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Keynotes

• Technology companies today have become more competitive and resilient and they have made big money during the global financial crisis.
• Global end-demand is recovering while new product releases and increased capital spending bring stronger demand for technology products.
• The NASDAQ 100 Index is expected to hit 2,884 points in 2012, a potential increase of 65% from the current level (as of 10 February 2010, when the index closed at 1,749), based on our scenario analysis and earnings estimates.
• We expect to see more upgrades in both earnings and valuation.
• Key risks in 2010 include a possible slowdown in end-demand, fierce competition, exit strategy and monetary tightening.

Information Technology, the top-performing sector in the S&P 500 Index, jumped 59.9% in 2009 (Table 1). As many as 90% (47 out of 52) of the companies within the S&P 500 Information Technology sector have reported better than expected quarterly earnings since 11 January 2010 while S&P500 index earnings surprises averaged at 29%. Despite the outperformance of technology companies’ earnings, the tech-heavy NASDAQ 100 Index fell sharply by 7.24% between 11 January 2010 and 10 February 2010.  

We believe that the recent pullback offers a good opportunity to increase the technology exposure in your investment portfolio. We expect the NASDAQ 100 Index to breach 2,884 points in 2012 (Table 2), a potential increase of 65% from the current level (as of 10 February 2010, when the index closed at 1,749). We hereby make a strong call on the technology sector.

More re-ratings to come!
Our analysis shows that that the technology sector appears to be undervalued in terms of both the valuation and earnings growth, suggesting potential upgrades for both in the future.

Earnings Re-ratings
Chart 1 illustrates the relationship between the Price Earnings (PE) ratio and the expected earnings growth across major global equity markets. The X-axis is the compound annual growth rate (CAGR) of the consensus earnings from 2010 to 2012 while the Y-axis shows the 2010 forecasted PE.

From the chart, earnings growth of the technology sector represented by the NDX is lower than the global average earnings represented by MSCI AC World Index and earnings growth of the semiconductor sector indicated by SOX is significantly higher than that of the technology sector.

Being high-growth businesses, technology companies’ three-year CAGR seldom falls below global average. Hence, we believe that earnings growth of the technology sector is currently underestimated. Moreover, the large earnings growth deviation between NDX and SOX (a leading indicator of technology sector) suggests that the earnings of NDX should be upgraded accordingly in the future, if not anytime soon. We therefore raise the three-year CAGR projection of the technology sector from 15% to the global average of 20% - a fairly conservative upgrade in our Base Case Scenario.

Valuation Re-ratings (PE re-ratings)
During the last bull run between 2004 and 2007, techs were valued approximately 40% above the broad-based S&P 500 Index (Chart 2). The global financial crisis depressed this premium and techs were trading at a 17% discount to S&P 500 in the fourth quarter of 2008 amid a panic sell-off. The strong rally in 2009, in our view, was the effect of a mean reversion. At present, techs are merely valued at a 5% premium of S&P 500 Index (as at 10 February 2010). We are confident of future re-rating which will factor in additional premium, hence we add on a 30% premium to our Base Case Scenario with respect to the S&P 500 Index historical average of 14X, bringing up the sector’s estimated PE Ratio to 18X.

Our scenario analysis is summarised in Table 2 and in our Base Case Scenario, we expect NASDAQ 100 Index to hit 2,884 points by 2012 with a PE of 18X and a three-year CAGR of 20%.

How do the re-ratings work?
Techs made big money during the global financial crisis
Since the Tech Bubble crash in 2000, the survivors in the industry have sharpened their competitiveness and resiliency and their profits have been improving since (Chart 3). During the course of the global economic slowdown in 2008, the technology sector only recorded a marginal decline in net income while most other sectors suffered from huge profit declines. It is also noteworthy that despite the substantial increase in corporate earnings in the past years, the share prices of technology companies remained relatively flat, suppressing technology companies at fairly low valuations at the moment. In 2009, the technology sector was the top earnings contributor of the S&P 500. The profit and income from continuing operations accounted for 17% and 18% of the index respectively. We expect techs to remain the largest earnings contributor in 2010.

