J.P. Morgan's Noelle V. Grainger published a report on December 9th. We think technology stocks are undervalued in general. We believe that investors can benefit from taking a look at J.P. Morgan’s (JPM) top stock picks in each segment.
The software sector is likely to succumb to adverse economic conditions. Investors are advised to remain defensive due to the slowdown in growth for this sector. For the same reason JP Morgan has only recommended one name and has sell recommendations for the other two.
Citrix Systems (CTXS) can be worst performing stock in the software industry. The Desktop Virtualization concept is likely to have negative effects on the company because of the potential of mass incorporation by the majority of the companies. The government, financial services, and healthcare will put an incremental pressure on this project. Citrix is currently trading at $73.23 and is expected to go south of $53. In the last 52-weeks, its stock has traded between $50.21 and $88.49. Market capitalization stands at $13.66 billion and a P/E ratio of 29.8x is expected to decrease to 27.8x by the end of 2012. Earnings per share currently stand at $2.08.
Red Hat Inc. (RHT) uses a simple calculation of billings proxy that, in the view of J.P. Morgan, exaggerates its business momentum whereas an annualized billings analysis is better because it would show investors where the company actually stands. With the upcoming subscription renewals, the Sales & Marketing team will be paid high commissions, leading to a loss of leverage in that sector. Currently, the company is trading at $50.55 which is expected to go south of $32 by the end of 2012. Market capitalization is $9.75 billion and earnings per share of $0.83 may rise in the upcoming year but the valuation (P/E) will come off.
Oracle (ORCL), a software enterprise company, is the only Overweight-rated company in this market segment. With the introduction of a new Exadata product line, Oracle is set to enjoy a positive secular trend. Its current market price of $29.58 has fluctuated in the range of $24.72 to $36.50. Earnings per share of $1.76 have been posted and market capitalization stands at $149.47 billion. Its recent P/E ratio was 16.88x and the company showed a net profit margin of 23.99%.
The software technology sector performed tremendously well in 2010, showing a performance that was three times greater than the market. The current year, on the other hand, reflected market rates with relatively flat performance. The next year’s performance depends mostly on the confidence of investors in earnings growth estimates and macroeconomic uncertainties. Autodesk (ADSK) and Rovi Corp (ROVI) are amongst top picks for the sector should the economy pick up drastically in 2012 with Neustar (NSR) being a defensive pick, should the economy move in the other direction.
Equinix (EQIX) is a market leader in the software technology sector and is the best pick for 2012 due to a stable recurring revenue model, high margins, and the presence of a number of large positive trends. The data-center industry is expected to show a growth of 15-20% over the next five years, keeping Equinix at the top of the market. With the rapid shift towards cloud-based technology, demand for data-center solutions by Equinix is rising. EBITDA margins greater than 45% are showing high visibility and cash flow generation for its business model. The shares of the company are currently trading at $102.48 and are expected to reach a target of $120. Within the last 52-weeks, its shares have traded between $78.78 and $107. Market capitalization of the company is $4.86 billion and earnings per share of $2.78 are expected to go north of $3.4 by the end of 2012. Equinix showed an operating margin of 18.71% in the third quarter of 2011.
Technology Supply Chain:
The technology supply chain industry has shown near-trough valuations and is underappreciated by investors due to a fear of cyclical downturn and increased competition. Medical, industrial, and energy industries are likely to be sources of non-traditional outsourcing, resulting in a growing market. If the industry aims for an investment strategy that is based on timing cyclical upturns, it is likely to be rewarded and companies likely Jabil Circuit and Flextronics (FLEX) will reap the most benefits. Electronic connector demand is expected to depend on global GDP and will benefit, despite uncertainties, due to diverse geographic revenue streams, low customer concentration risks, a decrease in the cost of materials and a move towards reduction in supply chain inventory.
Jabil Circuit (JBL) is the best stock idea for 2012 in this sector due to an expected margin improvement and above-peer growth from its growing materials business, an after-market services business, and an increasing number of opportunities in outsourced manufacturing. Almost 40% of JBL’s revenue comes from these opportunities and they have margins well-above the corporate average. Jabil’s stock is trading at $20.86 and is expected to reach a target price of $22. Market capitalization for the company stands at $4.34 billion and it has earnings per share of $2.34 which are expected to go north of $2.83. P/E stands at only 8x.
