Are Optical Component Stocks In Trouble?

While I continue to think there is a decent chance in a capital spending recovery in 2013 that should help telecom infrastructure suppliers like Ericsson and Cisco, I am not that positive on optical component companies like JDSU and Finisar.  The main reason for this is technology dislocation risks that are surfacing that might reduce the role traditional optical component companies play in networks.

This past week, Intel announced collaboration with Facebook on its developments efforts in silicon photonics, a new technology that uses less expensive silicon rather than the traditional more specialized materials used in optical materials. Intel and Facebook see silicon photonics as a way of dramatically reducing the cost and simplifying the design of rack architecture within the data center.  A quote from the press release on the silicon photonics technologies is shown below:

“… the new architecture is based on more than a decade’s worth of research to invent a family of silicon-based photonic devices, including lasers, modulators and detectors using low-cost silicon to fully integrate photonic devices of unprecedented speed and energy efficiency. Silicon photonics is a new approach to using light (photons) to move huge amounts of data at very high speeds with extremely low power over a thin optical fiber rather than using electrical signals over a copper cable. Intel has spent the past two years proving its silicon photonics technology was production-worthy, and has now produced engineering samples.”

In addition to these efforts by Intel on silicon photonics, Cisco acquired a private company called Lightwire in March of 2012.  Lightwire was developing advanced optical interconnect technology for high speed networking and Cisco viewed the enabling technology as a way of owning more of the optical subsystem technology within their products while also using a newer, lower cost design implementation than traditional transceiver technology purchased from optical component companies.

I believe efforts by Intel (and others) in the emerging field of silicon photonics and Cisco’s efforts in owning more of the optical value chain in their products does not bode well for traditional optical component companies.  While any telecom capital spending recovery would lift all boats (including optical components companies), the technology dislocation risk posed by silicon photonics and efforts by OEMs like Cisco post longer-term risks for optical component stocks.  It will be interesting to see if traditional optical component companies seek to invest in silicon photonics to protect their traditional businesses.

Disclosure:  I currently own shares of Ericsson and Cisco mentioned in this blog post. NT Advisors LLC may currently and in the future solicit any company mentioned in this blog post for potential consulting/advisory work.

Return of the Telecom Jedi?

I continue to be positive on large telecom equipment suppliers Ericsson and Alcatel-Lucent.  The main premise behind my positive view is the telecom infrastructure industry is a cyclical industry, and we are likely to see a recovery of capital spending by telecom operators in 2013. This recovery in telecom spending, combined with relatively low valuations for equipment companies like Ericsson and Alcatel-Lucent, should allow these stocks to have good relative performance in 1H 2013.

In addition to this primary thesis on these stocks, I also point to two other recent data points.  First, the strong recent operating results and profits by the telecom equipment infrastructure business at Nokia Siemens Networks (NSN).  As mentioned on a prior blog post, NSN has reported better than expected profit margins in the past three quarters and seems to be executing well on its restructuring plan.  Secondly, I believe the momentum of Chinese based equipment suppliers Huawei and ZTE is diminishing (at least for now), which should bode well for Alcatel-Lucent, Ericsson and others.  This is an important point as Huawei and ZTE have been massive market share gainers and price setters in the telecom infrastructure market over the past decade, which negatively impacted the entire sector.

Both Huawei and ZTE provided financial updates on their 2012 results in the past couple of weeks, which showed slowing momentum in terms of further market share gains and achieving their respective 2012 revenue targets.  According to the Financial Times, Huawei announced in January revenues of about $35 billion for 2012, but that was below the Huawei target of $38.7 billion it was discussing as late as September of 2012.   Over the past couple of years, Huawei has been seeking to achieve its long-term growth targets by entering the new markets of Enterprise Networking and Mobile Devices.  While the company seems to be doing well in Mobile Devices at the low end of the market, Huawei does not seem to be hitting its targets in the Enterprise Networking market.  These new efforts are also spreading the company thin in my view and puts Huawei on a multi-front competitive battle with Cisco and HP in enterprise networking, Samsung in mobile devices in addition to traditional competitors like Alcatel-Lucent, Ericsson and NSN in telecom infrastructure.

