Tech Titans: 3 Overpriced Giants And 2 With Upside Potential

by: Efficient Alpha

A strong week of economic reports and headline risk continues into Thursday with initial claims for unemployment and the ISM non-Manufacturing report. The services report comes closely on the heels of Tuesday's release of the ISM Manufacturing report which disappointed investors with a third consecutive month of contraction in the sector.

The risk in the claims data is to the downside while components in last month's ISM non-Manufacturing Index put the odds to an upside surprise. Since claims are out before market open and the ISM report is released 30 minutes after the bell, traders may want to position during Wednesday's session for a lower open but then look for a rebound on the ISM report. For longer-term investors, a weak open on Thursday may present an opportunity to accumulate a position in relatively strong companies in the business services space.

Risk to the Downside at the Open

Initial claims for unemployment are released before the opening bell on Thursday. Claims have come in fairly high the last two weeks but are holding steady under the important 400,000 level. The consensus is for 370,000 claims, a drop of 4,000 from the prior week. July saw some lower than expected reports on the seasonal adjustment and it could come back to inflate the report in September. Given the general complacency with the bullish trend, a negative surprise in claims will most likely have a larger effect than a positive report.

Service Sector Continues to Perform

The ISM non-Manufacturing index is released at 10am eastern and should continue to show an expanding service sector. The index recovered slightly last month to 52.6 after falling to 52.1 in June and posting strong growth in the first half of the year. The consensus is for the index to remain relatively strong at 52.5 but the strong rebound in new orders last month puts the risk to an upside surprise. While import orders fell into contractionary territory last month, exports increased sharply and business activity posted its best reading since March.

The employment component of the report also showed contraction for the first time this year but should recover above 50.0 this month. Overall the trend is to a slowdown in the economy but still commensurate with growth of about 1.5% or better.

Possible Weakness a Buying Opportunity in Technology and Business Services

A negative surprise in initial claims may push the market down on the open but investors may want to take the opportunity to position for a stronger ISM report. Companies with strong brands in business services should continue to do well as strong corporate balance sheets look for productivity gains before investing in more workers. Despite the relatively attractiveness of the sector, investors still need to watch for relative valuation and fundamentals.

Microsoft (NASDAQ:MSFT) is hoping that the launch of the new Lumia phones with its Windows Phone 8 system will help it regain market share from Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). The company is also releasing its new Windows 8 operating system soon, which promises faster performance and more customization. Windows systems are carried on less than 4% of the smartphone market versus 68% for Android and 17% for Apple.

Shares trade for 15.4 times trailing earnings, slightly above the five-year average of 12.6 times, but offer an attractive 2.6% dividend yield. The release of Windows 8 should help to boost earnings and lower the price-earnings to a more neutral valuation basis. The company's operating margin of almost 30% is high for such a large business with multiple and diverse products. Shares are up almost 20% over the last year but can still provide good protection against weakness in the larger macro environment. (NYSE:CRM) forecast a fiscal third-quarter profit below expectations on higher marketing costs as the company tries to gain market share into the growing field of cloud services. The company said that earnings should come in around $0.31 per share, almost 9% lower than the consensus estimate, on sales of $775 million.

The price-earnings for is not calculable due to a loss of $0.27 per share over the last twelve months, still revenue has increased by a compound annual rate of 32% over the last four years. The negative operating margin of 2% reflects the high amount of marketing expenses. While the market was disappointed by the earnings forecast, is making the long-run decisions that will make it a stronger company and that will reward investors. The company has a $4.1 billion backlog of signed contracts that should help to support earnings. Shares have increased almost 18% over the last year but offer an attractive investment for those willing to stay for the long-run.

Oracle (NASDAQ:ORCL) released an emergency fix last week four months after it initially warned of problems in its Java software. Bloomberg estimates that the delay may have allowed more than 100,000 computers to be hacked. While the emergency patch may slow the threat of hacking, it will likely not stop it entirely.

Shares are trading for 16.1 times trailing earnings, cheap relative to peers in the sector but more justifiable given the company's size. Oracle has grown revenue at a 13.4% compound annual rate over the last four years and is relatively well managed with an operating margin of 37%. The stock has increased by more than 17% over the past year and pays a 0.76% dividend yield. While only marginally expensive on a relative basis, the shares may still provide investors with a short opportunity against peers to hedge against headline risk in the macro environment.

International Business Machines (NYSE:IBM) is developing a version of its artificial intelligence system Watson for use in smartphones and tablets. The company plans on using the system to compete with Apple's Siri and boost revenue from business analytics to $16 billion by 2015.

The shares trade for just 14.2 times trailing earnings, which is low but reflects a four-year compound annual growth in revenue of just 2%. The operating margin of 20% is higher than peers and could be a function of a more established company. The stock has increased by almost 17% over the past year and pays a 1.7% dividend yield. The increase in shares may be premature unless the company can increase revenue at a faster rate.

Teradata (NYSE:TDC) jumped more than 5% last month on a strong earnings report and an increase to full year profit estimates. Slower growth in Europe, where revenue only increased by 16% and accounts for a quarter of total sales, has generally been offset by sales in other markets. The optimism has increased valuation to 33.8 times trailing earnings and may be too expensive given the company's low 8.5% compound annual growth in revenue over the last four years. The company's operating margin is relatively high at 21% but a share price just 5% under the 52-week high and no dividend is no bargain for investors. Sentiment may be a little high as the shares look expensive relative to fundamentals and peer comparisons.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.