The semiconductor industry is expected to bottom out in 2012, shown by stable orders by companies and distributors. J.P. Morgan believes that this market segment is currently in its second phase, as characterized by a lowering of estimates by companies. The first phase encapsulated a stabilization of orders and companies such as Intel (INTC), Texas Instruments (TXN), Microchip (MCHP), ON Semi (ONNN), Arrow (ARW), and Avnet (AVT) confirmed such deals. The next phase is seen to be an improvement in the orders and is expected to start in the first quarter of 2012. Estimates will then move up by the end of the first quarter of 2012, causing share price to gain.
Texas Instruments (TXN) has been given an Overweight rating by J.P. Morgan and is the top pick of the industry because it has positive potential to Consensus estimates over the next year. Currently, its stock is trading at $30.42 and is expected to reach a target price of $33. Earnings per share of $2.63 are likely to see a 10% accretion in C12 due to the company’s acquisition of National Semiconductor. Texas Instruments has market capitalization of $34.76 billion and its P/E ratio of 16.6x is likely to rise to 17.4x by the end of next year.
The historic growth in communications infrastructure, enterprise server/storage, and smart phones/tablets is likely to give rise to expansion opportunities in 2012 especially for companies such as Broadcom Corporation and Cavium Networks (CAVM), which are product cycle-driven stocks. SMid semiconductor stocks are set to rise amidst the recent macroeconomic uncertainty and the recent flooding in Thailand because it is discounting a larger-than-warranted impact to 2012 revenues and earnings. Some companies have shown a bottoming in order rates and a return to normal patterns. HDD will see an increase in demand in the aftermath of the manufacturing recovery and 3G and 4G networks will also see a rise in data processing demand.
Broadcom Corporation (BRCM) is the best pick for this industry due to its historic success in outperforming its peers, shown by a 15% increase in revenue as opposed to an industry average of 4%. Broadcom’s earnings also grew by a tremendous 16%. Its stock is currently trading at $30.10 and is expected to reach a price target of $45. Revenue is expected to grow by nearly 8%, as compared to a 1% increase in the related industry. Its stocks have traded in a 52-week range of $29.17 and $46.89. Broadcom’s market capitalization stands at $16.22 billion and its P/E ratio of 10.6x is expected to remain fairly consistent over the next year. Earnings per share of $2.7 were posted for 2011.
Alternative Energy- LED:
J.P. Morgan believes that the LED industry is currently in a trough and will recover in 2012 with the increase in utility-based energy efficiency studies and legislative mandates for conventional lighting technologies. The demand for LEDs for lighting is expected to increase tremendously with the introduction of third-generation LED lighting products, paving the way for a reduction in product cost and lower relative payback periods. J.P. Morgan strongly suggests investing toward LED-based lighting and away from companies which are more CE-centric.
Cree (CREE), the developer and manufacturer of semiconductor devices focusing on LEDs, is the top pick of the industry for 2012. With the recent acquisition of North America’s largest LED-based outdoor lighting company, namely Ruud Lighting, Creed is expected to be a fast growing business. Demand for LED components is expected to increase in 2012 due to the aforementioned introduction of third-generation LED lighting products. Cree has been given an Overweight rating by J.P. Morgan and its shares are currently trading at $25.68. They are expected to reach a target of $48 by the end of 2012. Cree has market capitalization of $2.98 billion and has earnings per share of $1.37. Cree also had an EBITD margin of 28.08%.
Alternative Energy- Solar PV:
J.P. Morgan recommends long investors to stay away from the solar sector due to an expected decline in returns and solar demand. Solar subsidies are expected to be reduced in 2012, which will drastically affect solar economics as most companies continuously tend to rely on subsidies. Most companies are already operating near breakeven and cannot afford to reduce prices further in line with the subsidy cut. Costs of financing are also expected to increase in 2012, adding to pressures in the solar industry. The next year is likely to see companies with poor balance sheets become bankrupt but this will not likely ease pricing in the industry.
First Solar (FSLR) has been picked by J.P. Morgan as the worst company in this sector and it is recommended that stocks be sold in the short run. With the reduction in subsidies, First Solar is likely to see a reduction in the sale of modules (which constitutes the largest part of its revenue). Operating margins are expected to be lower than expectations due to lower module margins. The stock is currently trading at $46.11 and is expected to go south of $40. Earnings per share of $7.71 are expected to decrease to $5.13 by the end of 2012. The company has market capitalization of $3.99 billion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.