creation and elevated M&A activity as incumbents attempt to reinvent themselves with even greater urgency.

Despite outperforming over the past year the sector has continued to de-rate, US technology stocks today trading on 11.8 times forecast next twelve month earnings. This not only compares favourably versus history (the median forward PE post-1976 is 15.3x) but once the sector’s superior balance sheet is considered, cash adjusted forward PEs are even more compelling. While sector-wide valuations are flattered by a number of inexpensive large-caps seemingly threatened by the new cycle, this appears to be well understood given the sector is currently trading at a rare market multiple. Prospects for a modest re-rating over the coming year look reasonable, especially as the sector has begun to attract new investors epitomised by Warren Buffet’s $10.9 billion investment in IBM. The sector continues to boast the strongest aggregate balance sheet (accounting for 30% of the $1.5tr cash on US balance sheets as compared to c.20% of US market capitalisation) and has become intrinsically more profitable as higher margin software and Internet companies have grown their share of revenues. This shift, together with the adoption of less capital intensive business models, has helped ameliorate cyclicality, improve economic returns while helping the sector generate record cash flows.

Furthermore technology companies have become significantly better at sharing the spoils via buybacks and dividends as more than half of the Russell 1000 Technology Index constituents reduced their shares outstanding (on average by 3.8%) during 2011. Similarly it has become the norm for larger technology companies to pay dividends, a volte-face epitomised by Apple’s recent decision to reinstate its first dividend in seventeen years.

In addition to buybacks and dividends, M&A activity is also likely to account for a significant portion of ‘excess’ corporate cash/cash flow over the coming year as competition between incumbents intensifies, exacerbated by slowing IT budget growth and the move from enterprise towards Cloud computing. This was certainly the case in 2011, which was the third largest year for global technology M&A by value since 2000. Just as the acquisition of 3PAR by Hewlett Packard in 2010 made it clear that a new cycle had commenced, so the increasingly ‘strategic’ nature of last year’s M&A transactions were reflected in premiums that averaged a remarkable 50% and Cloud-related M&A (both private and public) that rose 244% year-on-year to $11.7 billion. Given that the largest global technology companies boast more than $350 billion in cash and generate annual cash flow in excess of $100 billion, the pace of M&A should remain at an elevated level – IBM reiterating that they intend to spend an additional $18 billion on M&A by 2015. We are hopeful that M&A will continue to provide positive tailwinds, disproportionately helping small and mid-caps as incumbents continue to retool for the new cycle.

New Cycle
We believe this new technology cycle continues to be driven by three key themes:

- Cloud computing;
- Internet applications;
- ubiquitous computing (mobility).

Gartner’s recent CIO survey supported this view as it revealed that ‘mobile technologies’ and ‘Cloud computing’ represent two of the top three IT priorities today. Cloud computing continues to make significant progress as early objections relating to security (and disintermediation) have eased as CIOs – under massive pressure to deliver ‘more with less’ – have begun to embrace the cheaper and more flexible computing associated with this mass production form of IT. The shift towards Cloud architectures has been significantly aided by the adoption of virtualisation which today has become pervasive – by the end of 2012; 52% of workloads (units of computing) are likely to have been virtualised. Cloud adoption has also been advanced by the US Federal government’s ‘Cloud First Policy’ designed to migrate $20 billion of its $80 billion annual IT budget to the Cloud. This policy benefited one of our holdings, Concur Technologies (CNQR), when they received a $1.4 billion, fifteen-year contract to supply Cloud-based travel booking and expense management across all federal agencies. With 65% of CIOs already using some form of public Cloud environment, we anticipate rapid adoption over the coming years as the provision of IT as a service becomes increasingly the norm. (57% of workloads will be processed in the Cloud by 2015.)

Internet applications are also likely to experience continued strong growth over the coming year reflecting low penetration rates in key application categories such as e-commerce (4.9%), online advertising (17%) and Software-as-a-Service (SaaS). We are hopeful that this growth should prove relatively insulated from economicuncertainty, evidenced by US e-commerce growth of 15.4% year on year in Q1’12 despite the difficult backdrop. Increased smartphone penetration is certainly helping by creating new opportunities in e-commerce. For example, eBay (EBAY) expects its mobile gross merchandise value to exceed $8 billion this year. Smartphone ubiquity is also helping online advertising while spawning a plethora of new applications made possible by the Cloud and afforded relevance by mobile computing including social (Facebook (FB)), communications (Twitter), storage (Dropbox) and content synchronisation (iCloud).

Increased comfort with the Cloud is also driving “the most significant revolution in database and application architectures in twenty years”. As companies transition towards virtualised environments, they must decide whether to migrate (keep) or consolidate (end of life) their existing applications. This dynamic is likely to intensify over the coming years as decisions are made on tier-one workloads that are only 32% virtualised today. The SaaS sector is likely to prove the greatest beneficiary of this application migration process (forecast to grow by 18% this year) while incumbent vendors and IT developers responsible for existing applications appear to have the most to lose which helps explain why IBM (Demandtec), Oracle (RightNow, Taleo) and SAP (Successfactors, Ariba) have all made acquisitions in the SaaS space.

