Don't Be Afraid Of The Tech Giants

2/27/2012


Mobile gadgets now let us tap into the virtual world from virtually anywhere. Silicon chips increasingly power the most mundane products: home appliances, security cameras, even the roof signs affixed to taxi cabs. To feed these trends, businesses worldwide demand more servers, more data centers, more applications and software. Technology spreads, unevenly, but in a self-sustaining cycle; technology begets more technology.

In part because of that growth trend, we view the technology sector as an attractive space for equity investors of all stripes. For income-minded investors, the majority of technology stocks in the S&P 500 Index pay a dividend — and 56% of those dividend payers yield at least 2%. For those more interested in growth, total profits for the S&P 500 Index's technology sector have shown double-digit growth in nine straight quarters, a streak unmatched by any other sector.

SECTOR COMPARISON
The median technology company in the S&P 500 Index trades at a larger discount to its three- and five-year average P/E ratios than stocks in any other sector.
-------- Price/Earnings Ratio --------
-- 12-Month Growth --
Sector (No. Of Cos.)
Trailing
Versus
3-Year
Avg.
Versus
5-Year
Avg.
Versus
10-Year
Avg.
Sales
(%)
EPS
(%)
Oper.
Cash
Flow
(%)
Cons. Discretionary (80)
16.8
1.01
0.98
0.86
10
17
4
Consumer Staples (42)
15.5
1.10
1.01
0.92
8
8
3
Energy (43)
14.9
0.86
0.88
0.83
26
16
12
Financials (81)
15.0
0.89
0.83
0.80
9
13
NM
Health Care (52)
13.4
0.96
0.86
0.74
9
11
13
Industrials (61)
15.4
0.99
0.95
0.83
12
19
12
Materials (30)
15.6
1.01
0.95
0.89
16
21
9
Technology (71)
15.2
0.80
0.77
0.56
11
13
12
Telecom Services (7)
17.2
1.15
1.12
1.06
27
(5)
9
Utilities (33)
14.5
1.10
1.03
1.03
2
3
NM
S&P 500 Index (500)
15.3
0.99
0.92
0.83
11
13
10
NM Not Meaningful because very few companies in the sector report cash flow.

Tech is wrapping up a strong December quarter, with 85% of index components meeting or beating consensus profit estimates and an aggregate profit surprise of 10%, both percentages the highest among the 10 sectors. Nevertheless, at 15 times trailing earnings, the median technology stock trades at a 19% discount relative to its three-year average P/E ratio and a 23% discount to its five-year average. The median stock in the entire S&P 500 also trades at 15 times earnings but doesn't look nearly as cheap relative to its history, trading at a discount of just 1% to its three-year average P/E ratio and 8% to its five-year average.

While the technology sector earns solid Quadrix scores and seems reasonably valued, not all tech stocks are created equal. According to our analysis, bigger really does mean better when it comes to technology.

We separated the S&P 500 technology sector into five quintiles based on stock-market value. We then considered the median stock in each quintile to evaluate the groups' valuation, operating momentum, and outlook. By definition, half of the data points in a set are higher than the median, and half are lower. Our analysis favors the quintile containing the largest stocks:

BIGGER LOOKS BETTER
We divided the S&P 500 Index's technology stocks into quintiles (fifths) based on stock-market valuation. The median stock in the largest quintile is cheaper than the median for the sector and trades at a substantial discount to historical norms. The largest stocks have also delivered the strongest sales, profit, and cash-flow growth over the last year and are expected to deliver the strongest profit growth over the next year. The median is the value that divides a data set into equal-numbered groups. For example, the median S&P 500 technology stock trades at 14.7 times trailing earnings, which means half are more expensive and half are less expensive.
---------- Median Valuations ----------
---- Median Profit Outlooks ----
-- Median 12-Month Growth --
Tech Quintiles By
Market Value
Median
Stock-
Market
Value
($Bil.)
Trailing
P/E
Ratio
P/E Vs.
3-Year
Avg.
P/E Vs.
5-Year
Avg.
P/E Vs.
10-Year
Avg.
Est.
Growth
Next 12
Months
(%)
Est.
Annual.
Growth,
5 Years
(%)
P/E On
EPS For
Next 12
Months
Sales
(%)
Oper.
EPS
(%)
Oper.
Cash
Flow
(%)
1 (smallest 20%)
4.4
13.1
0.85
0.75
0.56
2
11
11.3
5.0
(2.3)
(4.5)
2
8.1
16.7
0.81
0.80
0.71
8
12
17.3
10.8
10.3
10.9
3
11.4
15.8
0.88
0.78
0.52
3
13
18.8
8.7
15.2
9.3
4
17.2
18.1
0.75
0.69
0.67
6
14
16.9
12.9
1.5
18.7
5 (largest 20%)
106.2
14.7
0.80
0.78
0.54
11
12
14.5
17.6
20.1
21.9
S&P 500 Tech
11.4
15.1
0.80
0.77
0.56
7
12
15.4
8.4
12.0
51.2

• At 14.7 times trailing earnings, the median stock in the largest quintile trades 20% below its three-year average P/E ratio, 22% below its five-year average, and 46% below its its 10-year average.

• Of the five groups, big tech has delivered the strongest 12-month growth for earnings per share, sales, and cash provided by operations.

• Looking ahead, big tech is projected to grow earnings per share by 11% in the next 12 months, nearly twice as much as the next-closest group. Yet it trades at less than 15 times estimated year-ahead earnings, cheaper than any quintile except that containing the smallest stocks.