Semi Equipment’s Book-to-Bill Improves
As shown in Chart 4, the Book to Bill ratio (BB ratio), a leading indicator within the semiconductor industry, demonstrated a trend of improvement and stayed above the parity for six months indicating strong demand as books are higher than orders delivered. Furthermore, the Semiconductor Equipment and Materials International (SEMI) is bullish on the chip equipment industry, projecting global semiconductor equipment sales to grow by 53% and 28% in 2010 and 2011 respectively. In particular, the improved spending by NAND flash makers, foundries and packaging subcontractors will likely be the key growth drivers.

Global Chip Sales posted a V-shaped Rebound
During the onslaught of the financial tsunami in 2008, manufacturers aggressively reduced capacity and cut spending while buyers liquidated inventory. However, they soon realised that they were too pessimistic about the end-demand. Rush-orders and inventory restocking activities subsequently caused a rebound in chip sales. As shown in Chart 5, global chip sales are now almost back to the pre-crisis level. Moreover, the Semiconductor Industry Association (SIA) expects global chip sales to grow by 10.2% in 2010, thanks to the strong demand of consumer electronics from emerging markets. 

Analysts were aggressively upgrading earnings estimates of semiconductor companies last year, forecasting a V-shaped recovery in the sector’s earnings. The upgrades were not surprising because every company usually stream-lines its cost structure during market downturn. When the economy recovers, their lean cost structure will result in accelerating growth in earnings due to a lower base. Earnings will likely reach a new record high and we expect to see further earnings upgrades in the broader technology sector this year.

Recovery of the end-demand
We have seen “green shoots of recovery” in technology product demand. According to IDC Quarterly PC Tracker Report, global PC shipments jumped by 15% in the fourth quarter last year. Asian markets displayed the strongest growth with an increase of a 31%, while improvement in demand is also evident in the US market with a growth of 24%, suggesting that the PC business has made a comeback.

Recovery in the broader market
Many economic indicators in US including consumer confidence, ISM Manufacturing and non-Manufacturing indices have improved significantly. Unemployment rate also appears to have peaked, and US GDP expanded by 5.7% quarter-on-quarter in 4Q 2009. We expect the economy to grow by 3.7% in 2010.

On the Emerging markets front, an expanding middle class boosted demand of consumer electronics, which has become a large portion of today’s global electronics consumption. During the crisis, the governments in these regions implemented massive stimulus packages and subsidies to bolster domestic consumption so as to offset weakened external demand. Retail sales and consumer confidence have remained robust and we expect the trend to continue in the post-crisis period.  

New products to drive stronger sales
In 2007, Apple’s iPhone brought upon a touch-panel fever. Recently, Apple announced the release of iPad which is expected to create a similar positive impact on tablet computers. We believe that the recent launch of Windows 7 by Microsoft will drive up the long-awaited replacement demand, accessories sales as well as hardware upgrades.

Rebounding Capital Spending
Corporations have underinvested in technology equipment and software for years (Chart 6) since the over-aggressive IT infrastructure spending during the dot-com bubble. Some IT upgrade projects were postponed after the outbreak of the financial crisis. With economic recovery underway, corporations will likely look at upgrading technology to help to boost productivity and streamline cost-structures. 4Q 2009 US GDP data reveals a sign of revival in capital spending as equipment and software spending gained an annualised 13.3% quarter-on-quarter.

What Are The Risks to Watch Out?
We identify three key risks that technology investors should watch out for this year.

1. Slowdown in end-demand: With fears of a double dip recession happening and developed nations being slower in the recovery, there may be a slowdown in end-demand. However, we believe that Asia has more material impact to the technology supply chain as it is the new growth driver.
2. Increased price competition: As companies ramp up production and with new players entering the market, companies making commoditised products (eg. DRAM Chips) may potentially see margins being eroded.
3. Premature withdrawal of liquidity: Exit strategies and monetary tightening will starve markets of liquidity in the short term which could negatively impact tech stocks. However, we strongly believe that the main determinant of equity markets is earnings, not liquidity. Hence, the impact of the policies to the equity market is limited over the longer term. Investors should keep an eye on valuation and fundamentals in making their investment decisions.

Conclusion: A Growth and Value Play
We believe that the recent profit-taking activities following negative news flows in January were overdone. Currently, the market is in the mid-stage of the recovery and we expect the earnings to be normalised this year. The technology sector remains attractive and is well-supported by the strong fundamentals hence our call for a strong buy. Investors seeking exposure to global technology can consider buying Henderson Global Technology.