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5 Tech Picks in a Pricey Sector

Peter Wahlstrom, CFA

Strategic M&A activity persists across telecom, but regulators may seek to alter the competitive landscape Semiconductors have had an excellent run, but tailwinds could turn quickly Economic moats trump technical innovation in the slow-moving cloud operating system industry

Several Secular Trends Are Playing Out Across Tech, but Growth Comes at a Price
Investors, enterprises, and consumers alike are still gravitating toward mobile and cloud-based computing themes, but valuations currently reflect some pretty aggressive growth ramps. Investors have definitely been rewarded for stakes in firms that already have strong positions in these key strategic areas of tech. For those firms still looking to round out their portfolios, the M&A market remains healthy, but valuation multiples of acquisition targets have increased as well. Although we agree with the notion that strategic acquisitions make sense in most cases, buyers appear to be citing meaningful costs and identifying operational synergies, or baking in aggressive growth expectations (or some combination of all three).

Some of the more attractive buying opportunities can still be found among firms that have strong hands to play in mobile computing and application software infrastructure; we like Tibco (TIBX) and IBM (IBM) in particular. Outsized profits and large, growing markets attract competition, and these firms aren't immune. However, they 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.

Strategic M&A Activity Persists Across Telecom, but Regulators May Seek to Alter the Competitive Landscape
Europe is witnessing a movement toward service bundles, and operators that have traditionally not offered a full suite of products are filling in the gaps through M&A. The most recent deals feature the merger of wireless and cable companies. U.K.-based Vodafone (VOD) recently agreed to acquire Ono, the largest cable television provider in Spain, following shortly on its purchase of Kabel Deutschland (KBDHY) in Germany. In France, Numbericable (NUM), the largest cable operator in the country, has entered exclusive negotiations with Vivendi (VIVHY) to acquire SFR, a large wireless carrier. By joining forces, these firms hope to gain greater scale and compete more effectively against the incumbent phone companies. We anticipate M&A will continue across Europe, but have seen valuations creep up recently. Unless anticipated synergies are realized, this could mean that some of the pairings actually destroy value, all for the prospect of top- and bottom-line growth.

Elsewhere, on more tepid note, regulators are stepping in and creating both near-term volatility and potentially opportunities. For example, as previously signaled and as we anticipated, Mexican regulators officially determined that America Movil (AMX) is a dominant operator and announced plans to impose asymmetrical regulations to hamper the firm's competitive position. We first learned of this potential outcome last summer and at that time preemptively moved our economic moat trend to negative. This regulatory move could prove to be more bark than bite, however. Although America Movil may lose some Mexican market share as a result of the new regulation, the company's scale, telecom network advantages, and financial flexibility should insulate its long-term competitive position.

U.S. regulators are faced with a major issue as well: how much control should one firm have over the nation's telecom and media infrastructure. Comcast (CMCSA) has proposed to acquire Time Warner Cable (TWX), a move that would create a cable company covering more than two thirds of the U.S. population with control of significant media assets through NBC Universal. Comcast management has rightly pointed out that this merger doesn't directly eliminate competition from the market, as the two firms don't serve overlapping territories. Given the massive scale that Comcast would enjoy, though, we expect that this proposed merger will end up as topic of debate among lawmakers in Congress, in addition to traditional regulatory authorities.

Hardware Continues Its Shift Toward Mobile and Integrated Platforms
The smartphone and tablet industries continue to thrive and Apple (AAPL) and Samsung (SSNLF) 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 exponential, iPhone growth over the next few years, as industrywide smartphone growth will most likely come from cheaper devices sold in emerging markets. In turn, 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 smartphones have sold well in recent years, while the company's Galaxy Note phablets (phone/tablets) fill a niche within the industry for even larger screen devices. We believe that much of Apple's skyrocketing growth in the past 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. Meanwhile, unit sales growth over the next few years may come from mid-range and low-end smartphones, and a host of Chinese OEMs like Lenovo, Huawei, and ZTE have fared quite well in selling sub-$300 smartphones in emerging markets.

And 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 (GOOG) 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.

Semiconductors: Excellent Run, but Tailwinds Could Turn Quickly
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 recent months, as broad-based semiconductor demand appears to be reflecting normal seasonal patterns.

Major chipmakers that serve a broad array of end markets, such as Texas Instruments (TXN) and Microchip Technology (MCHP), anticipate a modest pickup in business conditions after the normal post-holiday slowdown. By end market, increased electronic content in industrial applications and automobiles, in particular, should drive solid revenue growth in the long-term for high quality analog chipmakers that server these end markets. Linear Technology (LLTC), TI, Microchip, Analog Devices (ADI) and STMicro (STM) should all profit from these favorable tailwinds.

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, memory chipmakers, such as Micron (MU) and SanDisk (SNDK), have recently been boosted by an upturn in the memory segment. Both the computer memory (DRAM) and NAND flash memory markets are seeing solid demand-supply dynamics, which in turn have supported healthy pricing and profitability levels for memory firms. Nonetheless, we caution investors that the memory space is notoriously cyclical. Although memory chipmakers are benefiting from an upturn, business conditions in the memory segment tend to ebb and flow significantly over time.

