Cheap Tech Redux: Sifting Through the Bargain Bin Again

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Paul Sagawa / Artur Pylak

203.901.1633 /.1634

sagawa@ / pylak@sector-sovereign.com

twitter.jpg @SecSovTMT

April 26, 2012

Cheap Tech Redux: Sifting Through the Bargain Bin Again

  • A year ago, TMT stocks set a 20 year P/E low relative to the S&P500. Since then, tech has rallied back almost halfway to its historical relative P/E. However, the rising tide is not lifting all boats, with the dispersion of returns wide and a few big winners driving the sector performance. In June, we identified 26 large cap TMT stocks with cash adjusted forward P/Es below 10 and FCF yields above 10%. This group underperformed the S&P by 580bp and TMT by more than 970bp since June, flagging the risks of bottom fishing in the TMT pool. The 7 companies that screened as well on positioning against future opportunity and exposure to old paradigms appreciated more than 20%, while the 6 rated poorly fell -4.8% on average. Widening the 10/10% screen to include companies with <12x P/E and >8% FCF yields gives a new bottom fishing pool of 24 names. Using the same screens yields 6 attractive candidates and other 6 viewed as unattractive.
  • TMT is coming back, but performance has been concentrated, with a wide dispersion of returns relative to the S&P. Excluding 1998-2003, the average tech P/E has been 1.19x the S&P500. 800bp of outperformance YTD has raised the relative P/E of the S&P tech components from 0.99x to 1.06x. Meanwhile, performance has been widely dispersed, with the outperformance of a handful of megacaps driving cap weighted average returns 28% higher than median performance.
  • Bottom fishing has been treacherous – TMT stocks with <10x P/E and >10% FCF yields have broadly underperformed since June. Cheap tech stocks have always been something of a sucker’s bet. Historically, TMT stocks in the bottom P/E quintile have underperformed the top quintile by 640bp over the next 12 months. The 26 members of the 10/10 club that we identified a year ago June returned -0.3% since, vs. 5.5% for the S&P 500 and 9.4% for all of the TMT stocks in our universe.
  • We believe that the companies best positioned to exploit the once-a-generation paradigm shift will prove to be the best investments in the TMT sector. Specifically, we believe that portable devices using wireless networks to connect to distributed CDNs serving cloud-based, socially linked applications in an integrated user experience are quickly becoming the dominant consumer platform. Similarly, we believe that enterprises will increasingly adopt portable platform architecture and cloud-based infrastructure to improve IT efficacy and reduce costs. These changes will have negative implications for traditional TMT products – PCs, data center IT, and channelized TV amongst them.
  • Screening those cheap stocks for relevance against our long term sector vision yielded 7 that strongly outperformed, while 6 rated as risky performed very poorly. In June, we highlighted MSFT, CSCO, SYMC, SNDK, STX, WDC and FLEX as relatively well positioned for future opportunities and relatively insulated from old paradigm risk. These companies appreciated 22.4% since. At the same time, the 6 stocks flagged as poorly positioned and at risk from change – HPQ, DELL, CA, CSC, INTC and MU – fell -4.8% on average.
  • Widening the screen to <12x P/E and >8% FCF yield, leaves a pool of 24 bottom fishing candidates. With the overall market appreciation and with several of last year’s list falling off for losses and/or negative cash flow, the 10/10 club now has just 9 members, with Symantec, HP, RIM, Xerox and Pitney Bowes returning for a second time. Expanding the criteria to include companies with cash adjusted forward P/Es below 12x and cash adjusted FCF yields greater than 8% brings the pool back to 24 companies, with multiple media, advertising and cable/satellite names new to the list. Our screening process yields 6 well positioned companies and 6 viewed as having significant risk.

Value Investors Beware

TMT is a notoriously tough market for value investors for two main reasons. 1. Cheap TMT stocks tend to underperform. Since 1991, the average TMT stock with a trailing P/E in the highest quintile returned 610bp more to investors than did the average in the lowest quintile over the next 12 months (Exhibit 1). Exclude the bubble years of 1998-2002, and the outperformance remains a gaudy 380bp. Comparatively, for the non-TMT components of the S&P500, the lowest P/E quintile outperformed the upper by 280bp on average. 2. The relative performance of cheap TMT stocks is extremely volatile. The standard deviation for the difference between average performance of top P/E quintile stocks and bottom quintile stocks for TMT was 27.9 percentage points, compared to 6.7 percentage points for non-TMT stocks. In a sector where big companies can disappear while start-ups rocket to multi-billion dollar market caps, bottom fishers are properly warned to fish carefully.

