4Q11 Earnings Update: Plenty of Runway for Cloud Leaders


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4Q11 results revealed continued strong growth for TMT companies that we believe are poised to lead a comprehensively disruptive shift to the cloud that could open hundreds of billions of dollars in new opportunity.  Nonetheless, valuation for these companies and for TMT in general remains starkly weak compared to the broader market, a reflection that investors anticipate sharp reductions in growth, profitability or both.  We believe that this is a worst case scenario with no obvious catalysts, and remain comfortable recommending an overweight position in the sector and in these types of stocks in particular.  We are making no changes to our large cap model portfolio and changing two companies that have been acquired and two others that seem to have lost competitive traction in our small cap model portfolio.

The past three months have rewarded risk, as the high-beta TMT sector outperformed the market and small caps outperformed large caps.  Since December 1, large cap TMT stocks have outperformed the S&P500 by 400bp, appreciating 14.1% on average.  Within that, the best returns were seen in contract manufacturing, consumer electronics and hardware, areas with betas at or above the sector average.  Small cap TMT also performed well, with tech components of the S&P600 up 9.6%, about on par with the broader benchmark.

Yet P/E ratios for the biggest TMT companies are only slightly above other top 50 stocks despite significantly higher sales growth, net margins and cash as a percentage of cap.  Excluding Amazon and its anomalous 147 P/E, the average multiple for the 13 TMT components of the top 50 US stocks by market cap is about 13.5 times, just a half point ahead of the rest of the list, despite average cash and investments equaling 18% of market cap, vs. 12% for non-financial firms.  At the same time, the average 5yr sales CAGR for the 14 TMT stocks has been 16%, vs. just 6% for the rest, and the average net margin was 16.4%, 230bp above the rest.

We believe that the TMT sector has begun a paradigm shift to the cloud that will disproportionately benefit a concentrated set of well positioned leaders.  This architecture sea change will favor portable, wireless, cloud-based platforms and services, to the detriment of traditional PCs, the enterprise data center, fixed networks and multi-channel broadcasting.  In this, we expect value in TMT to concentrate to the leaders of the new paradigm, even as TMT siphons value from the rest of the economy.

Cloud platform leaders are delivering extraordinary growth, profitability or both, but low multiples for most suggest expectations for sharp deterioration in earnings trajectory.  The leaders of this tectonic plate shift are well represented in our large and small cap model portfolios, both of which have performed well relative to the broader market, with 11.2% and 17.7% appreciation since 12/1/11, respectively.  In particular, we see Amazon, Apple, Google, and Microsoft (and soon to IPO Facebook) as central to our long-term growth thesis.  These companies have averaged 29% growth over the past 5 years and delivered net margins of more than 21% in 2011, vs. 7% growth and 14% margins for the biggest non-TMT stocks.  Amazon carries an outsized 147 P/E, anticipating, expansion of its 1% net margins, but the other three trade at a discount to both TMT and the broader market, despite cash and investments of more than 20% of market cap.  Investors are anticipating a sharp sales deceleration, a significant margin contraction, or both.

We believe many investors are underestimating opportunity and overestimating risk, and advocate focus on players well positioned for the shift to the cloud.  The cloud may be a better than $1T opportunity as it takes value from the huge global spending on retail, advertising, media and transactions.  The growth of the market for elements of the transition – smartphones, tablets, 4G wireless service, internet video streaming and advertising, Software-as-a-Service, etc. – have been strong enough for long enough to establish a firm trajectory for change.  We have reflected our conviction in this paradigm shift in the composition of our model portfolios, which comprise representative stocks that we believe are poised to exploit this change, including those companies that we believe are at its core.

We are maintaining our large cap portfolio as is and making small adjustments to the small cap portfolio, as both performed well in the quarter.  We believe that our large and small cap portfolios are well composed to address the changes happening in the TMT landscape.  As such, we are making no changes to our large cap selections.  In the small cap portfolio, two stocks have been acquired (Bluecoat, Interclick) and two others appear to have lost competitive position (Comtech, Omnivision).  All four are being replaced, as we add Allot, Constant Contact, Ultratech and Super Micro Computer.

For the full research note, please visit our published research site.

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