How Tech’s Big Guns Could Ambush the Stock Rally
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The Fiscal Times
July 12, 2013

Like the other major U.S. stock indices, the technology-heavy Nasdaq Composite Index has been on a tear of late. Unlike the Dow Jones Industrial Average and S&P 500, which both reached new all-time highs Thursday, the Nasdaq remains far from the record level it reached in the go-go days of early 2000. Still, it closed Thursday at 3,578, it best level since September 2000. At the same time, the outlook for second-quarter earnings for the technology sector is dire. So why is the industry doing so well in the market?

Part of the answer seems to be that investors are just more willing to add risk to their portfolios, particularly now that Ben Bernanke has made clear that interest rate hikes aren't on the immediate horizon. In the tech world, risk has fallen into two categories: First, the risk that the growth being priced in to stocks such as that of Netflix (NASDAQ: NFLX) may not materialize as anticipated. Second, there’s the risk that turnarounds in some more mature businesses won’t materialize.

But folks appear to be looking on companies like Hewlett-Packard (NYSE: HPQ) with a kinder eye. Citigroup analyst Jim Suva may have undergone one of the most dramatic transformations out there, switching his rating on HP from a sell to a buy (no point in dithering around in “hold” territory, it seems) and boosting his price target to $32 a share from $16. To some extent, the latter move simply reflects reality – the stock had already been trading north of $20, after all. Yet Suva believes that the company’s cost cutting may prove even more successful than HP thinks in boosting earnings down the road, and that after more than a year of losing ground to competitors, its service business will regain some of that market share.

Still, earnings growth that relies on cutting costs is inherently less attractive than higher profits that result from higher sales and profit margins. That has been difficult for companies in all sectors to deliver, and technology is no exception. That means investors need to keep a close eye on a company’s ability to deliver lower costs and higher margins in the absence of significant organic growth. For instance, Microsoft (NASDAQ: MSFT) Thursday announced a big corporate shakeup, one that CEO Steve Ballmer hopes will make it more nimble in the smartphone and tablet era.

Is it too early to price in some potential upside? Not if your risk tolerance is robust and you have some kind of anti-anxiety drug ready at hand for the times when the market’s outlook on this longer-term strategic shift will sour.

Overall, however, the short-term outlook for technology profits – and thus, for tech stock valuations – is rather bleak. True, of the tech stocks in the S&P 500 index that have reported their results so far, 71 percent have beaten analysts’ earnings forecasts, according to data from Thomson Reuters. The remainder have come in on target. But only 57 percent have beaten revenue expectations, and the outlook for earnings growth continues to deteriorate. At the beginning of April, analysts were anticipating 2.5 percent growth in second-quarter profits; by the time the quarter ended on July 1, that figure had been transformed into a 3.7 percent loss. As of yesterday, with a handful of companies reporting, the outlook had slipped further, to a 3.8 percent decline.

Some companies may buck the broader trends. For instance eBay (NASDAQ: EBAY), which is expected to report its earnings on July 18, is one of small number of stocks in the technology sector that Birinyi Asociates identified as having delivered positive earnings surprises at least 80 percent of the time. Others are Chinese Internet giant Baidu.com (NASDAQ: BIDU) and Intuit (NASDAQ: INTU).

The online auction giant is an interesting hybrid: while eBay remains a technology stock, it also offers investors exposure to the worlds of retail and financial services, with the technology element simply being what the company does to make sure its users can bid on items or use its PayPal service to pay for goods and services. Electronic payments are a big emerging market trend, and eBay is on top of it, which could be good news for the company’s long-term growth in profits. In the meantime, analysts are predicting earnings will be nearly 15 percent higher in the just-ended quarter, while the company also is expected to deliver healthy topline growth, an all-too-rare phenomenon. Nor does it have the same kind of capital spending needs that online retailing rival Amazon (NASDAQ: AMZN) faces, and that have weighed on the latter’s profit margins.

Sandisk’s (NASDQQ: SNDK) earnings also are due out next week, on Wednesday. Supply and demand for storage and memory devices has been tricky for investors to navigate, making Sandisk a volatile and uncomfortable stock to own. But Thomson Reuters’ Harrison notes that analysts are calling for the company to report an astonishing 336 percent increase in earnings as a turnaround in the memory industry seems to be underway. That outlook gains support from Micron (NASDAQ: MU), which just bucked its historical pattern of falling short of estimates and reporting a loss: SanDisk’s rival beat estimates and reported a profit.

Growth in smartphone penetration could help SanDisk and its NAND flash storage solutions continue to generate profits, even if the average price per unit does start to dip. One encouraging sign is that neither Micron nor SanDisk appears prepared to start another battle for market share by ramping up output and allowing prices to fall below the level at which sales generate profits. This is a particularly interesting area to keep an eye on, given that analysts expect the storage and peripherals business to suffer a 21 percent slump in profits.

Of course, one of the biggest reasons for the bearish forecasts for technology is Apple (NASDAQ: AAPL). Just as its dramatic earnings gains made the tech sector look appealing only a year or two ago, the company’s fall from grace has overshadowed earnings gains from its smaller peers. To some investors, like value/growth-at-a-reasonable-price manager Bill Miller over at Legg Mason, Apple is cheap, trading at just below 10 times trailing earnings, while eBay commands a premium valuation of more than 26 times trailing 12-month profits. But the second quarter’s results (it’s actually the company’s fiscal third quarter) may remind investors that it’s cheap for a reason, at least for the time being.

Analysts expect Apple’s revenues to be flat and profits to be down, with the consensus for earnings per share standing at $7.37. That’s well below the $9.32 the company earned in the same period last year and serves as a signal, says Harrison, that “margins are crumbling.”

Amidst the recent enthusiasm for technology stocks, Apple remains volatile and may come under more pressure even if earnings that are in line with analysts’ expectations. There are some risks that even dedicated technology stock investors just don’t appear willing to take, and one of them, it seems, is that Apple’s next generation of new products will be game changers. In this case, at least, they’ll wait for proof.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.