1 August 211 Sector Report Software & IT Services Economics & FI/FX Research Credit Research Equity Research Cross Asset Research UniCredit's global menu 8 211
2 Contents 3 Executive summary 5 A tribute to current market turbulences 7 Amuse-gueule: A maturing industry or re-thinking growth 1 Hors-d'oeuvre: Implications of higher maturity for the industry 1 "The" growth industry is now bound to cycles 11 The phenomenon of increasing vertical consolidation 14 How did the increasing maturity affect the valuation compared to the overall market? 17 Software stocks: How the shift of the revenue mix affected the valuation multiples 18 Comparison with the earnings growth and valuation of other sectors 19 La soupe: A closer look at the different segments of the technology sector 19 The hardware players: trying to re-invent themselves 26 IT services: Global market overview 28 The traditional IT services players: Part 1 competitive advantage "America" 35 The traditional IT services players: Part 2 the "Europeans" stuck in the middle? 49 The offshore IT services players: What comes beyond the salary arbitrage game? 59 The software players: The fight for double-digit revenue and earnings growth 79 Plat principal: Could the maturity thesis be wrong? 8 Software as a Service: The sky's the limit 85 Mobility: A larger penetration of the customer base 87 In-memory: A game changer? 91 Salade: Stocks ready to re-rate, to de-rate or to remain stable 97 Fromages: Part 1 IT Services: Valuation, profitability and guidance overview 12 Fromages: Part 2 Software: Valuation, profitability and guidance overview 17 Dessert: Company section 19 Allgeier Holding 114 Atos 119 Capgemini 124 COR&FJA AG 129 Dassault Systèmes 133 Indra Sistemas 138 Logica 143 REALTECH 148 Sage 153 SAP 158 Software AG 163 Temenos Share prices as of 22 August 211 Knut Woller, CEFA (UniCredit Bank) Alexander Rummler, Equity Analyst (UniCredit Bank) UniCredit Research page 2 See last pages for disclaimer.
3 Executive summary What to expect from "UniCredit's global software & IT services menu"? UniCredit's menu your choice In September 29, at the height of the downturn, we published a sector report with the title: a brief history of the transformation of the software & IT services sector. The report was designed as a strategic view of the global industry and the trends driving the sector. Almost two years later again with question marks beyond the growth prospects and the outlook for corporate earnings due to the EMU crisis and the debt problems of other countries it is time for us to revisit our 29 report with its successor: UniCredit's global software & IT services menu, a report with a similar strategic approach. Hence, readers looking for a report driven by tactical ideas, will be disappointed. However, we hope to excite those looking for an in-depth analysis of the current state of the global software & IT services sector and its trends. We hope you will enjoy reading and find some food for thought. UniCredit's global software & IT services menu is designed as a seven-course menu: 1. Amuse-gueule: A maturing industry or re-thinking growth. The increasing maturity of the industry in general is our working hypothesis and probably common sense among investors, last but not least also reflected in the de-rating of many tech stocks in the last couple of years. 2. Hors-d'oeuvre: Implications of greater maturity for the industry. After the years of high growth lasting until the tech bubble, the industry has now grown up and is bound to economic cycles. This is also reflected in the increasing vertical consolidation of the industry with the leading vendors like IBM and Oracle driving the consolidation and recurring revenues (maintenance) often contributing the majority of revenues. The consequence: while the earnings growth profile of tech stocks resembled the earnings growth profile of stocks labeled as "cyclical" during the high growth phase of the industry, it has become more similar to stocks labeled as "defensive" today. 3. La soupe: A closer look at the different segments of the technology sector. The analysis in this section considers the three sub-segments of the technology sector: hardware, IT services and software. It provides an overview of the forecast growth rates, structural changes and challenges faced by each sub-segment. In addition, it introduces the global leading players of each segment, including an overview of their history and business model over time. 4. Plat principal: Could the maturity thesis be wrong? We are playing devil's advocate in this section and question the maturity thesis. We identify three current topics that could accelerate growth in the industry, although mainly for software companies: SaaS (software as a service), mobility and in-memory-based technologies. We provide an in-depth analysis of all topics. 5. Salade: Stocks ready to re-rate, to de-rate or to remain stable. There are several examples of tech stocks that were able to achieve a re-rating in their history, albeit often only for a limited period of time (e.g. Apple following its move into the consumer segment in 27) or that suffered a de-rating (e.g. SAP starting in 26). In this section, we are analyzing apart from the current recession fears which stocks in our universe could be ready for a re-rating (SAP, REALTECH and Capgemini), de-rating (Dassault Systèmes and Indra Sistemas), or are likely to remain stable (Allgeier Holding, Atos, COR&FJA AG, Logica, Sage, Software AG and Temenos) and why. 6. Fromages: We are aware of the risk of spoiling our "menu" metaphor by using the term "financial", but we have no choice: No (financial) menu would be complete without an extensive valuation overview. 7. Dessert: Company section. Possibly not hungry anymore, but still curious after a substantial meal, here you will find all in-depth information regarding the companies in our coverage universe. UniCredit Research page 3 See last pages for disclaimer.
