Some Tech Sector Optimism

Over the past few months, even the most seasoned investors have become a little "sea-sick". Extreme volatility is more the norm, and triple-digit swings in the Dow are occurring far too often. So….has the market finally reached bottom? As much as I would love to be an optimist, I suspect that we'll have at least one more test of the 52 week lows before things get better (so, a bit less than 8000 for the Dow, and a bit over 800 for the S&P).

Ok, enough for the negative! On a more positive note, I do think that we are close to a bottom in the Tech Sector, and that Tech will be one of the sectors that will outperform most other sectors in the mid to long term (12 Months to 10 Years).

Where does my optimism come from? Here are a few reasons:

Unlike many purchases by a corporation, IT spending is often viewed not only as a way to increase worker productivity, but also to cut costs. These cost reductions could be in the clerical section (Worker Automation / Automated Data Entry), communications costs (move to IP) or in sales costs (increased Web Presence). Companies are more willing to spend on things that will increase their competitiveness and cost base in this economy. Many IT decisions are often based on multi-year cycles, and many pieces of equipment need to be replaced today (whether due to failure, or due to a lack of continued support from the manufacturer). In many cases, there is only so long that companies can put off buying recurring IT purchases before it actually costs them more NOT to buy new products.

Many locations in the Developing World are moving towards rapidly expanding their economies, and improving certain areas of their technology base (such as Internet Connectivity), even in a down market.

So, what companies should you avoid?

I would avoid companies that are "Commodity Brokers." I define these as companies who sell products that are fairly easily exchanged for another company's products, and therefore, tend to compete on Price.

Companies in this area include: Dell (DELL), HP (HPQ), - and although I do like the EDS deal longer term - Canon (CAJ).

I would also avoid "Former Dot.com darlings that now look cheap," including: Nortel (NT), Sun Microsystems (JAVA), and Juniper (JNPR).

So, which companies would I recommend?

First, some Honorable Mentions: Research in Motion (RIMM), Oracle (ORCL), IBM (IBM) and Apple (AAPL).

In no particular order, here is who I like for the Mid to Long term:

Intel (INTC)

There is a lot to like about the Santa Clara-based company. First, with the problems at AMD, Intel has pretty much locked up the Processor market to themselves. Next, the PC Market is a bit weak now, but the availability of low priced laptops and PCs have allowed many people around the world to buy their First PC, helping Intel. Finally, Intel does the majority of its work outside of the U.S., so it will benefit from a weaker U.S. dollar (which is likely, due to the Fed's recent "Money printing binge").

Intel has never been a cheap stock, due to its high quality nature. Analysts expect (once the current market issues begin to subside) that it will be able to grow its earnings by 10-12% annually for the next five years. This is a reasonable target, considering its potential market expansion overseas. It is yielding over 4%, but has a reasonable Dividend Payout ratio, so this should be relatively safe.

I'm a little more optimistic than most of the analysts, so I suspect Intel will earn about $1.20 in Fiscal 2009. Towards the end of the year, Intel will return to its more lofty multiples, so I would suspect that it will return to the lower $20 range in the next 12 months.

Cisco (CSCO)

This one has been frustrating to own, which I have for a while. Cisco has a strong position in the Corporate space, and with some of its recent acquisitions, a decent position in the Home Wireless Router space. Cisco has a dominant position in the IP Appliance space (Routers, Switches) as well as virtually every other aspect of the IP world. As well, Cisco does have some recurring revenue from its Services sector, although not as high of a percentage as the IBMs of the world.

John Chambers, the Cisco CEO, once said that a bet on Cisco is a bet on the continued development of the Internet. I do believe that he is correct. While Cisco will undoubtedly see a drop in spending in the Financial Sector in North America (a key customer), it will see increasing business overseas over the next few years, as many customers start to access the Internet in Asia, Africa and South America for the first time. Finally, many of Cisco's services can be considered to be cost-saving, such as VoIP, so there are some companies who will move towards their products as a way to cut costs.

There are two factors that you should take into account before buying Cisco. One, it doesn't pay a dividend (although there continue to be rumours that it may one day). The second is that they tend to be a bit "liberal" in the awarding of Stock options. They have promised to get this under control, but I would still keep an eye on it.

Cisco should return to its usual lofty multiples once it appears that IT departments are starting to spend again. I would expect to see Cisco return to the Mid to Upper 20's towards the later part of 2009.

Microsoft (MSFT)

Microsoft could be the third most hated company in the world after Wal-Mart (WMT) and ExxonMobil (XOM). However, this may be a once in a lifetime chance to buy into a company that may have the second best Competitive Moat in the world (after Coca-Cola).

How dominant is Microsoft? Well, they released a new product (Vista) that is about as widely criticized as any other product released in the past decade. Most companies would have had huge drops in their profits with such a disaster, but not Microsoft. In fact, analysts have pegged Microsoft to grow its earnings at a double digit pace in the next Fiscal year (which may be a bit optimistic, I admit).

