Rethinking technology stocks: Opportunities in today s IT sector

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1 Wells Fargo Advantage Funds June 2011 Rethinking technology stocks: Opportunities in today s IT sector Michael Thomas, CFA, and Rob Allen Wells Fargo Funds Management, LLC Domestic Equity Group Although it might have been difficult to imagine at the start of the millennium, few sectors appear to be as well positioned as the information technology (IT) sector to navigate today s recovering yet still challenging economy. We believe the sector offers unique secular growth opportunities stemming from two key sources: IN THIS REPORT Today s IT sector IT innovations: Cloud-based computing... 5 IT innovations: Mobile devices Conclusion Increased enterprise spending on cloud computing and virtualization technologies, which can yield distinct cost savings and operational efficiencies for businesses. Further spending on the latest mobile devices by both consumers and businesses. We believe these are significant long-term trends with the power to reshape the IT sector in the years ahead much as the internet did more than a decade ago and reward discriminating investors. However, comparisons with previous investment cycles can be misleading. In our view, the investment opportunities to be found in today s generation of fast-growing tech stocks are not only compelling but also unprecedented.

2 Today s IT sector Many investors still have vivid memories of the tech boom and bust cycle, so it is important to stress that today s IT sector bears little resemblance to that of the early 2000s. The tech stock rally of the 1990s drove valuations to unsustainable heights given the companies earnings, culminating in the collapse of the sector in Since then, the unwinding of the tech bubble and a rebound in technology spending have prepared the way for a much improved sector landscape. Corporate IT spending climbed to $488 billion as of March 31, 2011, after bottoming out at $336.6 billion in late 2002 a 45% increase. In addition, consumer spending on technology has steadily risen since early 2009 and is approaching the peak it reached in May Much of the spending on technology can be attributed to overseas countries; the sector now derives more than half of its total revenues from abroad, providing many IT firms with a globally diversified revenue stream. Thomas Pence, a Wells Fargo Advantage Funds portfolio manager, commented, We continue to favor companies tied to mobility, cloud computing, and network virtualization trends. To a large degree, the recent upward trajectory in IT spending reflects strong demand for these innovative technologies, which we expect to garner an increasingly larger percentage of total IT spending going forward. Chart IT spending on computers, software, and communications equipment $ billion Q1 90 Q1 93 Q1 96 Q1 99 Q1 02 Q1 05 Q1 08 Q1 11 Source: International Strategy & Investment (ISI) 2

3 IT innovations driving fundamentals In order to gauge how well industry leaders have exploited the market for IT innovations, we looked at 149 large- and mid-sized technology companies in the Russell 1000 Index. We isolated the top 50 companies by their expected three- and five-year earnings growth and refined the list further by looking at those that were meaningfully influenced by secular trends in either cloud computing or mobile devices a total of 22 companies. We assessed these 22 companies fundamental results over the past five years to evaluate the strength of end demand. To do that we first examined historical sales growth and sales surprises, followed by earnings per share surprises, to determine the impact of top-line results on the bottom line. Finally, we performed a valuation analysis relative to the broad IT sector. Based on our findings, we concluded that most of today s leaders in new technologies have demonstrated favorable fundamental characteristics and appear to be at least fairly valued for their growth potential. For both the cloud computing and mobile peer groups, sales growth consistently outstripped that of the overall IT sector. The cloud computing group recorded positive sales growth even in the midst of an economic downturn in 2008 and parts of 2009, highlighting the resilient market for such technologies. In mid-2009, both peer groups began a string of upside sales surprises, with roughly 80% or more of the names in each group beating top-line estimates in every quarter since. Although earnings estimates for these companies were revised upward, many of their earnings also surprised on the upside despite the fact that Chart Sales surprises: Percent of cloud, mobile, and Russell 1000 IT companies beating quarterly sales estimates 80 Percent Source: FactSet Mobile Cloud R1000 IT

