Large Cap Tech: The Revolution Will Be Streamed

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Paul Sagawa

203.901.1633

sagawa@ssrllc.com

September 23, 2010

Large Cap Tech: The Revolution Will Be Streamed

  • In the wake of the financial crisis, large cap technology stocks have performed poorly over the past three years, with cash-adjusted valuations approaching par with the rest of the market on trailing earnings and well below it on forward expectations. On one hand, this is anomalous, as the technology sector portends to continue overall growth and profitability well ahead of the full economy. On the other hand, this may represent investor anxiety over the uncertain effects of disruptive paradigm shifts underway that threaten to remake the TMT landscape as profoundly as the technological sea change of the late ‘80’s, the last time that relative tech valuations fell this low for a protracted period of time.
  • In the ‘80’s, the birth of the PC, the break-up of the Bell System, the first cell phones, the rise of cable TV, and the early days of TCP/IP networking rocked established value chains in traditional computing, telecom and broadcasting, while nourishing the growth of future giants Intel, Microsoft, Dell, Apple, Nokia, RIMM, Nokia, Qualcomm, Texas Instruments, Comcast, and Cisco. Today, portable platforms, cloud applications, Internet TV, wireless broadband and content delivery network (CDN) architecture are a significant challenge for today’s established TMT players, particularly those dependent on PC architecture, channelized video entertainment or telephony.
  • We have written about the serious threats facing the PC – a $250B+ global revenue stream. Fast CDNs and wireless broadband networks are enabling streamlined non-PC devices – i.e. smartphones, tablets and netbooks – to access increasingly popular cloud-based applications running on powerful servers with effectively limitless storage. The early stages of this may be apparent in the myriad signs of PC demand weakness, and the effect could be profound for all companies dependent on PC architecture, including components, hardware, peripherals, software, and services.
  • Similarly, we see significant long-term threats to value chains in cable television and traditional telecommunications, as Internet-based services delivered by CDNs push facilities based carriers ever closer to “dumb pipe” commodity status. This will affect carriers and system operators, but also traditional suppliers and channelized video content providers as well, as “over the top” becomes a reality. All together, around $200B in industry value chain revenue streams will be under siege.
  • Of course, there are extraordinary opportunities in the face of these threats. Technology spending relative to the US economy has grown dramatically looking back over any interval, with little reason to suspect anything different looking forward. We believe smartphones, tablets, streaming media, social networking, cloud apps, 4G, telepresence, CDNs, etc. are likely to become huge businesses and to spawn related opportunities up and down emerging value chains.
  • However, investors appear unconvinced that the future winners in our scenario will come from the ranks of large cap tech – of course, excepting Apple. We believe that the imbalance of the perceived threats to TMT leaders relative to the perceived opportunities to invest in the agents of change is a major factor in the malaise that continues to grip TMT investors. This was certainly true during the mid ‘80’s, as relative tech valuations fell sharply, hitting bottom in 1985 and not rebounding for good until after 1990. Now, as in 1990, some of the biggest future winners are likely still small, or even privately held.
  • At the same time, we believe that the general weakness in TMT masks significant opportunities in companies that have limited exposure to the biggest threats and that are positioned to address the new emerging business models. Screening the 100 largest tech names for exposure to both threatened revenue streams and growth opportunities yields 18 stocks that are statistically well positioned – Apple, Google, Cisco, Qualcomm, Amazon, EMC, VMWare, eBay, NetApp, Broadcom, Salesforce.com, Juniper, Citrix, Akamai, F5, ARM, Xilinx, and Cree. These companies sport an aggregate 20.44 P/FE relative to the 14.79 tech average.
  • Similarly, we have previously identified small and mid-cap companies that are positioned against the major growth opportunities in TMT. These companies could also be acquisition candidates, as large cap players use their prodigious cash positions to reposition themselves to address the changing landscape.
  • In 1990, the best way to play tech was to back the new breed – Microsoft, Intel, Dell, Cisco, Compaq, Sun, Oracle, et al. – despite seemingly rich valuations, and to avoid the old breed value traps – DEC, Wang, Unisys, Kodak, Xerox, Control Data, and others. We believe the same circumstances hold today.

