Tech Outlook 2005 - Part 2


The tech sector lost some shine in 2004, as worries about economic growth and weaker demand persuaded investors to look elsewhere for growth. So far this year through Dec. 10, the Standard & Poor's Information Technology index edged up just 0.4%, vs. a 6.8% gain in the broader S&P 500-stock index. The tepid gain is not too surprising after the 47.2% jump for Info Tech in 2003.

However, telecommunications stocks have faired much better this year, climbing 15.2%, after rising just 3.2% in 2003, amid consolidation news and more focus on dividend-paying stocks. The strongest performers in 2004 were Internet software and services (up 61%), followed by wireless telecom services (up 53%). Semiconductor-related shares were the big losers.

For clues on what to expect for info tech and telecom, BusinessWeek Online asked a team of analysts at Standard & Poor's for their 2005 outlooks for key industry segments, along with their favorite stocks. Overall, S&P has a marketweight recommendation on the info-tech sector, and an overweight recommendation on the telecom. This means investors should be particularly choosy.

S&P has its top ranking on a few familiar names, including software makers Microsoft (MSFT), McAfee (MFE), and Veritas (VRTS), and hardware giants IBM (IBM) and Dell (DELL). In the Internet advertising area, S&P's favorite pick is ValueClick (VCLK).

OVERVIEW. S&P also has strong buy recommendations on two analog chip outfits, Maxim Integrated Products (MXIM) and Linear Technology (LLTC); electronic manufacturing services provider Sanmina-SCI (SANM); storage provider EMC (EMC); and outsourcing companies Affiliated Computer Services (ACS), Automatic Data Processing (ADP), and Computer Sciences (CSC).

In telecom services, S&P's top picks include Verizon (VZ), Alltel (AT), CenturyTel (CTL), and Canada-based BCE (BCE). Among wireless telecom equipment, Qualcomm (QCOM) and Motorola (MOT) get the top ranking.

The second part of this two-part series provides overviews from Scott Kessler, who covers Internet software and services; consulting and outsourcing analyst Stephanie Crane; wireline telecom services analyst Todd Rosenbluth; wireless equipment analyst Ken Leon; and communications equipment analyst Ari Bensinger.

Part 1 of this tech survey provided outlooks from S&P chip analyst Amrit Tewary, semiconductor-equipment analyst Colin McArdle, computer hardware analyst Megan Graham-Hackett, information-technology services and data storage analyst Richard Stice, software analyst Jonathan Rudy, and specialty software analyst Zaineb Bokhari.

Scott Kessler, Internet software and services and Internet retail

One of the themes we're emphasizing for 2005 is online advertising. In our view, 2004 has been a banner year for Internet marketing. We forecast an increase of 28% in U.S. online-advertising spending in 2005 (to around $13 billion), which we consider very healthy growth. We believe online-ad spending will continue to benefit from more Internet users and Internet-enabled devices, faster Internet connections, and greater Internet usage in the U.S. and around the world.

We also think corporations will spend an increasing percentage of their marketing budgets online to capitalize on these favorable trends and more effectively target and interact with online users.

Reflecting our optimism about Internet advertising, we recommend the shares of ValueClick (VCLK

; strong buy; $13) and Yahoo! (YHOO

; buy; $37). Yahoo owns and operates one of the world's most popular online content, communications, and commerce networks. We see Yahoo as the place to go for advertisers wishing to reach a large online audience and believe that Yahoo's compelling inventory continues to be in high demand around the world.

WEB WRAPUP. ValueClick enables marketers to advertise and sell their offerings via a variety of online channels including display advertising, keyword search, e-mail, and affiliate programs. It also provides software that aids advertising agencies with information management for financial, workflow, and offline media buying and planning purposes. We expect ValueClick to gain market share and expand internationally in 2005.

We also expect 2005 to be a year of consolidation for Internet companies. In our opinion, many online players have nicely profitable businesses, very healthy balance sheets, and considerably appreciated stocks. Two stocks we recommend that we think could be acquired at premiums are ValueClick and priceline.com (PCLN

; buy; $24). We think ValueClick could be attractive for an online or offline advertising-focused company, and priceline might make sense for a larger Internet travel player like Sabre Holdings (TSG

; sell; $23) seeking brand and channel diversification.

Stephanie S. Crane, IT consulting and outsourcing

We expect the IT consulting and outsourcing services sector to benefit from an increase in corporate spending in 2005. We project double-digit growth for services aimed at business process outsourcing (BPO) as well as high-end IT applications and value-added consulting services, driven particularly by solid demand from corporations in the U.S. and Europe. In fact, we believe European corporations are beginning to appreciate the operational efficiencies garnered from outsourcing.

