Why Valuation Suggests Upside In Large-Cap Tech Is Limited

 |  Includes: IBM, MSFT
by: The Independent Investor

Not all companies are created equally. That obvious statement couldn't be more true than with technology companies today. While few companies in this market are not directly or indirectly related to technology products, large-cap tech companies like Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM) have performed significantly better than most technology stocks over the last two years.

While some technology companies in the hardware and software space are more tied to the retail consumer, companies like IBM (IBM) and Microsoft (MSFT) have been more tied to product refreshments and steadier corporate spending patterns.

What is interesting to me about comparing IBM to Microsoft is that while both companies have very different business models, both are at or above their five year highs. Microsoft today is around $32 a share, just a couple dollars off its 10-year high. IBM is now nearly 50% above its previous all-time high, at around $200 a share.

IBM and Microsoft have distinct business models, and each company has been able to survive the economic downturn fairly well for similar reasons. While IBM specializes in hardware updates to help companies streamline their IT process and save money, Microsoft still relies on its strong corporate customer base for consistent product upgrades.

While Microsoft does have greater exposure to the consumer in the PC market and with their small but growing video game division, they still have a virtual monopoly on the software that PC's use. Likewise, IBM, which relies on cost-cutting and streamlining products and services for companies, was able to keep revenues strong during the recession because they offered companies with strong balance sheets ways to grow their bottom line in a very difficult environment.

IBM and Microsoft both have very steady business models that rely primarily on product refreshment for existing customers. This concept has enabled both companies to maintain their revenue stream even during a down economy, but it may also limit their upside if the recovery accelerates. Let's look at the charts.

Bottoming at around $80 a share in March of 2009, IBM stock has doubled over the last three years to around $200 a share today.

However, looking at analyst future growth projections for IBM over the next year, they look within the high single to low double digit range.

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Analysts are projecting 10-12% EPS growth over the next year for IBM. Remember, IBM announced in April of 2011 that they would add an additional $8 billion to the remaining $4 billion of their existing share buyback program. This means that the company likely plans to buy back about 5-6% of its existing shares over the next couple years since its current market capitalization is around $240 billion. Taking into account the company's buyback, it looks like the company's organic growth will likely be in the high single digits this year.

Now let's look at Microsoft.

While, obviously, Microsoft does have more exposure to the consumer than IBM with the software and small video game division, the company's core business model is still fairly stable since they rely on product refreshments within the PC division where they have a virtual monopoly for most of their revenue. While the company's earnings jumped considerably from Q1 to Q2 of 2010 when Windows 7 began to take off, they've held fairly steady for the last two years.

Also, while Microsoft's recent windows modification, Windows 7, was successful, the company has no new major product launches planned in the next year that are anywhere near that scale. While Microsoft has had a nice run, earnings estimates for the company are for about 10% growth a year for the next year.

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Microsoft's organic growth is also less than what is seen on paper since the company recently completed a $40 billion buyback program, and is currently completing a second $40 billion buyback program in the last 10 years. Since most analyst estimates call for about 10% EPS growth over the next years, and about 8-9% of that is organic growth, the company looks fairly valued at around 10.5-11x next year's average earnings estimates.

While earnings estimates are always hard to predict, especially going out several years, Microsoft and IBM are two of the most covered names on the street, and their business models have been fairly steady for a number of years now. IBM has also given guidance going all the way out to 2015.

Now let's look at earnings projections for the cyclicals, whose shares have obviously not rallied nearly as much as many big cap tech names because their earnings have not significantly accelerated yet.

First, let's look at earnings projections for the largest holding of most industrial funds, Caterpillar (NYSE:CAT).

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As we can see, analysts are projecting EPS growth for Caterpillar over the next two years to be in the mid to high double digits. Analysts also expect the company's EPS to double within the next four years. Now, obviously, analysts usually overestimate a company's growth looking out longer-term, and gauging growth for cyclical companies in an uncertain economic environment is very difficult. Still, clearly, if the economic recovery does accelerate, analysts believe that cyclical companies in the construction sector like Caterpillar have considerable upside.

Now let's look at another beat-up cyclical sector, the auto industry. Here again, looking at EPS growth projections for the next year, analysts have clearly built an at least moderately stronger economic recovery into their models then we are currently seeing. Let's start by looking at Ford (NYSE:F).

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Now let's look at GM (NYSE:GM).

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While again, these analyst models built in an accelerating economic recovery, and they may be too optimistic, the estimates still suggest that if the economic recovery begins to pick up steam, companies like GM and Ford could see their earnings grow in the mid to high double digits over the next year. Ford also currently trades at around 6x next years average earnings estimates, while GM trades today at around 7x next year's average earnings estimates.

Obviously it is difficult for companies to have it both ways. If your business model is recession resistant, whether it's because your a cost-cutter, a tobacco company, or a software giant with a virtual monopoly in the PC market, you can't also expect a big bump in earnings as more cyclical business models if the economic recovery accelerates. While large-cap tech companies are valued at 11-12x on average estimates of next year's earnings, analysts have been much more accurate in their projections for these companies than for businesses in other sectors. The more precise investors are able to gauge a company's earnings, obviously the fair valuation is likely to be.

While certainly, all major technology companies will benefit from an increasingly strong economic recovery, given share prices have outperformed the cyclicals by 35-40% over the last several years, and business models are based more on product refreshments and cost-cutting, it is likely capital would go to where the biggest upwards revisions in earnings will be.

Certainly, some technology companies like Apple (NASDAQ:AAPL) could be more sensitive to economic growth cycles since their business models are more heavily exposed to the cyclicals, companies like IBM and Microsoft have business models that have tended to be more steady.

While I do believe that even Apple will benefit less from an economic recovery than most standard retailers because of their already strong market share, companies with strong reoccurring sources of revenue should benefit even less.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.