4 Rating and/or target price changes The following table summarizes our current ratings and target prices for our coverage universe. It highlights, in addition, rating and/or target price changes, which we made in our sector report. Our target price changes result from lowered estimates and applied lower target multiples due to the increasing risks of a slowing economic momentum. OVERVIEW OF OUR COVERAGE UNIVERSE Rating Currency Target price Company prev. new prev. new Allgeier Holding Buy Buy EUR Atos Hold Hold EUR Capgemini Buy Buy EUR COR&FJA AG Hold Hold EUR Dassault Systèmes Sell Sell EUR Indra Sistemas Sell Hold EUR Logica Buy Buy GBp REALTECH Buy Buy EUR Sage Not rated Hold GBp 265. SAP Buy Buy EUR Software AG Buy Buy EUR Temenos Buy Buy CHF Source: UniCredit Research A comparison of our and consensus estimates The following table highlights our EPS estimates for our coverage universe and current consensus estimates, according to Reuters and Vara. OVERVIEW OF PRO FORMA EPS ESTIMATES AND VALUATIONS Target Consensus UniCredit Consensus UniCredit Consensus UniCredit Company Rating Curr. Price price 211E 211E 212E 212E P/E 212E P/E 212E Allgeier Holding** Buy EUR n.a. 1.2 n.a n.a. 5.9 Atos Hold EUR Capgemini Buy EUR COR&FJA AG*** Hold EUR n.a..12 n.a..14 n.a. 9.8 Dassault Systèmes Sell EUR Indra Sistemas Hold EUR Logica Buy GBp REALTECH* Buy EUR Sage Hold GBp SAP Buy EUR Software AG* Buy EUR Temenos**** Buy CHF Average *Reported; **Operating EPS; ***Cash EPS, ****EPS estimates in USD Source: Company data, Reuters, Vara, UniCredit Research UniCredit Research page 4 See last pages for disclaimer.
5 A tribute to current market turbulences UniCredit's toolbox Software companies: a more defensive revenue mix than IT services Recession fears caused by the EMU crisis as well as the downgrade of the USA by Standard and Poors in combination with comparably week economic data lead to turbulent times at the capital markets in the recent weeks. To respond to the current concerns, we decided to do three things: 1. Providing an overview of the trough and peak multiples of the last two recessions and the EPS downward revisions from peak estimates to trough estimates in the last recession. 2. Revisiting our model assumptions for all stocks with a more conservative stance towards revenue growth and margin expansion potential in 211 and mainly in Saying goodbye to peak multiples, where we still applied them and instead opting more conservatively for average multiples instead. Although our economists recently reduced their GDP forecast for some regions (e.g. Euro zone from 2.1% to 1.7% in 211 and from 1.7% to 1.% in 212), we are not expecting a fall-back into recession for the world economy and hence no testing of the trough multiples of the last downturn. Software stocks are not defensive due to their cyclical revenue component "licenses" and hence vulnerable to sudden break down in demand (as e.g. witnessed after 9/11 or the Lehman bankruptcy). But the shift of the revenue mix towards the high margin maintenance revenues, which often account for around 5% of total revenues today, provides them some visibility and "defensiveness" in that respect that earnings downward revisions are less pronounced than for IT services companies at least in Europe. In contrast to IT services stocks, where as a rule over thumb multiples contract significantly faster than earnings estimates are cut, software stocks tend to reflect the expected earnings cuts significantly faster. The following heuristic helps assessing possible share price downside: taking peak EPS estimates as base, reducing them by the expected earnings cut and multiplying them with the trough multiples of the last recession helps by deriving a possible downside. The simplification of this approach is that it is an analogy and does not assess whether there have been any company specific changes suggesting higher or less earnings downside than in the last cycle. The following table summarizes what would happen if we would fall back into recession and the companies had to face the same downward revisions like in the last cycle. TROUGH AND PEAK 1Y FWD P/E MULTIPLES OVER THE LAST TWO CYCLES Recession Trough 21-3 Recovery Peak 24-8 Consolidation = multiple contraction Peak 27-8 Recession Trough 28-9 Recovery Peak August 211 1Y fwd EPS August 211 EPS correction of the last recession (%) Implied share price with Trough EPS Current share price 22 August 211 Software Dassault Systèmes Microsoft Oracle Sage SAP Software AG Temenos TIBCO *Temenos is the only software stock in the panel above that faced earnings downward revisions in 211. Hence, the implied share price is derived by reducing peak EPS estimates of this cycle of USD 1.9 by 32% Downside (%) Source: Thomson Datastream, UniCredit Research IT service stocks: Average downside risk in a recession scenario of 26% For IT service stocks we derive the possible share price downside by multiplying the current consensus 1Y fwd estimates by their recession trough multiple at which the stocks traded during the last recession (28-29). Excluding Logica and Indra, the average downside risk is 26% as the following overview shows. Logica is currently trading at its recession trough level and hence is not exposed to additional downside risk. Indra Sistemas' significantly higher recession trough P/E multiple of 12x, which is approximately the double of the recession trough multiple of the European IT Service of 6x, is striking. UniCredit Research page 5 See last pages for disclaimer.
