Cover story of Shares Magazine on 25 March 2010. Original article here.
Dot-com promises come of age
It is now ten years since the internet bubble spectacularly burst, but so much of what was expected to happen then is finally coming good now – and tech firms’ share prices are miles below what they were a decade ago. Jessica Furseth highlights the key trends.
This month marks the tenth anniversary of the peak in the dot-com bubble, when the promises of the new and shiny internet future caused valuations of technology stocks to reach heights so dizzy the subsequent bust swallowed up what has been estimated at between one and five trillion dollars’ worth of shareholder value. Investors could be forgiven for being once bitten, twice shy when it comes to technology stocks and their promises of innovation and rapid earnings growth, but now, a decade later, it is worth keeping in mind two things. First, valuations are so much lower; second, the internet now looks capable of delivering on its promises, helped by growing adaptation of third-generation (3G) mobile telecoms and the advent of fourth-generation (4G) technology for good measure.
Technology stocks on both side of the pond peaked in March 2000 and, as a group, have never got back to the heights seen then. America’s tech-laden NASDAQ Composite index hit a summit of 5,048 before bottoming two and a half years later at 1,114. At the time of writing it has clawed its way back to 2,393. The UK’s FTSE techMARK index has fared even worse: peaking at 5,743 before hitting the bottom 90% lower three years later at 558. It has still only made it back to 1,870, barely a third of where it was ten years ago.
A good illustration of this is American software giant Microsoft. Despite a renaissance over the past 12 months, inspired by the launch of the Windows 7 operating system and the new Bing search engine, the Seattle firm stands at $29.68 compared to its bubble peak of $53.59. Even more startling is the re-rating suffered by Microsoft’s stock, which now trades on an attractive prospective price/earnings (P/E) ratio of 16 times for 2010 against the multiple of 70 times seen during the bubble. In the UK, the Technology Hardware & Equipment sector trades on an average P/E of 22.3 times for 2010, according to broker Evolution, on the back of 42% growth in earnings per share (EPS) this year.
Back to the future
Just as importantly, the technology sector looks capable of meeting market expectations and delivering on the promises that got everyone so excited about the internet dream ten years ago. The technology is in place for high-speed, affordable internet at home, and we are all getting increasingly comfortable using it to do pretty much anything – watching video, sharing photos, filing tax returns, setting up direct debits, and going to those all so-easy-to-use online shops that sell everything from shampoo to insurance. In a trend which has been dubbed ‘the third wave of the digital age’, we are increasingly able to do these things on our internet-connected mobile phones as well.
‘The technology sector has been, and always will be, volatile,’ says Mike Bourne, manager of the newly-launched Stellar Technology EIS fund, and with over 20 years’ sector experience. Referring to recent tough fundraising conditions, Bourne says: ‘The sector has had its back to the wall for a number of years now, so the entrepreneurs have had to become more business-like.’ As for his portfolio, Bourne is especially interested in companies which are ‘exploiting the web and providing services there, be it through the cloud, through security issues or in connection with wireless. But the lesson from the boom is to look a bit more closely at the substance of the technology. Make sure it is a good business proposition with a good management team, and with the right valuation’.
The government’s ‘Digital Britain’ report, published in June 2009, set out a goal that all Britons should have basic broadband access by 2012. Furthermore, £1 billion has been promised to help BT and Virgin Media build fast broadband for 90% of the population by 2017. This means laying miles of new cable, while our hunger for all things online also means there is increasing strain on existing networks. A quarter of TVs sold in February had internet capability, as devices are increasingly connected and multi-purposed.
Nowhere is this more true than for the mobile phone. The smartphone-driven mobile internet explosion is turning into a major headache for network owners such as Vodafone, which expects to see 103 petabytes worth of traffic in its European businesses in 2010, as usage continues to double every year. Forecasts from Cisco show similar growth expectations, meaning some serious network upgrades are on the cards. Telefonica-owned mobile operator O2 is spending £100 million on its networks this year, but as strong competition prevents operators from passing on much of these costs to consumers, the winners here may well turn out to be the hardware providers.
Delayed investment in the recession meant Israeli firm BATM, a supplier of internet-carrying ethernet solutions, reported losses in two of three divisions, and flat performance in the third, at February’s full-year results. While sluggishness may remain an issue for a bit longer, the subsequent 28% drop in the share price means the group is starting to look cheap again, with a P/E of 6.7 for 2010 and a 2.6% yield. Analyst price targets suggest there is around 30% upside in the stock to near the 50p mark. BATM’s route to market is via equipment partners such as Finnish-German combine Nokia Siemens and Alcatel-Lucent, but the group also sells directly to operators such as America’s Verizon.
While the management of BATM may have been muted in its outlook, the recent upgrades from Cisco and Juniper Networks lend weight to expectations that things are picking up in the industry. Giant US telco AT&T went against a perceived trend when it gave contracts to build its 4G mobile network to France’s Alcatel and Sweden’s Ericsson, rather than Chinese suppliers as had been expected. Alcatel, and potentially by extension BATM, should also benefit from the release of the US broadband stimulus package, expected to happen this year.
