TMT in 1Q11: The Curse of Great Expectations, Launching a Model Portfolio

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1Q11 was an odd quarter for large cap TMT – growth in sales and earnings were well above historical norms, while the distribution of surprises was unusually poor.  Against this, valuations remain near historic lows.  Parsing out the quarterly results, we can make several observations.  First, consumers are driving the bus – surging spending on devices and on-line services, and a robust advertising rebound, were behind many upside surprises.  Along these lines, channelized TV purveyors, which we believe faces extinction long term, scored a short term comeback.  In the enterprise, data center upgrades are in a sweet spot as corporate IT departments are in the middle innings of their transition to virtualization, with cloud options gaining momentum.  In contrast, revenue for companies focused outside of the data center – PCs, networks, etc. – was weak

While financial performance in 1Q11 was generally strong, stock performance in TMT YTD has been poor (+4.62%), and valuations remain near historical troughs.  Reaction to 1Q11 results was largely negative, with only the most dramatic upside surprises able to stimulate significant sustainable moves.  Several bellwether tech stocks delivering torrid sales growth – e.g. Apple (+83%YoY), Oracle (+37%), Google (+69%), Qualcomm (+45%) – now sport forward P/Es well less than 20 in a sector that has historically used P/E to growth (PEG) ratios of less than 1 as a sign of value.  This appears emblematic of investor fears that hot market demand will cool, that future competition will erode market share and that talent costs and infrastructure investments will destroy margins.  While there is some basis for these fears, we believe that the overhang on valuation is excessive

Meanwhile, valuations in mature tech segments sit at historic lows, almost irrespective of 1Q11 results – Microsoft, Intel, Cisco, HP and Dell each sports a single digit P/E multiple – indicative of market acceptance that the future for PCs and enterprise networking is dim.  In contrast, valuations for cable system and network operators remain robust – i.e. Disney (13.7 P/E), Comcast (13.3), Time Warner (11.3), Viacom (12.1) and TWC (13.5) – roughly in line with the likes of Apple or Google, despite showing a small fraction of the growth and facing potential obsolescence of channelized video just across the investment horizon

History suggests that quantitative models have been relatively ineffective as stock predictors in TMT vs. the rest of the market.  We believe that this is due to the inability of these tools to capture the effect of technology innovations that allow new companies to quickly rise from obscurity to prominence, while destroying businesses tied to the status quo.  In our research, we have identified several current themes that we believe will largely determine TMT winners and losers over the next decade, specifically: Smart Portable Devices, 4G Wireless, CDN Architecture, Cloud Applications, Streaming Media, On-line/Mobile Advertising, and Energy Conservation IT.  Few large cap stocks can be considered pure plays on these themes, but we have rated the largest TMT stocks as to the size of their exposure and the quality of their position against these opportunities.  Combining these two aspects to a single 1-10 rating, 48 of 189 TMT stocks with market cap above $3B are rated at 7 or above, with Google, Salesforce.com and ARM judged as 10

Having subjectively screened companies on a thematic basis, we have created a secondary screen based on the most effective quantitative tools.  P/E, projected sales growth and free cash flow yield have also shown modest, but significant, correlation to future performance.  Interestingly, many of the stocks rating highly on our thematic screen cluster tightly on performance ratings with 9 or 25 stocks rated 8 or better with PEs between 15 and 25, projected sales growth of 10-20% and strong cash flows

Applying both screens, we have selected a 15 stock model portfolio.  Leading the roster are Google, and Apple, which are leaders across several of our growth themes.  We selected four companies primarily tied to the spread of smart portable devices – ARM, Skyworks, Cypress and Nuance – and Qualcomm, which adds leadership in 4G wireless technology.  Riverbed and JDSU should benefit from capacity expansion in content delivery networks.  Salesforce.com, Ariba and OpenText are leaders in cloud-based enterprise applications.  Priceline represents the consumer cloud and Rovi is positioned for streaming media.  Finally, Cree is positioned to address coming mandates for energy efficient lighting.  We are tracking the performance of these stocks on an equal weighted basis, and will revisit the composition of the portfolio on a quarterly basis

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