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.

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.