M&A takes center stage across the telecom space. Looking for signs that the semiconductor market doesn't stall out midcycle. Although we are positive on long-term fundamentals, Internet valuations already bake in optimistic growth and profitability.
Greed Trumps Fear in Several Pockets of Tech; Favorable Mobile and Software Themes Continue to Play Out
With consumers continually gravitating toward mobile and cloud-based computing, and consensus now embracing the fact that global PC shipments will drop by 10% in 2013, investors rewarded firms that already have strong positions in key strategic areas of tech. For example, shares of Twitter (TWTR) have doubled since the November IPO (garnering a $30 billion market cap, equal to that of consumer staple General Mills (GIS)), Facebook (FB) stock has soared, up 125% since mid-June, and shares of internet giant Google (GOOG) are up another 50% this year.
Meanwhile, M&A activity remains healthy, as announced (and rumored) deals range from land-grab-based tuck-ins to a potential $40 billion Time Warner Cable (TWC) deal. Most of these deals are being completed at seemingly high valuations, where buyers must either be taking advantage of favorable credit markets, cutting meaningful costs and identifying operational synergies, or baking in aggressive growth expectations (or some combination of all four). In any case, we continue to see the shift toward mobility as playing a key role in firms' investment decisions.
Some of the more attractive buying opportunities can still be found among firms that have strong hands to play in mobile computing, and we like Qualcomm (QCOM), Apple (AAPL), and American Tower (AMT)). Outsize profits and large, growing markets attract competition, and none of these firms is immune. However, these companies possess structural competitive advantages, and we expect each firm to generate substantial free cash flow and economic profits for many years. The combination of economic moats, reasonable valuations, and strong exposure to mobile computing is compelling. We highlight these names as investment ideas to consider against a backdrop of moderate economic growth and generally uninspiring valuations.
Rumors of Strategic M&A Activity Have Ruled the Headlines Across the Telecom Sector
Gaining scale to improve competitive positioning and control costs is the primary name of the game. Charter Communications (CHTR) director and Liberty Media chairman John Malone got the ball rolling within the cable sector earlier this year, commenting on the need to gain stronger leverage over content creators, like Disney (DIS). Content costs for the cable and satellite television companies have risen significantly faster than the average cable bill over the past couple years. Although consolidation may help, we believe this trend will remain firmly entrenched as the Internet provides content creators with a compelling distribution alternative. In addition, we expect the cable and phone companies will increasingly look to television service as a means of driving high-margin Internet access business, effectively shifting profit dollars to the services in which they have the strongest competitive advantage. We continue to believe this shifting dynamic presents a significant risk to the satellite companies over the next several years.
Cable stocks have been on a tear recently, with Time Warner Cable, the primary target of the M&A speculation, leading the way. Paradoxically, we believe the jump in valuations across the sector reduces the odds of consolidation happening. We estimate Charter could save about $400 million annually if it received the same pricing for content as TWC, an amount with a net present value of, say, $4 billion. This amount equates to about $15 per TWC share. With TWC shares trading nearly $50 above our fair value estimate stand-alone basis, we believe Charter will struggle to strike a deal for TWC without paying a premium that essentially transfers all of the benefit of reduced programming costs to TWC shareholders. As such, we would use the M&A frenzy to take profits in the cable sector.
Last quarter we stated that strategic wrangling across the U.S. wireless industry was finally nearing an end. However, it looks like the last potential deal within the sector, the merger of Sprint (S) and T-Mobile (TMUS), might be nearer at hand than we had expected. We believe neither Sprint nor T-Mobile has an economic moat currently because of each firm's small scale, and we've long held that they need to join forces to better compete with AT&T (T) and Verizon Wireless (VZ). Scale is critical to maintain low network operating costs, procure phones on the best possible terms, and secure additional spectrum without endangering the balance sheet. A combined Sprint and T-Mobile would still operate at a disadvantage relative to AT&T and Verizon Wireless, but the gap would certainly be much smaller than either firm faces individually today.
