Historically, bottom fishing has not been a successful strategy for tech investors. However, the extreme nature of the current market calls this truism into question. Today, nearly 20% of all technology companies with market cap of more than $3B trade at cash adjusted forward P/Es of less than 10x and have free cash flow yields in excess of 10%. Putting this in perspective, assuming a market beta, 15% yield equates to FCF declines of 10% per year over 20 years, with no terminal value. These stocks are priced to fail – many of them quickly and spectacularly
Grouping 26 companies into categories, 7 are “old line” IT systems companies, 6 are suppliers to the PC value chain, 3 are share-losing mobile device makers, another 2 are document processing specialists at risk to a paperless future, and 3 more are niche communications technology suppliers in the midst of industry change. The remaining 5 – 3 are non-PC semiconductor manufacturers, and 2 are semiconductor capital equipment suppliers – are inherently cyclical and their valuations reflect the anticipation of an ebb of their currently strong cash flows
The first two categories turn on the same issue. A new IT paradigm based on thin, portable devices, wireless networking, and internet-based cloud applications threatens to make the previous architecture based on increasingly powerful PC-based devices networked to private data centers obsolete. “Old line” systems providers, such as HP, Microsoft, Cisco, and Dell, generate the majority of sales and earnings from the status quo – PCs, desktop applications, enterprise Ethernet networks, Windows-based servers, etc. – and thus, will likely face a slow, but irreversible deterioration in their core markets. Similarly, PC-suppliers face a double-whammy of weak future demand in a core business and severe fixed cost leverage typical of a cyclical
While we wholeheartedly back the paradigm shift thesis, current valuations imply an excessively gloomy future. We believe efforts to “milk” traditional franchises for maximum cash flow may prove successful for forward thinking players, and some companies may be better positioned to address the opportunities created by the new paradigm than is commonly assumed. This creates opportunities for investors willing to wait out the poor sentiment plaguing these stocks, but caution and patience are advised. In assessing these opportunities, we have rated companies as to their exposure to deteriorating markets and their position to exploit new opportunities.
Amongst the systems companies, we estimate exposure as the percentage of cash flows from hardware and software tied to Windows/x86 device platforms, to enterprise level Ethernet switching and routing, paper-based document processing, and traditional client-server data center architecture. These businesses face commoditization in the near term and obsolescence in the longer term. We rate Microsoft as the most exposed company of the 7, and Cisco as the least. For suppliers, exposure is based on estimated cash flows specifically from PCs. Here, Intel is rated the most exposed and Flextronics the least.
Positioning against the emerging new paradigm is a more subjective consideration. For both systems companies and component suppliers, we consider the applicability of current products, technology assets and skill sets, and the progress in addressing future opportunities in thin smart mobile platforms, wireless broadband, CDN architecture, public cloud data centers, and cloud-based applications. Amongst systems companies, we see Microsoft and Cisco as fundamentally well positioned, but HP, Dell and the others as poorly positioned. Amongst component players, SanDisk is well positioned for mobile devices and Western Digital and Seagate should eventually return to growth from cloud installations, while Intel appears particularly misaligned.
Noting that pressures on traditional core businesses could continue to feed negative sentiment for several quarters, we believe that the balance of risk and reward make several of the companies on our list appropriate for long term investors. Amongst systems companies: Microsoft faces enormous headwinds, with 30% of sales from Windows on devices, 30% from business applications that will see vigorous new competition, and 24% from server software. Nonetheless, we believe it is positioning itself to be a leader in cloud-based applications and hosting, a reasonable #3 competitor in portable device software, and a viable residential gateway. Cisco battles the commoditization of nearly a third of its sales and more of its profits, while suffering from its exposure to the moribund Government market. On the positive end, it should profit from seemingly endless growth in demand for internet capacity, and thus core routing and optical gear, and from on-line media streaming, where its prowess in digital video processing should prove invaluable.
On the component side, SanDisk stands out as well positioned – its flash memory products play well in the thin, smart, portable devices expected to dominate the future. Western Digital and Seagate will certainly suffer from the PC’s golden years, but the shift to the cloud will bring with it huge demand for cheap storage, a concentrated market dominated by these two hard disk drive makers.
To the negative, we are concerned that Computer Associates, Hewlett Packard, Dell and Intel are both highly exposed and poorly positioned. To the extent that the pace of change remains modest, these companies may show short term strength through cost controls and share gains, but all remain vulnerable to the long term trends.