Losing Altitude

Large cap tech has been sputtering. Despite superior earnings growth, tech P/E multiples on a trailing basis have fallen nearly 30% over the past 36 months vs. a 15% drop in the average value of the rest of the market. (Exhibit 1) With this relative contraction, tech valuations are within hailing distance of parity with the broader index, a condition that has occurred in two periods over the past 20 years. (Exhibit 2) Considering consensus expectations for strong future tech earnings growth, forward multiples for large caps in the sector are 25% below historical average on a relative basis vs. the rest of the S&P500. (Exhibit 3) Clearly investors are worried about something.

Cash, Cash Everywhere, but Not a Drop to Drink!

The disaffection for tech stocks is doubly curious given the extraordinary cash position of many tech stalwarts. The average net cash position for large cap tech has reached almost 10% of total market capitalization, doubling over the past two years. (exhibit 4) Meanwhile, the average non-tech stock in the S&P carries a similar level of net debt. Adjusting tech and non-tech P/Es for this substantial difference shows that tech valuations hit par in late 2008, and appear poised to revisit the level again. (exhibit 5) Again, forward multiples are even more depressed on a cash adjusted basis (exhibit 6).

It has been raised that the market may be discounting tech stocks because of their longstanding tendency to hold cash rather than pay it back to shareholders. However, these policies are not new, and have not been obvious impediments to performance in the past. Moreover, there are signs of change. Several high profile technology bellwethers have either announced their willingness to consider dividends – e.g. Cisco – or have begun to pay them – e.g. Microsoft – and many are executing aggressive stock repurchase programs. At the same time, political debate over the tax implications for the repatriation of cash held overseas has begun. Reform in this area could stimulate more aggressive payouts. It seems unlikely that a newfound disrespect for cash is behind the weakness in large cap tech.

Instead, we believe that the TMT landscape is in the early innings of a major transformation from a PC, packaged software, wire, and channel dominated state to one where untethered portable devices access applications and content at lightning speeds directly across the internet. It is our thesis that investors see the threats to existing business models more clearly than they see the companies positioned to exploit the new opportunities. This asymmetry yields broad-based weakness across large cap tech, particularly those tied to PCs, while a handful of stocks that are obviously tied to the emerging paradigm shift – e.g. Apple, Salesforce.com, and Netflix – have soared. Of course, history is repeating itself.

A Brief History Review

The last time tech P/E’s fell to parity with the rest of the market for an extended period of time was the turbulent late ‘80’s. The IBM PC had been launched in 1982 with PC-DOS, and Windows followed in 1985, driving the US installed base to 51 million by 1990, but also crushing the huge market for mini-computers. The first cell phone calls were made in 1982 as well, with the first hand portable models hitting the market by decade end, popping total US cellular subscribers from 5 million in 1990 to 11 million two years later. Paging companies were growing rapidly, hitting 22 million subscribers by 1990 and 64 million by 1994. The consent decree breaking up AT&T was signed in 1982 and executed on January 1, 1984, creating the Baby Bells and fanning the flames of long distance competition. The 1984 Cable Act deregulated cable television and stimulated $15 Billion in spending on cable infrastructure between 1984 and 1992. Over the course of the ‘80’s total US cable subscribers grew from 16 million to 53 million, and over 50 new cable networks were launched, including MTV, CNN, and ESPN. Ethernet, invented in 1973, hit its stride with the 1985 introduction of networking over ordinary twisted pair wiring. This sowed the seeds for wide-spread access to the Internet, the beginnings of which may be traced to the 1989 decision by CompuServe to connect its millions of users to the pre-WWW net, at least for email.

