The technology sector has persisted as a top-performing sector in the Standard & Poor’s 500 index in the last 10 years due to its attractive valuations, superior earnings growth profile, high-margin recurring software revenue, and fast-growing dividends.
While the sector has outperformed the S&P 500 by 3.5 percent per year for the last 10 years, not all tech stocks have ridden this wave despite having robust business franchises, strong balance sheets, and generous dividend and stock buyback histories.
Technology can be a very fast-moving space where competitive moats can rise and disappear quickly.
Cisco Systems (Nasdaq: CSCO) and eBay ( EBAY) are two great examples of businesses that have lagged in recent years, but may be positioned to regain leadership. They both have methodically transformed their business models during these years and have emerged healthier and with a more robust growth profile. As the economy matures and leadership changes, investors may find these stocks offer a better risk-reward profile than their comparable peers.
[See: 7 of the Best Stocks to Buy for 2018.]
Cisco. CSCO provides a broad line of products for transporting data, voice, and video. It is trading at 10 times enterprise value to its free cash flow and is paying a 3.4 percent dividend. The dividend has grown 15 percent per year in the last three years. The stock has trailed large-cap tech stocks by 2.35 percent per year for the last five years.
Historically, Cisco has struggled to integrate acquisitions under previous management and ultimately ended up writing them off or selling them at a loss. However, new management has taken a more thoughtful approach to acquisitions and integrating them.
The recent acquisition of BroadSoft will bring in additional software technology, which will lay the groundwork for driving more recurring, high-margin software revenues. The networking space has significantly increased in complexity with ever growing security threats, the need to accommodate large data analytics streams, and a shrinking pool of talent to manage all of this complexity. CSCO has laid the groundwork for next-generation ethernet switches and routers that are secure, automated and can dynamically allocate resources to accommodate surges in traffic using increasingly predictive artificial intelligence techniques rooted in regression algorithms.
In addition to a more robust product platform, the growth of traffic is likely to accelerate with gigabit 5G traffic, which will enable real-time data analytics to be implemented into various products, including self-driving vehicles, jet engines, smart trucks, smart homes, smart watches, etc. Dynamically allocating bandwidth will be critical in assessing the probability of a car crash in real-time, a failure of a critical engine component, or even a heart attack.
Also, carriers around the world will need to upgrade their network to accommodate this flood of traffic, as will the data centers operated by Apple ( APPL), Microsoft Corp. ( MSFT), Amazon.com ( AMZN), International Business Machines Corp. ( IBM), Oracle Corp. ( ORCL), Salesforce.com ( CRM), etc. Early signs show CSCO is well-positioned to competitively capture this market.
Wall Street is currently modeling low single-digit earnings-per-share growth for the company, which is perhaps conservative. The company has repurchased 17 percent of its shares outstanding in the last 10 years, and this policy, given the valuation, remains an accretive use of cash given a free cash flow yield of 10 percent. The change of tax policy in the U.S. as it relates to overseas earnings may even accelerate share repurchases.
[See: 7 of the Best Tech Stocks to Buy for 2018.]
eBay. eBay’s stock has returned 13 percent per year for the last five years, lagging the broad tech index by 7.5 percent per year. Compared to Amazon, eBay has lagged by 23 percent per year. In the last 12 months, eBay has delivered $2 billion of free cash flow versus $7 billion for Amazon, yet eBay’s valuation is more than 10 times smaller than Amazon’s.
This valuation differential may be beginning to close with the latest technology upgrades to eBay’s platform. Amazon has attracted users partially because of a structured approach to data, which facilitates a more compelling user experience and works well with Google’s search engine, both paid and unpaid. eBay grew up as a classified technology platform and never really adopted a structured data engine to the same degree as Amazon, which made it harder for users and search-engines alike to interpret their listings.
eBay’s latest technology upgrade is starting to close the gap with Amazon and this architectural shift has translated into higher conversion rates and higher productivity for eBay. Artificial intelligence has also played a key role in the higher conversion rate as the engine can personalize the user experience on a mobile or desktop platform to rebuild its brand.
The company is reinvesting these benefits back into brand advertising to reengage with consumers and retailers alike. Retailers are likely to be receptive to eBay as Amazon is increasingly viewed as a key competitor, whereas eBay offers a scale platform to help retailers move slow moving merchandise without diluting margins on their own website.
The company is trading at 16 times its next 12-months earnings, which is in line with the market, but the street is now expecting the company to deliver accelerating growth of 11 percent per year for 2018. The company remains disciplined regarding buybacks having reduced its shares outstanding by 20 percent in the last 10 years. Provided the company can deliver fixed cost leverage going forward, share repurchases remain accretive given a 13 percent return on invested capital. (By comparison, Amazon’s return on invested capital is 6 percent.) At some point, a dividend policy may need to be implemented.
[See: 7 Stocks Primed for an Amazon Buyout.]
Also, an acquisition of eBay by Softbank, Tencent Holdings, or Alibaba Group Holding ( BABA) could make sense given their scale in Japan and China, and their desire to be global e-commerce players. In August of 2017, eBay contributed $500 million and its eBay India assets to acquire a stake in Flipcart, an India-based online retailer. This market is another reason an acquisition of eBay makes sense. Stubhub, a subsidiary of eBay, has slowed considerably in the last 12 months given the focus on the NFL and shootings at public places. However, this slowdown is starting to bottom, according to eBay.
Disclosure: Leslie Thompson and clients of Spectrum Management Group own Cisco.
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Cisco Systems, Inc. (CSCO) and eBay Inc Are Left Behind By the Tech Boom originally appeared on usnews.com