As for ZTE, the company pre-announced lower than expected results for 4Q12 last week.  Not only were the results lower than expected, but also some equity research analysts now believe ZTE’s market share gains in the international telecom equipment market have stalled.  Below is an exert from a research report on this topic from UBS Investment Research:

“After large-scale staff layoffs and the closure of a few representative offices in

overseas markets, we believe ZTE’s growth in the overseas equipment segment

will slow significantly. Our channel checks suggest the pipeline for new

contracts is limited. In the longer term, we believe ZTE’s withdrawal from some

developed markets means the prospect of ZTE gaining a top-three role as a

global equipment vendor by overtaking Nokia Siemens Networks (NSN) and

Alcatel-Lucent has become quite slim.”

Source: UBS Investment Research Report Dated 1/28/13

 

Disclosure:  I currently own shares of Alcatel-Lucent, Ericsson, HP and Cisco all of which are mentioned in this report.  I also may solicit any company mentioned in this report as a potential consulting client for NT Advisors LLC.

 

 

 

 

I Continue To Be Positive On Technology for 2013

Following up on my blog post in the beginning of the year, I continue to expect the technology sector to outperform the overall market (S&P 500) in 2013.  This opinion is based on three years of underperformance of the technology sector given a depressed level of telecom and enterprise capital spending which has compressed valuations for technology stocks vs. other sectors like consumer discretionary which as been a strong relative performer over that three year period.  I continue to believe we will have some recovery on capital spending in both telecom and enterprise networks in 2013, which together with lower relative valuations, should allow the technology sector to outperform in 2013.

So far in 2013, the technology sector is up around 4.5% vs. the 2.5% return of the S&P 500.  While it is still very early in the year, this initial outperformance and strong stock performance from IBM and Google (two large components in the technology sector index) today after their reporting their earnings (both are up about 5%-6% so far this morning) are very good signs.   The depressed level of technology stocks has also been supported by recent discussions in the press of Dell being a potential LBO candidate, and HP potentially being broken up to create shareholder value if the company does not show signs of a turnaround in 2013.

The biggest potential risk to technology outperforming in 2013 in my view is the performance of Apple as it makes up to 20% of technology index given its large market cap.  I am not particularly positive on Apple as it is losing momentum (see my prior blog post on Apple for more details) and does not play into the theme of recovering capital spending for technology stocks.  However, the stock has declined close to 30% off its high and is discounting many of the negative fundamentals I discussed in my earlier blog on the stock.

Disclosure:  I am currently not long or short any stock mentioned in this blog post (i.e. Apple, IBM, Google, Dell or HP).  I also do not plan on taking a position on any of these stocks in the next couple of days.  I am long the technology ETF ticker VGT.

Addendum – With the selloff in tech shares today 1/24/13, I am considering purchasing shares in technology stocks mentioned in this post.

Will Alcatel-Lucent Follow the Nokia NSN Playbook?

Today, Nokia pre-released 4Q12 results that were better than the copmany’s prior guidance and analyst expectations.   The stock is up about 20% so far this morning given the combination of Nokia beating expectation, having a low valuation and the stock being under-owned by investors and under-loved by analysts with a low valuation.  While Nokia is mostly known for its device/handset business, a big part of the earnings composition and surprise today is the performance of the Nokia Siemens Networks (NSN) division (a joint venture between Nokia and Siemens).  In particular, NSN represented about half of Nokia consolidated sales (although keep in mind, Nokia owns about 50% of NSN, so prorated impact to Nokia’s profits are about 50% of reported NSN operating profits) and the vast majority of operating profit in 4Q12 (even when adjusting for the 50% ownership of the JV).