The key question is whether regulators will allow the U.S. market to consolidate to three nationwide players from four today. Ironically, the success that T-Mobile has had recently in attracting postpaid customers might actually work to its detriment here. Although we have been impressed by T-Mobile's turnaround of late, we aren't yet convinced that it has the network strength, spectrum position, and financial firepower to maintain the progress it has made recently. By pushing hard in the market to win customers today, T-Mobile may actually eliminate the possibility of merging with Sprint in the near term, weakening its competitive position over the long term. Until one of the firms actually proposes a deal, we have to assume that the management teams of both firms aren't yet convinced that a deal would have a reasonable shot at passing regulatory muster. We expect that both companies will gain familiarity with new FCC chief Tom Wheeler in the coming months; a decision on whether to attempt a merger in early 2014 should serve as a strong indication regarding whether these firms will join forces soon or wait for a new administration to take over beyond 2016.
Hardware: Smartphone and Tablet Industries Continue to Thrive
In hardware, Apple and Samsung remain at the head of the pack, gaining share from struggling competitors like HTC, BlackBerry (BBRY) and Nokia (NOK). Apple's stellar integration of hardware, software, and services into easy-to-use devices has driven the firm's strong revenue growth and profitability in recent years. We project decent, but not heroic, iPhone growth over the next few years, though we recognize that pricing pressure and gross margin deterioration may occur on future iPhone sales. Meanwhile, we anticipate strong tablet adoption over the next few years, both for larger iPads and lower-priced iPad Minis. As long as Apple can continue to build upon its success (and we see little evidence to the contrary thus far), we think the company will remain a leader in the premium smartphone and tablet markets for years to come.
Meanwhile, Samsung continues to take advantage of gaps in Apple's product portfolio, as well as windows of opportunity between iPhone refresh cycles. Samsung's larger-screen Galaxy S4 sold more than 10 million units in its first month, while the company's Galaxy Note phablets (phone/tablets) fill a niche within the industry for even larger screen devices and also crossed the 10 million unit sold threshold quickly. We believe that much of Apple's skyrocketing growth in the last five years came from a first-mover advantage with little competition in the smartphone space, but Samsung has now clearly emerged as a major threat to Apple in high-end devices.
Separately, Microsoft (MSFT), via Nokia's handset business, is making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apple's iOS and Google's Android. Nokia's Windows-based Lumia phones haven't gained much traction thus far, spurring Microsoft to bid for Nokia's handset business in an attempt to better align the Windows Phone ecosystem and emerge as a viable third operating system in the smartphone space.
On the enterprise hardware front, we expect competition among enterprise infrastructure suppliers to be intense in 2014. Cisco (CSCO), Hewlett-Packard (HPQ), EMC (EMC), Dell, and IBM (IBM) will all look to capture a growing portion of IT customers' overall infrastructure budget. At the same time, cloud computing and a general reluctance by enterprises to increase hardware infrastructure spending will put downward pressure on end-market demand, in our view.
In order to fuel revenue growth, we expect the largest vendors will look to increase investment in systems management software, IT analytics, and security; and we would not be surprised to see acquisition activity increase in 2014. HP's balance sheet is much healthier, Dell is now private, and Cisco continues on its journey to shift its portfolio toward software. Moreover, all three firms' management teams have recently reiterated their interest in acquiring tuck-in firms that fill existing product gaps.
Equity prices are at all-time highs, cloud computing is driving significant change, and a handful of large suitors will likely be targeting the most desirable start-ups and mid-size firms. As a result, we are moderately concerned that the tech giants will be tempted to overpay, and each deal warrants additional shareholder scrutiny, in our view.
Concerns That the Semi Recovery May Be Running Out of Steam
The semiconductor market made a nice recovery in the middle of 2013 following a cyclical downturn that hampered the space in late 2012. However, this recovery appears to be running out of steam in the fourth quarter of 2013. Major chipmakers that serve a broad array of end markets, such as Texas Instruments (TXN) and Microchip Technology (MCHP), saw an encouraging pickup in order activity in the middle of the year. Both firms foresee stalling chip demand at the tail end of 2013 because of lower manufacturing activity during the holiday season, but Microchip, in particular, expects growth in early 2014 once these seasonal headwinds subside.
