Although Standard & Poor's suggests investors only market weight technology stocks now, the info tech sector has a number of attractive opportunities. That's the report from Scott Kessler, S&P's group head for information technology stocks -- and analyst of stocks in the Internet software and services and Internet retailing industries. So far this year, two parts of info tech -- Internet software and services, and semiconductors -- have done best. But Kessler also points to application software and home entertainment software as promising areas.
Kessler sees podcasting as a "significant opportunity" for both Internet and traditional media companies -- the latter because of all the content they have available. At the "forefront" of that opportunity, he names Audible (ADBL) as a company that makes it possible to assess unique uses of a podcast.
These were among the points Kessler made in an investing chat presented Nov. 22 by BusinessWeek Online, in response to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat.
(Scott Kessler is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.)
How have the info tech stocks been doing as the broad market finally appears to be gaining some ground?
Information technology stocks, in recent weeks, have acted quite well. In fact, the S&P 1500 information technology sector turned positive year-to-date in recent weeks. It's fair to say that investors are interested in committing capital to tech stocks. We continue to recommend a market weight position in technology, which accounts for roughly 15.5% of the S&P 1500.
Google's (GOOG) ascent above $400 -- what does that mean to you?
The $400 mark was clearly a psychological barrier for the stock, as is often the case concerning whole numbers that end in zero. However, our recommendation on Google remains hold. We recommended the stock earlier this year but became and remain concerned about the company's lack of diversification beyond online search advertising, and what we perceive as mounting significant competition to Google's core franchises from the likes of Microsoft (MSFT) and Yahoo (YHOO), for example.
We think Google is an excellent company that has executed extremely well in recent quarters, but we believe that notable risks are not adequately reflected in the stock price at this point. We are not recommending that people purchase the shares at these levels. Alternatively, we are recommending Yahoo, reflecting the potential related to online advertising, as well as Yahoo's diversified and proven business model.
What part of the info tech sector looks best nowadays?
That is a good question. In terms of year-to-date performance, Internet software and services and semiconductors have performed the best. However, our relative strength measures indicate that application software and home entertainment software have been performing well. We also have a number of recommendations in the computer storage and peripherals area and the data processing and outsourcing services subindustry.
The bottom line is that there is a lot to choose from, and just quickly ticking off a stock in each of those areas, we have strong buy recommendations on EMC (EMC) and Fiserv (FISV), and a buy recommendation on Yahoo [however, on Nov. 23 S&P downgraded Yahoo to hold, based on valuation concerns]. We have a strong buy on Marvell Technology Group (MRVL).
We've heard rumors of Yahoo being involved in some kind of takeover -- any inklings on that?
There were rumors that were confirmed that Yahoo had engaged in preliminary talks to explore options with AOL, which has been widely reported to be talking to suitors for a minority stake in that business unit of Time Warner (TWX). However, these talks recently concluded, and Yahoo is no longer pursuing such a relationship with AOL.
Do you think another company would be able to buy Yahoo?
With a market capitalization recently exceeding $60 billion, I don't perceive Yahoo as a likely acquisition candidate.
Speaking of market caps and such, how do you see valuations in your area? Expensive?
It depends. If we look at valuations in terms of p-e's, tech stocks (as they usually do) look a bit pricey. However, incorporating growth considerations, technology stocks -- particularly, large-cap technology stocks -- only trade at a modest premium to their peers. Technology stocks also often have very strong balance sheets and are increasingly using their capital to deliver shareholder value in the form of stock buybacks, dividends, value-added acquisitions, and debt retirement.
However, it's important to keep in mind that technology companies frequently have notable exposure to stock options, and in keeping with recent SEC and FASB pronouncements earlier this year, companies inside and outside the technology sector must expense stock options in 2006. This will detract from earnings, and [on Nov. 21] S&P indicated that our estimates will take into account stock options for the period 2006 and beyond (see BW Online, 11/22/05, "Option Expensing: The Time Is at Hand").
Going back to including options expenses in earnings estimates, do you think tech stocks will suffer from the resulting reduction in earnings growth?
The answer is I'm not sure. On one hand, I think that there are some who will ignore this mandated change, and it will be business as usual. There will be others such as S&P who will more strictly adhere to the spirit of the change that has been mandated. Ultimately, those companies that deliver growth in sales and profits will be those that generate returns for investors. But clearly, the options issue is a potential overhang for 2006.
How have earnings for the info tech companies done so far this year?
Earnings have been coming in quite strong this year. Third-quarter earnings increased at roughly 25% over last year. And we expect mid- to high-teens growth in the fourth quarter. So overall I'd say earnings growth, although it has been decelerating and will probably continue to do so, this is happening off what we consider a fairly high base. We foresee growth of 16% for the S&P 500 tech sector EPS in 2006.
How is the fast spread of podcasting affecting Net companies? Who might benefit?
I look at podcasting as a significant opportunity for Internet and traditional media companies. Traditional media companies often are those with the access to unique content that could be increasingly monetized through podcasting and other next-generation vehicles. Internet companies will play a role whether it's through amassing and aggregating audiences or hosting podcasts or facilitating groups around podcasting.
I cover Audible (ADBL), which is at the forefront of the podcasting opportunity. The company is already the leading provider of spoken-word audio over the Internet and recently introduced software that will allow podcasts to be better managed and monetized.
Specifically, Audible's offering will enable the assessment of unique users actually listening to a podcast, something that has significant appeal to companies looking to enter and capitalize on the opportunities in the segment.
What else is on the leading edge in info tech that we should be watching?
I can tell you about two things. One is so-called Web services or application virtualization -- the notion of being able to access computer programs solely by use of the Internet via a wide variety of devices. Microsoft (MSFT) recently announced a major push to these on-demand services. We believe that one of our strong buy recommendations, Citrix Systems (CTXS), will be one of the major beneficiaries of this trend.
Second is WiMax, which is essentially fixed broadband wireless. It essentially is a more powerful incarnation of WiFi. It will allow more robust wireless data and communications. We cover two WiMax companies that are very speculative and are rated hold -- Alvarion (ALVR) and Airspan Networks (AIRN).
You told us about a few strong buys in your area -- do you have other names with the same high rating?
A: Ones that I have not mentioned already include Automatic Data Processing (ADP), Brooks Automation (BRKS), Cognos (COGN), Cree (CREE), Electronic Arts (ERTS), Ingram Micro (IM), Lam Research (LRCX), McAfee (MFE), Motorola (MOT), PowerWave (PWAV), Amdocs (DOX), and Seagate (STX). Last but not least, Microsoft.
Finally, any thoughts on the situation with Microsoft and the Xbox?
Well, we obviously are positive on Microsoft and think that the Xbox 360, given its new functionalities and timing coming to market earlier than its competitors, will gain share in the coming months in the video game market. We also think that this is a time that investors should be buying developers of video game software such as Electronic Arts and Activision (ATVI), both of which already have released titles for the Xbox 360. Last but not least, we think that a company like Flextronics (FLEX), which plays a role in the assembly of the consoles, could be a beneficiary of strong demand.