4 their operating expenses were higher than those of the broad sector due to stepped-up spending (for example, sales force expansion) to meet burgeoning demand for their products and services. A key indicator of these firms future prospects will be the extent to which business reinvestment translates to continued earnings momentum. As of March 31, 2011, the median forward price/earnings (P/E) multiple for these stocks exceeded that of the IT sector, yet we believe valuations are in many cases easily justified by healthy underlying fundamentals, including: Visible and recurring growth in revenue and earnings, as discussed above. Attractive market opportunities in cloud computing, virtualization, and mobile devices. Scalable business models to address a large customer base without a substantial increase in costs. Companies with direct ties to cloud computing have traded at the highest premiums in the wake of the solid revenue growth they have posted over the past several quarters. As a result, we believe that potential share price gains may be more heavily influenced by earnings growth than by price multiple expansion. With regard to the mobile peer group, valuations are only modestly higher than those of the rest of the sector and actually contracted up until the past few quarters. In both peer groups, bottom-up stock selection will be pivotal for investors as higher levels of anticipated future growth get factored into stock prices, potentially magnifying the downside risk from any disappointments in revenue or earnings. To understand why growth expectations are being ratcheted up, a closer look at both cloud computing and mobile devices is warranted. 4

5 IT innovations: Cloud-based computing With economic and employment growth unlikely to accelerate rapidly in the near term, and with many enterprises holding sizable cash reserves, we expect businesses in a variety of sectors to continue to turn to IT innovations that can: Boost company productivity by promoting faster, more efficient workplace performance and communication. Cut costs by producing a positive return on invested capital through realized savings. Most of these innovations can be traced to the advent of the internet, which has spawned tremendous advancements in how businesses and their employees communicate and use information. So-called cloud-based computing systems cloud being a metaphor for the internet basically involve using the internet to connect to and share a range of virtual resources, hence the term virtualization. The onset of the era of cloud computing and virtualization has revolutionized IT at the enterprise level. Virtualization The development of virtualization technologies has given businesses the means to more effectively leverage cloud-based solutions. Until recently, businesses were sharing information mainly through physical servers connected to on-site computers with limited capabilities through the internet, often leading to operational inefficiencies and higher IT and energy costs. Growing demand for data sharing and more efficient computing led to the creation of new server and desktop virtualization technologies that enable the consolidation of physical IT hardware. In effect, the days of companies using multiple on-site servers in different remote locations to handle data computing and storage have been replaced by a virtual environment that relies on centralized, large-scale data centers. This represents a tectonic shift in the information technology sector, with the benefits from an enterprise standpoint having been well documented by market research firms. For one, server and desktop virtualization allows applications and data to be accessed and shared by numerous users in a more cost-effective manner. In fact, a Forrester Research study of 29 enterprises that implemented server virtualization found that the majority of these companies managed to recoup their investments within one year through decreased hardware and other costs. In addition, even though only 10% to 30% of their servers had been virtualized at the time of the study, most of the 29 companies were able to augment capacity in their data centers, making the delivery of their IT services more efficient and predictable. Virtual servers can also typically be brought online in a matter of a few days or less, much more quickly than physical servers, thereby minimizing the risk of business interruptions. Key benefits of server virtualization: Decreased hardware and other costs Increased data center capacity More efficient, predictable IT services Faster time to market The transformative role of such technologies bodes well for IT firms that offer state-of-the-art virtualization solutions. VMware, for example, is a leading provider of server and desktop virtualization solutions for many of the complex IT issues faced by today s businesses. 5

6 Private versus public cloud Many companies IT departments are currently ramping up their cloud computing efforts through what are known as private, or internal, companyspecific clouds. Larger enterprises especially have recognized the productivity and cost efficiencies to be reaped by harnessing many of these virtualization technologies while continuing to manage their own data centers. At the same time, the consolidation of computing resources to the data center has fostered the need for tools that help facilitate the smooth flow of applications and data through the cloud. While the expansion of the private cloud is well under way, another promising growth avenue for IT firms offering cloud-based technologies lies in what can be described as a more complete outsourced solution public cloud computing. In a public cloud setting, clients use the cloud provider s existing hardware (for example, servers) in its data center. This supplies the bandwidth needed to handle the data and the power to run the server and permits the user to simply connect to the internet to access shared applications and data. While small- and mid-sized businesses are beginning to adopt public cloud solutions, larger organizations have generally been slower to latch on to the concept. Over time, however, we expect more companies to realize that moving to the public cloud can potentially maximize efficiencies. Along with others, we believe the IT sector is in the very early stages of a gradual migration toward more widespread usage of public cloud computing. According to research firms Gartner and ISI, the public cloud services market was valued at approximately $59 billion in By 2014, it is projected that public cloud services will total $149 billion an increase of 153%. Chart Public cloud services: Total market value $149 billion $ billion $59 billion (est.) Sources: Gartner and ISI 6

