Hidden tech gems

Indicating renewed shareholder confidence, these stocks have collectively bounced back over the past few months. However, there are legitimate reasons to be concerned about the US’s five best-known technology giants. For starters, they command mountainous valuations. At the extreme end of the scale, Netflix’s shares trade at a forward price/earnings ratio (PE) of around 100. Such a multiple implies massive growth expectations and almost no room for error.

The FAANGs are also facing an intensifying backlash. Success has given way to genuine fears about the clique’s economic, political and social dominance – and their ability to be reined in by lawmakers.

This week’s other feature on US tech considers this phenomenon in greater detail, along with the massively hyped private tech stocks whose lofty valuations appear to lack sturdy financial foundations. 

Many more opportunities

Readers would be forgiven for thinking that this is where the cast of characters ends. But – away from all the action and drama – a plethora of understudies can be found beavering away backstage. In fact, there are more than 80 stocks listed on the IT segment of the Nasdaq Composite index with larger market caps than the smallest member of the FTSE 100.

Moreover, notwithstanding macroeconomic tensions, the broader technology industry is expected to keep swelling in size. The Computing Technology Industry Association (CompTIA) expects growth of 4 per cent to $5 trillion in 2019 – with $1.6 trillion of this relating to Uncle Sam alone.

It follows that tech comprises a veritable hunting ground for investors. And there is no better hunting ground for mature, quality, mid-sized stocks in this sphere than the US. In this feature, we have identified a selection of these companies across Nasdaq’s information technology and consumer discretionary sectors. To do so, we have built a screen for stocks valued between $5bn and $100bn and based on a series of tests fulfilling classic ‘growth at a reasonable price’ (GARP) criteria.

These include share price momentum; strong earnings forecasts; a net-debt-to-cash-profits ratio below 1.5 times, and a PE/growth (PEG) ratio in the bottom half of the wider sector.

A modest rating should, of course, be treated with a healthy dose of scepticism; as we shall see, some of these stocks face major challenges. In any case, our screening approach can’t claim to present exhaustive results. But it does throw up a range of provocative investment ideas; from payroll software, to industrial robotics – even to online dating.

Modified GARP: Nasdaq IT sector (passing at least 4 out of 7 tests)

Automatic Data Processing

In 1949, 21-year-old Henry Taub founded the payroll company that would become Automatic Data Processing (US:ADP) in a room above an ice-cream shop. At the time, his resources extended to a book-keeping machine, calculators and an addressograph to print cheques.

Today, ADP has evolved into a global provider of cloud-based human capital management (HCM) services – spanning areas such as payroll, human resources (HR), recruitment, attendance, tax and benefits. It boasts more than 700,000 clients and a market capitalisation of around $70bn.

Of course, HR software might sound rather boring – especially when juxtaposed with the innovative technologies under development at FAANG headquarters. But that shouldn’t belie ADP’s investment appeal. For starters, it benefits from long-term client relationships and recurring revenues. In its most recent annual report, the group estimated retention for employer services (ES) – its largest business – at around a decade.

And while sales and earnings per share (EPS) haven’t exactly skyrocketed – with compound annual growth rates (CAGRs) of 7 per cent and 8 per cent, respectively, over the three years to June 2018 – positive change is under way. Last summer, the group outlined its strategic vision and transformation initiatives – explaining that it was “reshaping the HCM industry” through new platforms and recent acquisitions. It also brought forward its financial outlook, guiding towards an adjusted operating margin of 21 to 22 per cent for FY2019 – one year ahead of schedule. For FY2021, it expects this to rise to 23-25 per cent.

ADP’s latest results – for the third quarter to March 2019 – missed market revenue expectations, showing growth of 4 per cent to $3.8bn. Citing currency movements, management reduced full-year revenue guidance to the lower end of its previous forecast range. But ES bookings beat analysts’ forecasts, rising by a tenth to $1.5bn, and ADP lifted its full-year growth EPS projection.

For Bill Ackman, founder of the Pershing Square Capital Management hedge fund, these numbers “continue to highlight the significant opportunity for accelerated revenue growth and improved prospective profitability”. Encouraging words – particularly given that Pershing announced an 8 per cent stake in ADP back in August 2017, citing a “need for transformational change”. A spat between the two parties ensued, as Pershing tried and failed to win board seats. It has since reduced its position.