Bill Burns, chief executive officer (CEO) of Spirent Communications, reported strong markets for wireless when the testing company unveiled solid final results earlier this month (4 March). ‘We have seen a recovery in the market for broadband testing solutions, especially in North America and Europe,’ Burns tells Shares. Spirent tests devices and networks ahead of launch to ensure they are performing as they should.‘Verizon and AT&T are starting the rollout of 4G now, and once some of the operators start others will follow in order not to lose market share. We are seeing a host of other companies showing interest … but the process takes time.’ Burns expects Spirent to see medium term revenue growth of 7% to 10% per annum. Third-quarter numbers (3 March) from testing peer Anite also pointed to emerging traction in 4G, but the group warned full-year revenues, expected at £76 million, will depend on contract timing.
The chip core
Following from the PC boom in the mid-1980s, the shift towards smart phones may well be the ‘third wave’ of the digital age. A rise in smartphone penetration, from the 15% to 20% mark, should mean the UK’s semiconductor experts are well placed to clean up. With silicon chips based upon its microprocessor architectures to be found in 98% of the world’s mobile handsets, semiconductor IP (intellectual property) group ARM leads the pack. It licences out its IP for an upfront fee, and then pockets a royalty every time a device is shipped featuring its designs. The Cambridge firm is supremely well positioned, as rising handset volumes and rising silicon content per unit should drive strong growth, but after a great run to 227p the shares stand at levels not seen since 2002. A prospective P/E of 33 times for 2010 is the highest rating the firm has seen since the bubble, and the fact ten directors, including CEO Warren East and finance director Tim Score, exercised options and sold stock earlier this month, suggest it might be time to wait for a pull back.
The same may hold true for Imagination Technologies, which provides graphics technology to two of the world’s leading chip firms, digital signal processor leader Texas Instruments and Intel, as well as iPhone king Apple. Royalty payments are benefiting from the popularity of the iPhone, of which Apple is supposedly hoping to sell 45 million this year, but a P/E of 53 times for 2010 means there may be better entry points ahead.
Cambridge’s CSR has been winning new sockets for its Bluetooth, WiFi and GPS (global positioning system) chip designs, including securing a new contract with global mobile phone leader Nokia. Even after the recovery overseen by CEO Joep van Beurden in the past 12 months, CSR’s valuation is not excessive, on a P/E of 16.6 for 2010, and this could prove good value for a company with a sound strategy and contract win momentum. Another to note is IQE, whose crystal chip wafers are extensively used in the iPhone and likely also in the newly launched iPad, among a range of other devices which include laser electronics and next-generation LED lighting.
Up in the clouds
As the internet grows, so does the industry which houses the servers that physically store all this data. Telecity continues to expand as its premium data centre space sells like hotcakes. When asked about the future of cloud computing, the concept of storing ever more data remotely, the firm’s CEO Mike Tobin says: ‘The cloud is evolving in a couple of ways. First of all the general concept of outsourcing is growing and that’s not just a cloud thing. Take the BBC, if it wanted to build its own data centre for the iPlayer it would need to spend millions. With the cloud, we have seen a certain acceptance level of the Google and Amazon-type offerings [of remote storage], but it just isn’t resilient. Customers are telling us they like the concept of the cloud, … but they are more interested in making their own, private cloud. What they are actually doing there is virtualising their resource without having to throw away all their current infrastructure, almost like an intranet.’
While Tobin does not think people are ready to fully trust the cloud concept yet, ‘unless you are doing it yourself and you know its done in a dedicated, resilient fashion,’ he believes they will in the future, similar to how we all got over our fear of paying for goods online once we got used to the idea, and started to trust it was safe.
Rather than ushering in a host of new dot-com businesses, the new emerging high-speed internet is likely to boost those software companies whose business is to help others work or play online. Areas such as payment, security, analytics and targeted advertising all look set to boom.
‘I think the web will become one of the main drivers for any business. … Any company that’s plugged into the internet needs a content management system and analytics, and that’s where our focus is,’ says Mark Lancaster, CEO of global content management group SDL. The £356 million cap has been broadening its offerings, most recently by acquiring e-commerce software group Fredhopper, and continues to progress on margins and cash generation.
Alterian has travelled sideways since January’s profit warning, but the company’s social media monitoring tool is ahead of the competition. The group is making progress with its WebJourney software, which analyses behavioural data so marketers can maximise the effects of advertising. Blinkx uses Autonomy software, which understands the meaning of unstructured data, to pair relevant advertising with its video-search technology. Blinkx CEO Suranga Chandratillake tells Shares how the group is finding new ways to deploy this, notably with the Express newspaper group where his firm powers a player which shows a video related to the article, followed by an ad. ‘Newspaper sites have huge and loyal audiences,’ says Chandratillake, explaining how the tie-up is a way for newspapers to monetise their online offerings. This summer MiniWeb, which has close ties with BSkyB, will trial a Blinkx-powered set-top box which will enable viewers to access online video through their TV sets.
Mobile content providers such as Win are pairing up with the likes of Vodafone to offer music, videos, games and apps (applications). ‘We manage their storefront, or web portal, for them,’ CEO Graham Rivers explains to Shares. ‘We can run these services on their behalf in a way that is more effective and cheaper for them.’ After being locked in bid talks for most of last year, Win is now back to focusing on sales and customer support. House broker Arden Capital has the company returning to mid-teens EPS growth this year and next.
‘There is very high demand for real-time convergent billing as network operators struggle to keep up with the explosion in data traffic from the proliferation in smartphones,’ says Altium analyst Jonathan Imlah, who identifies Intel Telecom Systems as ideally placed to take advantage of this trend. The recent stock weakness is a buying opportunity.