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State of the sector: technology

Valuations for the tech sector overall continue to be reasonable.

  • Information Technology Sector
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Amid a less-than-supportive global macroeconomic environment and several areas of industry-specific weakness, the information technology (IT) sector posted two consecutive quarters of negative earnings-per-share (EPS) growth in the first half of 2013. In the second quarter, EPS growth was –6.9%, versus initial EPS growth estimates of –0.5% (see the second chart below, right). Revenue growth for the sector was modestly positive, increasing 1.7%, but fell shy of its initial target of 3.9%.

On a year-to-date basis through July 31, 2013, the sector’s absolute return was 12.8%, the second lowest of the 10 major market sectors.

Macro environment

The macroeconomic backdrop for technology companies was mixed through the first seven months of 2013. From a geographic perspective, the United States was generally supportive for tech stocks, with continued low inflation, cash-heavy corporate balance sheets, and strong capital markets.

However, macro conditions were not as favorable outside the U.S. Despite some signs of improvement, the strength of Europe’s economy is still a question mark. But the biggest disappointment year to date has been Asia, primarily China, which posted weak economic growth and warned of a grim outlook for trade—a signal of weaker demand within its own nation and for imports as well.

Secular slowdown in computer hardware?

The computer hardware industry (or “computers & peripherals”) consists of companies that assemble and manufacture computers, computer hardware, and computer peripherals, including storage devices, keyboards, printers, monitors, Webcams, and more. After an extended period of strong growth spurred by consumer demand for smart phones and other personal devices, market demand and growth is slowing due to saturation in developed markets—and increased competition.

As a result, earnings and revenue growth for some major computer hardware companies have fallen sharply. In Q2 2013, initial EPS growth estimates for the computers & peripherals group was –10.7% (see Earnings Scorecard, right). Unfortunately, the actual results were worse than expected, as EPS growth fell –22.8%.

On an absolute return basis, computer hardware stocks fell 7.2% in Q2, the only tech industry with a negative return. Computer hardware manufacturers suffered another setback in August on reports that worldwide PC shipments fell 14% in Q1 2013, the worst decline on record.1

The low P/Es for computer hardware during the past few quarters suggest future earnings for the largest players in the industry could fall further, particularly as competition intensifies. Some of the stiffest competition on the tablet and handset fronts is from low-cost providers in China, whose products are slightly lower in quality but only cost a third or a quarter of the price. Meanwhile, PC makers face pricing and volume headwinds due to the increased market share of tablets, especially in consumer markets.

Industry snapshots

Of the eight industries that comprise the overall IT sector, communications equipment was the only one to surpass its EPS and revenue estimates in Q2 2013. These stocks, especially telecom services providers, could see even stronger acceleration if spending continues to recover. IT services also beat its initial EPS growth estimates by a comfortable margin; however, stock valuations relative to the tech sector overall have been stretched, and the quality of reported earnings is beginning to deteriorate. This is especially true for Indian outsourcing companies, many of which will lose their competitive low-cost advantage due to landmark immigration legislation recently passed by the U.S. Senate.

There was an interesting performance dichotomy within the semiconductors & semiconductor equipment category. Despite having the second-worst EPS growth (–12.7%) and the worst revenue growth in the IT sector during Q2, it had the sector’s highest absolute return. Memory chip stocks are doing particularly well, thanks largely to high smart phone unit sales. A tightening of supply and higher demand—especially from the lower-tier manufacturers—has contributed to the strong performance on the memory front. No technology industry had better revenue growth (15.8%) in Q2 than the internet software and services group. It also posted the sector’s second-best EPS growth. Enterprise software suffered a weak Q1, but it picked up steam in Q2 and seems poised for a strong second half of 2013.

Tech sector valuations

Technology stocks—as measured by their enterprise value-to-free cash-flow ratio (EV/FCF)—continue to be inexpensive on a historical basis.2 The EV/FCF ratio adjusts the value of a company for its cash and debt obligations, and also measures a company’s ability to earn actual cash. At the end of Q2 2013, the technology sector’s EV/FCF ratio was approximately 13, less than half the sector’s median ratio of 29 and roughly one-third its average ratio of 37 (see the chart, right). As we discussed in this report several months ago, the declining EPS trajectory of some of the world’s largest computer hardware companies is continuing to pull down the sector’s overall valuation.

Outlook for tech stocks

New smart phone and tablet launches on the horizon could provide a spark for the tech sector in the coming year. On the consumer front, advances in “wearable technology” (e.g., glasses, watches) may be particularly compelling on a longer-term basis. ABI Research forecasts that 1.2 million smart watches will be shipped in 2013 due to the high penetration of smart phones in many world markets, the wide availability and low cost of microelectro- mechanical system (MEMS) sensors, energy-efficient connectivity technologies such as Bluetooth 4.0, and a flourishing app ecosystem.

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I continue to believe that emerging markets are the new frontier for smart device and social mobile network demand. Less-expensive devices should really help the industry penetrate emerging markets, which is good news for memory chip demand over time. However, this may not bode as well for the largest original equipment manufacturers, whose market share in EM is much lower due to their high prices.

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Fidelity Thought Leadership Vice President, Senior Investment Writer Matt Bennett provided editorial direction for this article.
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1. Bloomberg, “Microsoft Windows Weak Demand Spurs Worst PC Slump on Record,” April 11, 2013.
2. The EV/FCF ratio compares a company’s enterprise value with its ability to generate free cash flow. Enterprise value is the market capitalization of a company adjusted for debt and cash holdings, while free cash flow is defined as a company’s operating cash flow adjusted for capital expenditures and dividend payments.
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