ADP faces competition in the US from the likes of New-York-listed software giant Oracle (US:ORCL) and smaller, Nasdaq-quoted Workday (US:WDY). Still, Oracle’s shares have underperformed ADP’s in recent years, and although Workday has enjoyed a relatively superior share price trajectory, it remains loss-making.

IC View: ADP’s employment-focused technology leaves it vulnerable to changing macroeconomic conditions. But we like its earnings prospects and decent 2 per cent forecast dividend yield – underpinned by free-cash-flow-to-the-firm (FCFF) of $2.98bn for FY2019, per JP Morgan’s estimates.

Teradyne

Teradyne (US:TER) – founded in 1960 – is really a tale of two businesses. On the one hand, the group makes automatic test products for a range of electronics devices – from semiconductors, to wireless systems, to circuit boards. On the other, it sells industrial automation equipment – or, simply put, robots.

Testing is the larger and more mature of Teradyne’s two lines of trade, although growth here has proved less impressive than at its sister division. While semiconductor testing alone made up 70 per cent of the group’s $2.1bn total sales in 2018, this reflected a 10 per cent decline year on year. The issue lay in a more than 50 per cent drop in demand for mobile-device testing from its largest customer.

That said, figures for the three months to March offered positive signs of progress. Semiconductor sales contracted to $341m, but came in ahead of guidance. Notwithstanding softness in some areas, such as automotive, there were also “pockets of strength”, including 5G testing.

For Walter Price, manager of the Allianz Technology Trust, “the reason that we like Teradyne on the test side is that the breadth of customers is expanding significantly”. For one thing, automotive companies are moving towards electric cars, which have higher levels of semiconductors – requiring more test systems. And as additional industries buy testers, Mr Price reckons the growth rate of [Teradyne’s] semiconductor business “is going to reaccelerate”, with 10-13 per cent as the baseline for revenue growth over the next few years.

Industrial automation (IA) only saw $66m in first-quarter sales, although this was up 35 per cent on the prior year. The group attributes its continued investments in IA to the view that “global industry is undergoing a fundamental structural change in production methods” – triggered by factors including labour shortages.

Universal Robots – a business bought in 2015 – makes collaborative robotic arms or “cobots”, which work alongside humans, implementing manual tasks such as machine-tending and ‘pick and place’. Mr Price notes that their “competitive moat” is that they “are more precise, safer than other copycats, and it’s not easy to do that”. Their applications are broad – spanning industries such as automotive, electronics, and food and agriculture. Management expects IA to see 35-40 per cent growth for 2019 as a whole.

IC View: There are risks to consider. The test market is concentrated, and sales of Teradyne’s products and services rely on cyclical demand. In any case, Teradyne’s shares have outperformed each of the FAANGs over the past year, but trade at a reasonable 20 times forecast earnings. The group also paid out $891m to investors via share buybacks and dividends last year.

NetApp

In a world underpinned by technology, data is arguably the most valuable of all currencies. Used effectively, it can help companies become more efficient in the way they do and grow business. The trouble is that data is widely distributed, and constantly changing, and harnessing relevant information and insights is no mean feat.

Enter NetApp (US:NTAP). It provides various so-called hybrid cloud data services, which combine companies’ on-premises infrastructure with private cloud services and a public cloud, such as Amazon Web Services.

Among other advantages, the hybrid cloud offers flexibility. The public cloud can provide extra capacity for fluctuations in organisations’ workloads, while the private cloud can be used for sensitive, confidential data. NetApp’s ‘data fabric’ integrates data management across clouds and premises – allowing customers to manage and protect data, even as it expands rapidly. The group boasts partnerships with major tech players including Microsoft (US:MSFT) and IBM (US:IBM).

True, the latest numbers might not inspire much enthusiasm. Fourth-quarter sales and adjusted EPS declined year on year to $1.59bn and $1.22, respectively. That was below analyst expectations, but was partly attributed to some European customers taking longer to make purchasing decisions, and the company is now shifting its focus towards markets and customer segments that offer a greater return on investment.

Management was also disappointed by the performance of NetApp’s ‘all-flash array’ business, for which the annualised net revenue run rate rose by 11 per cent to $2.7bn. But this is where its investments should bring the earliest benefits. The ‘cloud data services’ business is where the magic is happening, so to speak. Annualised recurring revenues here soared by more than half to $51m. The business is expected to achieve annual revenues of $400m-$600m by FY2021.

