Over the next five years, we expect the complexity of technology architecture and the increasing ubiquity of data transmission to drive demand for software that simplifies structures, makes data ever more accessible, and protects corporate networks. We also expect continued consolidation, as large players acquire smaller firms, rolling the point-specific technology solutions into their larger suite-level solutions.
Entertainment/education media is the one group, based on valuation, that currently appears undervalued. We especially like the gaming industry, given the demographic trends, the opportunities from online sales and in-game advertising, and the recent release of the upgraded gaming consol
es from Microsoft, Sony, and Nintendo. Electronic Arts is the big player, but we also like its smaller competitors--Take-Two Interactive.
| Segment |
Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
|
Entertainment/ Education Media |
3.75 | 0.84 | 4 |
| Systems and Security | 2.67 | 1.06 | 12 |
| Business Applications | 2.60 | 1.07 | 35 |
| Development Tools | 2.50 | 1.09 | 14 |
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| Data as of 31-12-06 | |||
We are not as enthusiastic about the other software groups at this time, because they appear to be overvalued. However, the complexity and consolidation trends over time should benefit several firms that are worth keeping on your investment radar screen. Within business applications, information technology (IT) outsourcing will persist as an ongoing phenomenon, as executives deal with increased technological complexity by farming out that technology to third parties, increasingly those based offshore. Here we particularly like EDS and Accenture among the traditional players and Infosys and Wipro among the offshore firms.
We continue to see an increasing focus on security integration into networking and storage products, with EMC, Cisco, and Symantec leading the fray. In this game of musical chairs, some niche security providers may find themselves standing alone when the music stops. Although this group rebounded nicely in the back half of 2006, we think most companies are currently fully valued. Consolidation will remain another key theme over the next several years, as enterprise customers push to decrease their overall number of technology vendors. Given Oracle's role as the leading consolidator in the industry, we'd keep this firm on our investment radar screen. IBM has also been acquiring niche technology firms to broaden its solutions suite.
What about Microsoft, the 800-pound software gorilla? Software-as-a-service poses a threat, but we believe Microsoft has the means and the will to invest heavily to ward off potential threats from the likes of Google. We're forecasting 10% average growth over the next five years for Microsoft. For fiscal 2007, we're expecting double-digit revenue growth in both the client (Windows) and information worker (Office) segments due to the introduction of Windows Vista and Office 2007.
Hardware Sector
The themes of complexity and consolidation carry over to technology hardware and are joined by a third "C": China. Overall, our outlook for most of the big players in the hardware sector is subdued. There are, however, niche areas of explosive growth--most notably in storage and networking--where the big players are acquiring firms to boost top-line growth.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Contract Manufacturers | 3.40 | 0.93 | 10 |
| Wireline Equipment | 3.09 | 0.89 | 11 |
| Data Networking | 2.89 | 1.03 | 9 |
| Optical Equipment | 2.83 | 1.08 | 6 |
| Wireless Equipment | 2.82 | 0.97 | 11 |
| Semiconductors | 2.67 | 1.00 | 58 |
| Components | 2.38 | 1.01 | 8 |
| Computer Equipment | 2.37 | 1.12 | 30 |
| Semiconductor Equipment | 2.21 | 1.13 | 24 |
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| Data as of 31-12-06 | |||
Consolidation in hardware is directly linked to the increasing complexity. Stand-alone niche businesses are being acquired and becoming a feature set for larger firms' offerings. For instance, as more digital data is put out on a network, security becomes an ever-larger concern. Firms with a history of integrating acquisitions well, such as Cisco, IBM, EMC, and Symantec, should benefit from this trend. While we do like companies in niche areas, like F5, their stocks are currently overvalued, in our opinion.
We expect both telecom-service providers and corporations to continue to invest in their networks as the volume and variety of traffic traversing networks continues to grow. After missing out on most of the rally in the second half of 2006 due to spending slowdowns associated with carrier consolidation, traditional wireline telecom equipment vendors should benefit during the next few years. We expect carriers to return to fiber build-out investments to better compete with cable companies, and beneficiaries should include Alcatel-Lucent, Tellabs, and ADC. Data-networking vendors such as Cisco and Juniper should benefit not only from carrier demand, but also as greater network complexity drives increased network equipment spending as a percentage of total IT budgets. We also like the prospects of EMC, and a big reason for that is the firm's focus on building software on top of its hardware solutions to augment storage-capacity utilisation: By managing how and where data is stored on a network, the software improves the data-management capabilities of complex and incongruent systems.
China looms as an increasingly important question mark: Is it an explosive consumer growth force or is it a disruptive competitive threat? Chinese consumer demand for wireless service should benefit handset makers that have invested in the market, such as Nokia and Motorola, but it remains unclear whether China-based vendors will continue to place downward margin pressure on other hardware vendors. As for semiconductors, as a group we don't think they're very attractive currently, but China could be an interesting growth area over the next few years. China's semiconductor industry is still in its infancy, but it is one of the world's largest consumers of chips. Given the opportunities present to fill the large domestic demand gap, we believe the growth opportunity for local semiconductor firms is excellent. One such Chinese firm is Vimicro, which designs semiconductors that enable multimedia functionality in consumer electronics and mobile phones.
