TMT Model Portfolio Update: Escaping the Death Watch

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We assessed the valuations of 187 US traded large cap TMT stocks, separating their EV into near-term and long-term components and graphing them on these axes. In the framework, the names fall into quadrants that have interesting implications for trading. This quarter, we are looking more closely at the “Death Watch” – i.e. stocks with below average 5-yr cash flow growth expectations and where the implicit 5th year terminal value represents less than 75% of the total EV. Amongst these 47 names are a motley crew of old IT suppliers and fallen internet stars who’s best days are likely behind them, but also several post-peak cyclicals, industry vertical suppliers, and a few surprises. We see particular opportunity in MSFT, QCOM, STX and WDC, where we feel management has navigated past obvious dangers and where their positions for the future are poorly appreciated. We also note that AAPL has fallen from the skepticism quadrant into the death watch – its recent cash flow performance has been so strong, that analysts and investors no longer project significant growth, perhaps also discounting its overseas cash assets as well. We are sympathetic to this perspective, although we are keeping AAPL in our Large Cap Model portfolio, which outperformed its benchmark in the quarter by 40bp, up 950bp. We are swapping STX for WDC, and PAY for AMZN. Our Small Cap Model Portfolio underperformed dramatically, up just 110bp, on very poor performance from OPWR, MRIN, RKUS and WWWW. We are removing JDSU, WWWW and MRIN, along with CNVR, which was acquired. We are adding HUBS, RENT, QLYS and SMCI in their place.

MSFT stands out amongst 16 traditional IT suppliers. The largest part of the Death Watch are suppliers to enterprise data centers, a clear market endorsement of a public cloud future. We see MSFT as clearly different from the others, a list that includes erstwhile stalwarts ORCL, CSCO, EMC and HPQ. A strong, early commitment to the cloud gives MSFT important assets, like its Azure IaaS platform and its Office 365 SaaS franchise, that suggest a bright future, even as older products fade.

The narrative on QCOM is overly pessimistic. Long time Skepticism quadrant member QCOM dropped onto the Death Watch, after worries about the future of its IPR royalties spurred significant downward revisions. Investors’ long term concerns are particularly acute, with only 5 companies in our overall large cap universe showing lower terminal values. Given the recent resolution of an anti-trust investigation by Chinese regulators and with new self-designed processors due, we see upside to expectations and possible multiple expansion.

Opportunity in disk drives. Along with QCOM, STX and WDC are amongst 7 component suppliers on the Death Watch. With just 3 remaining global disk drive manufacturers, clear signs of discipline, and a bullish future for cloud storage, we believe both are significantly undervalued. Strong performers in 2014, we expect a pattern of beats and revisions to continue in 2015.

Why is AAPL here? AAPL has fallen into the Death Watch, as its estimates and share price have not kept pace with its cash flows. Investors, apparently, have difficulty in projecting significant growth off of the greatest FCF quarters ever posted by any company and may be heavily discounting its overseas cash. While it is easy to argue that AAPL is undervalued, it is also easy to see the potential for future stagnation against the most difficult compares in history. We are holding on to AAPL in our model portfolio for at least one more quarter, but fear that hum-drum iPhone announcements for the fall could easily reverse the current momentum.

Not much to look at amongst other consumer plays. The Death Watch also contains a dog’s breakfast of one-time Internet stars. EBAY, at least, has the look of acquisition bait after its spin out of PayPal is complete – we see the e-commerce assets of the parent as much more attractive than its competitively outflanked payments subsidiary. YHOO becomes much less interesting without its BABA stake, and could become irrelevant if it were to divest its Yahoo Japan position, as has been rumored.

Idiosyncratic opportunities in industry vertical plays. SMB financial SW leader INTU has potential as it executes its shift to a SaaS model. Thinly covered and fast growing investor services software provider BR is also intriguing. Other stocks in the category are tied to investment cycles in their specific target industries, several of them – AMAT, PTC, SNPS, CGNX, CDNS and TER – tied to semiconductor manufacturing that is trending toward trough spending,

The Large Cap Model Portfolio returns to strong performance. Our Large Cap Portfolio was up 950bp since our last update on Oct 30, 40bp above the tech components of the S&P500. Performance had been weak in the 6 months from April, after outperformance in the two prior years. NFLX, DATA, ARM and AAPL were particularly strong performers, with the negative reaction to the most recent QCOM and MSFT quarters partially offsetting them. We are removing STX in favor of its competitor WDC, based on their recent records of execution. We are also returning AMZN to the portfolio, given expectations of improving near term margins, replacing PAY. As noted, we are retaining AAPL with expectations of further appreciation, but with a note of caution given the very difficult compares that will begin in September.

The Small Cap Model Portfolio performed poorly. Our Small Cap Portfolio was up just 110bp from October, vs. a 610bp rise in the S&P 600 and a 1050bp increase in its tech components. Performance was scuttled by sharp declines in OPWR, WWWW, MRIN, and RKUS, overshadowing strong appreciation by PFPT and SYNA. We must replace CNVR, which was acquired by ADS during the period, as well as WWWW and MRIN, which are being removed for their disappointing performance, and JDSU, which has grown above our $3B cap guideline and doesn’t fit well to our thematic heatmap. In their place, we are adding HUBS, RENT, QLYS, and SMCI.

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

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