Tech Stocks: Down But Not Out

After a weak performance in the first quarter, S&P's Scott Kessler expects some improvement ahead and highlights a few solid buys

The once-glamorous technology sector suffered in the first quarter of 2005. Scott Kessler, director of information technology research for Standard & Poor's, reports that the sector in the S&P 1500 fell by nearly 5 more percentage points than the index as a whole.

Kessler attributes the drop in part to "good but not necessarily great" first-quarter earnings. But he thinks the info tech group will do better in the second quarter by at least tracking the market. And nevertheless, S&P sees a number of strong buys among info tech stocks.

Asked about the recent buyout of Sungard Data Systems (SDS ) by private-equity firms, Kessler responded that it may not be the last such deal. He notes that software company NetIQ (NTIQ ) has just announced the sale of its WebTrends Web analytics business to a private-equity firm for $100 million.

Kessler made these and other points in an investing chat presented Mar. 29 by BusinessWeek Online and Standard & Poor's on America Online. He answered questions from the audience and Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

(Scott Kessler is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Scott, how have the stocks in the info tech area been doing, as S&P sees it?

A:

Well, year-to-date through Mar. 24, the S&P 1500 information technology sector fell 8%, while the S&P 1500 [as a whole] fell 3.1%. And year-to-date through Mar. 24, each of the 15 subindustries within tech was down. So clearly, it has been a challenging first quarter for technology stocks across the board. Notwithstanding that, we continue to recommend a market-weight position in technology stocks, which recently accounted for roughly 15% of the S&P 1500.

Q: Do you see a revival coming for tech despite the recent lag?

A:

I don't know if I see a revival, although I do expect these stocks to act better as the second quarter begins. We believe the fundamentals in technology are solid, the valuations reasonable, and the balance sheets strong. Those together constitute the bullish case for tech stocks. The negatives are sentiment and stock options. At this point, we believe technology stocks will track the broader averages -- an improvement from first-quarter performance.

Q: To what do you attribute the first-quarter lag in tech stocks?

A:

I think part of it was attributable to fourth-quarter results that were good but not necessarily great and forward guidance that was perhaps overly conservative -- if provided at all. The market as a whole has been quite choppy due to concerns about rising interest rates and oil and other commodity prices. Higher interest rates, we think, support our opinion that large-cap technology stocks are a good place to be, given their limited need for capital and their diversified business models.

Q: Do you feel stocks like EMC (EMC ), Cisco (CSCO ), JDS Uniphase (JDSU ), and 3Com (COMS ) can ever make a comeback?

A:

Interestingly, we believe that two of the stocks you listed are compelling opportunities right now. We have strong buy recommendations on Cisco and EMC. Large-cap technology stocks like CSCO and EMC are as reasonably priced as they have been for some time. In fact, based on S&P Equity Research's projections, the S&P 500 technology sector trades at a p-e/growth rate equal to the S&P 500.

Generally, as you may well know, tech stocks have traded at a premium to the broader market. Thus, we think there's opportunity to be had with large-cap technology stocks, including CSCO, EMC, IBM (IBM ), and Microsoft (MSFT ), for example. We do cover 3Com and JDSU. We have hold opinions on both stocks. For all four of the stocks you asked about, we believe it will be some time before their early 2000 highs are eclipsed, if ever.

Q: What do you think of the buyout of Sungard Data Systems? Will there be other such deals?

A:

I used to cover Sungard and believe it's a unique company that offered the private-equity community with a unique opportunity. I think the proposed purchase of Sungard, although the largest private-equity transaction I can remember in technology, may not be the last deal of significance for this type of buyer.

Just yesterday [Mar. 28], software company NetIQ (NTIQ ) announced the proposed sale of its WebTrends Web analytics business to a private-equity firm for nearly $100 million. My sense is that these firms are moving up the food chain and looking at larger acquisition candidates because many of them are fraught with capital. I expect additional private-equity deals to be announced and technology to be a fertile center for activity.

Q: Could you mention a few likely takeover or merger candidates in the telecom-equipment area? Or elsewhere?

A:

First off, the companies that I will mention are possible acquisition candidates, not likely ones. In the telecom-equipment area, companies have been dealing with purchasing delays from the major wireline and wireless carriers that are engaged in transactional activity. That being said, two companies we like in particular in the telecom-equipment subindustry are small-cap stocks Harmonic (HLIT ) and Powerwave Technologies (PWAV ). Harmonic is a play on converged video, voice, and data services. Powerwave is a play on growth in wireless communications.

Q: What do you think about Nokia (NOK )?

A:

Our opinion on Nokia is buy. Our 12-month target price is $16. We believe the company has been gaining market share and improving its average selling prices. We also believe that the company could deliver greater shareholder value with enhanced stock buyback or dividend activity. We like the stock.