This is the third quarter in a row that NSN has performed better than analyst expectations.  What I find relevant in the recent NSN results is whether there is a read through to Alcatel-Lucent, another legacy telecommunications equipment supplier that has been suffering.  As I wrote in a prior blog on December 17th, I am positive on the Alcatel-Lucent stock (ticker ALU) given what I believe to be an improving capital spending environment in 2013, a low valuation, an under-owned/loved stock and the recent debt financing the company was able to raise which dramatically reduced the risk of bankruptcy in the next two years.  I find the NSN results and business execution relevant to ALU and continue to be positive on the shares.

What I find most compelling in the NSN results in the past couple of quarters and in particular the 4Q12 preliminary results, is the improving profit margins of the company.  NSN has targeted an operating margin of 5%-10% and delivered a 4Q12 operating margin in the 13%-15% range. While fourth quarter operating margins in any year are typically much higher than the full year average given the favorable seasonality of the telecom equipment in the fourth quarter, NSN continues to outperform on its operating margin guidance.  I think a good part of this outperformance is the company’s restructuring program including its services business.   In particular, NSN is in the middle of reducing 17,000 employees, has announced plans to sell its Optical unit to Marlin Equity Partners, has sold its Access business to Adtran and is aiming to be a more focused company specifically in the mobile broadband infrastructure market.  NSN’s profitability seems to be benefiting from this new focused strategy.

Alcatel-Lucent in my view is probably 6 to 12 months behind NSN in terms of its restructuring and focused strategy but shares several of the problems NSN had a year ago, namely, a bloated cost structure primarily in Europe, unprofitable services contracts and being in too many businesses with lack of scale.  I hope the ALU management team is watching at how the NSN restructuring actions has led to improved profitability and share price appreciation.  I continue to think that ALU should focus on fewer businesses and be more aggressive in cutting its high cost structure in Europe. NSN shows, that while such a course of action is painful, it can be done and generate great results for shareholders.  In particular, I have written in the past that ALU should consider selling its mobile infrastructure and enterprise networking businesses and become more focused on high market share business like Routers and Optical, after which the company could focus on margin improvement.  Whatever the course of action the company choses to take, I still believe that the stock could be a strong performer if we see real action in restructuring in Europe, more focus in less business area and an improving telecom capital spending environment.

Disclosure:  I do currently own shares of ALU, but do not own or plan to own shares of NOK in the next few days. 

Technology Sector Likely to Outperform S&P 500 in 2013

While the Information Technology sector had a reasonably good year in 2012 with a 14.0% return, the sector still underperformed the S&P 500, which returned 16.0%. In fact, the technology sector has underperformed the S&P 500 for three consecutive years.  While 2013 could prove to be another volatile year for the stock market given ongoing uncertainty on the global economy and the ultimate outcome regarding the U.S. fiscal cliff, I believe the three-year trend of underperformance of the technology sector will reverse, and the technology sector will likely outperform the S&P 500 in 2013.

In looking at the following table, one can see how in the past three years the consumer discretionary sector has been a consistent outperformer as compared to the S&P 500 while the technology sector has been an underperformer.  In fact, the consumer discretionary sector has been the best cumulative performer in the past three years among the ten market industry sectors.  One question is why has consumer discretionary outperformed the overall market while technology has underperformed for three straight years after the 2009 recession when normally both consumer discretionary and corporate capital spending recover nicely post a recession?

2012 2011 2010
Consumer Discretionary 24.6% 3.7% 30.6%
Information Technology 14.0% 0.5% 12.7%
S&P 500 16.0% 2.1% 15.1%

One could argue the outperformance of the consumer discretionary sector made some intuitive sense as the U.S. consumer started to gradually become more confident in 2010 post the 2008/2009 Great Recession and began to gradually spend more on discretionary items while at the same time taking advantage of record low interest rates to repair their personal balance sheets post the deb crisis.  On the other hand, corporate and telecom services capital spending growth have been lackluster in the past three years.   The ongoing economic slowdown and uncertainty in Europe combined with anxiety over U.S. economic/tax policy has led to cautious capital spending.  Thus, consumer discretionary spending has rebounded more strongly in the past three years and corporate/telecom capital spending.