One segment of the chip space that continues to show signs of weakness is the PC-related chip market. The popularity of tablets continues to pressure PC demand, which has created some headwinds for chipmakers exposed to that area, such as semiconductor behemoth Intel (INTC), the world's biggest supplier of PC microprocessors. Nonetheless, we think Intel can still grow over time, thanks to its server processor segment. We expect the firm to see significant sales growth in server chips in the coming years, driven by the continued build-out of the cloud infrastructure.
Finally, one of the more interesting announcements in recent months came from Intel and programmable chipmaker Altera (ALTR). Intel will provide manufacturing services based on next-generation 14-nanometer tri-gate transistor process technology for future programmable logic devices from Altera. The move certainly furthers Intel's foray into the foundry business, as the firm currently provides manufacturing services for a handful of chip startups. For the time being, we believe Intel will remain selective with any additional foundry tieups and will partner with customers with similar profiles to Altera--a highly profitable chipmaker that doesn't compete with Intel, yet can take advantage of Intel's cutting-edge manufacturing capabilities. As a result, for now we don't anticipate Intel's providing foundry services for chips based on designs from ARM Holdings (ARMH), including Apple's A-series processors for iPhones and iPads. While the Altera deal will have little impact on Intel's financials, the firm's interest in the foundry business is something worth keeping an eye on.
Internet: Greed Wins Out Over Fear and Valuations Become Riskier
In spite of our bullishness for digital ad spending and our positive views of the competitive positions of several stocks in our coverage universe, we see meaningful downside risk in most of the sector. During the quarter, Twitter priced its initial public offering exactly at our fair value estimate ($26), but has gone on to double as investors have thrown caution to the wind. Furthermore, continued strong performance from Facebook and Google highlighted the advantages of these wide-moat firms as industry spending is consolidating around these market leaders. Deceleration in revenue growth is likely to pressure these stocks, however. We'd feel most comfortable holding Google at these levels, given its relatively modest overvaluation. By contrast, Yahoo (YHOO) continues to lose market share, although increasing optimism about the potential for an IPO of Alibaba Group (a portion of which is owned by Yahoo) by the end of 2014 has pushed its stock price to a level where, if the IPO were to be delayed, investors may be disappointed.
Strong growth in digital advertising spending should continue, and Google, Facebook, and LinkedIn (LNKD) are all well positioned to capitalize on this growth. For Google, the market leader, we believe revenue growth from desktop-based internet search will begin a modest slowdown, and advertising revenue coming from (Google subsidiary) DoubleClick and mobile advertising will continue to grow in importance. Furthermore, we believe a focus on the lack of attractive economics of the Motorola (MSI) handset business may begin to take on greater importance. These businesses have lower structural operating margins. As Google's advertising reach broadens, the company will be forced to share revenue with a greater number of partners, including handset manufacturers, content owners, and developers. Although the company is actively pruning its product portfolio, we do not expect to see a measurable improvement in the overall cost structure.
Software: Slow and Steady Can Still Win the 'Big Data' Race
In the software sector, we still believe Oracle (ORCL) is an underappreciated story that represents an attractive buying opportunity for patient investors. As the market focuses on new trends in cloud-based software and "big data" solutions, we note that Oracle's position as an incumbent technology provider is as important as ever. Companies with economic moats such as Oracle (and similarly, IBM) will be able to defend their turf even as these technologies disrupt others. As a result, thanks to an inexpensive valuation, Oracle remains one of the most attractive names in our software universe.
Windows 8.1, a refreshed Surface lineup, and the Xbox One hit the market this holiday season with the hopes of accelerating Microsoft's device sales. The company's recently approved acquisition of Nokia's handset business should close sometime during the first quarter of 2014, and, on a somewhat related note, Windows Phone appears to be gaining traction in unsubsidized mobile markets. We think the headline issues will remain pointed toward the adoption of Windows 8.1, any incremental gains Microsoft may make in the tablet and smartphone markets, and any updates on CEO Steve Ballmer's replacement. Revenue run-rate milestones for Office 365 and Windows Azure point to early signs of success for Microsoft's software-as-a-service productivity application and cloud strategy. We remain cautiously optimistic that Microsoft can build on its still small market share in the tablet and smartphone markets to help slow the declines of its flagship Windows OS while driving additional sales of its Office franchise.
