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The Transformation of Technology Stocks

April 21, 2010

Technology Stock Performance

Information technology has been among the best performing sectors during the past two volatile years in the US equity markets.  The technology stocks performed surprisingly well during the bear market and outperformed the overall market during the recovery over the past year.  As a result, both small and large capitalization technology stocks outperformed their respective benchmarks since January 1, 2008 (See Table I).   Technology stocks are generally perceived as “high risk” because of their historical volatility and infamous implosion around the technology bubble of the late 1990s.   Since that time period information technology companies have matured, their demand is more established and the companies’ outlooks are more predictable.     

 

Table I

 

        Large Cap Stocks                 Jan. 08 – Mar. 10                                Small Cap Stocks                   Jan. 08 – Mar. 10

        Large Cap Tech Stocks                  -4.24%                                        Small Cap Tech Stocks                   -5.43%

        Russell 1000                                     -8.30%                                         Russell 2000                                     -15.31%

    

No Longer a Beta Trade

One of the most visible measures of change in the technology sector is the dramatic decline in its beta.  During the technology bubble in the late 1990s and early 2000s, technology stocks were notorious for their volatility, which was evident by the group attaining the highest beta of any sector.  However, during the past decade, the beta for large cap technology stocks has declined from 1.83 to a below equity market beta of 0.93.  Of the 10 sectors, only three experienced a falling beta over the past decade with technology stocks declining the most.  The technology sector dropped from the highest beta to the fourth lowest.  

 

Technology Is a Better Business

The dramatic decline in beta (e.g. risk) for technology stocks can be directly connected to significantly improved fundamentals and lower valuations across the sector.

  • Fundamentals.  Technology companies are more mature today with much larger revenue bases.  The average technology company in the Russell 1000 had revenues of $2.3B during the past year compared with $1.5B a decade ago.  Moreover, technology company businesses are more predictable and sustainable as the companies serve established markets, many of which were merely concepts during the technology bubble.  Information technology has become a routine capital expenditure for organizations and upgrade cycles are regularly budgeted in advance.

  • Business Models.  During the past decade, technology companies have redefined their business models with new pricing structures; subscription pricing is an example that emphasizes consistency and reduces the historical “hockey stick” order pattern.  This pattern resulted in companies booking a majority of their revenues at the end quarter and increased the risk of missing quarterly expectations. 

  • Quality.  Technology businesses have better underlying financial metrics now than during the bubble.

    • Operating margins have jumped from 11.4% to 13.2%.

    • ROIC improved by almost 100bps to 17.4%.

    • A higher percentage of technology stocks are profitable today than were a decade ago.

  • Cash.  The balance sheets of most technology companies are flush with cash and the great majority of the companies are generating free cash flow.  On average, cash on the industry’s balance sheets is equal to 16% of the market capitalization of technology stocks.  Apple (AAPL), Google (GOOG), and Cisco Systems (CSCO) each have more than $25 billion of cash on their respective balance sheets.  Not only does this cash provide significantly more financial flexibility to weather a downturn such as the recent recession but also the ability to return capital to shareholders during better environments through share buybacks and dividends.  For example, industry leaders such as Microsoft (MSFT) and Intel (INTC) have dividend yields at or above the S&P 500.  

  • Valuation.  Technology stocks had high valuations during the technology bubble compared to other sectors on multiple metrics.  Over the past decade, the absolute and relative valuation of technology stocks has declined (see Table II).  Technology stocks no longer trade at premium valuations.

Table II

 

                                                                Valuation Metrics                2000                2010

                                                                Price/Earnings                      62.5x                23.1x

                                                                Price/Cash Flow                   32.3x                  9.5x

                                                                Price Sales                                11.3x                  2.9x

 

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