Large cap tech is famously cheap, as several articles on Seeking Alpha repeatedly proclaim. The undervaluation has gotten so egregious as to be perfectly easy to spot. A simple table reflecting the P/E on several of these stocks, such as Microsoft (MSFT), Intel (INTC), Dell (DELL) and Hewlett-Packard (HPQ), together with the expected earnings growth for next year, shows that we really are talking low multiples together with (some) earnings growth, at least in MSFT and INTC.
Yet, the market, driven by the investment decisions of millions of investors, always has some kind of reason. So what is the market seeing or fearing, that’s not reflected in those multiples and growth estimates? The market, in my view, simply fears "the tablet effect" and the way it might impact these particular stocks.
When Apple (AAPL) announced the iPad on January 27, 2010, not even Steve Jobs himself could have guessed the phenomena he was about to unleash. From sales estimates that called for 3-5 million units to be sold in the first year, the following 12 months went on to see 14.8 million iPads sold, and the creation of an entirely new market that accounted for around 20 million units in total.
It was also a market where explosive growth continued to be expected, with those 20 million units expected to turn into 65 million and onwards. And here the problem started, when you get to this kind of number, it become relevant in the context of the whole PC market, which numbers around 360 million units per year. And sure enough, there was cannibalization between tablets and PCs, namely netbooks and laptops, both because the price range was comparable, and because a tablet can do a lot of what can be accomplished in a netbook/laptop, especially when the main purpose is consumption, not creation, of content.
Now, cannibalization between different computing products should not be a problem for the suppliers to those markets -- unless, that is, the products are considerably different. And here, they were.
First of all, nearly every tablet in the market, either running Apple’s iOS or Google’s Android, is based on a CPU architecture made by ARM Holdings (ARMH). That is to say, they don’t use CPUs made by Intel. So this cannibalization was directly against Intel’s market position, at least in the retail segment.
Also, none of the tablets runs Windows. They run iOS or Android, but not Windows. So every unit that cannibalizes, once again, is a complete loss for Microsoft.
Here, Microsoft seems to have a bit of an answer. First, Microsoft managed to argue that there were bits of Android that fell under its own IP, and is thus managing to convince several manufacturers to pay royalties on those patents. Secondly, although Microsoft is just a smallish player in the smartphone sector, through Windows 7, that operating system seems to be well received and there are great hopes for Windows 8 in being able to break into the smartphone and tablet market.
But the tablet effect didn’t stop at the obvious. There were further impacts to be had. One of them was that since the tablets didn’t use disk drives for storage (they use flash memory – SSD, solid state drives), most of the netbook/laptop units cannibalized meant less sales or growth in the disk drive sector – a sector prone to vicious competition and cyclicality even before this impact. Not all was negative here, though, as flash memory producers like Sandisk (SNDK) were hugely benefited by this trend.
Whereas a netbook/laptop uses anywhere from 2Gb to 8Gb in RAM, the typical RAM memory for a tablet is just 0.5-1Gb. Hence, a lot less usage per device, in another industry characterized by strong competition and cyclicality. No wonder RAM prices languished (a whole lot more than flash memory). Micron (MU) was a victim here.
As we have seen above, the effects of the tablet introduction cut deep and wide in the overall tech industry. The question now is, in spite of it all, does it make sense that the large cap tech valuations got so low? Part of the problem might be that there are other trends affecting these same stocks, like the movement towards cloud computing. But still at least some stocks, like Microsoft and Intel, seem technologically able enough to adapt without having too much of an earnings impact. Others, like Dell and Hewlett-Packard, might face serious problems, but already have those discounted on their incredibly low valuations. These include EV/EBITDAs of less than 4, while playing in segments of the market that are unaffected (though HPQ’s Autonomy acquisition seems a clearly ill-advised blunder).