In the face of growing demand, we expect additional competition in BPO, as more companies, such as IBM (IBM

; strong buy; $96) and Hewlett-Packard (HPQ

; hold; $21), add offerings, which we believe could force a mix shift where contracts and pricing focus on value-added instead of boiler-plate products. We see Affiliated Computer Services (ACS

; $60), Automatic Data Processing (ADP

; $46), and Computer Sciences (CSC

; $57) benefiting from these trends, and have strong buy recommendations on each.

We have a 12-month target price of $67 on shares of Affiliated Computer Services. Our target price is based on our discounted cash flow (DCF) calculation as well as the discount that the shares trade at to the S&P MidCap 400 on a p-e-to-growth basis. In fiscal year 2005 (ending June), we expect revenue growth of 17% for ACS, with EPS up 19% to $3.16.

GOOD TIDINGS. ACS benefits, in our view, from the fact that roughly 90% of its revenue is recurring, providing significant visibility into the future as well as a buffer against volatility. New business contracts in the pipeline for the upcoming year exceed $1 billion. More than half of ACS's business is in BPO-related contracts, which offer higher revenue growth than traditional IT outsourcing and provide a greater contribution to the company's gross margins.

We also believe ACS will benefit significantly from a pipeline of state and local government business expected to come from changes in legislation related to Medicare and child welfare payments.

Our 12-month target price of $63 for Computer Sciences is arrived at through our analysis of the stock's p-e multiple relative to that of the S&P 500. We use a p-e of 20 with our fiscal year 2005 (March) EPS estimate of $3.19. CSC currently trades at about 18 times our fiscal 2005 estimate and 16 times our fiscal 2006 estimate. We see momentum driven by new contract announcements, a shift toward outsourcing, improving earnings, as well as return on investment, and the acquisition of DynCorp, which we think has helped expand CSC's opportunities in the federal government marketplace.

Automatic Data Processing shares currently trade at a discount to our 12-month target price of $54. Our target price is based on our DCF analysis and relative enterprise-to-sales valuation. We believe the shares deserve a premium valuation to peers, based on our view of ADP's market-share leadership, healthy balance sheet, and strong cash flow generation.

UNTAPPED MARKET. We expect fiscal year 2005 (June) operating EPS to increase 17%, to $1.82, from $1.56 in fiscal 2004. Our strong buy recommendation is based on valuation, as well as a continued expected improvement in the job market, which we see aiding payroll providers such as ADP in 2005. We think the market for payroll outsourcing is relatively untapped, providing opportunities for future earnings growth. We view the balance sheet as strong, with $2.2 billion in cash and securities and little debt.

Risks to our recommendations and target prices for ACS, CSC, and ADP come from potentially increased competition in BPO, which could hurt pricing of contracts and margins. We also consider any adverse trends affecting demand from corporations as a key risk causing lower expectations for revenues and earnings.

Todd Rosenbluth, telecommunications (wireline) services

As we head into 2005, we remain positive on the integrated telecommunications services subindustry, as we expect these companies will be focused on what to do with their free cash flow. In the second half of 2004, carriers such as Citizens Communications (CZN

; hold; $15) and MCI (MCIP

; hold; $19) established relatively large dividend payouts and we expect the trend of returning cash to shareholders to continue.

However, we see competition from wireless, cable, and Internet telephony companies intensifying in 2005, resulting in continued access-line losses. To combat competition and reduce customer churn, we anticipate that discounted bundled offerings will expand to include satellite, as the number of alliances with industry-leading communications companies increases, as well as fiber-based broadband and video offerings. Growth in DSL and wireless units should continue to be relatively strong, in our view, but discounted bundled offerings should help to pressure margins for some.

We expect integrated service providers to focus their capital spending on newer services, such as wireless broadband and fiber-based services, but we remain skeptical about the benefits from cost savings and improved customer loyalty.

DIGESTION PAINS. Separately, we believe that BellSouth (BLS

; strong sell; $28) and SBC Communications (SBC

; sell; $25) will face sizable operational challenges for the next 12 to 18 months as their Cingular Wireless joint venture attempts to digest its mammoth acquisition of AT&T Wireless. We expect the wireless carrier will need time to improve its brand-recognition and customer-care issues, while also integrating its multiple digital voice and data networks.

We believe that investors should focus on integrated telecoms that have revenue and earnings growth to support capital spending, as well as dividend increases. Our top picks in the group include rural telecom providers Alltel (AT

; strong buy; $58) and CenturyTel (CTL

; strong buy; $44) and Canada-based BCE (BCE

; strong buy; $24), which face less competitive pressures and have more stable margins than peers.

In addition, we favor Verizon Communications (VZ

; strong buy; $42) for its ability to take wireless market share during wireless consolidation and increase revenues in its wireless and data operations.

