By David Sterman
Of the 11 sectors covered by S&P Capital IQ, only one is on track for lower profits in 2013: technology.
The profit anemia stems from several factors, including:
- Extremely low levels of government spending due to the current sequester.
- Depressed sales activity in Europe. The tech sector has more exposure to Europe than any other sector.
- A lack of any hot new products or trends to trigger interest among buyers.
Yet as we've noted many times, several tech firms are sitting on stunning levels of cash. Cisco Systems (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL) and others may have a hard time generating organic growth, but they have a long track record of acquisitions to help get the needle moving.
Though it's unwise to buy a stock simply because you suspect it is a buyout candidate, you can't ignore a company's appeal in a merger and acquisition (M&A) scenario if it has a strong base of technology or an impressive customer list. And you surely need to pay attention if that stock has recently traded sharply lower, creating more compelling valuations for a potential buyer -- or simply on a stand-alone basis.
Here are two slumping tech stocks that now hold solid value in light of their considerable growth prospects and market positioning.
Palo Alto Networks (NYSE:PANW)
This company has arguably the most comprehensive suite of network security system capabilities, helping companies and governments operate their servers without malware, spoofing and other gremlins that can cripple a company's networks. Palo Alto's major clients include Splunk (NASDAQ:SPLK), Citrix Systems (NASDAQ:CTXS), Aruba Networks (NASDAQ:ARUN) and Ericsson (NASDAQ:ERIC).
Those partnerships have helped fuel triple-digit annual sales growth for five straight years, and sales are on track to rise another 50% this year to around $400 million. Still, the "laws of bigness" are starting to kick in and sales growth could slip below 40%. Slowing growth may explain why this stock has suddenly fallen out of favor.
Another explanation for falling shares: Management has decided to sharply boost headcount (from a recent 950 to roughly 1,400 a year from now) to help keep sales growth above 35% for the foreseeable future. That hiring spree is eating into near-term profits.
Right now, Palo Alto is the fourth-largest network security firm behind Cisco, Juniper Networks (NYSE:JNPR) and Check Point Software Technologies (NASDAQ:CHKP). However, other companies involved in network management -- such as Microsoft, IBM and Hewlett-Packard (NYSE:HPQ) -- have reportedly been eying the security niche in recent years, thanks to its robust growth prospects. Palo Alto Networks would quickly make them one of the leading security vendors in terms of software functionality.
Analysts at JMP Securities "believe Palo Alto leverages significant technology advantages in the next-generation firewall market," and they see shares rebounding toward a $60 price target.
Fusion-io (NYSE: FIO)
I have written about this company several times in the past, and I've repeatedly taken note of Fusion-io's radical and game-changing approach to data storage management.
Trouble is, management was never able to clearly articulate the company's approach. Analysts at Lazard noted: "To some, FIO is a component vendor, a business based on PCIe-based flash cards that will inevitably commoditize. Others correctly point out that FIO boasts a unique software portfolio, but we believe many are oblivious as to what the strategy and value proposition of FIO's software portfolio really is. While we all have our view, we believe there may have been an identity crisis within the company itself." Those analysts see shares rising to $23.
That confusion has led to a shake-up in management and a 55% drop in the stock from the 52-week high. Yet even with that turmoil, this is still a fast-growing business. Sales shot up from $36 million in fiscal 2010 to $359 million in fiscal 2012, and analysts see that figure exceeding $550 million in Fusion-io's current fiscal year, which began this week.
As is the case with Palo Alto Networks, Fusion-io is investing heavily to handle the next leg of growth, which is dampening profits. That's a real turn-off for myopic investors, but crucial if this company is to eventually meet its goal of $1 billion in annual sales. At a minimum, it's a necessary effort to ensure that this business realizes its full potential if new management decides to put the company up for sale.
Risks to Consider: Never buy a stock solely on the basis of buyout hopes. Instead, look at possible M&A activity as a potential catalyst.
It's hardly a bold move to predict that we will see major transactions in the technology sector in the second half of this year. Deal-making is the lifeblood of this sector, and cash-rich balance sheets, along with an anemic top-line organic growth, set the stage for more deals. Whichever tech stock you are researching, analyze them in the context of the broader landscape. Do the companies you're looking at have the right products or customer bases that would hold appeal to bigger players? Those traits have been markers for success in the past.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.