Once again ubiquitous computing enjoyed the most remarkable growth last year driven by further smartphone and tablet adoption. Having grown 75% in 2010, the smartphone market expanded by a further 58% in 2011. However, the market coalesced around two key vendors, Apple and Samsung, who began to dominate industry profits. Despite the death of CEO Steve Jobs, Apple increased its dominance of the high-end smartphone market, achieving 85% share following the release of the iPhone 4S. Similarly Samsung realised a commanding share of Android-based devices that this year are forecast to account for 61% of the overall smartphone market. This potential duopoly is likely to put further strain on former leaders such as HTC (2498), Nokia and Research in Motion and their supply chains. While smartphones should enjoy another good year of growth this year (+39%) overall penetration rates already exceed 30% and are substantially higher in developed markets. As such we expect to pare our smartphone exposure over the coming year although we are in no immediate rush given that the tablet market represents a significant incremental opportunity. Tablet units are forecast to grow from 82 million units in 2011 to more than 400 million by 2017. In addition to both Apple and Samsung (and their supply chains), we believe that the most exciting investment opportunities in this space relate to new applications made possible by the growing ubiquity of computing such as mobile payments, remote access and application delivery. We are also hopeful that wireless data traffic growth, which is forecast to increase eighteen-fold between 2011 and 2016, together with the adoption of 4G LTE devices, will drive a recovery in mobile infrastructure spending.

While smartphone and tablet growth significantly outpaced the PC industry in 2011, a more important watermark was established last year when total smartphone and tablet shipments surpassed combined desktop and notebook PC shipments. Although rumours of the PC’s demise may appear greatly exaggerated given that worldwide shipments (ex-netbooks) increased 5.6% in 2011, industry growth has become increasingly reliant on emerging markets that accounted for just over 50% of the PC market last year. In the developed world, the PC market already appears to be in decline as US unit shipments fell 5.9% year-on-year during the fourth quarter of 2011 with share gains by Apple and Lenovo (00992) making life worse still for encumbent vendors HP and Dell (DELL). Little wonder then that Michael Dell, having only recently argued that the idea of a post PC-world was “nonsense”, appears to have accelerated the acquisition strategy that has seen Dell buy more than 25 non-PC companies since 2007. Although ‘Windows 8’ and the introduction of ‘ultrabooks’ may reaccelerate PC units in 2012 and 2013, this renaissance is likely to prove fleeting as the personal computer continues to cede ground to more mobile alternatives.

The disruption already being experienced by handset and PC vendors is likely to be repeated across the technology universe over the coming years as ‘Cloud computing’ gains significant traction. Just as it took the skyscraper two decades to begin to alter the skyline, so our sense is that after a number of years of being ‘stress-tested’ by CIOs with relatively unimportant workloads, the Cloud is about to change the landscape of computing. Best understood as the IT industry moving away from complex enterprise computing towards a mass production alternative, the Cloud is likely to cause disruption across the technology universe by delivering a highly automated, elastic form of computing at vastly lower prices. Datacentre technologies such as virtualisation, tiered storage, solid state drives and, in the future, software-defined networking are significantly increasing hardware utilisation rates. Application consolidation and the shift towards SaaS will likely come at the expense of incumbent software vendors and IT services companies responsible for legacy applications while creating rare fluidity in the database market. Not only does the transition away from enterprise computing diminish the value of incumbency, new opportunities in the Cloud are almost always associated with lower pricing and a rental model. On the client side, smartphone and tablet growth will continue to change user behaviour while undermining PC applications such as printing, end-point security, operating systems and office productivity suites. Faced with the prospect of significant disruption, M&A activity looks set to continue at a frenzied pace even though success is hardly guaranteed, evidenced by declining year-on-year licence revenue growth at Automony and the departure of Mike Lynch so soon after HP acquired it for £6.7 billion.

Conclusions
We believe that the new technology cycle is likely to enter a more disruptive phase as the growth in each of our core themes increasingly comes at the expense of incumbent technologies and vendors. This is entirely consistent with previous periods of economic uncertainty that have been associated with rapid adoption of new technologies. While this new cycle should disproportionately benefit small and mid-cap companies without legacy exposure, ‘top-down’ concerns have resulted in investors seeking refuge in inexpensive mega-cap ‘stores of wealth’ leading to a significant ‘crowding out’ of smaller companies.  With markets significantly below their 2012 highs, small-cap technology stocks having given up all of their FY10 outperformance and with the ‘new technology cycle’ likely to become significantly more disruptive. We believe now is an appropriate time to increase small-cap, mid-cap and next-generation exposure.

Related links:
Our Outlook for Technology Stocks The technology landscape continues to be shaped by a few key mega-trends and companies. 

Fund Managers' Favourites: 3 Technology Picks Polar Capital fund manager Ben Rogoff discusses his three favourite technology stocks.

Tech Companies: Go Big or Go Home Tech fund manager Ben Rogoff explains why you should avoid tech companies with low P/E ratios.

This article was provided by Ben Rogoff from Polar Capital. The views contained herein are those of the author(s) and not necessarily those of Morningstar.

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