Despite persistent currency concerns, the technology sector looks set to report a typical second half with accelerating revenue growth offset by higher promotional expenses as well as continued investment in expansion and R&D.
Also, given its manufacturing dependence on and sales exposure to China there are mixed sentiments about how the country’s slowing growth will impact the sector.
In the second quarter, the sector saw earnings growth of 1.9% on the back of revenue growth of 2.1%, better than the S&P on both counts. If all goes well, revenue growth will accelerate to 3.7% in the third quarter, although earnings growth will continue to languish at 1.8%.
It’s unlikely that the aforementioned negatives will have either a prolonged or massive impact on the sector because of the existence of several very strong secular drivers that should continue to drive it.
The single-largest factor affecting technology stocks is the combined effect of mobile and cloud computing. This is changing the level of chip integration and their design innovation, shrinking the size of computing devices and increasing their portability, creating the tendency to shop, entertain and pay from these mobile devices, building dependence on central resources in clusters of hardware referred to as cloud, which are in turn leading to new parameters in storage, networking and security.
The trends are evident across the world, representing tremendous opportunity especially for U.S. players, many of which are at the cutting edge of technology.
Given the prospects, most technology companies are viewed as “growth” and therefore trade at a premium although some also pay dividends. Here’s a look at the sector going into the earnings season.
Ecommerce
In this group, we have a growing number of companies including Amazon, eBay, Alibaba and JD.com. The group is focused on expansion and innovation to make all the people moving online loyal to their platforms. There is a lot of investment going on, which could hurt near-term profits, so the thing to watch more closely is revenue growth.
While it remains one of the largest ecommerce companies, Amazon investors are currently focused on its AWS business which is involved in providing cloud infrastructure to companies. AWS is growing very fast, leading to significant upward revision to estimates. Significant further upside may not be in the cards.
Alibaba operates in China with even greater dominance in that country than Amazon enjoys in the U.S. Its cloud business is small but fast-growing. Amazon and Alibaba, while sporting Zacks Ranks of #3 (Hold) can’t be recommended since their Earnings Expected Surprise Predictions (ESPs) don’t support a positive surprise.
But take Alibaba competitor JD instead, which is expected to turn in a profit next year. JD has a Zacks Rank #1 (Strong Buy) and the company is expanding aggressively in China (expects to reach 100,000 villages this year). It also recently inaugurated Hong Kong and Silicon Valley offices to get closer to the American and Asian markets, respectively, facilitating the sale of authentic foreign goods on its platform.
eBay EBAY, Zacks Rank #2 (Buy), competes with Amazon and may be worth looking into following the separation of its payment arm PayPal and the adjustment of related estimates. The company also has a good chance of beating estimates given its positive earnings ESP of 3.13% and good track record.
OTA
Although severely impacted by currency effects and continued industry consolidation especially in the U.S., the segment appears hot because most travel bookings are still made offline. The larger players also have high market share and are up against growing competition in countries like China.
All the major players including Priceline, Expedia and Travelport carry a Zacks Rank #2. TripAdvisor, which recently enabled direct booking is a slight laggard with a Zacks Rank #3. While the ESPs for this group are all at 0.0% making surprise prediction difficult, earnings surprise history is positive for Priceline and Travelport.
Chips
This is a motley crowd serving a variety of end markets including computing, communications, automotive, industrial, medical, military, and the list goes on. These aren’t exciting times for the segment, given design constraints, rising costs, growth concerns across industries and competitive considerations.
The thing to keep in mind here is that as long technology paradigms keep shifting, demand for new chips, which are the enablers, will also increase. So mobile, IoT, cloud, electronic content increases in aircraft and automobiles, industrial automation, security, network innovation, etc. will remain positives for the segment.
Given that background, it’s a bit of struggle to find two of a kind, especially when most of the market leaders have issues and none of the companies have a positive ESP. But considering just the rank and surprise history, it’s possible to short-list a few that might be worth tracking.
Mellanox MLNX has to top this list given that it caters to the rapidly expanding cloud, carries a Zacks Rank #1 and has a solid surprise history. Pixelworks PXLW, also has a Zacks Rank #1 and positive surprise history, which are particularly positive given the company’s focus on video and pixel processing chips, which are becoming the rage in tech world today. That leaves Avago, AXT, CEVA, MoSys and Semiconductor Manufacturing International, all of which have a Zacks Rank #2 and solid positive surprise history.
Storage
The storage segment is evolving rapidly to adopt cloud computing and traditional players like EMC are falling by the wayside. In fact EMC had to sell itself because it couldn’t adapt. Western Digital and Seagate are better placed because they have strong relationships with enterprise customers. So they are taking a hybrid approach as they transition to more modern technologies. It should also be kept in mind that the storage and processing needs of the cloud aren’t homogeneous and the finances available to companies need to be managed efficiently. This could be enough for these legacy players.
Seagate currently has a Zacks Rank #2 and a positive surprise trend. Imation, with a Zacks Rank #1 has cloud exposure and a few positive surprises in its history. But investors may need to be a bit more patient with this company, as it also has some sizeable costs to absorb. Another storage provider NetApp has a Zacks Rank #1 and dismal surprise history. But there have been solid upward revisions to estimates in the last 30 days.
Software
A lot of the action in tech world is currently in this segment since software is the glue building the cloud and supporting it, with servers, networks and operations increasingly getting software driven.
Based on our chosen criteria, there are a few clear winners: Paycom PAYC and Dassault DASTY carrying a Zacks Rank #1, and Apigee Corp APIC and Attunity Ltd ATTU carrying a Zacks Rank #2.
Internet Companies
These would include Internet-enabled service companies including social networking, search, delivery, etc as well as operators specializing in certain verticals like real estate or automotive. These companies typically set up the infrastructure and attract users to their platforms. Still later comes monetization, which is when they become worth holding.
Top picks here would be MeetMe MEET, Pandora P and Zillow ZG, all of which have a Zacks Rank #1.
Summing Up
For many of the big technology companies, this earnings season will be business as usual. But this may also be just the right time to pick out lesser-known stocks that are bigger performers.
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