Exh 1: Upper Versus Lower Quintile Performance, TMT and S&P 500 ex TMT, 1992-2012 YTD

Last June, when we last took a look at cheap tech, TMT stocks were selling for a lower average cash adjusted P/E than the overall market for the first time in the 17 years for which we have data and far below the 20% average premium. In the 10 months since, the median TMT stock has outperformed the median S&P 500 constituent by 390bp and the median relative P/E multiple now shows a 6% premium. On cash adjusted Free Cash Flow Yields, the sector rates as slightly expensive vs. the broader market (Exhibit 2).

Exh 2: Historical Upper and Lower Quintile Cash Adjusted P/E ratios, TMT versus S&P 500

While the overall TMT sector has rallied, the effects are not evenly spread, putting an unusual premium on stock selection. Returns in TMT have generally shown a wider dispersion than the broader market, and the recent tech rally is no exception. Year to date, 14.3% of TMT companies have appreciated by at least 30%, compared with just 6.4% of the non-TMT components of the S&P500. The standard deviation of returns for TMT stocks was 17.5%, much wider than the 13.5% standard deviation for S&P500 constituent returns (Exhibit 3). Given that the list of big winners is capped by Apple and includes stalwarts EMC and VMWare, the performance was also skewed toward the highest market caps. Cap weighted average TMT performance beat the median return by 530bp and the S&P500 mean by 788bp (Exhibit 4).

Exh 3: S&P 500 ex TMT Return Distribution Summary, 2004-2012YTD

Exh 4: TMT Returns and Distribution Summary, 2004-2012YTD

The Race to the Bottom

Given this backdrop, it is no surprise that bottom fishers have generally fared badly in TMT. In June, we generated a list of 26 companies that carried cash adjusted forward P/E ratios below 10 times AND cash adjusted Free Cash Flow Yields of greater than 10%. At the time, we noted that these stocks were priced to fail, and while none has failed yet, some certainly could be on their way. In the 10 months since, the 10/10 club stocks failed to break even, while the S&P500 appreciated 5.5% and the average tech stock returned 9.4% (Exhibit 5).

Exh 5: The June 2011 List of 26 – Companies with after cash P/E multiples of less than 10x and after cash FCF Yields of 10% or more

Four of the stocks – Corning, Nokia, STM, and Flextronics – have fallen off the list for virtue of making losses or burning cash, thus rendering their statistics meaningless. Another, Motorola Mobility, escaped via acquisition by Google, yielding a 57% gain for MMI investors and pushing the overall average return above zero. Five others, Hewlett Packard, Research In Motion, Xerox, Pitney Bowes and Symantec, remain stuck in the 10/10 club a year later after significant share price depreciation. Four stocks –Computer Sciences Corporation, STM, SanDisk and Micron – saw their earnings or cash flow drop more quickly than their falling share prices, pushing their ratios beyond the thresholds. Four more – Dell, AMD, ADI and Marvell – saw sufficient appreciation to fall off of the list, but still underperformed the S&P. This leaves just eight stocks that earned their way off of the list with superior shareholder returns – CA, Cisco, Microsoft, Intel, Seagate, Western Digital, Novellus and Amdocs.

The Screens Worked

In June, we applied a screening mechanism, assessing the exposure of the 10/10 club to older, declining paradigms and their positioning against the opportunities being created by the new paradigms. Those screens returned a list of six stocks – Cisco, Microsoft, Seagate, Western Digital, SanDisk, and Flextronics. These stocks have returned an average of 22.4% in the 10 months since vs. -0.3% for the 10/10 club as a whole, 5.5% for the S&P500 and 10.4% for our full universe of TMT stocks. Cisco, Microsoft, Seagate and Western Digital were the big winners for the group, but while FCF yields have dropped well below the threshold, all four still sport forward, cash-adjusted P/Es of less than 10. SanDisk and Flextronics turned in weak, but not catastrophic, performance, with SanDisk’s FCF yield falling below the 10% threshold, and Flextronics burning cash for the period.

Exh 6: The June 2011 Winners and Losers Performance Since 6/3/2011

In contrast, the six stocks we called out as carrying unusual risk according to our screens – HP, Dell, CA, CSC, Intel and Micron – depreciated by -4.8% on average, despite 31.7% appreciation from Intel and 19.0% appreciation from CA. Dell eked out 5.3% returns for the period, but Micron, CSC and HP each dropped by at least 20%. HP remains in the 10/10 Club.

