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To find technology bargains you have to look past the low PEs of behemoths like Microsoft and Cisco
06/10/2011 8:30 am EST
The numbers seem to back that up. “Seem.”
Computer stocks trade for just 9.3 times reported earnings before interest, taxes, depreciation and amortization (EBITDA), according to Bloomberg. That’s just 1.3 times the multiple for the Standard & Poor’s 500 stock index for a whole. And that’s the smallest premium for computer stocks since Bloomberg’s data begins in 1998.
The price to earnings ratio for the companies in the information technology sector as compiled by Standard & Poor’s is just 14.8. The multiple for the entire index is 14.7. The 14.8 multiple for the information technology sector is the lowest multiple since December 2009.
And if you want to talk individual stocks, the numbers seem to make the argument even stronger. Cisco Systems (CSCO), one of the technology names to conjure with for decades, trades at a price-to-earnings ratio of just 11.5. Intel’s price-to-earnings ratio is just 10.2.
But, I’m sorry, I just don’t buy it.
I think technology stocks as a whole are pretty accurately priced. The big companies that dominate the sector, the names we all recognize, may even be slightly overpriced. And the true growth companies in the sector may be attractive buys on their growth but they sure aren’t cheap on their price-to-earnings ratios.
I think the whole “Technology stocks are cheap” argument fails to understand exactly how much the technology sector has changed from the good old days and how sweeping the revolution is that is now turning the sector upside down.
Let’s take a look at the assumptions in the technology is cheap argument.
There’s an assumption, for instance, that Cisco Systems, to take one example, shouldn’t trade at a trailing-12-month price to earnings ratio.
Why, in heavens, not?
Here’s a company that has belatedly admitted that it pursued a profit-margin killing strategy of heading off into the consumer market and that it needs to refocus itself—and then presented a clearly inadequate reorganization plan.
Operating earnings—a figure that doesn’t include any onetime charges—will grow, Standard & Poor’s calculates by just 6.7% in the fiscal 2011 year that ends in July 2011 and by just 8.4% in the fiscal year that ends in July 2012.
That 11.5 multiple doesn’t look so out of line to me.
And lest you think this is simply the raving of someone who has recently lost money on an investment in Cisco, which I have, take a look across the other big names in the sector. Intel’s (INTC)10.01 PE look out of line with projected earnings growth of 7.3%? Hewlett-Packard (HPC) look cheap at a price-to-earnings ratio of 7.9 against projected earnings growth of 9.5%? Microsoft does look cheap against fiscal 2011 earnings growth of 25% at a trailing-12-month PE of 9.7%, but not so cheap when you notice that earnings growth is projected to drop back to 10.3% in fiscal 2012.
Compare these valuations to those of General Electric (GE) at a price to earnings ratio of 14.81 and a projected earnings growth rate of 18% or even stodgier Verizon (VZ) at a PE of 16.4 and a projected growth rate of 21%.
This part of the technology sector at least doesn’t look especially cheap to me.
To get past the anemic rates of projected growth, you could argue, and I’ve heard analysts and investors make this case, that the consensus projected earnings growth rate is wrong. It’s too low. These technology companies are set to grow faster than this and therefore they are cheap at these price-to-earnings ratios.
I’d find this more convincing if these technology companies were acting like they agreed. Instead I see one after the other of these giants repositioning its shares as a value instead of a growth stock by raising dividends to the levels that appeal to value investors. Intel now yields 3.1%--that’s more than General Electric. Microsoft pays 2.5%. Even Cisco Systems has added a miniscule dividend. Growth stocks don’t have to pay dividends to lure investors and they’ve got better things to do with their cash—like invest in new business opportunities. Apple (AAPL) doesn’t pay a dividend. Neither does Google (GOOG).
I’d argue that one of the reasons that the technology sector as a whole seems cheap by the numbers is that the big technology companies, the ones with the names we all know, have slowed until they now resemble value stocks and should command the multiples that go with those kinds of stocks. I’ve even heard Microsoft compared to a utility. Well, American Electric Power trades with a price to earnings ratio of 12.2. That’s higher than Microsoft’s 9.7, but then the electric utility pays a yield of 4.8% too.