All but four of our recommended tech stocks fall inside the largest quintile of the S&P 500 Index. Our big tech stocks are listed in the table below. EMC ($27; EMC) is profiled in Analysts' Choice, Cisco Systems ($20; CSCO) is being added to the Buy List and Long-Term Buy List in Portfolio Review, and three more stocks are reviewed below.

IBM ($193; IBM) shares, up 19% over the past year, are flirting with an all-time high set in December. The stock is no longer a bargain at 14 times trailing earnings, in line with its five-year average P/E ratio and 5% below the median for S&P 500 technology stocks. But IBM holds enviable leadership positions in many technology areas, providing hardware, services, and software for business clients. The company continues to expand via acquisitions, accumulating niche analytics and cloud-computing companies that shift its product mix toward the more-profitable software group. Software accounted for 26% of revenue and 47% of pretax profit in 2011, up from 22% and 40% in 2008.

Rising analyst estimates call for per-share profits to climb 11% to $14.91 this year, and IBM seems capable of sustaining similar profit growth over the next several years. IBM trades at 13 times projected year-ahead earnings, a 17% discount to the median S&P 500 technology stock. IBM is a Long-Term Buy.


MasterCard ($400; MA) grew cash provided by operations 58% and free cash flow 62% last year. Although MasterCard had to dole out rebates and incentives to attract new customers, it still managed to fatten operating profit margins for an eighth straight year and expects another gain in 2012. The European business continues to post strong growth, while MasterCard's exposure to the region's worst economies is minimal. Portugal, Italy, Ireland, Greece, and Spain combined to account for less than 5% of total revenue last year.

The improving U.S. jobs outlook could spark shares in the near term. The migration toward electronic payments — roughly 85% of global transactions still involve cash or checks — should drive long-term growth. MasterCard is expected to grow per-share earnings by 17% in 2012 and average 18% growth in the next five years. The stock scores above 85 in four of six Quadrix categories and earns an Overall score of 90.

At first blush, MasterCard doesn't look like a tech stock. But it falls into the data-processing industry subgroup, which is one of several categorized as technology services. MasterCard is a Focus List Buy and a Long-Term Buy.


Qualcomm's ($63; QCOM) semiconductors are powerful enough to stream web video on mobile gadgets — and efficient enough to keep the devices' batteries from draining too quickly. Its internal investments helped create technology used in 4G and Long Term Evolution (LTE) connections, likely to be utilized in Apple's ($515; AAPL) forthcoming iPhones and iPads. Unlike Intel ($27; INTC), Qualcomm does not operate its own foundry, but contracts out the manufacturing, assembly, and most of the testing of its semiconductors.

The consensus estimate calls for 17% higher earnings per share in fiscal 2012 ending September on 29% revenue growth. Profits are projected to rise at an average of 16% annually over the next five years. Annualized dividend growth over the last five years (14%) has closely tracked the upward trajectory for sales (14%) and earnings per share (13%). The stock trades at 19 times trailing earnings, a 21% discount to its five-year average and a 36% discount to its 10-year average. Qualcomm is a Focus List Buy and a Long-Term Buy.

SCREEN OF THE MONTH: OUR TECH GIANTS
For tech stocks, the cutoff to make it into the top quintile (one-fifth) of the S&P 500 Index by stock-market value is $37.6 billion. Many top-quintile tech stocks have considerable appeal, as shown in the chart in Sector Snapshot and the table below. The Forecasts covers 14 A-rated (above average) tech stocks from the top quintile. Stocks recommended for purchase are presented in bold.
---------- Valuation ----------
--- Est. EPS Growth ---
------ Operating Momentum ------
Company (Price; Ticker)
Stock-
Market
Value
($Bil.)
Trailing
P/E
Ratio
P/E Vs.
3-Year
Avg.
P/E Vs.
5-Year
Avg.
Next 12
Months
(%)
Next
5 Years
(Annual.)
(%)
12-Month
Sales
Growth
(%)
12-Month
EPS
Growth
(%)
12-Month
Operation
Cash Flow
Growth
(%)
Quadrix
Overall
Score
Accenture ($58; ACN)
37.6
16
1.11
1.04
10.0
12.0
19
27
28
79
Apple ($515; AAPL)
480.0
15
0.78
0.61
22.0
21.0
68
97
101
100
Cisco Systems
($20; CSCO)
109.5
12
0.71
0.65
11.0
9.0
6
11
7
97
EMC ($27; EMC)
55.8
18
0.77
0.77
14.0
15.0
18
21
25
92
Google ($614; GOOG)
158.4
17
0.72
0.58
17.0
21.0
29
19
31
73
Hewlett-Packard
($29; HPQ)
58.0
6
0.58
0.48
(16.0)
8.0
1
(1)
6
67
IBM ($193; IBM)
224.3
14
1.11
1.04
11.0
12.0
7
20
2
69
Intel ($27; INTC)
138.3
11
0.77
0.65
0.0
12.0
24
18
37
97
MasterCard
($400; MA)
48.5
21
1.12
0.95
17.0
18.0
21
33
58
90
Microsoft
($31; MSFT)
263.8
11
0.93
0.80
2.0
9.0
8
17
14
88
Oracle ($29; ORCL)
144.4
12
0.67
0.64
6.0
12.0
15
30
45
84
Qualcomm
($63; QCOM)
106.2
19
0.80
0.79
14.0
16.0
36
13
130
95
SAP ($65; SAP)
80.2
22
1.12
1.07
31.0
13.0
12
20
26
74
Visa ($114; V)
60.0
22
0.99
NA
18.0
19.0
14
30
11
94
Note: Quadrix scores are percentile ranks, with 100 the best.     NA Not Available because of a lack of history.     

 


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