While it is anyone’s guess how spending trends will fare in 2013, my view is corporate/telecom capital spending has underperformed for too many years relative to consumer discretionary spending and will show more robust growth in 2013.  We already have some encouraging signs in this regard by strong 2013 capital spending plans by major global telecom operators like AT&T, Deutsche Telekom and Sprint as examples.  I think this relative recovery in corporate/telecom spending will allow the technology sector to outperform in 2013.

The strong outperformance of consumer discretionary stocks relative to technology stocks in the past three years has also been evident when one looks at valuation metrics between the two sectors.   While valuation metrics like price/book and price/sales for the consumer discretionary sector have expanded nicely in the past three years, the same valuation metrics have actually contracted for the technology sector.  Thus, one could argue that the outperformance of the consumer discretionary sector was not only driven by better relative spending by consumers over corporates/telecoms, but also expansion of valuation metrics.  I think 2013 will be a catch up year for technology stocks in terms of valuation metrics, which should also help the technology sector outperform the S&P 500.

The table below shows the top eight stock holdings of the Vanguard Consumer Discretionary ETF (ticker VCR) and Information Technology ETF (ticker VGT).  The two tables below the list of stocks show how the valuation metrics for these 16 stocks have changed since the beginning of 2010 through the end of 2012 (i.e. over the three year period of underperformance of the information technology sector).

Consumer Discretionary (Ticker: VCR)

Information Technology (Ticker: VGT)

Comcast (CMCSA) Apple (AAPL)
Home Depot (HD) International Business Machines (IBM)
Amazon.com (AMZN) Microsoft (MSFT)
McDonalds (MCD) Google (GOOG)
Walt Disney (DIS) Oracle (ORCL)
News Corp. (NWSA) Qualcomm (QCOM)
Time Warner (TWX) Cisco Systems (CSCO)
Lowes Cos. (LOW) Intel (INTC)

 

Consumer Discretionary Valuation Metrics 12/31/09 vs. 12/31/12

Price/Book

12/31/2009

Price/Book

12/31/2012

Price/Sales

12/31/2009

Price/Sales

12/31/2012

Comcast 1.12 2.02 1.34 1.62
Home Depot 2.32 5.26 0.68 1.29
Amazon.com 11.08 15.02 2.38 1.98
McDonalds 4.80 6.41 2.96 3.24
Walt Disney 1.59 2.12 1.66 2.11
News Corp. 1.44 2.26 1.16 1.78
Time Warner 1.01 1.51 1.34 1.58
Lowes Cos. 1.49 2.85  0.64 0.79
AVG Increase

63%

28%

Information Technology Valuation Metrics 12/31/09 vs. 12/31/12

Price/Book

12/31/2009

Price/Book

12/31/2012

Price/Sales

12/31/2009

Price/Sales

12/31/2012

Apple 5.33 4.22 4.09 3.19
IBM 7.56 10.10 1.80 2.09
Microsoft 6.11 3.25 4.61 3.10
Google 5.46 3.4 8.32 4.87
Oracle 4.10 3.70 4.90 4.31
Qualcomm 3.62 3.14 7.33 5.51
Cisco 3.2 1.98 3.70 2.23
Intel 2.70 2.10 3.21 1.92
AVG Increase

-19%

-22%

In summary, technology has lagged the S&P 500 for the past three years while consumer discretionary has dramatically outperformed. In doing so, consumer discretionary valuation metrics have expanded dramatically, while technology valuations have contracted.  With the potential for a corporate/telecom capex recovery in 2013 and relatively low valuations, the technology sector is poised in my view to finally outperform the S&P 500 in 2013.