6 We believe Indra Sistemas' historic recession multiple would not be sustainable in a future economic contraction scenario as Indra's P/E multiple has already started to contract below this level with the start of the austerity programs in 21 and is expected to continue to suffer due to Indra's high Spain exposure (>5% of FY11E revenues). In addition, the historically high valuation level of Indra was mainly attributable to its high margins, which benefitted from increasing R&D capitalization, which is also not sustainable mid-term, in our view. We expect Indra's valuation to come down as its margins are expected to fall in FY12. TROUGH AND PEAK 1Y FWD P/E MULTIPLES OVER THE LAST TWO CYCLES Recession Trough 21-3 Recovery Peak 24-8 Consolidation = multiple contraction Peak 27-8 Recession Trough 28-9 Recovery Peak August 211 1Y fwd EPS August 211 EPS correction of the last recession (%) Implied share price with Peak EPS Current share price 22 August 211 IT Services Accenture Atos Capgemini IBM Indra Sistemas Logica Tietoenator Downside (%) Source: Thomson Datastream, UniCredit Research An overview of our model changes The following table summarizes the changes of our estimates for the stocks in our universe: MODEL CHANGES FOR THE SOFTWARE AND IT SERVICES STOCKS IN OUR UNIVERSE Revenues (mn) Pro-forma EBIT (mn) Pro-forma EBIT margin Pro-forma EPS (EUR) Curr. Rating 211E 212E 211E 212E 211E 212E 211E 212E Allgeier Holding EUR Unchanged Atos EUR Prev. 6,891 8, New 6,875 8, Capgemini EUR Prev. 9,694 1, New 9,694 1, COR & FJA AG* EUR Unchanged Dassault Systèmes EUR Prev. 1,766 1, New 1,754 1, Indra Sistemas EUR Prev. 2,673 2, New 2,647 2, Logica** GBP Prev. 3,883 4, New 3,88 4, Realtech EUR Prev New Sage** GBP New 1,485 1, SAP EUR Prev. 13,955 15,369 4,65 5, New 13,89 15,29 4,523 5, Software AG EUR Prev. 1,157 1, New 1,157 1, Temenos USD Unchanged *Cash-EPS, **EPS (GBp) Source: UniCredit Research UniCredit Research page 6 See last pages for disclaimer.
7 Amuse-gueule: A maturing industry or re-thinking growth The thesis: "M" like "Maturity" Higher maturity = lower (organic) revenue growth rates There is a lot of discussion among investors regarding the increasing maturity of the technology sector and its implications for the valuation of technology stocks. Since the bursting of the tech bubble in 2 the sector has witnessed a broad based de-rating. While many tech stocks enjoyed a multiple expansion in following the economic recovery, unfulfilled growth hopes, as well as increasing M&A activity since 23, has led to a further de-rating. While some companies (e.g. Dell and IBM) are trading at their multiples from 1992, others (e.g. Oracle and SAP) are currently trading well below their levels of the beginning of the 9s. In the following, we are analyzing the increasing maturity of the technology sector and its impact on earnings growth and valuations. Growth rates in the technology sector (hardware, software and IT services) did not recover to the pre-tech bubble burst levels at least for the established players. There are still some structural growth stories left (e.g. salesforce.com and/or Temenos). However, the majority of the players have never achieved a return to the growth rates of the past. This holds true for all individual segments in the industry as can be seen from the chart below (SAP and Oracle as software companies, IBM as an IT service company and Dell as a hardware company). REVENUE GROWTH RATES (PRO-FORMA) OF DELL, IBM, ORACLE AND SAP 14% SAP IBM Oracle Dell 12% 1% Heigh time of the tech bubble (1995-2) 8% 6% 4% recession recession 2% % -2% -4% Source: Company data, UniCredit Research Higher maturity = bound to cycles The strong revenue growth rates that the technology stocks enjoyed in the course of the tech bubble is also reflected in substantial earnings growth as highlighted by the EPS trends of Dell, IBM, Oracle and SAP up to the year 2 (please note that Oracle's FY ends May). The recession left skid marks in the EPS trend of the cited companies as well as the recession, although Oracle and IBM were able to avoid declining earnings by cost cutting and the earnings accretive nature of their acquisitions. Still, having "grown up" means for the majority of the technology companies that they are now exposed to the traditional economic cycles just like any other industry. UniCredit Research page 7 See last pages for disclaimer.
