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Tech Stocks: A Summer of Love

New products—plus buybacks, dividends, and enticing valuations—lure investors into technology names

Technology stocks are enjoying an uncommon summer of love, as investors have been shifting money away from financial companies in light of the subprime and credit market troubles. "This year, tech stocks are outperforming pretty notably," says Scott Kessler, head of the technology group at Standard & Poor's Equity Research. "Actually, tech stocks were outperforming before the housing and credit issues came to the fore."

In the last 13 weeks through Aug. 24, the S&P Information Technology index has been the best performer among the 10 sectors tracked by Standard & Poor's, with a gain of 3.1%, vs. a 2.4% drop in the S&P 500 index. And for the year (through Aug. 24), the tech index has climbed 10.2%, beating the 4.3% rise in the S&P 500.

Though Kessler is relatively optimistic about the sector's healthy fundamentals, he's worried that the mess in the financial sector will harm the overall economy and spending on technology products and services (see, 8/27/07, "Tech Stock Oasis: Can It Last?"). That's why he favors a limited number of large companies with proven track records, such as Intel (INTC), Microsoft (MSFT), Oracle (ORCL), IBM (IBM), and EMC (EMC).

"Many of the names that appear on our strong buy list are names that people knew and loved in the late '90s," Kessler says. "In many ways, it's back to the future."

BusinessWeek's Karyn McCormack spoke with Kessler on Aug. 28 about the sector and his team's favorite stocks. Edited excerpts of their conversation follow.

Is leadership shifting back to technology stocks, now that financial stocks are getting punished for the subprime and credit mess?

Looking back, 2003 was the last full year that tech stocks outperformed. This year, tech stocks are outperforming pretty notably. Actually, tech stocks were outperforming before the housing and credit issues came to the fore.

There are a number of different reasons for this. One reason is solid fundamentals, based on new products and services as well as the fact that companies really look at technology to both grow revenue and restrain costs and expenses.

The most obvious new products are Microsoft's Vista and Office software and Apple's (AAPL) iPhone. The iPhone had a lot of excitement and caused competitors to step up their product development and marketing. And Nintendo's (NTDOY) Wii was a surprise hit beginning in last year's holiday season and continues to do really well.

Plus, we have a lot of confidence in the longer-term growth prospects outside of the U.S. If you look at the 10 sectors that S&P tracks, only one other sector besides tech generates a higher percentage of revenue outside the U.S.: energy. What a lot of people don't appreciate is that the dollar has fallen and that gives tech companies the ability to generate bigger revenue outside the U.S. And many other countries have lower corporate tax rates. So these companies can convert more revenues into profits.

After getting ravaged from 2000 to 2003, tech companies were more conservative in how they spent their money, so now they have outsized balance sheets. In the last six to 18 months, tech companies big and small have been deploying their balance sheets to create shareholder value.

In fact, tech companies in the S&P 500 have been the biggest buyers of their own stocks. In 2006, when stock-options expenses were recognized as actual expenses, we saw a change in behavior. Tech companies are compensating employees less with options and more with restricted stock. So companies are sitting on a lot of cash and are buying back more stock.

We're also seeing companies initiating and raising dividends. Corning (GLW), for example, is now paying a dividend. Some sport a dividend of 2% or so. People don't think of the tech sector as a value zone, but now you have a lot of names that are generating ample growth, paying a dividend, and buying back shares. Companies have also been making strategic acquisitions.

Those are some of the reasons that technology is benefiting as money comes out of financials—the largest sector in the S&P 500 index.

Why do you have a neutral recommendation on the tech sector?

That really reflects their business right now. On one hand, we feel good about the fact that companies are benefiting from new products and services in the market and seeing adoption. We see companies benefiting from upgrade cycles, and the international story is strong.

But with the problems in the financial sector, we see some kind of impact on the economy. Our economist David Wyss thinks a recession is more likely now than he thought a few months ago. So we have concerns about what these developments might portend for the economy and global growth.

Some tech companies have strong ties to financial companies. So if they delay spending, that would affect tech companies. Financials have been among the biggest spenders on technology, and in this kind of environment it's unclear how that will play out.

What are some new products you're watching for the rest of the year and 2008?

Obviously we're watching Apple and iPhone. Our view is that it has garnered mixed results. It's a very nice product, but there's a lot of room for improvement. Sales have not been what some analysts expected. We see new iPhones in the holiday season, with wider screens and touch screens. There could be an iPhone Nano—a smaller device with less functionality at a lower price point. (Apple is making an announcement on Sept. 5.)

As for other new products, there's Fusion from Oracle—that's a 2008 story. Oracle has bought a number of software application companies over the last several years, including PeopleSoft. Fusion is their first effort to fully integrate many of these offerings under one regime. They're very focused on selling it for a reasonable price and then upselling additional features and services at a higher cost. That will be a major 2008 development.

What are your favorite stocks?

We consistently have a strong buy recommendation on very few stocks. We only have a dozen strong buys out of 260 tech companies covered. This means that we try to be conservative. Many of the names that appear on our strong buy list are names that people knew and loved in the late '90s. In many ways, it's back to the future.

Among large caps, we like Automatic Data Processing (ADP), the payroll processing company. The biggest single plus with ADP is it underwent a lot of change in the last few years. It refocused on payroll processing, and spun off other businesses. We think they're energized and looking for opportunities. It's pursuing small and medium businesses, which is an area that has been dominated by Paychex (PAYX).

EMC, the largest storage company in the world, is a grand beneficiary of the VMware (VMW) IPO. Despite the market environment, people wanted to be involved in it. My colleague Jawahar Hingorani said today that the per-share value for EMC's VMware unit is $10. EMC by itself may be worth around $14, so he has a price target of $24. The storage story is still intact, and it has all this value in VMware. The company is focused on delivering shareholder value.

We've also been recommending Corning. It has three different businesses that are pretty solid. Its flat-panel TV business is riding a strong growth trend. Its fiber business suffered recently as Verizon (VZ) didn't spend as much last quarter. It also has an environmental business. The stock is attractively valued, and the company initiated its first dividend and buyback program.

IBM is a play on software and services, and the stock is inexpensive. Intel is a solid company regaining market share and we like the valuation (see, 8/28/07, "Intel: Chips Above the Rest").

As for Microsoft, we like the Vista story. They're starting to get their Internet business right after making a couple of acquisitions, and the company has stabilized its market share in search. Oracle has continued to execute and the stock is still inexpensive.

Seagate (STX) is still among the least expensive stocks on a p-e and p-e-to-growth basis that we cover. The stock is at $25, and we figure the company will earn $2.13 in its June, 2008 fiscal year. Its p-e is 12, and we see growth of that level or higher. They're the biggest and most innovative [company] in the space. Texas Instruments' (TXN) chips power mobile offerings—the stock is attractively valued.

Do you like any smaller companies?

I'd highlight two names in the communications equipment area. The first is Arris Group (ARRS)—it's a great play on continued adoption of both video-on-demand and VoIP services from cable companies. The stock sold off from highs earlier this year but we see it attractively valued. We see earnings per share of 83 cents this year. The stock is trading at $14.50 stock, so its p-e is 17 and the growth rate is about that level. So we like the trend and valuation.

NDS Group (NNDS) provides technology to enable the transmission of secure transactions over set-top boxes. It's based in London and is majority owned by News Corp. (NWS). The growth driver is that everyone wants to deploy secure applications, such as games and interactive functionality, over set-top boxes. It has a great footprint with BSkyB and Sky Italia. I think the fundamentals are solid.

Citrix Systems (CTXS) is a midcap name. We like the theme of remote access that it's centered on. The stock is attractively valued.

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