Kenneth Leon, wireless equipment

We believe 2004 will be a tough act to follow in terms of the worldwide demand for wireless handsets. We estimate that the wireless industry will have shipped more than 630 million handsets by yearend 2004, a 30.4% increase from 2003 and significantly above the 14.5% increase experienced in 2003 over 2002.

The key drivers for handset growth in 2004 were a faster handset replacement cycle in developed countries in Europe and North America and in Japan, as well as burgeoning demand in emerging markets in China, Southeast Asia, India, and Latin America.

We're also at the beginning stage of wireless carriers transitioning their networks to third-generation (3G) network applications using code division multiple access (CDMA), 1x-EV-DO, and WCDMA. The countries most advanced in this transition are Japan and South Korea. We believe most of the major wireless carriers in North America will complete the network migration to 3G by 2006.

3G AT LAST? In the year ahead, we forecast near 700 million handset units will be shipped in the global market. In our view, the normalized growth for handset shipments may be in the 8% to 10% range for 2005 through 2008.

Another dimension to the handset market is the transition to 3G CDMA-related networks from 2G global system for mobile communications (GSM) systems. We estimate that 73% of total handsets shipped in 2004 will be GSM-based handsets, vs. 27% for 2G CDMA-related handsets. Our long-term forecast is for 45% of total handsets shipped will be CDMA-based in 2008 compared to 55% for GSM-related handsets.

Two companies that we see benefiting from the transition to 3G are Qualcomm (QCOM

; strong buy; $43) and Motorola (MOT

; strong buy; $18). We view Qualcomm as the best in its class, with one of the most attractive business models in the telecommunications industry.

QUALCOMM'S QUALITIES. In many ways, we see parallels to the success Microsoft (MSFT

; strong buy; $27) enjoyed in the last decade. Qualcomm has what we see as a unique position of pricing power from its intellectual property in designing CDMA for the mobile wireless industry. The strength of its patents has enabled Qualcomm to receive high-margin license royalty fees from all users, handset and infrastructure suppliers, as well as service providers that use CDMA for software enabling applications.

In addition, it's the leading fabless semiconductor company, with more than 98% of the worldwide market for CDMA chipsets. Fabless means the company designs and upgrades its product portfolio of CDMA chipsets, and then outsources the manufacturing to foundries of IBM and Taiwan Semiconductor Manufacturing (TSM

; hold; $8).

Plus, Qualcomm generates substantial operating cash flow to meet capital requirements, make strategic investments, and pay a dividend on common shares. As of Sept. 30, Qualcomm had approximately $7.6 billion in cash and cash equivalents, or approximately two-thirds of its total assets with no long-term debt. Applying a p-e multiple of 35.3 to our fiscal year 2006 (ending September) EPS estimate of $1.50, a premium to peers that we think is warranted by above-average growth potential, we arrive at our 12-month target price of $53.

MOTOROLA'S MARKET. As the number of worldwide users of cell phones has climbed, Motorola has become a leading supplier to the expanding wireless industry. Although it manufactures various electronic products, it's best known for its wireless gear.

Motorola's Personal Communications (handsets) segment (45% of 2004 third-quarter sales) primarily manufactures personal two-way radios and wireless handsets in all three major digital standards: GSM, TDMA, and CDMA. The handset segment represents 58% of the company's enterprise value (no other unit accounts for over 13% of enterprise value).

Applying an assumed price-to-sales ratio of 1.4 to our 2005 sales per share estimates and using sum-of-the-parts analysis, we arrive at our 12-month target price of $22 for Motorola shares.

Ari Bensinger, communications equipment

The communications equipment market is experiencing improving fundamentals, in our view, as demand for greater bandwidth to support voice, storage, and streaming-video applications leads to network investment. In both the service-provider and enterprise markets, traditional circuit-switched networks are being replaced with packet-based systems, while wireline networks are being migrated to wireless. Equipment vendors that help customers move to new technologies will likely find significant opportunity as the industry evolves.

We see telecom service operators boosting spending on edge network technologies, such as digital service lines and fiber to the premise, to meet impending voice competition from the expected accelerated deployment of voice over Internet protocol by cable operators. However, the new technologies are only a small part of carrier capital spending. Despite continued residential line loss by the regional Bells, we see 2005 telecom spending up slightly.

On the enterprise side, we see the Ethernet switching market set for an upgrade cycle to higher gigabit speeds and new Layer 3 routing applications. The core routing market is benefiting from strong consumer broadband growth that's straining the capacity of the data network. We expect industry pricing pressure to intensify from increased competition, especially from Asian manufacturers. Overall, we believe 10% to 15% annual growth in data networking gear is achievable for the next three years.

Our favorite stocks include Avaya (AV), Cisco Systems (CSCO), and Scientific Atlanta (SFA), all of which are ranked 4 STARS, or buy.

Note: S&P analysts have no stock ownership or financial interest in any of the companies in their coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com


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