8 EPS (REPORTED) TREND OF DELL, IBM, ORACLE AND SAP Dell's EPS trend since 1992 IBM's EPS trend since USD 14. USD Oracle's EPS trend since 1992* SAP's EPS trend since USD 1.8 EUR *Includes a net investment gain of USD 6.9mn in 2. Excl. these special items, EPS was USD.35 Source: Company data, Bloomberg, UniCredit Research Higher maturity = de-rating of the industry The technology companies had their "golden age" starting in the mid 9s until 2. In sync with solid revenue and earnings growth, multiples expanded well above market average, pricing in long-term above market average earnings growth rates. The tech bubble burst was the starting point for the de-rating of the sector. While Dell and IBM are currently trading at around the same 1Y fwd P/E level as they were at the beginning of 1992, Oracle and SAP are both trading below their 1992 levels, reflecting investors' concerns regarding the (organic) growth opportunities of the companies. UniCredit Research page 8 See last pages for disclaimer.
9 1Y FWD P/E TREND OF DELL, IBM, ORACLE AND SAP* Dell's 1Y fwd P/E trend since 1992 IBM's 1Y fwd P/E trend since Heigh time of the tech bubble (1995-2) Heigh time of the tech bubble (1995-2) Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Oracle's 1Y fwd P/E trend since 1992 SAP's 1Y fwd P/E trend since Heigh time of the tech bubble (1995-2) Heigh time of the tech bubble (1995-2) Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 *1Y fwd P/E's on a monthly base as of August 211 Source: Thomson Datastream, UniCredit Research UniCredit Research page 9 See last pages for disclaimer.
10 Hors-d'oeuvre: Implications of higher maturity for the industry "The" growth industry is now bound to cycles What does the cyclicality mean for the different segments? Given the higher maturity of the industry, the companies are exposed to the traditional cyclicality of the business today. Looking at the individual segments within the technology sector, some are more vulnerable than others to a downturn. 1. Hardware faces severe declines in demand in a recession. Companies prolong the use of existing hardware and slash hardware spending. Hence the traditional replacement cycle is delayed. In addition, hardware has the lowest margin in the industry with operating margins rarely crossing midsingle digits in a purely hardware-focused business model. 2. IT services-driven business models show a higher resilience to a downturn than hardware, given the often longer term projects (projects often run 3-6 months). Even in a crisis, projects are normally finished, providing some stability for IT services companies before they are hit by a recession. In addition, at least for onshore IT services business models, margins are traditionally somewhere in a range of mid to high single digit, providing more of a cushion than for hardware players. 3. Software driven business models are the most defensive. While license revenues are highly cyclical, the software players' life insurance in a downturn are the maintenance revenues that often account for more than 5% of revenues for the more mature players in the industry. This explains the relatively high earnings stability of software companies compared to the other segments of the technology sector. THE DEPENDENCE ON CYCLES: REVENUE AND MARGIN TREND OF THE DIFFERENT SEGMENTS Revenue growth rates of IBM's segments Operating margins (reported) in the industry 3% GTS GBS S&T Software Total 4% SAP Oracle IBM* Indra HP Dell 2% 35% 3% 1% 25% % 2% -1% -2% -3% Spill over of the financial crisis to the real economy 15% 1% 5% % 1Q7 2Q7 3Q7 4Q7 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q *Pre-tax margin Source: Company data, UniCredit Research UniCredit Research page 1 See last pages for disclaimer.
11 The phenomenon of increasing vertical consolidation The beauty of the tech industry: strong operating cash flows The higher maturity of the industry is also reflected in the trend of the cash out for acquisitions since 24. Based on companies' cash flow statements since 24, Oracle has spent the highest amount on acquisitions with around USD 36bn, followed by HP with USD 29bn and IBM with USD 22bn. All the other companies have spent significantly below USD 2bn since 24 cumulatively. Given the strong operating cash flow trend of the large tech companies based on the high-margin nature of their business and partly due to their sheer size, there is substantial financial leeway to pursue non-organic growth options. For example, Oracle had an operating cash flow yield (as a percentage of revenues) of 28% in 21 (calendar year), SAP reported 24%, IBM 2%, Microsoft and Google 38% and HP 9%. Given the increasing maturity of the industry and hence tougher times to generate sustainable double-digit revenue growth rates organically, this strong cash flow is used for acquisitions. Recent news flow like Google's announcement on 15 August to acquire Motorola Mobility and Hewlett-Packard's announcement on 18 August to acquire Autonomy highlight that the Big 6 are still "hungry". THE STRONG CASH GENERATION SUPPORTS M&A IN THE INDUSTRY The operating cash flow trend of the Big 6 Cash out for acquisitions net of cash acquired (24-2Q11) 3 USD bn SAP GOOG Oracle HPQ IBM Microsoft 4 USD bn Oracle 1 SAP 2 Oracle 3 Microsoft 4 Google 5 HP 6 Source: Company data, UniCredit Research Higher maturity = cross sector consolidation Although it has taken on a different flavor since the tech bubble burst, the consolidation of the industry is not a new topic. The (visionary) transformation of IBM from a hardware company in the early 9s to a service and software driven business model today is, in our view, the blueprint for many business model transformations happening today. Hardware vendors like HP and Dell try to lower their dependency on the commoditized and hence low-margin businesses by expanding their business into the less volatile and higher margin IT services and software segments. While hardware players have a high incentive to move to the higher margin segments of the technology stack due to the reasons discussed earlier, the majority of the M&A activity of IT services and software vendors happens within their segments or in higher-margin segments. For software vendors the reason is obvious: given the high-margin nature of their business, the appeal to risk a margin dilution by moving "downstream" through a hardware and/or IT services acquisition is relatively low (an exception could be the acquisition of an offshore-based IT services player, which often have comparatively high operating margins and work as software development suppliers to software companies). However, there are some examples of such acquisitions, where the bundling of products is the rationale (e.g. Oracle acquiring Sun) and/or cross selling (e.g. Software AG acquiring IDS Scheer). UniCredit Research page 11 See last pages for disclaimer.