The New Paradigm – A Quick Review

We believe that the TMT landscape is in the midst of a comprehensive paradigm shift that is making obsolete many of the old architectures that have dominated TMT since the last sea change 25 years ago. Specifically, we believe that portable devices, connected via wireless networks, utilizing distributed data center architecture, delivering cloud-based collaborative applications, from tightly integrated user platforms are on their way to replacing the PC, commoditizing data center IT, and marginalizing Cable television. We can refer you to many pieces that we have published detailing the many elements of our overarching view, but the following pieces are a good start:

June 22, 2011 – Mobile Devices: Flying in the Clouds:
http://www.sector-sovereign.com/wp-content/uploads/2011/12/11.06.22-Mobile-Devices-FlyingintheClouds.pdf

December 16, 2011 – The Four Horsemen of the Internet:
http://www.sector-sovereign.com/wp-content/uploads/2011/12/12.12.16-The-Four-Horsemen-of-the_Internet.pdf

January 19, 2012 – Virtualization and the Cloud:
http://www.sector-sovereign.com/wp-content/uploads/2011/12/12.01.19-Virtualization-_the-Cloud.pdf

January 31, 2012 – Multichannel TV: What, Me Worry?:
http://www.sector-sovereign.com/wp-content/uploads/2011/12/12.01.30-Multichannel-TV-What-Me-Worry.pdf

The Second Screening

With the strong performance of TMT stocks in the market, the 10/10 club has shrunk to just 10 members – Advanced Micro Devices, Applied Materials, Expedia, Gannett, Pitney Bowes, Research in Motion, SAIC, Symantec, and Hewlett Packard, and Xerox. Expanding the boundaries to companies with at least 8% cash-adjusted free cash flow yield AND less than 12 times forward cash adjusted P/E increases the club membership to 24 stocks (Exhibit 7). As we did the last time, we are assessing these companies on two screening criteria. First, how much of their cash flow is at risk from the changing technology landscape, and second, how well positioned are they to compete for leadership in emerging growth business categories?

Exh 7: The April 2012 List of 24 Companies with after cash P/E multiples of less than 12x and after cash FCF Yields of 8% or more

We have estimated the percentage of company cash flows stemming from at-risk product categories for each of the companies based on published revenue splits, management comments and our estimation. We have also reviewed each company’s participation in the areas that we believe will drive future growth for the sector – i.e. smart portable devices, wireless broadband, distributed data center architecture and Cloud applications – giving each stock a 1-10 rating solely on the quality of the new businesses (Exhibit 8). Essentially, we are trying to judge each company as two companies, one a dying cash cow and the other a fast growth start-up. Using free cash flow yields net of balance sheet cash as a third variable, we graph the 24 companies in three major buckets: Media/Advertising, Semis/Semi Cap Equipment, and Other.

Exh 8: The April 2012 List of 24 Positioning and Revenue Threat Scorecard

From amongst the Media and Advertising group, our screens highlight Omnicom, NewsCorp and Dish Network (Exhibit 9). We believe that Omnicom is positioned to participate as advertisers shift their budgets toward internet based media. NewsCorp has been innovative and aggressive in using the internet to distribute its content in a variety of formats, while risks to their newspaper holdings is likely already accounted for in the bargain valuation. Dish network holds valuable spectrum assets and media streaming technology, while their subscriber base skews rural, making cord-cutting a less imminent threat. We also see Electronic Arts well positioned with its stable of hit gaming franchises and moves to capture mobile app gamers. On the negative side, we believe many of the risks for traditional media players are still too far out to make an aggressive play.

Exh 9: Media/Advertising Companies Positioning for New Opportunities in Tech

We believe that the semi cap equipment market may well be in the midst of a cyclical turn for the better, driven by demand for process improvements and capacity from mobile platform semiconductor players. As such, we see Applied Materials and Lam Research as attractively positioned with little risk from older paradigms (Exhibit 10). At the same time, we believe that AMD’s fealty to the x86 processor architecture places it a substantial risk of obsolescence without corresponding opportunity from new platforms.

Exh 10: Semi/Semi Cap Companies Positioning for New Opportunities in Tech

From the rest of the 8/12 club, our screens do not suggest obvious opportunities, but highlight risks in several stocks (Exhibit 11). Expedia might seem to be well positioned, but our thesis includes an expectation that major mobile platform owners, such as Google and Apple, will look to integrate functionality directly into their platforms, obviating the need to look to the internet for 3rd party services like Expedia. Research in Motion appears to have lost the mobile device platform wars, with little chance of recovery. Hewlett Packard remains enormously exposed to both PCs and printers and has made little progress in positioning itself to succeed in the new paradigm. Computer Associates and Computer Sciences Corporation both remain overly dependent on traditional IT architectures without evidence that they can pivot to be winners in a cloud oriented world.

Exh 11: The Rest of the 8/12: Positioning for New Opportunities in Tech

Exh 12: Positive versus Negative Risk Reward

Conclusions

With the appreciation of TMT stocks relative to the broader market over the past year, the risks inherent in value investing in the sector may be even more threatening. That said, we believe thematic investing is a best practice when bottom fishing. Our framework represents an attempt to apply thematic principles to cheap TMT stocks and suggests six stocks – Applied Materials, Dish, Electronic Arts, LAM Research, NewsCorp, and Omnicom– that may be in position to rerate in the coming year. Meanwhile, we see risk outweighing opportunity for six other stocks – AMD, Expedia, RIMM, HP, CA and CSC (Exhibit 12).

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