Brett Owens is a leading on income investing; the editor of the industry-leading Contrarian Outlook ...
The Best Tech Bargain Out There
06/10/2011 9:00 am EST
Giants like Cisco and Hewlett-Packard look inexpensive, based on some valuation measures. But if you consider where trends are heading, there is an obvious winner.
I keep hearing that technology shares are cheap.
The numbers seem to back that up.
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 S&P 500 index as a whole. And that's the smallest premium for computer stocks since Bloomberg's data began 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 IT sector is its lowest since December 2009.
And if you look at individual stocks, the numbers seem to make the argument even stronger.
- Cisco Systems (CSCO), one of the top technology names for decades, trades at a P/E ratio of just 11.5.
- Intel's (INTC) P/E is just 10.2.
But 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 consider exactly how much the technology sector has changed from the good old days, and how sweeping the revolution that’s now turning the sector upside down.
Let's take a look at the assumptions in the technology-is-cheap argument one at a time. There's an assumption, for instance, that Cisco Systems shouldn't trade at a trailing 12-month P/E ratio.
Why in heavens not?
Here's a company that belatedly admitted that it pursued a profit-margin-killing strategy of heading off into the consumer market, following that by saying it needed to refocus. Then it presented a clearly inadequate reorganization plan.
Operating earnings—a figure that doesn't include any one-time charges—will grow, S&P calculates, by just 6.7% in the fiscal year that ends in July, 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 rant of someone who has recently lost money on an investment in Cisco (which I have), take a look at the other big names in the sector.
Does Intel's 10.2 P/E look out of line with projected earnings growth of 7.3%? Does Hewlett-Packard (HPC) look cheap at a price-to-earnings ratio of 7.9, given projected earnings growth of 9.5%?|pagebreak|
Projected Growth Is Low
Microsoft (MSFT) does look cheap against fiscal 2011 earnings growth of 25%, given its trailing 12-month P/E 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 with those of General Electric (GE), which has a price-to-earnings ratio of 14.8 and a projected earnings-growth rate of 18%. Or consider an even stodgier Verizon (VZ), at a P/E of 16.4 and a projected growth rate of 21%.
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 too low. These technology companies are set to grow faster than this, you could say, and therefore they are cheap at these P/E ratios.
I'd find this more convincing if these technology companies were acting as if they agreed. Instead, I see these giants, one after another, repositioning its stock for value instead of growth by raising dividends to levels that appeal to value investors.
Intel now yields more than General Electric, while Microsoft pays only slightly less. Even Cisco has added a minuscule 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 reason the technology sector as a whole seems cheap 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 (AEP) trades with a P/E ratio of 12.2. That's higher than Microsoft's...but then the electric utility pays a yield of nearly 5%.
There's another reason a technology stock like Microsoft should trade for a lower P/E ratio than a utility—the utility isn't facing massive disruptions in its basic market that make the future look very, very risky.
Microsoft, for example, is facing a challenge to its core Office franchise from applications that live in the cloud. And in popular non-PC devices, such as smartphones and tablets, Microsoft's Windows isn't the dominant operating system. Can 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 can Intel capture a significant market share in the non-PC device market?|pagebreak|
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.
The low prices for these market leaders reflect the serious challenges posed to the basic business models of companies of their generation by rivals such as Apple and Google.
Can They Live in the Cloud?
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, and the iPad—and more importantly, with its iTunes and 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, not the center of the 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 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 suddenly seems like the wrong question.
Apple's vision might seem quixotic if so many other companies weren't headed down the same path. 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 best right now.
And do you still want to know why these big technology names should trade at lower P/E ratios than utilities do?
Consider how quickly Nokia (NOK) has gone from being the unquestioned sector leader to a 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 long for a company to blow through billions in market value these days, once the direction of the market turns against it.
One Truly Cheap Tech Stock
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 overpriced either.|pagebreak|
Looking at these established growth stocks, I don't see any signs of the technology bubble that the LinkedIn (LNKD) initial public offering and the valuations awarded to Facebook and Groupon have raised for some investors.
- EMC (EMC), my favorite among storage stocks, trades at a P/E 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 P/E 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.)
- F5 Networks (FFIV), one of the companies taking market share from Cisco (in something called the application delivery controller market), trades at a P/E of 45, with projected earnings growth of 52%, according to Bloomberg.
I can give you the name of one true technology growth stock that I think is 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own 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 here.
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