Down from its ridiculous multiples during the Dot.com fiasco, MSFT now trades at less than 10x next year's earnings. This is an incredible price for a cash flow machine such as Microsoft ($10+ Billion annually). This is also a company that pays out a 2.5+% dividend, has an extremely low pay-out ratio and has tens of billions of dollars in cash. One thing to be cognizant of is the on-going talks with Yahoo (YHOO). While I think this would be a good deal for MSFT in the long run, it will likely pummel its shares in the short term.

If the takeover does happen, I wouldn't be surprised if this stock tested its 52 week low of just under $19. Consider that to be a dream entry point. Microsoft won't be the high-flyer that it once was, but a return to a 15x Current year Multiple is not unreasonable. This means a 12 month target price of north of $30, with a nice dividend.

Disclosure: Long CSCO, RIMM.

Comments

[tipalia:]

Hello Larry,
great article as usual, a lot of why or why not buy every stock you mention.
What would you think of buying YHOO in anticipation of a MSFT takeover?
If it does happen it would be at a much higher price it is trading today,isn t it? and we would not have to wait too long for a nice gain.What are the chances of the takeover to happen? I know it could only be a guess but what I mean is why this deal would suddenly happen now? Thanking you in advance...

2008 Nov 17 09:39 AM

[Roger Knights:]

Regarding Microsoft: I just read a speculation somewhere (I forget where) that Google might release its own OS in two years. (It's already putting together the pieces for an ecosystem with Chrome, Android, online aps, etc.) This is a potential Black Swan.

2008 Nov 17 09:49 AM

[jepittman:]

It is nice to finally read a piece by someone who is willing to 'look over the valley'. I would add QCOM to your list. Very well done article.

long: csco,intc,xlk,qcom

2008 Nov 17 03:21 PM

[Jason Rines...:]

I think your picks are sound, all of these businesses have a high barrier to entry. MSFT could have more exposure to overseas markets and face further anti-trust but the potential reward seems to outweigh that risk at this price. These picks are also good because Washington will have little influence on these sectors. Which of these companies do you maintain a position in?

Now that we have all done our bit of philosiphying on human nature and markets, it's high time we in the investment community get back to this kind of disclosure at SA.

2008 Nov 17 04:46 PM

[Larry Belle...:]

Hello all...

May be the first time that I haven't been called an "Idiot" in a long time in the responses....=)

138602 -- Buying Yahoo may be a good way to gain on this deal, if you're ok with the risk of a deal collapsing again. I'm not much for buying into a company in this scenario unless it is a company that I feel I would be comfortable in owning for the long term if the deal fell through. If this is the case with you and Yahoo, then I would say Go for it.

Roger -- Nothing with Google would surprise me anymore. I haven't heard the same rumour, but since they are doing some work in the Smart phone space, they could likely use some of that work towards a PC Based system. Even if they did, however, it might be tough to take on the MSFT machine. They released their own versions of Office, and this hasn't dented the earnings like I thought it might. Something to watch though, whenever Google sets you in their sights....

Jepittman -- I'd be a little hyprocritical to add Qualcomm now, as I wrote an article that attacked their business model in the past. However, with their new Gobi Chipset hitting the market (does GSM and CDMA), I may have been premature.... Time will tell on how much play they will have in the LTE market (if they can show half of the dominance as they showed in the CDMA space, which they invented, you may be dead-on).
Disclosure -- I am a Director at a company that indirectly buys products from Qualcomm. No position in the company.


IThinkBig -- My disclosure is listed at the end of the article. I am long (and painfully underwater) on Cisco, and Research in Motion (wasn't one of the picks, but was mentioned in the article). I have my buy order in for Intel @ $12.75 and for MSFT at $18.50 (might be too low, actually), so I have my money where my mouth is....

Cheers
Larry

2008 Nov 17 07:34 PM

[assman:]

"Regarding Microsoft: I just read a speculation somewhere (I forget where) that Google might release its own OS in two years. (It's already putting together the pieces for an ecosystem with Chrome, Android, online aps, etc.) This is a potential Black Swan. "

I fucking hate google as a stock and a company. If I shorted I'd short the fuck out of Google. Google is a horribly run company in a a great industry. As for google creating its own OS, so what. Google is also releasing its own toilet called the Goolet. But in the end none of this will save Google. Google is just a bunch of crazy arabs that struck oil and have no idea what to do with the money. The expanded too fast, went public when they should not have, hired way too many people and started way too many useless products. I don't know why people fear Google. They have one successful product: Search. That is it.

BTW, I have to disagree with one of your picks: INTC. Intel is a good company in a horrible industry and it is not going to do well. My view is that INTC has way too high a price and cost pressure/R&D expenditures are going to clobber the stock in the long run.


On 2008 Nov 17 09:49 AM Roger Knights wrote:

> Regarding Microsoft: I just read a speculation somewhere (I forget
> where) that Google might release its own OS in two years. (It's already
> putting together the pieces for an ecosystem with Chrome, Android,
> online aps, etc.) This is a potential Black Swan.

Jun 17 08:58 AM