Analyst Insight: Technology, Communications and Utilities Q&A
In this edition of Analyst Insights, Cathy Lloyd updates us on how the pandemic has shaped the Technology, Communication Services, and Utilities sectors and what she’s looking for when evaluating investment opportunities.
From a broad market perspective, can you talk about how the valuation spread between value and growth still impacts the sectors you cover and what significant changes or trends have you seen since value’s recovery in the past year?
The Utilities sector hasn’t been impacted much by the growth vs. value gap, particularly due to the low interest rate environment, and most recently, renewable energy incentives in the Biden administration’s infrastructure plan. The Technology and Communication Services sectors are different. There’s a bifurcation in these sectors. If you break down different types of tech businesses, there’s software, semiconductors, IT services, and hardware. Generally, we don’t find many value stocks in the software space, but we have found value in IT services and hardware. Prior to the value rotation this past year, these stocks had been underperforming, but once investors began to anticipate the recovery, their valuations improved significantly. Within Communication Services, you have internet services, media and telecom services. In media and internet services, we see more growth prospects; whereas in telecom, we tend to find more opportunities where we see a disconnect between market valuation and our view of normalized fair value. So, I would say we have seen improved stock performance in the telecom industry since the value rotation that started last year.
Cathy, looking at the communication services sector, how has recent M&A activity impacted the portfolio, and what opportunities might it create as you look ahead?
We’ve all heard about competing video streaming platforms, and I think it’s fair to say that most people have spent a fair amount of time streaming content during the pandemic. As these platforms compete with each other, they’ve dramatically ramped up content spend. This has led to increased M&A activity across the sector, and in some cases, to elevated valuations, creating a seller’s market of sorts. Two stocks we’ve owned that have been impacted by M&A activity are AT&T and ViacomCBS.
AT&T is taking advantage of this attractive backdrop with three recently announced divestitures. Not only do these transactions provide for greater focus on the core communications business, but the company will receive over $50 billion in proceeds, which will be used to pay down debt. We’ve always been intrigued by the opportunity to use a “sum of the parts” analysis with AT&T, which has both media and telecom businesses, particularly given the disparate ways in which media and telecom companies are valued in the marketplace. Media businesses tend to trade at richer valuations than telecom businesses. So, using a sum of the parts construct, we believe there is significant upside in AT&T. On the other side of this M&A feeding frenzy was ViacomCBS. Between the Discovery Warner Media transaction and Amazon’s planned acquisition of MGM, we saw the pool of potential buyers for Viacom diminish, leaving the company without a dance partner. As a result, we sold the stock in the quarter.
As you think of the sectors you cover, how do you see the companies fitting into the COVID recovery buckets- reopening, reflation, and defensive? Are there opportunities you’re seeing today that look different than what you were seeing six to nine months ago?
The tech sector is broad enough to span all three of these buckets. Taking a step back, I will emphasize that these buckets are influenced by shifting macroeconomic developments, and that will strongly correlate to where we find opportunities. That being said, Tech hardware companies are currently benefitting from the second leg of reopening as people shift from working at home to being back in the office. Software might be considered part of the defensive bucket with higher levels of recurring subscription revenues, and IT services can benefit from the reflation trade as wage pressures increase incentives for companies to either outsource or streamline their processes.
While these macro classifications can create opportunities for us, we continue to focus on bottom-up company specific factors. For example, an IT services company like DXC Technology might benefit from the reflation trade, but we focus on the fact that the company is just in the middle innings of a turnaround. Accenture alum and DXC CEO, Mike Salvino is reorienting the company back to growth, and he’s targeting a 10-11% operating margin in an industry that generates mid-teens operating margins. DXC is trading at just 10x while competitors are trading at 30x. This implies that if DXC reaches its target, there’s tremendous value to unlock from here.
While none of us know when interest rates may go up, how might higher rates impact the companies in your sectors, and would certain types of companies embed better value in a higher rate environment?
There are a few different ways higher rates would impact the companies I cover. I’ll start with Utilities, which we haven’t talked about yet. Stocks in that sector have been viewed historically as bond proxies, offering attractive yields with relative stability. As interest rates rise, that sector tends to lose favor among yield hungry investors. Secondly, as interest rates increase, borrowing costs also increase. So, for companies that have higher debt levels, it becomes more costly to refinance maturities. Finally, rising interest rates have proven to be a headwind for growth tech stocks. These growth stocks have taken up most of the oxygen in the tech space over the last several years, particularly as interest rates have remained depressed. In fact, as value investors, over the last year, our Technology portfolio weighting is the lowest it’s been on a historical basis. Currently, we only own two technology companies in the portfolio, DXC and IBM. I’ve already mentioned DXC, but IBM, like AT&T, is a sum of the parts story. We believe that significant value can be unlocked when they spin off their IT outsourcing business in the fourth quarter. Furthermore, our two technology investments trade at just 10-12x calendar 2022 earnings estimates in a sector that generally trades north of 30x. So, to summarize, I expect that as interest rates increase, we may see more investment opportunities materialize in the Technology sector, and consequently, our allocation may increase moving forward.
We’d love to continue the conversation. Please contact Patty Shields (email@example.com or 626-304-6045) is you’d like to schedule a call to discuss this or any other topic.