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State of the sector: information technology

Earnings haven’t been great in this sector, but many valuations appear low.

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After beating earnings-per-share (EPS) growth estimates for 13 consecutive quarters, the information technology (IT) sector fell short of analysts' expectations in the third quarter (Q3) and fourth quarter (Q4) of 2012. The sector appears likely to miss its earnings target for the first quarter (Q1) 2013 as well.

As of March 8, the predicted first-quarter earnings growth rate for IT was –3.1%, down from a projected 1.4% at the start of Q1.1 As a group, the combined EPS growth reported by information technology companies was 1.5% for the fourth quarter of 2012. That result trailed the 8.0% EPS growth projected by Wall Street analysts going into the quarter. Revenue growth for the sector was up 5.0%, compared with initial expectations of 6.8%.

Much of this weakness can be attributed to a small number of stocks whose large size and disappointing performance more than offset the sector’s bright spots. One such detractor was Apple, a well-known U.S.-based manufacturer of consumer electronics, smartphones, and computers, which represents the largest stock in the MSCI U.S. IM Information Technology 25/50 Index.2 The company’s fourth-quarter results disappointed Wall Street, and it later issued Q1 2013 revenue and margin guidance below analysts' targets. Consequently, the price of the stock declined 33% from the start of Q4 2012 through the end of February 2013.

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Nevertheless, Apple's U.S. operations did relatively well. For example, it gained even more share—from an already very high level—in the U.S. smartphone market. It has had a tougher time overseas. Demand from China has been weaker given the slowdown in its economic environment. At the same time, competition from Chinese firms is really stepping up. They are able to build low-cost devices that, while not as good in quality, are biting into Apple’s share at the low end of the market. The company also has some distribution restrictions in China that are hampering its growth in that market.

A domino effect

The personal computer (PC) industry has struggled with other issues as well. In particular, there was the lukewarm response to the launch of a major new computer operating system, which negatively affected PC unit sales. This in turn hurt a number of tech industries throughout the supply chain, such as chip makers (semiconductors), the PC manufacturers themselves, and, to a lesser extent, distributors.

Against this backdrop, the computers and peripherals industry—the largest segment of the IT sector—had the worst stock performance of any technology industry in Q4, while the semiconductors and semiconductor equipment industry had the poorest EPS growth, falling roughly 21%.

Fiscal cliff and macro concerns pressure corporate and government IT spending

Enterprise and U.S. government spending on technology initiatives slowed in Q4 amid fiscal cliff concerns, as companies were noticeably cautious in terms of making large software and hardware purchases. The U.S. government is a key consumer for technology. Unfortunately, its spending on technology continued to be disappointing during the first quarter of Q1 2013, which has further compressed profit margins in the sector.

Communications equipment stocks stand out

Communications equipment stocks had an excellent Q4 2012 on the earnings front, posting an EPS growth of 12.1% against estimates of 0.2%. The industry also beat its revenue growth estimates. Heavy demand for smartphones has been a key driver of growth within the communications equipment industry.

With that said, I am somewhat cautious about the sustainability of demand growth for smartphones in developed markets given the high penetration levels of the devices.

Assessing valuations

Technology stocks appear cheap relative to their median value

Valuations in the sector continue to be inexpensive on a historical basis, as measured by its enterprise-value-to-free-cash-flow ratio (EV/FCF).3 I prefer to measure valuations by EV/FCF because, unlike the price-to-earnings ratio, it adjusts the value of a company for its cash and debt obligations, and it also measures a company’s ability to earn actual cash.

At the end of Q4 2012, the technology sector’s EV/FCF valuation was 12.4 (see the chart right), which is less than half of the sector’s median average of 29.8 since Jan. 1991.

One reason for the low overall IT valuation could be the influence of several large stocks in the sector. For instance, valuations for some of the largest stocks in the MSCI U.S. IM Information Technology 25/50 Index are close to their all-time lows. Combined, they represent nearly 20% of the industry’s market cap and about 20% of the index’s overall weighting.

The companies have question marks about the sustainability of their growth rates, and could potentially have a declining growth trajectory for the next three to five years. With little visibility into the sustainability of their cash flows, these stocks could be stuck in a trading range—range bound—and likely won’t be significant detractors or outperformers over the next several years.

Outlook for tech stocks

Despite its recent trend of earnings disappointments, I believe the outlook for the IT sector continues to be exciting. There are always new and innovative products in the sector, which can drive profit growth. Currently, major secular trends, such as mobile Internet and cloud computing, continue to be driving forces in technology. I believe we are only in the second or third year of what could be a decade-long transformation.

As we move through 2013, I believe there is also a certain amount of pent-up demand for enterprise IT systems and corporate PCs that were never really refreshed in 2012. This could be a bit of a tailwind for the second half of this year. In addition, we may see more spending on communications equipment now that the fiscal cliff is somewhat behind us, and corporations may loosen their tech spend budgets. On the consumer side, I have concerns about the sustainability of growth rates for smartphones given stepped-up competition and saturated penetration levels in several markets.

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1. FactSet Earnings Insight, March 8, 2013.
2. The MSCI U.S. IM Information Technology 25/50 Index is a modified market capitalization-weighted index of stocks designed to measure the performance of Information Technology companies in the MSCI U.S. Investable Market 2500 Index. The MSCI U.S. Investable Market 2500 Index is the aggregation of the MSCI U.S. large Cap 300, Mid Cap 450, and Small Cap 1750 indexes.
3. 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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