December 11, 2013 – TMT: The Good, the Bad and the MEH

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TMT: The Good, the Bad and the MEH

We recently published research (“TMT: How the Mighty Can Fall”) detailing the trajectory of companies and market sectors that have been overtaken by innovation. Threats to incumbents typically take 4-6 years from the appearance of alternatives until real impact shows in financial results. However, once begun, the deterioration proceeds faster and more forcefully than most investors expect. We have screened the universe of U.S. TMT companies with market caps in excess of $10B, judging exposure to threatened business areas and ability to exploit the innovations that are reshaping the sector. Exposure is measured by sales in the affected areas, weighing near term threats more heavily than those further away. Positioning is assessed subjectively, looking at the scope of new paradigm initiatives at each company and judging their relative ability to execute. Of the 80 companies, 26 fall into the attractive” little exposure/well positioned” quadrant, while another 29 suffer from the converse – in both cases, the implications are obvious. 12 companies boast strong positioning against opportunity, but must cope with deterioration from threatened business areas. We judge these by their commitment to the new paradigm and by their ability to mitigate near term threats, balanced by market expectations. The final 13 companies are neither particularly threatened nor well positioned. These typically compete in focused subsectors, such as defense or manufacturing systems, and the business drivers may be idiosyncratic.  We are adjusting our large cap model portfolio – removing N, which we believe may be vulnerable to more nimble SaaS competitors with more modern architecture, and adding TWTR.

Leadership in TMT is changing with an innovation-driven paradigm shift. We recently wrote about the destructive effect of paradigm shifts in TMT on previously vibrant market segments. The waves of change are typically slow to develop – 4-6 years from appearance to effect – but almost universally devastating to the companies in their path in the 1-3 years after impact. We believe that waves of destruction, driven by mobile user platforms, cloud data processing, and wireless broadband, will threaten entire business segments ranging from consumer PCs and traditional cell phones in the immediate term, to areas like enterprise data center technology, channelized TV, fixed broadband, and credit cards in the future.

Many large cap TMT bellwethers face big threats to their current revenues. We have identified 15 different businesses that we expect to face disruption, and have broken them in to 4 buckets based on how quickly we expect to see impact on sales and profits for incumbents. Parsing the current revenues of 80 large cap TMT companies into these buckets, and applying a discount to those with more distant threats, we have scored each stock for its exposure to the paradigm shift. Companies like HPQ or IBM, with clear and present danger, score poorly, while cloud economy leaders, like GOOG or FB have essentially no exposure.

Investments in the new paradigm have had varying degrees of effectiveness. We rated the same 80 companies based on their positioning for emerging opportunities and on our assessment of their ability to execute. For example, many traditional IT vendors have stepped up activity in delivering cloud-based services, but remain constrained by their need to sustain dying architectures and by their insufficient skill sets. Such players – such as ORCL or IBM – may have reasonable position but questionable execution. This is consistent with history, as incumbent vendors have typically failed in attempts to shift into a disruptive technology.

Companies in the “little exposure/strong position” quadrant are obvious winners. The companies without exposure to threatened business areas and deemed likely to succeed in the new paradigm are poised to lead the next era of TMT, with stocks like GOOG and QCOM at the positive extreme of the quadrant. Conversely, companies that are highly exposed and poorly positioned – such as HPQ, ORCL or cable MSOs – represent serious long term risk, even if sales and cash flows are robust today.

Players that are both well positioned and threatened may be interesting. Value may be best mined from the threatened but well positioned quadrant in companies where threats have been more apparent to investors than their future prospects. Companies like MSFT and STX fall into this category. In contrast, companies where positioning has overshadowed future risks may be overvalued. SaaS pioneers CRM and N, both currently tied to expensive relational data bases and sub-scale dedicated infrastructure, are examples.

Unthreatened, poorly positioned companies are mostly idiosyncratic. Interestingly, few companies are both unthreatened and poorly positioned for future opportunity. Those that fall into the quadrant tend to be focused industrial electronics players that may face risks farther in the future should new paradigm approaches – e.g. “the Internet of things” – spread into unexpected arenas.

We are adding Twitter to our large cap model portfolio. While our timing is unfortunate, given the past week’s run up in the share price of TWTR, we are adding it to our model portfolio for three main reasons: 1. TWTR is exceptionally well positioned to prosper from the cloud era, with sustainable leadership in the delivery of increasingly valuable “real time” information; 2) Expectations for coming quarters are easily beatable given new revenue initiatives in play; and 3) Valuation is reasonable given the likelihood of future growth and profitability. To make room for TWTR, we are removing N, which recently turned down after a long run of outperformance. We believe that new competitors, exploiting the cost, performance and flexibility advantages of public cloud platforms such as AMZN and GOOG, will begin to pressure early SaaS leaders like N and CRM, which rely on older vintage architecture. We are also adding two new names to our small cap portfolio – XONE, a 3D printer maker, and GTAT, which sells equipment for manufacturing crystals for solar, LED and high performance semiconductor components.

For our full research notes, please visit our published research site.

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