With rapid technological change as the driving factor, the IT sector usually presents exciting investment opportunities around major secular shifts. The challenge is in finding companies that are well-poised to take advantage of multi-year trends. Valuations for growth companies tend to fluctuate widely and are subject to short-term corrections, so a useful approach for a cautious investor is to stay focused on long-term earnings potential.
Mobile messaging as a popular platform
In many countries outside the U.S., mobile instant messaging through in-device applications is a cheaper form of communication than text messaging. In China, Korea, and Japan, mobile messaging apps have rapidly built subscriber bases of hundreds of millions of users, and the numbers keep growing. Like social networks, these services give subscribers an easy—and free—way to communicate with each other, which encourages current users to get their friends to join. Companies have monetized their subscriber bases not by charging for the core service, but through extra features delivered within the application, such as gaming, advertising, and commerce.
Increasingly, instant messaging applications are allowing users to better multitask on mobile devices. For example, while chatting with a few friends about plans for later, you might use a function within the service to check a calendar and vote for the best time to get together. In the future, you may be able to look up reviews of local restaurants, then make a reservation at the one you pick. Even with the huge subscriber numbers already in place, we are still relatively early in the cycle for these applications, especially for companies that are expanding into emerging markets (such as Latin America and Southeast Asia) where full-featured smartphones have yet to dominate and there is plenty of room for growth.
A shift toward cloud computing
Despite all the discussion of “the cloud” in the popular press, a paradigm shift from client/server to cloud architecture is still just getting started. Cloud computing, generally defined, is the use of network infrastructure to deliver computing resources that are not rooted in any single piece of hardware (for example, one personal computer or one particular server). Instead, cloud-based computing tasks can be flexibly distributed over many connected computers and multiple data centers. The “public cloud” refers to one approach: rather than owning or leasing all the hardware required for their computing workloads, companies can simply rent cloud computing resources on an as-needed basis. Users thereby avoid the expense of overbuying resources to account for peak usage needs, and also outsource the expenses of hardware setup and maintenance. For cloud computing providers, economies of scale and fast network connections are critical for success.
As I wrote in my outlook for 2013, the movement to cloud computing seems likely to happen over a period of five years or more, and we are still in the initial expansion phase. Currently, approximately 7% of computing workloads run in the public cloud, but that number is expected to grow to 17% by the end of 2014 (see Exhibit 1, below). Companies that run public cloud resources may gain a lot of new revenue over the next few years, as may companies that deliver particular services using cloud architecture. Additionally, IT services companies that can help an enterprise migrate functions to the cloud are likely to benefit over short- and mid-term periods, even though the long-term expectation of cloud computing is that it will eventually reduce the need for IT consultants.
Companies in related industries may reap some secondary gains from the secular shift toward cloud computing. Both the hardware and software providers that support the required intensive networking capabilities are likely to benefit from steady growth. In addition, the need for “hyperscaling”—the ability of a cloud computing system to scale near-instantly and massively, adding resources as necessary to fill demand—also translates into an increased need for large and efficient data centers, which are expected to continue replacing locally owned computing facilities and even many of the thousands of mid-sized data centers in use today.
Software as a Service continues to transform
Software as a Service (SaaS) is one example of how cloud computing can transform a business. SaaS allows users to access software through the Internet (generally through Web browsers), which eliminates many of the startup and ongoing service costs of hosted software. It also allows SaaS providers to use different payment models (usually subscription and/or usage-based pricing) that may be attractive to many business clients. SaaS providers can use free or low-priced entry-level services to build market share (so-called “freemium service”), luring users away from traditional software vendors. In response, many of the major producers of enterprise software have integrated SaaS offerings into their overall strategies, signaling that a real paradigm shift in the way we think about software may be in the works.
After the early years of explosive development off a small base, the growth rate of SaaS overall has become slower but more sustainable, as economies of scale and network effects increase. There is still plenty of room for new business; our estimates suggest that even in the most mature areas, only approximately 15% to 20% of application dollars are currently spent on SaaS.1 We expect that market share to grow to more than 60% over the next decade.2
As the SaaS business matures, it may become easier to differentiate between companies within the space. I look for those with ongoing opportunities to boost earnings growth, even in the midst of slowing revenue increases. Valuation is also a vital concern, as the gap between median price-to-earnings ratios of the most expensive companies and the cheapest is quite wide. However, valuations are not a selection criterion in isolation. Instead, I look for best-in-class SaaS companies with sustainable growth trajectories, even among the higher valuations. At the lower end, investors should be careful to avoid “broken business model” companies offering products with a limited shelf life; the stock may seem like a bargain and the secular shift to SaaS may continue to lift earnings for a while, but over time the market share for these companies is likely to fade quickly.
Several of the technology giants have been trading quite cheaply on a price-to-earnings basis, which may continue into 2014. The secular headwinds these companies face have not disappeared, but many of these titans have ongoing franchises that continue to generate significant cash flows even as revenues decline. A tech megacap holding net cash and trading at 8x to 10x earnings may be worth considering, especially since a new wave of activists may finally convince one or two of them to return more capital to shareholders.
Risks: What to watch in 2014
Semiconductor supply difficult to predict
The market for microchips is unsettled right now, so despite understandable cyclical and secular dynamics (and one particular extraordinary event), it may be difficult to make confident predictions about 2014.
Longer term, the memory chip market is likely to continue the recent pattern of growth, even though the short term is less clear. Secularly, the migration of chip content from personal computers to mobile devices represents more of a shift than a massive expansion in demand, but the need for hyperscale data centers, which drive efficiency by packing in more memory, may eventually accelerate demand growth. Cyclically, the industry tends to respond to tight supply by overbuilding capacity. The dislocation this time, however, is that a September fire in the Chinese plant of a major memory chip fabricator has disrupted worldwide supply, leading to price increases and uncertain capacity going forward as the plant is gradually brought back up to full production.
The processor chip market has stalled in an extended cycle, because the technology required for the next breakthrough in shrinking chip size (i.e., extreme ultraviolet lithography) has been difficult to perfect but may be coming soon. For chipmakers, planning has become a challenge: Few makers want to increase capacity by adding older chip fabricators that may be outdated soon, nor does it make sense to build a large inventory of chips that may then quickly lose value. Until the cyclical dynamics become clearer, investors with short time horizons may want to be cautious.
It is always worthwhile to monitor macroeconomic trends that might affect earnings in the sector. Although the global macroeconomic environment has been getting better in general, IT companies with high exposure to various emerging markets may face challenges to earnings growth as government debt and sluggish national economies hold back infrastructure and IT spending. In the U.S., federal spending in the technology sector has been relatively weak, and another government shutdown, if it occurs, could have a detrimental effect on revenues.