Q: What's your take on Brooks Automation (BRKS ) and Applied Materials (AMAT )?

A:

We actually have buy recommendations on both large-cap Applied Materials and small-cap BRKS, both of which are in the semiconductor-equipment subindustry. Interestingly, year-to-date through Mar. 24, the semiconductor and semiconductor-equipment subindustries were the two best performers within the technology sector. We like both of these stocks. In fact, Applied Materials recently initiated a dividend.

Q: Invidia (NVDA ) has a good-sized position. What's your take?

A:

We have a buy recommendation on shares of Invidia. The company posted January-quarter results that exceeded our expectations, and we recently raised our fiscal year '06 EPS [earnings per share] projection and 12-month target price. We think recent deals with Intel (INTC ) and Sony (SNE ) have broadened the company's market opportunity.

Q: Your opinion on eBay (EBAY ) and Juniper Networks (JNPR )?

A:

Well, eBay is an easy one, given that I actually cover the stock. We liked and recommended the shares for all but about two months last year, but downgraded them in late November on valuation concerns. Since then, the stock has fallen appreciably.

We have a hold recommendation on eBay, although we believe there are still some significant risks to the story, including a 2005 p-e of 47. As for Juniper, we have a hold recommendation on the stock, largely reflecting the competitive pressures associated with its much larger rival Cisco Systems.

Q: Are there any tech stocks that exhibit growth and stability?A: I'm not really sure exactly what you're asking, although data-processing and outsourced-service companies do exhibit those characteristics. They tend to be more defensive technology plays with significant recurring revenues, notable free cash-flow generation, and more-limited exposure to stock options.

We have a positive outlook on the subindustry and have strong buy recommendations on ADP (ADP ) and Fiserve (FISV ) and buy recommendations on Affiliated Computer Services (ACS ) and Computer Sciences (CSC ). I'd also point out that some of the companies within this subindustry, such as ADP and FISV, should benefit from rising interest rates.

Q: Scott, are there any other strong buy recommendations in S&P's tech-stock universe?

A:

I will list them all in alphabetical order: ADP, Canon (CAJ ), Cisco, Citrix Systems (CTXS ), Cognos (COGN ), Dell (DELL ), EMC (EMC ), Fiserve, Harmonic, Lam Research (LRCX ), Linear Technology (LLTC ), Maxim Integrated (MXIM ), McAfee (MFE ) -- which is S&P Equity Research's Stock of the Week for the week of Mar. 28, Microsoft, Novellus Systems (NVLS ), Powerwave Technologies, Qualcomm (QCOM ), RSA Security (RSAS ), ValueClick (VCLK ), and last but not least, WebEx Communications (WEBX ).

Q: And in the other direction, any tech stocks investors should sell?

A:

Two strong sells are Adtran (ADTN ) and NEC (NIPNY ). Sells include CNET Networks (CNET ), Callidus Software (CALD ), Extreme Networks (EXTR ), FormFactor (FORM ), Intersil (ISIL ), Red Hat (RHAT ), Unisys (UIS ), and Veeco Instruments (VECO ). That's a good number of the shares we're recommending as strong sell or sell.

Q: I own Xilinx (XLNX ) at a much higher price -- do you have any thoughts?

A:

We have a hold recommendation on XLNX. We would recommend Linear Technology and/or Maxim Integrated instead. We believe they're higher-quality companies and stocks.

Q: Do you think the prices of Research in Motion (RIMM ) and Sirius Satellite Radio (SIRI ) are justified?

A:

In mid-March, RIMM announced a legal settlement with NTP that we think removed a cloud of uncertainty from above the shares. Nonetheless, RIMM trades at a premium to peers. We have a hold recommendation on RIMM.

As for Sirius, we initiated coverage of the satellite-radio companies earlier this year, and we have hold recommendations on both stocks -- SIRI and XM Satellite Radio (XMSR ). This reflects significant growth prospects that we believe are more than amply priced into the stocks. These are all exciting yet risky investments, and we believe the premium valuations offset the growth potential.

Q: And broadly speaking, despite the recent lag in tech stocks, you at S&P still see some good opportunities for investors right now, based on your list of buys. A fair summary?

A:

Absolutely. And to sum up our thoughts related to the types of stocks we like, think about three key themes: First, quality -- both in companies and in earnings; second, security -- we have a number of recommendations in the security software segment; and third, Internet advertising -- which is an area I'm directly responsible for, within which we're recommending Google (GOOG ), ValueClick, and Yahoo! (YHOO ). The bottom line there is: Corporations will continue to spend more and more money on Internet advertising.

Edited by Jack Dierdorff

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