12 IT services: Large scale software acquisitions by IT services companies are rare. The major asset of an IT services company is the neutrality that would be at risk if a large scale software acquisition were on the agenda. IBM's software acquisitions are an exception and the majority of the IT services acquisitions focus on regional expansion and market share gains within the IT services sector. THE IT MARKET SEGMENTS: A SIMPLIFIED OVERVIEW OF THE CONSOLIDATION DYNAMIC Software Operating margins: up to 5% Software players try to consolidate the partly still fragmented different layers of the software stack to position themselves as one-stopshopping alternatives. They rarely move into other lower margin segments in an effort to offer the full stack and to bundle products. IT services (onshore) Operating margins: up to low double digit Hardware Operating margins: up to mid single digit IT services players expand their product portfolio to the higher margin software segments. Offshore IT services generate operating margins comparable to a software business model Hardware players expand their product portfolio to the higher margin IT services and software segments. Source: UniCredit Research A sample of acquisitions in the industry The following sample of acquisitions in the industry highlights the existing market dynamic. We take this schema as a guide to describe the current strategies of the leading industry players in the different segments of the technology stack in the following chapters. A SAMPLE OF ACQUISITIONS ACROSS THE SEGMENTS Software IT services Hardware Source: Company data, UniCredit Research UniCredit Research page 12 See last pages for disclaimer.
13 A comparison: the individual tech companies in 24 and today The reshaping of the technology sector following the bursting of the tech bubble is also reflected in the ranking of the leading players in the industry. We have chosen seven of the leading technology companies to provide a brief overview of the evolution of the industry (HP, IBM, Microsoft, Oracle, Google and SAP): While HP was able to overtake IBM in terms of revenues compared to 24 and is hence the largest company revenue-wise, it is the fifth largest vendor in terms of market capitalization today. In terms of revenues, Oracle maintained its number four position in the industry, although in terms of market cap it lost its number three position from 24 to Google. SAP is the smallest player of the six cited companies and while it was number four in terms of market cap in 24, it is the number five today. AS TIME GOES BY: SELECTED IT COMPANIES RANKED BY MARKET CAP AND REVENUES Revenues* (24) and market capitalization* (24) 12 USD bn 3 USD bn IBM HP MSFT ORCL SAP Google MSFT IBM ORCL SAP HP Google Revenues** (211E) and market capitalization** (currently) 14 USD bn 25 USD bn HP IBM MSFT ORCL Google SAP MSFT IBM Google ORCL SAP HP *MSFT: FY5 end June 25, ORCL: FY5 end May 25, HP FY4 end October 24; **MSFT: FY12, ORCL: FY12, HP FY11 Source: Bloomberg, Company data, Thomson Datastream, UniCredit Research How does the technology stack look today? While several segments of the technology stack have already been oligopolies for some time (e.g. Database Management Systems) or even a de-facto monopoly (e.g. operating systems and office suites), the degree of concentration is still less pronounced in others, where the Top 3 players often combine a market share of around 5%. The large players in the industry position themselves more and more as technology mega stores and the focus of current consolidation is mainly on those segments that still show a relatively low degree of consolidation in order to expand existing product portfolios and hence to gain a larger share of the market. The security segment is the only segment where none of the Top 5 players of the global software market (Oracle, IBM, Microsoft, HP and SAP) are present in the Top 3. UniCredit Research page 13 See last pages for disclaimer.