Internet: The Market Is Underappreciating Downside Risk
After strong financial performance in the past quarter for companies in our Internet coverage universe, most stock prices remain overvalued; we think some stocks face meaningful downside risk in the coming quarters. Although we remain optimistic about the secular shift from offline to digital advertising, growth comparisons will become increasingly challenging as user growth slows.

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 second half of 2014 has pushed its stock price to a level where, if the IPO were to be delayed, investors may be disappointed. Twitter (TWTR), in particular, may see a significant sell-off if revenue growth is constrained by continued slowing growth in users.

Facebook's (FB) near-term growth will likely be strongest in our universe, supported by upcoming launches of advertising products for its Instagram platform. For Google, the market leader, we believe revenue growth from desktop-based Internet search will begin a modest slowdown, and advertising revenues coming from less profitable products such as mobile, YouTube, and applications will become more significant. Although we are encouraged now that the company has divested its Motorola business, its recent acquisition of Nest demonstrates its willingness to embrace less profitable businesses. Although the company is actively pruning its product portfolio, we do not expect to see a measurable improvement in the overall cost structure.

Software: Economic Moats Trump Technical Innovation in Slow-Moving Cloud Operating System Industry
In the software sector, a space which has its share of high-flying valuations for companies which have yet to turn in an operating profit (GAAP or non-GAAP alike) we instead turn to Tibco, which we believe is an underappreciated story that represents an attractive buying opportunity for patient investors. The computing shift from the client/server model to a device/cloud model is undoubtedly causing enterprises to rethink the way they purchase and consume software applications and computing resources. As a result, we've seen newer application software vendors like Salesforce.com and cloud computing providers like Amazon quickly grow mind share and revenue over the past few years. At the same time, many "old guard" enterprise IT vendors, like Oracle (ORCL) and IBM, have experienced a recent slowdown in results. We believe the market is extrapolating these recent results and making a spurious assumption that the old guard is being disrupted. In our view, we believe that the plumbing that allows enterprise software applications to work together--middleware--will grow in prominence over the next five years, and firms including Oracle, IBM, Tibco, and Accenture are very well positioned to leverage their product and services portfolios and capture a significant portion of a growing market. As the market focuses on new trends in cloud-based software and “big data” solutions, we note that Tibco is an incumbent technology provider that is well positioned to participate in the growth of analytics and business intelligence.

Our Top Tech and Communication Services Picks
After ending 2013 with a total return of 32% the U.S. stock market (S&P 500) has been on a bit of a bumpy ride but flat through the first quarter of 2014. We peg the average price/fair value ratios for our technology and telecom coverage at 1.13 and 0.98, respectively. After a brief pullback, the technology sector has again approached its recent peak valuation of 1.15 (reached in mid-November 2013). Although there are still a few undervalued names in international telecom, 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 broader technology sector, there is a wide dispersion of under- and 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 that possess a combination of scale, switching costs, financial flexibility, and pricing power in categories where perceived differentiation matters, and strong cash flow profiles.

Top Tech & Communication Services Sector Picks
Data as of 03-25-14.

Tibco (TIBX)
Star Rating: 4 Stars
Fair Value Estimate: $25.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Consider Buying: $17.50
Tibco is a provider of middleware, business analytics, and business process management software. Its independent status is seen as a positive for customers who are looking to avoid vendor lock-in from the mega-vendor competitors that Tibco faces. With its highly-rated SpotFire business analytics software, Tibco has been able to ride the wave of big data analytics while cross-selling to its existing core middleware customers. We think the increasing complexity of the computing environment will continue to drive demand for middleware, and Tibco should benefit.

Symantec (SYMC)
Star Rating: 4 Stars
Fair Value Estimate: $25.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Consider Buying: $17.50
Symantec is a leading provider of IT security, storage, and systems management tools and it has carved out a narrow economic moat. The company benefits from high switching costs associated with its enterprise security and storage solutions, its large install base, and its high recurring revenue. A surprising change at the helm increases the near-term execution risk for the firm, and we have increased our uncertainty rating accordingly. In the meantime, the firm generates ample free cash flow ($1.3 billion) and pays a healthy quarterly dividend of $0.15 per share. However, the real path for unlocking value for investors hinges on consistent operational improvement.

American Tower (AMT)
Star Rating: 4 Stars
Fair Value Estimate: $100.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Consider Buying: $70.00
With the network densification stage of LTE deployment cycles accelerating and carriers transitioning their focus from coverage to network quality, American Tower has a long runway for incremental organic growth. The firm's 2012 REIT conversion has been accretive to shareholders since it allows the firm to save on taxes without compromising its growth profile. Ultimately, 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.

Cisco (CSCO)
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 make 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 past two years, the firm has acquired numerous software-heavy startups 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 12-month free cash flow yield of 10% and $32 billion in net cash on hand, we think Cisco's market valuation is extremely compelling.

IBM (IBM)
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