Our Top Tech & Communication Services Picks
With continued gains in the U.S. stock market (the S&P 500 is up 25% year to date), we peg the average price/fair value ratio for our technology and telecom coverage at 1.08 and 0.97, respectively. The technology sector reached a peak valuation of 1.15 in mid-November, however the group has retreated somewhat over the past few weeks. There are still a couple undervalued names in international telecom, but most carry at least some macro, regulatory, or political risk, and with limited visibility on an economic recovery in some of these regions, our theses could take several years to play out. As for the technology sector, there is a wide dispersion of under-/overvalued names, but in general the group remains slightly overvalued. We would prefer a wider margin of safety and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility. In general, we like companies possessing a combination of scale, switching costs, and pricing power in categories where perceived differentiation matters, and strong dividend-growth potential.
Top Tech & Communication Services Sector Picks
Data as of 12-19-2013
Star Rating: 3 Stars
Fair Value Estimate: $40.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Consider Buying: $28.00
Oracle is one of the highest-quality names in our tech coverage universe, and we expect that its core software business (which accounts for approximately 75% 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 the firm to drive additional software sales and strengthen its wide economic moat.
Star Rating: 3 Stars
Fair Value Estimate: $600.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Consider Buying: $360.00
Although Apple's current market price implies maturity, we forecast continued growth. Smartphones still account for less than 50% of total handset shipments, and we expect this penetration rate to continue to grow. Additionally, Apple still retains a dominant position in the tablet market, which should grow quickly during the next several years. Apple's success in tablets and smartphones has helped the firm drive strong sales of its Macs, even as the overall PC market shrinks. As Apple sells more devices to its customers, it can increase customer switching costs around its software and services.
Star Rating: 4 Stars
Fair Value Estimate: $100.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Consider Buying: $70.00
While some investors might fear that American Tower's recent REIT conversion will handcuff the share price, we continue to believe that plenty of upside remains. There is no shortage of fundamental growth drivers on the horizon, with the number of smartphone users likely to double over the next three years, all the U.S. carriers deploying 4G networks, and AMT expanding internationally. Ultimately, the REIT conversion can be accretive to shareholders because it allows the firm to save on taxes without compromising its growth profile. Even during an economic downturn, carriers cannot afford to let the health of their networks erode, and while many often worry about carrier consolidation, the T-Mobile/MetroPCS merger will affect revenue by less than 1%. The tower firms are a major beneficiary of this phenomenon, and American Tower remains the best-run company of the peer group.
Star Rating: 4 Stars
Fair Value Estimate: $26.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Consider Buying: $18.20
Cisco's dominant position in the data networking industry, copious free cash generation and depressed valuation makes the firm's stock an attractive investment opportunity, in our view. Although competitive pressures and tepid end market demand have caused revenue growth to moderate from historical levels, we think Cisco's free cash flow can continue to grind higher over time. Over the last two years, the firm has acquired numerous software-heavy start-ups that enhance its competitive position in wireless networking, security and cloud systems management. We expect these investments will help offset competitive pressures in routers and switches and reduce revenue volatility over time. Given Cisco's current dividend yield of 3.3%, trailing twelve month free cash flow yield of 10% and $32 billion in net cash on hand, we think Cisco's market valuation is extremely compelling.
Star Rating: 4 Stars
Fair Value Estimate: $208.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Consider Buying: $145.60
IBM's entrenched position as a premier global consultant, systems integrator and software infrastructure supplier to large enterprises will allow this firm to generate economic profits for many years. While cloud computing, competitive pressures and tepid end-market demand have led to weak top-line results for IBM, the firm continues to expand gross profit margin as it shifts its portfolio toward software and higher-value services. IBM's superior track record of successfully navigating technological transitions, strong management team and unparalleled service delivery model leave us comfortable that the firm will successfully emerge as a strong competitor during the next era of computing. We think long-term investors have an opportunity to purchase shares of one of the highest-quality firms within the technology sector at a reasonable price.
Peter Wahlstrom, CFA, has a position in the following securities mentioned above: AAPL INTC MSFT CSCO.