14 A (SIMPLIFIED) OVERVIEW OF THE SOFTWARE AND IT SERVICES STACK IN 21 Market Operating Market share % size* margin Top 3 Top 3 Oracle IBM Microsoft HP SAP IT Services USD 793bn 5-1 IBM, HP and Fujitsu n.a Storage USD 12.4bn 15-2 EMC, Symantec and IBM n.a. 5.7 n.a. IT operations management USD 15.9bn 15-2 IBM, CA and BMC n.a. DBMS USD 23.3bn >5 Oracle, IBM and Microsoft n.a. 3.2*** Operating System USD 3.4bn >7 Microsoft, IBM and HP n.a. Middleware USD 17.6bn >2 IBM, Oracle and Microsoft ** Application Development USD 8.3bn >2 IBM, Microsoft and HP Security USD 16.6bn >2 Symantec, McAfee/Intel and Trend Micro n.a. Business Intelligence USD 1.5bn 15-2 SAP, Oracle and SAS Institute n.a ERP USD 21.2bn >25 SAP, Oracle and Sage n.a. 4.5 n.a ECM USD 3.9bn >2 IBM, Open Text and EMC n.a. n.a. Desktop (Office Suites) USD 14.2bn >6 Microsoft, Adobe and Apple n.a. n.a. *Gartner includes in the market definition of software segments the following revenues: new licenses, updates, subscriptions and hosting, technical support, and maintenance **incl. Sterling Commerce ***incl. Sybase Source: Gartner Group (March 211), UniCredit Research Where does the technology sector stand in terms of valuation in comparison to the overall market? How did the increasing maturity affect the valuation compared to the overall market? Following the bursting of the tech bubble, the technology sector has witnessed a broad based de-rating across all segments. Although our panel of software vendors (Oracle, SAP, Dassault Systèmes and Software AG) has de-rated over time, it is still enjoying a premium compared to the S&P 5. While SAP enjoyed a premium (1Y fwd P/E) of more than 5% compared to the S&P 5 at the beginning of 23, the premium has come down to 24% today. In contrast, our panel of IT services vendors (Accenture, Capgemini, Atos and IBM) shows a mixed picture with only two companies (Accenture and IBM) having a premium compared to the S&P 5, while Atos and Capgemini are trading at a discount (1Y fwd P/E). Our panel of hardware vendors (Dell, HP and Acer) is drawing the opposite picture compared to the software panel with the majority of the players trading at a discount compared to the S&P 5 in terms of 1Y fwd P/E multiples: the exception is Acer, which is trading at a premium. However, it is worth mentioning that earnings estimates have been declining since May. Although our two "other technology" companies (Google and Apple) have faced a substantial de-rating over time, both are trading at a premium compared to the S&P 5 today. UniCredit Research page 14 See last pages for disclaimer.
15 1Y FWD P/E TREND OF TECHNOLOGY STOCKS COMPARED TO THE S&P 5* Selected software players compared to the S&P 5 Selected IT services players compared to the S&P 5 4 S&P 5 SAP ORCL DSY SOW 35 S&P 5 IBM CAP ACN ATO Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Selected hardware players compared to the S&P 5 Selected other tech companies compared to the S&P 5 35 S&P 5 DELL HPQ ASK 9 S&P 5 AAPL GOOG Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 *1Y fwd P/E's on a monthly base as of August 211 Source: Thomson Datastream, UniCredit Research A closer look at earnings growth across the technology sector Given the de-rating of the industry, we think it is worth taking a closer look at the earnings trend of the individual companies and to compare it with the earnings growth of the S&P 5 (1Y fwd earnings growth). The earnings estimates for software companies have shown a higher resilience than the S&P 5 in the last recession, but the majority of the companies did not show the same upside during the cyclical recovery. However, after having returned to a "business as usual" environment, the companies in our software panel show an estimated stronger earnings growth rate than the overall market with the exception of Dassault Systèmes, where consensus expects earnings growth in line with the S&P 5. There is apparently a divide in our panel of IT services vendors in terms of earnings resilience. While both US companies (Accenture and IBM) have shown a more stable earnings growth trend than the S&P 5 in the last recession, earnings growth estimates of the two European players (Capgemini and Atos) had to face almost the same correction as the S&P 5. In the currently normalized economic environment, earnings growth estimates of all IT services companies have broadly converged, with Accenture, Atos and Capgemini exceeding the expected earnings growth rate of the S&P 5. UniCredit Research page 15 See last pages for disclaimer.
16 From our panel of hardware vendors, HP showed the highest resilience in terms of estimated earnings growth rates, given its hybrid business model. Dell and Acer's earnings growth expectations were significantly more cyclical than HP's. From the hardware vendors only Dell is currently expected to deliver higher earnings growth than the S&P 5. The two "other technology" companies (Google and Apple) were not as vulnerable to the downturn than, e.g. the hardware companies or the European IT services players. 1Y FWD EARNINGS GROWTH TREND OF TECHNOLOGY STOCKS COMPARED TO THE S&P 5* Selected software players compared to the S&P 5 Selected IT services players compared to the S&P 5 6% S&P 5 SAP ORCL DSY SOW 1% S&P 5 IBM CAP ACN ATO 4% 2% 8% 6% 4% % 2% -2% % -4% -6% -2% -4% -6% -8% -8% Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Selected hardware players compared to the S&P 5 Selected other tech companies compared to the S&P 5 12% S&P 5 DELL HPQ ASK 4% S&P 5 AAPL GOOG 1% 35% 8% 3% 6% 25% 4% 2% 2% 15% % 1% -2% 5% -4% % -6% -5% -8% -1% Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 *1Y fwd EPS growth on a monthly base as of August 211 Source: Thomson Datastream, UniCredit Research UniCredit Research page 16 See last pages for disclaimer.
