TMT in 2Q11: Debt Crisis Aftermath Leaves Value Opportunities in Growth Themes

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The 2Q11 earning season was obviously eventful, with wrangling over the US debt limit a catalyst for a major rerating of the entire market.  Against this, technology, despite its unusually low relative valuation, performed in line vs. the broader index.  While the mean large cap TMT EPS surprise for Q211 was still positive, the distribution skewed considerably lower than recent history.  Our TMT portfolios, designed to capture longer term opportunities created by the tectonic changes underway in the landscape, carry an average beta of 1.3 and P/E of 19.3, a considerable liability during a flight to safety.  As such, both our large cap (-14.7 QoQ returns, -3.6 relative) and small cap (-16.7, -5.9) underperformed their respective S&P benchmarks considerably.  However, in the long run, we remain convinced that companies that are well positioned to exploit change, generate strong cash flows, and who’s valuation is reflective of their expected growth, are attractive investments

To recap, our research supports a thesis that the confluence of innovation in mobile device platforms, 4G wireless networks, content delivery network architecture, and cloud-based applications is in the process of dramatically redefining the TMT landscape.  Companies with sustainably differentiated positions in fomenting this change are favored to prosper, while those tied closely to the status quo – the PC platform, high-end enterprise data centers, and channelized video entertainment – are expected to suffer.  We have ranked the large cap stocks explicitly based on their exposure to attractive areas vs. unattractive areas and the strength of their position to exploit those opportunities.  Well ranked stocks were then evaluated on projected growth, P/E and free cash flow returns to select large and small cap model portfolios

In our large cap portfolio, our worst performing subsectors were network technologies, mobile devices and semiconductors.  Of 15 stocks, 10 beat estimates, 4 missed and 1 was in line for 2Q11, and only 2 showed appreciation over the past 3 months – Apple (+14.5%) and Google (+1.5%).  3 stocks, Cypress, JDS Uniphase, and Ariba, have dipped below our $3B market cap threshold for large cap, and are being removed from our portfolio, although we will not automatically remove such stocks in the future.  In their place, we are adding SanDisk, IAC, and Microsoft

Flash memory innovator SanDisk, which scores exceptionally well on growth, P/E and cash yield, is ideally positioned for a long-term shift toward solid state storage.  IAC has a collection of mostly well positioned on-line properties, with strong cash flow and good growth prospects.  We have reconsidered the strength of Microsoft’s position against our growth themes given momentum behind the Windows Phone 7 platform, making their valuation and cash flow compelling

Relative to large caps, small cap TMT stocks have suffered over the past 3 months, echoing the broader market.  Parsing out stocks tied to our growth themes, Smart Portable Devices, 4G Wireless, Cloud Computing, Media Streaming and Energy Conservation all saw slowing growth and P/E contraction, while Online/Mobile Advertising values contracted despite accelerating sales.  Meanwhile, CDN Architecture stocks actually showed expanding P/Es amidst slowing sales growth.  In our model portfolio, we saw particularly poor results from the CDN category, with 4G Wireless stocks also disappointing.  Our poor small cap portfolio performance was exacerbated by 6 stocks which lost more than 40% of their value.  We are removing 5 of these – Powerwave, Dragonwave, Limelight Networks, RealNetworks, and NetScout.  In addition, we are removing Blackboard, which has reached agreement to be acquired by Providence Equity Partners.  In their place, we are adding Ceragon Networks, OpenTable, Digimarc, Fusion-IO, Itron and Take Two Interactive

Ceragon Networks sells wireless backhaul systems and appears to be taking share from larger rivals as the deployment of 4G systems is poised to accelerate.  OpenTable has penetrated 37% of all U.S. reservation-taking restaurants, establishing critical mass and a substantial barrier to competition.  Digimarc is the leader in digital watermarking and other authentication technologies, with a substantial patent portfolio that will be value with the ongoing growth in mobile payments, e-commerce and media streaming.  Fusion-IO is a heralded recent IPO focused on solid state storage for data centers, a trend we expect to be amplified with the ongoing shift to the cloud.  Itron leads in smart metering technology, a key element in the long term initiative to reduce electricity consumption, yet trades at just .75 times sales.  Take Two Interactive has several enduring video game franchises, and is positioned to address new opportunities in mobile and social gaming

Across both portfolios, we have taken a more aggressive value stance with cash flow rich companies trading at unusual discounts to the market.  While such an approach has not been successful during more normal times, the current environment is obviously not normal.  With more than 20% of large cap TMT stocks trading at cash adjusted P/Es of less than 10 and free cash flow yields of greater than 10%, we believe that identifying “value” stocks that are well positioned against the themes that we believe will drive future growth will prove a profitable investment strategy from this point

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