Of course, total tech sector revenues were growing rapidly. The 1980 Fortune 500, ranked by total revenues featured 22 technology companies. By 1990, 18 of these companies remained – Burroughs had acquired Sperry and Memorex and renamed itself Unisys, GE had acquired RCA and AT&T had been broken up and its pieces moved to the newly formed Fortune Service 500 list. The average annual sales growth of those companies over the course of the decade was a healthy 10.7% vs. 7.3% for the S&P500, but the P/Es of these tech stalwarts languished, falling to par vs. the S&P in 1985 and not recovery for the balance of the decade. (exhibit 7)

Meanwhile, a new breed of tech companies was rising. Apple had its IPO in 1980, followed by Compaq in 1983, Microsoft, Oracle, and Sun Microsystems in 1986 and Dell in 1988. Intel was already in the Fortune 500 list at #368 for 1980, but moved up rapidly, breaking into the top 100 by 1993 and the top 50 by 1997. Cisco went public in February of 1990. Obviously, investors that picked these stocks were richly rewarded, although it wasn’t until the ‘90’s that the companies were large enough to change the trajectory of the overall technology market sector. The skepticism around much of the previous generation of tech leaders proved to be well founded, as many suffered in the wake of the many paradigm shifts of the era. A chart of market leaders from the early ‘80’s to the early ‘90’s shows a stark changing of the guard. (exhibit 8)

The net result of this was a historically weak market for tech stocks that began in the mid ‘80’s and extended to the end of the decade. The average tech P/E slid from double the broader index as late as the beginning of 1986, to less than parity by 1988, the result of an absolute decline in the value of large cap technology during a period of generally rising prices. We believe that this dynamic is closely related to the uncertainty generated by the massive changes in progress in the technology landscape – the threats were obvious, but the biggest winners were a cast of mid-cap start-ups that may have seemed unduly risky to the investors of the day.

Déjà vu All Over Again

Like the late ‘80s, we believe the technology sector landscape is in the midst of a massive tectonic plate shift. The technologies inherent in smartphones, wireless broadband, content delivery networks, cloud applications, and streaming media are coming of age together, reaching critical mass and technological maturity and enabling entirely new paradigms for using information. It is this “cosmic alignment” of multiple innovations emerging simultaneously that makes for revolution rather than evolution. (Exhibit 9) The iPhone heralded a breakthrough in the user experience on mobile devices that has been echoed and extended by Android powered competition, but would these devices have been popular without adequate Internet connectivity via 3G, WiFi and soon, 4G networks? At the same time, would mobile Internet connectivity have been valuable without the range of cloud-based applications – mobile search, navigation, e-mail, social networking, streaming media, etc.? Would these applications have taken off without the rapid response times enabled by content delivery networks that put servers as close as possible to the user? Would CDNs have been possible without server virtualization techniques and content aware networking technologies? This happy set of coincidences creates conditions ripe for a sector makeover that will likely surprise investors with its pace and scope.

As the dawn of the PC age had marked a dark hour for mini-computers and mainframes, the reforming landscape today is a troubling omen for those companies still tied to the PC architecture, many of which are amongst the largest tech companies in the market. (exhibit 10) Of the 100 largest US TMT companies by market cap (of which 81 are tech companies), Microsoft, IBM, Taiwan Semi, Intel, HP, Texas Instruments, Dell, Hitachi, Adobe, Intuit, LG Display, Marvell, Amphenol, SanDisk, Autodesk, Linear, Micron, STMicroelectronics, and Western Digital all have obvious ties to PC architecture, with Applied Materials KLA-Tencor, and other semiconductor capital equipment makers tied in to PC demand farther up the value chain. (exhibit 11) All together, more than 25% of the largest tech companies by market cap have direct exposure to PC demand, with the total value chain encompassing more than $250B in total global sales.

Similar concerns are warranted for other smaller, yet still significant technology platforms. Traditional cable architecture is under serious threat from video delivered over broadband internet, as users begin to shift their viewing to web based sources. While this is the main overhang for cable system and cable network stocks which account for more than $150B in sales, it also hits Motorola, Harmonic and others, all of whom derive a chunk of profitable revenues from the $15B market for cable boxes and channelized cable infrastructure. Point to point telecom gear has been under pressure for years, but the remaining purveyors – Alcatel Lucent, Ericsson, Nokia Siemens, Tellabs, et al. – will get no relief in that part of their businesses looking forward.

