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Tech giants going cheap

By Malar Velaigam, 15 February 2012

News of consumer electronics giant Apple‘s share price surpassing the $500 mark (we tipped them last October at $376) has dominated headlines around the world – but the shares are still trading at just 11.8 times forecast earnings, implying that they are undervalued. In fact, on a PE basis, fellow technology behemoths Microsoft and Google are also looking cheap.

“Greater visibility underpins greater valuations,” says Victor Basta, managing director of Magister Advisors, a financial advisory company to technology businesses.

If earnings visibility is not particularly strong, valuations will reflect this.

“Apple’s stock market performance has clearly been stunning, often leading to the erroneous view that the equity must be expensive,” says Ian Warmerdam, the co-manager of the Henderson Global Technology Fund and Henderson Horizon Global Fund. “The truth is that share price appreciation has been less than earnings growth and the stock has thus been de-rating.”

But why are the shares of such a hugely successful company trading at such an undemanding multiple?

Director of Technology at Polar Capital Fun, Ben Rogoff, believes the shares are undervalued due to the “hit-driven” nature of Apple’s products.

“Apple is only as good as their last product,” he says. However, the key attraction of Apple is the stickiness of its business model, which is a result of its well planned ‘ecosystem’ of services. For example, an Apple iPhone user will subscribe to Apple’s application store, iTunes, and will use Apple’s internet-based storage service iCloud. As such, users will be naturally inclined to upgrade their smartphone to the next generation iPhone rather than leave the ecosystem, and set up new accounts elsewhere. This ‘stickiness’ has underpinned analysts and investors’ positive stance on the shares. Indeed, of the 57 analysts that cover Apple, 52 have a buy recommendation. And if all else fails, Apple has its $97bn cash pile to turn to.

“This cash pile gives Apple a get out of jail free card,” says Mr Rogoff – if Apple finds that there has been a material change in the sector, it will have the firepower to make a big acquisition to rescue the company.

Meanwhile, despite operating in what has been deemed a shrinking and increasingly obsolete market (personal computers), Microsoft has yet to fail its investors. While its recent second quarter results may have shown a slight contraction in profits from last year, earnings of $6.62bn on the back of revenues of $20.9bn were still ahead of analyst estimates. And, with $59.3bn of cash in the bank, Microsoft has been distributing dividends for the last eight years. Investors have certainly taken note of the company’s resilience; shares in Microsoft have been steadily gaining traction since January, and are currently trading at a 12-month high of $30.6. That said, the shares still trade on a lowly multiple of 11 times. However, contrary to popular belief, Microsoft does offer some defensiveness from the ongoing malaise of the PC market through a promising slate of new product releases. The most significant of these is the new Windows operating system (OS), Windows 8, which will run on an ARM chip. This means that its operating system can be run more efficiently on mobile devices and should allow Windows to run smoothly on smartphones and tablets.

“The shares have priced in the effects of the technology (PCs) becoming obsolete,” says Mr Rogoff. “However, this ARM-based system certainly alleviates the timeline on that risk.”

Note that, once the products are released, there may well be a re-rating based on the take-up of these products and their effects on earnings.

Shares in online search engine Google are the most expensive of the three companies highlighted, trading at 14 times earnings. “The valuation is pricing in the potential of the Facebook effect,” says Mr Rogoff. “Investors are concerned that Facebook will be the recipient of the sizeable advertising revenues that Google has been dominating.”

Whilst investors should rightly see Facebook as a threat, the social network company has yet to monetise its user base. And until it has, such a fear should not be priced into the shares. Moreover, the valuation is not pricing in the fact that Google dominates the search engine world with research firm Comscore estimating that Google accounts for 66.2 per cent of all internet searches conducted worldwide. There are also new innovations such as social networking tool Google + and online storage service Google docs, which are both still relatively young and growing fast. Indeed, the company also owns Android – the widest reaching and fastest growing mobile operating system in the world. However, this is also having “dampening effect” on the company’s earnings profile. Mr Rogoff points to recent results which demonstrate that Google’s revenues per click may start to deteriorate as mobile revenues increase and overtake revenues from desktops. This is because users are more likely to respond to advertising on desktops, and make purchases as opposed to when they are browsing on their mobile phones. “While this may end up cannibalising desktop revenues per click – we don’t see it happening that way,” he adds.

Google also has some firepower on the balance sheet, with $44.6bn in cash – even if $12.5bn is spent on acquiring Motorola’s mobile phone business.

Ultimately, investors should look to the company that offers the most potential for innovation – technology companies thrive on innovation, and take-up or penetration of the resulting products and services thereafter.

“Investors should look for the company that can innovate into a brand new area,” suggests Mr Basta.

Indeed, Apple’s domination of the mobile device market has been well documented, while Google’s move into the mobile phone market, through Android, has proved to be increasingly successful too. Microsoft’s only real venture into a new area is its gaming console Microsoft Xbox, which although successful, remains a tiny portion of Microsoft’s business.

IC VIEW:

Our top pick is Google based on its adaptability and innovation, which is underpinned by its continued dominance in the search engine market. Analysts certainly agree – 80 per cent of analysts covering the shares have a buy rating on them. And so does Mr Rogoff: “At 12 times earnings – it’s a very good bet.”

We also favour Apple, despite its more risky hit-driven business, and would probably avoid Microsoft, which has the weakest long term outlook of the three.

Read more news and analysis on shares.

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