Broker Stifel lowered its estimates post-results, but views NetApp as “well-positioned in a changing enterprise storage landscape”. Allianz’s technology fund reduced its position because, in the words of Mr Price, “we got more cautious about the world economy, and about on-premise investment”. However the fund manager reckons the stock should perform well next year “if the cloud does what we think”.

IC View: NetApp should stand to benefit from more companies moving to a hybrid cloud model. Notwithstanding the shares’ speculative characteristics, they might appeal to income-seeking investors. Decent cash generation underpinned a return of $2.51bn to investors during FY2019, via share repurchases and dividends.

Modified GARP: Nasdaq Consumer Discretionary (passing at least 4 out of 7 tests)*

Booking Holdings

Danish author Hans Christian Andersen once wrote that “to travel is to live”. Many of us appear to have followed his advice. According to the World Travel and Tourism Council (WTTC), travel and tourism accounted for $8.8 trillion or 10.4 per cent of global gross domestic product (GDP) in 2018. By 2029, the sector’s GDP is expected to reach a colossal $13.1 trillion.  

Such expansion should bode well for the companies that facilitate holidaymaking. Booking Holdings (US:BKNG) is a case in point. As a leading provider of online travel services, the group operates through a portfolio of well-known brands including the eponymous website Booking.com, which offers hotel and apartment reservation services, as well as restaurant platform OpenTable.

The group’s shares fell on the release of its fourth-quarter and full-year 2018 results – ostensibly reflecting concerns about macroeconomic pressures in Europe. But it delivered a solid set of numbers for the three months to March 2019, with nights booked in rooms rising a tenth to 217m – above the upper end of management’s guided range.

Chief executive Glenn Fogel believes “organic growth investment, share repurchases and opportunistic M&A” are key to shareholder returns. Investments in the core accommodation business through brand marketing, merchandising and customer acquisition programmes have so far pleased management.

Booking has also now completed the final portion of its latest $10bn buyback programme, and looks set to implement a further $15bn programme over the next two to three years. Of course, one should consider the frequency and level of buybacks when monitoring any company’s EPS growth rate, as reducing the number of shares in issue can amplify this figure.

IC View: In Booking’s own words, its marketplace is “intensely competitive, constantly evolving and subject to rapid change”. As many UK investors know well, the travel industry is vulnerable to decline in times of uncertainty, and the occasional hit from currency movements. But noting a currently healthy backdrop, Barclays calls the group “the gold standard of travel names”. Booking doesn’t pay a dividend, but free cash flow estimates of $4.4bn for 2019, rising to $5.3bn for 2021, should give firepower for further buybacks and judicious acquisitions.

eBay

To say the past six months have been busy for eBay (US:EBAY) would be an understatement. In January 2019, activist investor Elliott Management wrote a letter to the e-commerce group’s board, lauding the shares’ “value opportunity”, but lamenting a “history of mis-execution”. The 4 per cent shareholder said “change is urgently needed to address both public perceptions and real business issues”.

First off, Elliott proposed a comprehensive portfolio review – suggesting that eBay’s ticketing platform, StubHub, and its classifieds property business – “high-value, strategic assets” – be divested. This could, potentially, bring in a lot of cash. It would also enable management to “devote the entirety of its attention” to its core marketplace offering.

A week later, eBay announced new capital allocation measures – including the introduction of a quarterly dividend. It added that it expects to return around $7bn to shareholders via dividends and repurchases over the next two years. Then, in March, the group revealed that it had worked alongside Elliott, the Starboard Value investment firm and other significant shareholders to develop new strategic initiatives – including the addition of two directors, and a review of its assets.

It’s perhaps unsurprising that eBay’s shares are well up since the intervention. But where does this leave would-be investors?  

eBay has many attractive qualities. Elliott reckons the group is one of only two global e-commerce companies that continues to see ongoing user and revenue growth. It is also strongly profitable. First-quarter numbers to March beat analysts’ expectations, with adjusted EPS of $0.67, up 26 per cent. Management also raised its full-year guidance, despite a dip in the volume of merchandise sold.

Richard Clode, a portfolio manager at Janus Henderson, is one investor who expects “the start of a cleaner growth and profit story for the core business”. He sees the stock as “more of a special situation than a plain GARPy play”, and reckons “the fire has been lit under management” in relation to the potential disposal of non-core businesses. 

IC View: The group may be a big fish in a pond that includes an Amazon-shaped whale, but the actions under way could reap serious rewards, and we expect further catalysts from the result of an operational review this autumn.