December 26, 2012 – Large Cap TMT Valuation: It’s Never ALL in the Price

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Large Cap TMT Valuation: It’s Never ALL in the Price

Valuation is a double edged sword in TMT.  Stocks prices that imply growth and/or profitability below expectations, may be undervalued, but may also portend disappointments and revisions.  These risks are amplified by the once-a-generation paradigm shift underway and the inflection points that it is causing for many TMT stalwarts.  In this environment, one investor’s buying opportunity is another’s value trap, and traditional value metrics are useless in distinguishing between the two.  We are introducing a valuation framework that makes explicit the range of growth and profitability outcomes consistent with share prices and contrasts it with consensus expectations.  Referring to the iso-value curves, we evaluate each stock based upon the reasonableness of the embedded assumptions and consensus expectations vs. the threats and opportunities facing the company.  Particularly wide gaps between market price and consensus may reflect concerns for increasing CAPEX (e.g. T, VZ, CMCS.A), future revisions (e.g. MSFT, CSCO) or both (e.g. APPL).  In contrast, AMZN, EBAY, FB estimates sit well below their iso-curves, particularly curious as all three are overwhelmingly rated as buys.  Given our growing concern that consensus expectations for Apple are unlikely to be achieved given emerging competitive pressures, we are removing it from our model portfolio and replacing it with Citrix.

Value metrics are poor predictors of TMT stock performance.  Quantitative analysis has shown that value investing strategies have been historically ineffective in selecting technology stocks.  Against this back drop, we believe the TMT sector is in the midst of an architectural sea change that is rendering many long-standing technology standards obsolete to the severe detriment of erstwhile sector stalwarts tied to these tired paradigms.  The last generational upheaval occurred during the 1980’s, catalyzed by the rise of PCs, cell phones, and multichannel cable systems, along with the break-up of the Bell System, and resulted in the rise of new market leaders and the dissolution of many of the old guard.  In these circumstances, valuation may be an even more tenuous indicator of forward performance.

Thematic approaches may help to anticipate surprises and revisions.  Earnings surprises and estimate revisions have been strong predictors of performance, but only if they can be anticipated.  This phenomenon is particularly acute around sector inflection points, where pure momentum strategies can be disastrous.  Given our belief that TMT is in the midst of a comprehensive paradigm shift, we believe that a thematic approach to assessing the likelihood that individual companies will surprise against expectations, either upward or downward, will be the most effective stock selection strategy.

We have created a tool to help evaluate the growth and profitability assumptions embedded in TMT stock prices.  For each of the 20 largest TMT stocks by market cap and for the constituents of our large cap model portfolio, we have built models that assess the five year growth rate and profitability assumptions inherent in current stock prices.  The models return an iso-curve of revenue growth and operating margins consistent with market valuation and juxtapose the curves with current consensus expectations.  Significant deviations where consensus is far above the iso-curve may be explained by expected non-margin changes in cash flow, such as rising capex, but largely represents market pessimism relative to broker estimates.

Misses and downward revisions are rarely fully priced in.  For stocks where consensus is unusually ahead of embedded expectations, the achievability of estimates is a vital concern.  Since 2001, tech stocks that miss quarterly earnings expectations have underperformed the rest of tech by 240 bp over the subsequent quarter, with a more than 50% greater likelihood of underperformance than of outperformance.  Of the 30 stocks that we modeled, 11 saw consensus estimates more than 10 percentage points above their iso-curve.  Of these, VZ, CMCS and T are likely related to market concerns of rising capital spending and its impact on cash flow, while IACI suffered a 10% drop in market cap on recent rating downgrade that did not impact the long term consensus estimate.

Iso-curves significantly above consensus may reflect overvaluation but may also reflect expectation for lower capex and have less risk of negative surprises.  10 of the stocks analyzed had consensus estimates more than 500bp below their iso-curves, including model portfolio components Amazon, Seagate and Nvidia.  We believe that expectations for these companies are overly pessimistic on growth, profitability or both, suggesting potential for further upside despite relatively strong market valuations.  In some cases, notably Facebook, the gap also seems to reflect an expectation that non-operating cash flow will improve, such as a reduction in capital spending, although we are also concerned about Facebook’s strategic challenges.  Similarly, we believe the other 2 stocks in this grouping, EBay and VMWare will also struggle to adapt to the ongoing generational paradigm shift.

We are replacing Apple with Citrix in our model portfolio.  Consensus estimates for AAPL are 1000 bp above its iso-curve.  Given our concerns that competitive pressures on the iPhone and iPad will sap both growth and profitability while requiring a substantial expansion of capital spending, we believe that the potential for disappointments and downward revisions is high.  While the current share price may be fair longer term, we would not expect the stock to outperform while the company adjusts to its threats.  We are removing APPL from our model portfolio and replacing it with CTRX, which is well positioned to exploit an expected boom in device-level virtualization.

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

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