Looking for a Hero

We believe that the transformed TMT landscape will favor several new technologies – e.g. non-PC smartphone/tablet hardware and software, cloud-based applications (social networking, CRM, document processing, etc.), cloud enabling infrastructure (content aware switching, ultra-dense blade server systems, large scale storage management, virtualization software, CDNs, etc.), wireless broadband (4G silicon, radio access network equipment, towers, spectrum, etc.), Internet video (video search, telepresence, high-speed streaming, compression, image processing silicon, etc.), and others. However, the crystal ball can be murky in looking for emerging winners.

Take smartphones for example. Investors appear to be in agreement about the iPhone – Apple is up 49% since the beginning of 2008 and is recommended as a buy by 47 of the 51 sell side analysts that cover the stock – but other smartphone plays have stagnated. Over the same time frame, the S&P500 is off 23%, while Motorola is down 50%, Research in Motion is down 59% and Nokia is off 73%. Even Google, who’s Android OS has overtaken iPhone as the second leading Smartphone platform behind RIMM’s Blackberry, has mustered little investor enthusiasm. Other growth arenas may feature a mid-cap cult stock or two that have dramatically outpaced the market. Examples abound – cloud application pioneer Salesforce.com has nearly doubled since 2008, CDN pure play Akamai is up 42%, streaming TV trailblazer Netflix has more than quintupled, and so on. There are also private companies – like Facebook, Twitter, Foursquare, and others – that would care substantial valuations if they were to come public, but remain outside the reach of most investors. (exhibit 12)

Against this, most of the largest tech stocks not named after fruits have suffered, including many that have no obvious exposure to the most threatened markets. Here, Google and Cisco, the 5th and 6th most valuable tech companies stand out, down 28% and 21% respectively, despite strong exposure to the new growth arenas, and relatively few revenues at risk on the wrong side of the paradigm changes. In addition to Apple, Google, Cisco, and Akamai, we would highlight Qualcomm, Amazon, EMC, NetApp, Broadcom, Juniper, Citrix, F5, ARM Holdings, Xilinx, Altera and Cree as technology companies in the top 100 that are better exposed to areas of opportunity than to businesses under threat. The bifurcation of the market between the smaller, upstart challengers and the out-of-favor big caps can be seen in the increasingly wide dispersions of returns in the sector. (exhibit 13)

Shop ‘til You Drop

The asymmetry of threat and opportunity is not lost on the participants on this battlefield either. M&A has picked up considerably in tech, with cash-heavy and overexposed PC-linked companies emerging as the biggest shoppers. HP and Dell’s bidding war over next-gen storage player 3Par is the headline, but far from the only big story. HP alone has spent over $7.8B this year acquiring 5 companies, including the aforementioned 3Par, data security company ArcSight, and smartphone maker Palm. In the wake of losing 3Par, Dell floated a $1.5B bond offering to raise cash for future deal making. IBM has spent over $4B on a dozen acquisitions in 2010, including its recent $1.7B purchase of Netezza. Intel spent over $9B on its deals for McAfee and Infineon’s wireless business. Oracle completed its $7.4B acquisition of Sun at the beginning of the year, and has done a handful of smaller deals since. SAP spent $5.8B on Sybase in May. Microsoft has been an aggressive acquirer in the past, but has been relatively quiet in recent months despite considerable cash resources. Google has made 22 acquisitions in 2010, but the only one greater than $200M was its $700M pick-up of on-line travel shopping technology leader ITA. Apple, Cisco, and Qualcomm have made just 9 acquisitions amongst them, all of them for less than $300M. (exhibit 14)

We believe that it is no coincidence that the companies under threat in their core businesses have been the most active in building new capabilities via M&A. Between them, Intel, Oracle, HP, IBM, and SAP have spent over $32B this year to date. Adding Microsoft and Dell to the list, and seven companies have over $160B in cash and investments available to support the ongoing shopping spree. Google, Apple and Cisco raise the cash ante to more than $250B. Given the spotty history of acquisitions creating value for shareholders, it is likely that the potential for spendthrift behavior by CEOs backed into strategic corners adds to the skittishness of the average would be tech investor.

