by Daniel Putnam | July 16, 2012 7:00 am
Concerns about global growth have weighed heavily on the technology sector in the past three months, and if Apple (NASDAQ:AAPL) is removed from the equation, the results are even worse. With sentiment about this earnings season already so poor, now may be the time to do some prospecting for value in the sector.
The challenge with tech stocks is to separate the actual values from the myriad of value traps. One way to do this is to avoid the temptation to bottom-fish among companies that have fallen behind the technology curve and/or are stuck in the mud of commoditized businesses.
Instead, the real value can be found in companies that dominate their respective industries but are being beaten up by short-term headwinds. IBM (NYSE:IBM), Qualcomm (NASDAQ:QCOM), and Cisco Systems (NASDAQ:CSCO) are three that fit the bill.
In late March, IBM had a trailing one-year return of 30.1%. The shares were looking rich, with a P/E at the top of its five-year range and a P/E-to-growth (PEG) ratio well above their historical average. Since then, the stock is down 12.2%, and the froth has been taken out of its share price. IBM now trades for just 13.7 times trailing earnings and 11.2 times forward, which puts it at a reasonable PEG of 1.06 (where 1 is considered fairly valued).
IBM continues to offer the combination of both growth and defensiveness. Although it’s one of the largest companies in the world — which makes big earnings gains challenging — IBM is at the forefront of both cloud computing and data analytics. The company is forecasting at least $20 of earnings per share for 2015 versus estimates for $15.07 in 2012.
On the defensive side, the company generates the majority of its revenue from long-term contracts — which puts it in an enviable position at a time of slowing global growth.
IBM also sports a nice yield of 1.8%, but it has room to expand. Its payout ratio, at 22%, is actually below that of Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC).
So what’s the problem? Right now, IBM is being hit by the concerns about the rising dollar’s impact on its revenues from overseas. A look at the chart below shows that the stock has had an almost perfect negative correlation with the greenback so far this year.
While the dollar is unlikely to reverse its recent gains until investors go back into “risk-on” mode, the note from Deutsche Bank analyst Chris Whitmore in January, as reported on allthingsd.com, continues to ring true today: “Although the stronger dollar is likely to impact reported revenue, IBM remains one of the most defensive names in our universe due to its high exposure to recurring profit streams, past backlog growth and wide geographic and business diversification.”
Add it up, and the recent sell-off looks like an excellent opportunity to “buy the dip” with one of the tech sector’s leading companies. IBM reports earnings on Wednesday, July 18.
The chipmaker Qualcomm is the definition of “GARP,” the acronym money managers use for the phrase “growth at a reasonable price.” Qualcomm has just about everything you want in a stock. Innovative? Check. High profit margins and returns on equity? Check, check. Growth? Absolutely — it’s on target for EPS gains of 16.95 this year and 10.7% in 2013, and estimates are holding in well at a time in which many tech companies are seeing their estimates coming down.
Value metrics? No issue there, either. The stock is trading at a forward P/E of 13.2, and its trailing P/E of 16.6 is far below its five-year average of 25.3. As a kicker, QCOM yields 1.8%. And all of this comes without exposure to the weakness in the PC supply chain.
Despite these positive attributes, shares have shed 11.5% since reaching a high of $68.59 on March 26. The primary issue weighing on the stock is the recent weakness in handset sales. And with earnings coming up next week (July 18) and Apple’s earnings due out on July 24, investors aren’t taking any chances.
However, the important thing to remember here is that mobile telecom is one of the fastest-growing industries in the world, and Qualcomm – whose chips are used in the iPhone 4, iPhone 4S and the vast majority of phones that run on Android — is one of the best-positioned companies to take advantage of this trend. And as Raymond James pointed out in continuing to recommend the stock last week, the company continues to gain market share.
All of this indicates that the recent sell-off in QCOM is a blip in a much larger longer-term story. Indeed, the median analyst price targets is $72, about 30% above current levels. It has paid to buy this stock on weakness throughout the past decade, and right now the evidence suggests that’s still the case. Take advantage of any earnings-related volatility in the second half of the month to build a long-term position in Qualcomm.
A party has been going on in large-cap tech during the past three years, but someone forget to invite Cisco. While this period has brought spectacular gains for the likes of Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Apple, Cisco is barely above its post-crisis trough of March 2009.
Just Friday morning, Stern Agee cut its estimate for the stock due to customers’ tendency to delay projects amid the weakening outlook for economic growth.
All of this raises the question: Will Cisco ever be a buy again?
With its valuation at these levels, it’s certainly worth a look. CSCO’s trailing P/E of 12 is at its lowest level in a decade. Its forward P/E is just 8.5, and it drops to 5.4 when the approximately $6 of net cash on the balance sheet is taken into account.
The stock also offers a 2% yield, and — like IBM — a low payout ratio (19%) and a boatload of cash on the balance sheet indicate show there’s room for growth on this front.
In the short term, however, Cisco is feeling the heat from slower government spending and the general unease about the impact of weaker growth on the tech giants. Still, bandwidth demand — like mobile phone penetration — is one of the most reliable trends in the world economy right now. Cisco is projecting a 29% compounded annual growth rate for global internet traffic in the 2011-2016 period, including 78% for mobile data traffic. The full report, with all of its gaudy numbers, can be viewed here.
The combination of growth opportunities and an all-time low valuation indicates that this one-time momentum stock may have some juice in it yet. The story will take some time to play out, and the stock could stay weak prior to the Aug. 15 earnings report, given Cisco’s tendency to offer cautious guidance.
But at these levels, Cisco — which is priced more like a Hewlett-Packard (NYSE:HPQ) rather than as the established leader in a fast-growing industry — is offering one of the best risk/reward profiles in the tech space.
It’s a tough time to go prospecting in technology. The combination of the summer doldrums, slowing economic growth and elevated uncertainty are undoubtedly taking a toll on the sector’s performance. But for longer-term investors, these challenges may be just the ticket to getting in on these three undervalued industry leaders at outstanding prices.
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