17 Software stocks: How the shift of the revenue mix affected the valuation multiples The higher share of the recurring revenues is reflected in the multiple contraction of the sector The higher degree of maturity of the majority of the software stocks is also reflected in the shift of the revenue mix: While the recurring revenues accounted for around 3% of total revenues for many software stocks in 2, the share of recurring revenues was often around 5% in 21. On the other hand, the share of the cyclical revenue component, the license revenues, has often fallen from around 4% to below 3% in the same time frame. The increasing share of recurring revenues is further evidence of the higher degree of maturity for the software sector in general. Software stocks have often faced a multiple contraction in sync with the decreasing proportion of license revenues we believe the reason is that investors increasingly question their valuation as growth stocks. SOFTWARE STOCKS: MULTIPLE CONTRACTION WITH A RISING SHARE OF RECURRING REVENUES* SAP: 1Y fwd P/E and revenue mix Oracle: 1Y fwd P/E and revenue mix 4 1Y fwd P/E License share (rs) Maintenance share (rs) 6% 4 1Y fwd P/E License share (rs) Maintenance share (rs) 6% % 3 5% % 2 4% % 1 3% 5 5 2% 2% Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Software AG: 1Y fwd P/E and revenue mix Temenos: 1Y fwd P/E and revenue mix 4 1Y fwd P/E License share (rs) Maintenance share (rs) 5% 5 1Y fwd P/E License share (rs) Maintenance share (rs) 8% % 4% % 6% 2 35% 25 5% % 25% % 3% 2% 2% Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 *1Y fwd P/E's on a monthly base as of August 211 Source: Company data, Thomson Datastream, UniCredit Research UniCredit Research page 17 See last pages for disclaimer.
18 Comparison with the earnings growth and valuation of other sectors A comparison with the valuation and earnings growth of other sectors Given the convergence of the multiples of tech companies with the S&P 5, we think it is worth analyzing in more detail the performance of tech companies together with other stocks labeled as "cyclicals" and/or "defensives". The cyclicals: We have chosen BMW and BASF as two examples for stocks labeled as cyclicals and compared their 1Y fwd P/E and earnings growth trend with SAP as an example for a tech stock. Our long term 1Y fwd P/E comparison shows that SAP enjoyed a substantial premium compared to the two cyclicals, but that the premium eroded following the bursting of the tech bubble. Following bursting of the tech bubble, the amplitude of SAP's earnings growth expectations have decreased and earnings growth expectations were significantly more stable than those of the cyclicals, due to the increased share of recurring revenues, in our view. The defensives: We have chosen Nestlé, Coca Cola and Johnson & Johnson as proxies for the defensive names. The 1Y fwd P/E trend of SAP compared to the defensives shows a similar pattern to the cyclicals. However, SAP is trading at the same multiple level as Nestlé and Coca Cola today. An aspect worth highlighting is that earnings growth estimates for SAP at the beginning of the economic recovery following the recession were above the defensives until mid-26. Afterwards expectations for SAP and, for example, Nestlé and Coca Cola followed the same trend. Hence, SAP (we believe due to the higher share of recurring revenues compared to total revenues than in the downturn) has shown defensive characteristics compared to cyclical stocks. However, consensus expectations for SAP's earnings growth are currently well above the expectations for the defensives. SAP IN COMPARISON TO STOCKS LABELED AS TRADITIONAL CYCLICALS AND DEFENSIVES* 1Y fwd P/E of selected cyclicals and expected earnings growth (1Y fwd) BMW SAP BASF 3% 25% 2% 15% BMW SAP BASF % 5% % -5% -1% Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 1Y fwd P/E of selected defensives and expected earnings growth (1Y fwd) 1 SAP NESN KO JNJ 1% SAP NESN KO JNJ % 6% % 2% % -2% -4% Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 *1Y fwd P/E's and EPS growth on a monthly base as of August 211 Source: Thomson Datastream, UniCredit Research UniCredit Research page 18 See last pages for disclaimer.