Mmmmm….TARGETS!

If investors are afraid of acquirers, they love potential take out targets. Intel’s deal for McAfee started a run on small and mid-cap security software firms, while the bidding war over 3Par did the same for data center storage management solutions. These arenas remain attractive, although price tags may send shoppers to other, less picked over sale racks. (exhibit 15)

  1. Wireless Focusing on the smartphone, we do not see any of the device makers( RIMM, MOT, etc.) as likely acquisition candidates. Rather, we prefer component suppliers (ARM Holdings, NVIDIA, CSR, Skyworks, RFMD, Triquint, Interdigital, etc.) Software apps for mobile devices is an attractive market but there are no obvious public candidates. Spectrum holders (Globalstar, Iridium, etc.) could realize the value of their holdings as the broadband wireless market emerges.
  2. Cloud Infrastructure This area has already been active. We see potential in platform software (e.g. Citrix, RedHat, etc.), storage (Brocade, NetApp, etc.), security (Symantec, Sourcefire, Check Point, VeriSign, etc.).
  3. Cloud Applications There are many private plays in cloud applications, including Facebook and Twitter, that will be subject to substantial M&A discussion. On the public side, both enterprise applications (Salesforce.com, Success Factors, Constant Contact, NetSuite, etc.), and consumer applications (Yahoo, ValueClick, Priceline, Netflix, eBay, E*Trade, and others) could fill niches for companies looking to offer broader sets of internet based services.
  4. Content Delivery Networks CDNs are rapidly becoming the primary way that internet content is hosted and delivered to end users. CDN operators (Akamai, Limelight, InterNap, RackSpace, TerraMark, etc.) and content aware technology providers (Citrix, F5, Blue Coat, Riverbed, RadWare, etc.) could become targets.
  5. Internet Video We believe streaming media is setting up as a Google vs. Apple battle, but deep pocket media players could look to acquire. Netflix is the obvious candidate, although it is expensive. We also see telepresence as an attractive arena – Polycom and Logitech stand out.

Summing it Up

We believe that the recent uninspired performance of the tech sector is related to an epic restaging of the entire industry. Mobile non-PC platforms, using broadband wireless connections to cloud based applications, including video, hosted on lightning fast content delivery networks are the quickly emerging future, driven by disruptive innovations happening simultaneously in many parts of the sector landscape. Many PC-dependent tech bellwethers face a looming irreversible deterioration in their core businesses, leading investors to discount their current cost control driven earnings growth and their prodigious cash positions as they grope for relevance, if not growth, in an emerging new world order. This is more than reminiscent of a similar tech sector malaise 20 years ago, when the lions of the PC age had yet to fully displace the data center tech leaders of the ‘70’s and early ‘80’s.

Investors with faith in the PC revolution who bought the likes of Microsoft, Intel, Dell, Oracle, Cisco, Sun, and others were rewarded handsomely, even as much the old guard – IBM, Kodak, Xerox, Unisys, Poloroid, Control Data, and others suffered – and others – DEC, Wang, Data General, Prime, etc. – ceased to exist as independent companies. We believe that PC-driven tech leaders – Microsoft, Intel, HP, and Dell amongst them – must radically reorient themselves or face the realities of their golden years. At the same time, companies that are prepared for the sea change – Apple, Google, Cisco, and Qualcom amongst them – appear positioned to prosper. We are also optimistic for the fortunes of smaller companies that are emerging as leaders, prospects that are enhanced for investors by the possibilities of acquisition by cash-rich but strategically disadvantaged large caps. (exhibit 16)

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