But there’s another reason why a technology stock like Microsoft should trade for a lower price-to-earnings ratio than a utility—the utility isn’t facing massive disruption in its basic market that makes the future look very, very risky.
So, for example, Microsoft is facing a challenge from applications that live in the cloud to its core Office franchise. And in popular non-PC devices such as smart phones and tablets, Microsoft’s Windows isn’t the dominant operating system. You tell me what the landscape is going to look like for Microsoft in five years?
I’d make similar arguments for companies such as Hewlett-Packard—How does the PC maker plan to become a serious player in phones and tablets?—and Intel—Can Intel capture a significant market share in the non-PC device market?
It’s not that these companies are doomed to irrelevance. It’s just that their stock prices should reflect the uncertainties of the technology sector now. These shares are cheap only IF you know how the current technology wars will turn out.
The low prices for the market leaders of the last generation reflect the very serious challenges posed to the basic business models of companies of that generation by companies such as Apple (AAPL) and Google (GOOG).
The battle between Apple and Microsoft (and PC makers in general) used to be about desktop PCs and laptops. And as long as that was the fight, it was Microsoft’s to lose.
But Apple has turned its success with the iPod, the iPhone, the iPad—and--more importantly—with its iTunes and, potentially, its iCloud services into the first real challenge to the dominance of the PC-centric model of computing. Apple CEO Steve Jobs made no secret of it when introducing Apple’s iCloud service—the PC is just another device in Apple’s view and, for Apple’s customers, it won’t be the center of their computing universe. Apple’s customers will consume, manipulate, store, upload and download media stored in the cloud and they’ll access the cloud from whatever device happens to be at hand.
This is total war against the Microsoft/Intel/Hewlett-Packard vision of the PC as the center of the media universe. Asking if the PC can replace the television as the center of the home seems suddenly like the wrong question.
Apple’s vision might seem quixotic if so many other companies weren’t headed down the same paths. Google and Amazon.com (AMZN), to name just two, are participants in the same revolution. Apple isn’t different in kind—it’s just the company that does it better right now.
And if you still want to know why these well known technology names should trade at lower price-to-earnings ratios than electric utilities do, consider how quickly Nokia (NOK) has gone from being sector leader to potential turnaround story with an army of investors doubting that the company can pull out of its nose dive before it runs out of altitude. (My opinion is that Nokia can—the company’s strengths are still formidable. But my point is that it doesn’t take very long for a company to blow through billions in market value these days once the direction of the market turns against it.)
There are still real growth stories in the technology sector, but they certainly don’t carry the market cap weight of companies like Microsoft ($202 billion), Cisco Systems ($84 billion), Hewlett-Packard ($74 billion), and Intel ($115 billion) in sector indexes. And they aren’t especially cheap. Although once you put their price-to-earnings ratios in the context of their earnings growth rates, they don’t seem tremendously over-priced either. Looking at these established growth stocks I don’t see any signs of the technology bubble that the LinkedIn (LNKD) IPO and the valuations awarded to Facebook and Groupon have raised for some investors.
EMC (EMC), my favorite among storage stocks, trades at a PE of 27, according to Bloomberg, and will grow earnings by 22% in 2011, according to Standard & Poor’s. VMware (VMW), my favorite among those companies crucial to the efficiency of large server and storage networks, sells for a price to earnings ratio of 97 times trailing 12-month earnings but shows a projected earnings growth rate of 68%. (By the way, EMC owns 80% of VMware.) F5Networks (FFIV), one of the companies that have done a good job at taking market share from Cisco (in something called the application delivery controller market), trades at a PE of 45 with the projected earnings growth rate of 52%, according to Bloomberg.
I can give you the name of one technology growth stock that I think is truly cheap: Apple. The stock trades at just 15.8 times trailing 12-month earnings and shows a projected earnings growth rate of 64%
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund owned shares of Apple, Google, and Nokia as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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