19 La soupe: A closer look at the different segments of the technology sector The hardware players: trying to re-invent themselves Stuck in the low end of the market and destined to move upstream Pure play hardware players like Acer and Lenovo are facing tough times in the low-margin hardware market. According to Gartner Group, HP was the clear market leader in the global PC market, based on shipments, with a market share of around 18% (21), followed by Acer with 13% and Dell with 12%. In contrast, all the remaining players each held a market share of less than 1%. While companies with a hybrid business model (hardware plus IT services and/or software) like HP and Dell were able to raise their operating margins above the 5% threshold, pure play hardware players like Acer and Lenovo had to cope with low single-digit operating margins. Given the high cyclicality of the hardware business and the relatively low operating margins, we believe that pure play hardware players have to continue to move upstream into the higher margin market segments like IT services and software. IBM was the first hardware company with a leading market position to realize the dilemma of having a stronghold in the low margin hardware segment and started the transformation of its business model in the early 199s. In contrast, HP started to make a stronger move into the (highmargin) software segment in 25 and in IT services in 28 with the acquisition of EDS. A SNAPSHOT OF THE HARDWARE PLAYERS Worldwide market shares of PC makers (21; 351mn units) Operating margins (reported) in the industry Others 36.7% HP 17.9% 1% 8% 6% Acer Dell HP Lenovo Dell 12.% 4% 2% Toshiba 5.4% Asus 5.4% Lenovo 9.7% Acer 13.% % -2% Source: Company data, Gartner, UniCredit Research Other market trends add to the tough times for traditional hardware players The cyclicality and the low margin nature of the hardware business are well known. However, there are some other fundamental market trends adding to the pressure for hardware players: The trend towards technology megastores: We have already described the phenomenon of the increasing vertical integration of the industry. Following IBM's transformation into a technology megastore (despite the mantra of remaining mainly applications neutral), Oracle was the first player to realize this structural change in the industry and is still one of the driving forces behind the industry's consolidation. While the majority of its acquisitions have focused on expanding the software product portfolio, the acquisition of Sun Microsystems (completed in January 21) provided the market entry in the server and storage market, where Oracle is now competing with traditional hardware players. Hence, the evolution of technology megastores forces companies with a more focused business model (like Dell) to copy the strategy of the other players in being able to offer everything as a one-stop-shop. Dell's acquisition of Perot Systems and HP's stronger move into software since 25 are proof of this. UniCredit Research page 19 See last pages for disclaimer.
20 Increasing market acceptance of alternative products that are substituting the traditional PC: In the last couple of years new products like tablets, smartphones and other mobile devices have enjoyed an increasing popularity. This market trend will especially eat into the established PC makers market share at the low end of the market, where consumers are mainly substituting traditional PCs with tablets and/or other devices with similar characteristics. This explains, among other reasons, why HP acquired smartphone producer Palm in 21 for USD 1.2bn. Cloud computing: Cloud computing is currently one of the buzz words in the industry. There is one substantial aspect attached to the cloud computing trend that impacts traditional hardware players, especially in the corporate segment. They are facing increasing competition from companies like Amazon, AT&T, Microsoft and Rackspace Hosting, that offers corporate clients the ability to store and process data in their server farms/data centers. Depending on customer adoption this could eat into server sales of traditional hardware companies like Dell and/or HP. This explains cloud-related acquisitions by Dell, that acquired data-storage company EqualLogic in 27 for USD 1.4bn, cloudintegration company Boomi and medical-archiving company InSite One, both announced in 21, whereas HP, after a bidding war with Dell, acquired data-storage company 3PAR for USD 2.4bn in 21. The hunt for margins and defensiveness The strategic redirection of many hardware players to higher margin market segments like IT services and software can be described as the "hunt for margins and defensiveness". Taking IBM as an example: The company divested its Global Network business to AT&T in 1999 and reduced its internal DRAM capacity in the same year via joint ventures with Infineon and Toshiba. The Hard Disk Drive (HDD) business was sold to Toshiba in 22 and the PC business to Lenovo in 25. As a consequence, hardware revenues declined from USD 36.2bn (46% of total revenues) in 1997 to USD 18.bn (18% of total revenues) in 21, while the share of the more defensive IT services and software revenues increased in the same time frame from 49% to 79%. Alongside IBM, there are two other players in HP and Dell with their roots in the hardware segment, currently on their way to lowering their dependence on hardware and to move more strongly into software and/or IT services to raise their operating margins and to become more defensive in their revenue mix. Hewlett Packard: How much of SAP will Léo Apotheker bring to HP? HP: following in the footsteps of IBM Comparable to IBM, the roots of Hewlett-Packard (HP) are also in the hardware segment. In the early 2s, HP was still focusing on increasing its footprint in the hardware segment. The acquisition of Compaq in FY2 initially provided the new entity the number one position in the global PC market. The acquisition of Compaq was a horizontal move. While IBM started the transformation of its business model in the early 199s, HP followed approximately a decade later with the stronger move into the software segment coinciding with Mark Hurd joining the company in early 25 as new CEO and becoming chairman of the board of directors in September 26. Under his leadership, HP also made a stronger move into the IT services segment with the acquisition of EDS in FY8. Since then, HP has been among the Top 3 players in the global IT services market. In November 29, HP acquired 3Com to strengthen its enterprise storage and servers segment (ESS) and smartphone producer Palm in April 21. In August 21, Mark Hurd left HP and joined Oracle in September 21. Shortly after his departure, HP continued to execute its acquisition strategy with the acquisition of 3PAR (after a bidding war with Dell) to expand its product offering in the ESS segment and ArcSight (security and compliance management) to strengthen its software segment, both in September. End of September 21, HP announced former SAP CEO Léo Apotheker as Mark Hurd's successor. Given Apotheker's longstanding track record in the software sector, the market is speculating on a further strengthening of the software segment under his helm. On 18 August, Hewlett-Packard announced that it intends to acquire UK-based Enterprise Information Management software company Autonomy for USD 11.7bn and that it considers a spin off of its PC business. Both moves underpin our view that HP is following in the footsteps of IBM. UniCredit Research page 2 See last pages for disclaimer.
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