Telecommunications Sector
Most telecom stocks offer decent expected returns, but on a risk-adjusted basis, they stack up poorly. The median stock in the sector is about 7% overvalued, in our view.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Wireless Services | 2.59 | 1.08 | 17 |
| Telecommunications Services | 2.43 | 1.07 | 55 |
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| Data as of 31-12-06 | |||
We aren't anticipating much growth from most telecom companies. Wireline phone service revenues are declining at a steady clip. Internet access, wireless services, and to a lesser extent television services, are replacing lost phone revenue, but those are often lower-margin businesses. Plus, to keep pace with competitors' offerings, these companies need to invest in network upgrades. In general, we are forecasting either flat earnings growth or growth in the low single digits.
For the largest U.S. carriers--AT&T, Verizon, and Qwest--we assume household penetration for fixed-line phone service drops to about 50% five years out from about 75%-80% currently. We think Verizon will do a bit better because of its more aggressive network build and that Qwest will do a bit worse because of its poor financial resources. We think network quality will also have a big impact on the Internet access and television businesses. For example, we assume about half of households in areas where Verizon has an upgraded network will subscribe to its Internet access service, while only about 30% in non-upgraded areas will subscribe. We put Verizon's television share in upgraded territories at 25% five years out. By comparison on the cable side, we put Comcast, which already has a solid network, at about 40% Internet access penetration of homes passed in five years.
Generally, the revenue that telecom firms get from business services is still in decline as businesses move from per-minute long-distance charges to IP/data services. We think it will take a couple of years for this transition to have sufficiently passed to allow for modest revenue growth. Consolidation has also eased pricing pressure in this market and should benefit growth and margins over time. On the wireless side, we assume that growth slows steadily as penetration reaches 90%, which we expect to happen over the next few years. We think market share at the four national carriers--Verizon, Sprint, T-Mobile, and AT&T (Cingular)--will be hard to change materially, though we think Verizon will take modest share at the expense of Sprint and, particularly, T-Mobile, over time. While Sprint has struggled and faces ongoing integration issues from a recent merger, we think the firm still possesses the resources to remain a strong industry player over time. Also, we think the market has over-reacted to the firm's troubles and that the shares are currently attractive.
In the developed markets of Western Europe, we expect similar results to the U.S. carriers, with limited growth in the firms' home markets. We also expect a greater pickup in television penetration as European cable operators tend to be weaker than their U.S. peers. We continue to expect higher growth from wireless operators in emerging markets, where many of the large European carriers have investments, with China continuing to grow rapidly, and India, Southeast Asia, and Africa picking up speed. We believe Latin America and Eastern Europe begin to slow somewhat as penetration rates are now 50%-90% in many of these markets. We think emerging-market growth prospects have already been reflected in the stock prices of most of the foreign telecom firms we follow, but many of these stocks are very volatile. We would monitor telecom companies for attractive entry points, as the cash flow these firms generate is often much more stable than their share prices. One stock we like right now is Tele Norte Leste, a Brazilian firm. But the company faces major management issues, and this is one of the riskier stocks we cover.
Media Sector
Media ranks near the bottom in terms of valuations, with an average star rating of just 2.58 across the sector. We slashed the fair values of many newspaper stocks in the fourth quarter of 2006, which erased our previous positive attitude on the publishing industry. Now, only broadcast TV stocks (including Cablevision, Univision, and Hearst-Argyle) appear fairly priced, in our view.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Broadcast TV | 3.00 | 0.98 | 5 |
| Media Conglomerates | 2.76 | 1.03 | 21 |
| Publishing | 2.50 | 1.06 | 14 |
| Radio | 2.46 | 1.13 | 13 |
| Cable TV | 2.25 | 1.14 | 8 |
| Film and TV Production | 2.00 | 1.18 | 1 |
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| Data as of 31-12-06 | |||
Big picture, we expect the trend of ad dollars moving from traditional media to new media to continue--and perhaps even accelerate. The proportion of ad dollars going to online advertising is well below the proportion of consumer time spent online. We expect to see this converge over time. The major beneficiaries of this trend would be names like Google and Yahoo, but lots of dollars will also flow to the new media assets of traditional players like newspapers, Time Warner (which owns AOL), and News Corporation (which owns myspace.com).
More specifically, the major conglomerates will likely grind out their usual 3%-5% top-line growth, largely from their cable networks, cable television, new media businesses, and studios. Most of the major studios had a rough 2006, and we'd expect to see some improvement in 2007 thanks to easy comps and an improved film slate. We expect 2007 will be another challenging year for newspaper publishers. We anticipate a slight decline in newspaper advertising revenue; continued declines in print advertising should offset robust ad-revenue growth from their Web sites. For the radio broadcasters, top-line growth in 2006 is expected to be 0%-1% for the year, and we would expect industry revenue to advance at a similar pace in 2007.
The wildcard for 2007 is the economy. If we see continued slowing throughout 2007, this would likely trickle down into ad spending, which would make even our measured forecasts for growth too optimistic. If this were to happen, traditional ad-based media--newspaper, magazine, radio, and television--would likely get hit harder than new media businesses; however, not even new media businesses would be able to sustain recent growth rates in the face of a weak, recession-driven downturn in ad spending.
Also see:
Services Super Sector: Commentary on the health-care, financial services, consumer services, and business services sectors.
Manufacturing Super Sector: Commentary on the energy, industrial materials, consumer goods, and utilities sectors.
