Hewlett-Packard employee Jamie El-Fattal , left, checks out the Google maps program during Google Developer Day 2007 in San Jose, Calif.Marcio Jose Sanchez
From software developers to makers of chips and desktop PCs, big technology is looking cheap these days. But as Hewlett-Packard Co.'s profit warning shows, value-seeking investors tempted by the sector should beware of why so many of these stocks trade at a discount to the market.
On Tuesday, HP, the world's largest maker of PCs, reduced its forecast for the current quarter and fiscal year, as its PC and services units struggle. The shares tumbled 7 per cent during the day and are off more than 20 per cent in the last three months.
Technology companies as a class used to trade at a hefty premium, thanks to expectations of explosive growth. But one of the reasons that the sector has lost that premium is that many investors now regard technology as inherently risky, says Duncan Stewart, director of research in technology, media and telecommunications at Deloitte Canada. "That risk relates specifically to the need for capital, and continual R&D innovation, and second to the ability of something to come out of left field and blindside you."
Microsoft demonstrates how expensive it can be for a tech company to defend its territory. It spent $6.7-billion (U.S.) on research and development in the nine months leading up to March 31. But its cash cows, the Office and Windows franchises, are looking increasingly vulnerable to competition and changing technology.
The traditional computing model that made Microsoft rich is being challenged by companies such as Google Inc. , which just last week announced that laptops using its Chrome operating system will soon be available from Samsung and Acer Inc. The software will connect users to applications on the Web instead of on the PCs themselves, essentially bypassing Microsoft's offerings.
Bumping Up Against Limits
Not all tech companies face such challenges. But several of the giants appear to be bumping up against the limits of their traditional markets and are being forced to move into new areas, with mixed success.
Cisco , for instance, decided to branch out of its core business of Internet infrastructure and two years ago spent $590-million to purchase Pure Digital, the maker of the Flip handheld video camera. This year, Cisco closed down the business. It no longer made sense at a time when smart phones such as Apple Inc.'s iPhone come equipped with high-definition cameras.
Other acquisitions are also raising concerns among investors. It's not so much the high prices of these deals, which are financed by healthy cash flows or large cash balances, but the fact that they don't always appear to fit.
Microsoft again provides an example: It says its agreement to buy Web-based phone firm Skype for $8.5-billion will enable it to build real-time video and voice communications into its products. But eBay Inc. made similar claims when it purchased Skype for $2.6-billion in 2005, only to be disappointed. When eBay decided to sell a 70-per-cent stake in Skype for $2-billion in 2009, Microsoft didn't jump at the chance to buy it. That raises questions about why Microsoft is investing in the company now at four times the price.
Similar to Microsoft, Intel Corp. looked to bolster its fortunes by acquiring a business outside of its core area of making microchips. It paid $7.7-billion last year for McAfee Inc., with a plan to integrate McAfee's prized security software into Intel's chip circuitry. But some analysts questioned the benefits of a merger since the companies had worked together closely for years.
Despite the problems they're encountering in diversifying their businesses, tech companies appeal to many value investors, because their financials appear as strong as they have ever been, making them tempting investments on a fundamental basis.
Legendary fund manager Bill Miller, chief investment officer of Legg Mason Capital Management, points to big-cap technology as one of the few areas where there is still value in today's market. Tech stocks have been more expensive 90 per cent of the time over the last 60 years, he wrote in the Financial Times last week.
In the last quarter, Microsoft's profit rose 31 per cent, to $5.2-billion, and revenue increased 13 per cent, to $16.4-billion. The software giant boasts $50.2-billion of cash and equivalents on hand and has an enviable free cash flow yield of 11 per cent. Intel also recently reported stellar financial results and boosted its outlook based on rising PC sales to businesses. It has raised its dividend twice in six months, and still boasted $12-billion of cash and equivalents on hand at the start of April, after spending $4-billion on share buybacks in the last quarter.
Margin of Safety
Apple has the biggest war chest of all, with $65.8-billion in cash and cash equivalents on hand. It said profit nearly doubled and revenue soared 83 per cent in the first quarter. Yet Apple's shares trade at a forward multiple of just 14 times estimated earnings, which is one reason why 90 per cent of the analysts who follow the stock rate it a "buy".
But even in these strong numbers there are red flags. Apple still refuses to pay shareholders a dividend, believing it can put its cash to better strategic uses.
Joel Achramowicz, an analyst with Blaylock Robert Van LLC in Oakland, Calif., is cool on Apple and his analysis seems to encompass the view point of many investors who have grown cautious on technology. He says the company cannot sustain growth at past levels in the face of intense competition from Google Inc., Microsoft and others.
"With all the thousands of engineers and creative marketing talent in the world, it's difficult to believe that Apple – in the long run – can lead the huge mobile device market by investing a small sliver of capital into its development efforts compared to the rest of the industry," he wrote in a recent research note.
"Simply put, the margin of safety in Apple shares remains extraordinarily low at these prices."