THE FORECAST WAS ALARMING. When Cisco CEO John Chambers announced the networking giant's latest quarterly earnings on Nov. 10, he warned Wall Street that, due in part to cutbacks in spending by budget-strapped governments, sales for the next three months would probably be less than half of what analysts were expecting. Even worse, he slashed the company's full-year revenue projection by about $1 billion. The stock of the tech bellwether immediately plummeted, dragging down the broader sector and the Dow with it.
That was just the latest twist in what has been a roller-coaster ride for tech stocks over the past couple of years. And the news raised questions about whether the long-delayed rebound in tech spending--which appeared to have momentum earlier this year--is sputtering. But for investors willing to weather some volatility, say tech analysts, the pullback in tech stocks is an opportunity. Over the longer term, they believe, increased tech spending is a real and powerful trend.
The PC-replacement cycle (a phrase that actually covers most computer-related hardware) should have kicked off in early 2009, when the average machine in use was three years old. That's about the age that office computers start to slow down and have problems, making it cheaper for companies to replace their equipment than repair it. However, the market collapse of 2008 and the subsequent Great Recession put that predictable surge in tech spending on hold. As the world financial system came unglued, corporate profits took a dive and company IT budgets went into a deep freeze. Global spending on computer hardware declined 12.3% in 2009, according to tech consultancy Gartner Inc.
In the first half of 2010, pent-up demand finally kicked in, before slowing a bit in the third quarter. Still, Gartner predicts computer hardware sales will rise 9.4% this year. And the firm envisions strong demand into 2012, despite the latest setback. "We're optimistic about the next couple of years," says Richard Gordon, Gartner's chief of forecasting.
The market has remained skeptical. Even before the Cisco news broke, prices of tech stocks were lagging profit growth. "Earnings have rebounded very strongly, in some cases faster than the stocks, so valuations have come down," says Ken Allen, who manages the $2.9 billion T. Rowe Price Science & Technology fund. Recent market analysis by Goldman Sachs concluded that, at current valuations, the market expects info-tech profits to grow at an annual rate of just 2.1% over the next few years. That's a nosedive from its 11.6% average over the past 10 years. And it means that right now technology may offer a rare chance to buy growth at a bargain price.
Not every corner of the tech sector is under-loved, though. Money has been pouring into the stocks of companies that benefit from the recent boom in so-called cloud computing, where work gets done and information is stored via a network rather than on PCs. The S&P software and services sector rose 80% in 2009 and is up another 25% in 2010, compared to 59% and 10% gains for the information technology sector overall.
Investors who want to play the tech rebound now are better off focusing on laggards, starting with none other than Cisco. The refresh cycle certainly benefits the tech behemoth, whose routers and switches also age and need to be replaced. Cisco is benefiting as well from expanding demand for networking products. Moreover, it has been moving aggressively into adjacent markets that offer growth. "People rightly perceive Cisco as a networking company, but they have a growing data-storage business, a big consumer electronics business, and web conferencing," says Scott Kessler, who heads Standard & Poor's technology research team.
Post-selloff, Kessler doesn't see too much downside for the stock. He points to the $39 billion in net cash that Cisco has on its balance sheet as a cushion. The shares now sell at roughly 13 times the revised 2011 earnings estimate, which should still grow about 10% from 2010. "So you're getting a well-managed tech company for a bit more than one times the growth rate," he says.
One important driver of Cisco's growth is acquisitions--and it's been averaging nearly one per month. "The company has shown that it knows how to absorb other technologies and make them their own," says Michael Pytosh, senior tech analyst at ING Investment Management. Among the company's notable buys are the $2.9 billion purchase of Starent, a provider of wireless telecommunications technology, and the April $3.3 billion acquisition of Tandberg, a videoconferencing company.
Allen of T. Rowe Price is betting on a couple of other tech giants whose once-highflying shares have been grounded for years. "Dell is well-positioned for the upturn in corporate PC demand, and it trades at just six times free cash flow," he says. In addition Allen has loaded up on Microsoft--his fund's biggest position--to ride the updraft from new product cycles for Windows 7 and Office 2010. (Many IT buyers had put off purchasing new PCs to avoid the much-criticized Windows Vista.)
Allen has also taken a big position in semiconductor stocks. His favorite is On Semiconductor, a 1999 spinoff from Motorola that has been an active acquirer of other chipmakers to both expand its industrial customer base--which ranges from automotive to medical--and fuel growth. Earlier this year the company acquired California Micro Devices, and it's currently completing its acquisition of Sanyo Semiconductor. The stock trades at just six times expected 2011 earnings, according to Zacks Investment Research.
Finally, a less glamorous way to play the replacement cycle is through the low-profile but high-volume business of tech distribution. Three companies--Tech Data, Ingram Micro, and Synnex--make up this mini tech sector. And Ananda Baruah, an analyst at merchant bank Brean Murray Carret, has all of them on his buy list.
What does a tech distributor actually do? Imagine a law firm that has 10 interns showing up for their first day of work. The firm's tech staff calls Joe's Computer store to order 10 HP desktops, all loaded with Microsoft Office, security software, etc. Joe in turn contacts his tech distributor, and the next morning the computer boxes arrive on the law firm's loading dock, all stamped with Joe's logo. Big corporations typically have their own tech departments, but small- and mid-size companies rely heavily on these distributors. Tech Data, for example, sells $88 million of technology every day--from PCs to smartphones--with orders averaging less than $1,000.
Though the shares of the distributors have started to move recently, the group's average P/E, based on Baruah's 2011 earnings estimates, is still less than 10. "The stocks are cheap and should get a nice boost from the upswing in demand," he says. Just like the rest of the industry.
"EARNINGS HAVE REBOUNDED VERY STRONGLY, IN SOME CASES FASTER THAN THE STOCKS, SO VALUATIONS HAVE COME DOWN."
--Ken Allen, manager of the T. Rowe Price Science & Technology fund
TECH SPENDING DROPPED OFF DRAMATICALLY AFTER THE MARKET COLLAPSE IN 2008. BUT IT BOUNCED BACK THIS YEAR AND SHOULD KEEP GROWING INTO 2012.
[The following text appears within a chart. Please see hardcopy or PDF for actual chart.]
GLOBAL IT SPENDING EXCLUDING TELECOM, IN BILLIONS
CHART SOURCE: GARTNER
GROWTH AT A DISCOUNT While earnings at information technology companies have been rising, the stocks have been getting cheaper.
[The following text appears within a chart. Please see hardcopy or PDF for actual chart.]
S&P INFORMATION TECHNOLOGY: OPERATING EARNINGS PER SHARE
S&P INFORMATION TECHNOLOGY: TRAILING PRICE/EARNINGS RATIO
CHART SOURCE: S&P; BLOOMBERG
Source Citation
Curran, John. "Shopping for Tech." Fortune 6 Dec. 2010: 55. General OneFile. Web. 27 Nov. 2010.
Document URL
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