7 Network application delivery and security tools Many companies across different sectors have experienced a sharp uptick in network traffic and have therefore placed a priority on ensuring that their networks provide more robust services. Not surprisingly, most also want faster network and application response time to help raise productivity while still maintaining a secure platform. Consequently, technology solutions that enhance IT network delivery and security have been in demand at the enterprise level. As a higher volume of data travels through data centers from PCs, tablets, and smartphones, there is a greater need to monitor and manage applications in the cloud. To meet their end users needs in this area, proactive IT firms, such as F5 Networks, have developed innovative solutions to manage how network data and applications are transmitted, stored, and optimized. Wide-to-area network (WAN) optimization and application-acceleration tools, for example, are designed to speed up response times and control bandwidth usage. These tools also support the cost reductions associated with server consolidation. To address their security concerns, some businesses employ a combination of private and public cloud technologies. Currently, the public cloud domain is mainly used for company data considered to be nonsensitive, while highly sensitive data has, for the most part, been housed on a private cloud or in an internal data center. As noted above, a broader shift to the public cloud could yield greater efficiencies and savings for businesses, but it would also bring a heightened need to secure data and applications. Before adopting public cloud solutions, large companies in particular would likely insist that enterprise security software providers, such as Fortinet, put the necessary security precautions in place. Software as a service As an alternative to installing their own software and just using a cloud provider s hardware, businesses can choose to purchase the provider s software as well. These software-as-a-service (SaaS) applications can add considerable value for a business and are fueling the first phase of growth in public cloud computing. SaaS applications are deployed over the internet and made available to companies on an on-demand service basis, which may be beneficial for smaller businesses that want to expand their reach to a wider end-user base without having to build an extensive IT infrastructure. Regardless of the business size, SaaS provides a fast time to market and can save money by giving companies the flexibility to match technology purchases to a variable-cost business model based on their needs, instead of having to make large, up-front expenditures or a long-term commitment. SaaS also enables firms to focus less on noncore business functionalities (for example, human resources) and more on their core competencies. Yet another advantage for the user is that all system upgrades and ongoing maintenance are instantaneous and seamless. 7

8 Likewise, development and maintenance costs are relatively low for IT firms offering SaaS, because there is only a single version of software across the firm s customer base. The software also requires minimal on-premise installation for the client. Certain Saas providers are already seeing strong revenue growth as the trend toward cloud-based computing gains traction. For instance, we believe salesforce.com is on the cutting edge of this paradigm shift. The company, which provides online customer relationship-management services, has a subscription-based SaaS business model that has generated recurring, highly visible revenues and has been actively expanding its product offerings to capitalize on untapped market opportunities. Chart Sales growth: Median year-over-year growth rates for cloud, mobile, and Russell 1000 IT companies Mobile Cloud R1000 IT 40 Sales growth (%) Source: FactSet 8

9 IT innovations: Mobile devices Technology innovations at the consumer level have been another growth catalyst for the IT sector. Even in today s subpar economic recovery and weak job market, consumers have shown a willingness to spend on newer-generation technology products over the past couple of years. Looking ahead, we expect consumer spending on the latest technologies to remain brisk amid a gradually improving economy and, most important, sustainable demand for these technologies. More specifically, the popularity of mobile wireless devices such as smartphones and tablets has surged in the past few years, presenting additional secular growth opportunities for specific IT firms. As Thomas Ognar, a Wells Fargo Advantage Funds portfolio manager, explained, The proliferation of these mobile wireless devices that consumers are grasping on to is starting to drive a ton of data and demand through the IT chain, whether it be networking, virtualization, or cloud computing. As a result, you re seeing a lot of benefits secularly within the technology space. Equally noteworthy is that use of such mobile devices is becoming much more prevalent at the enterprise level due to today s less centralized workplaces, so clearly the trend is not being driven exclusively by consumers. Beneficiaries of the growth in mobile devices include operating system providers (for example, Google), chip providers (for example, Qualcomm), and, of course, makers of the devices themselves (for example, Apple). Providers of virtualization technologies (see previous section) are also apt to benefit as more and more mobile devices feature desirable capabilities that require virtualization. Gartner forecasts that by 2012, more than half of all new smartphones will contain an element of virtualization. 9

10 Smartphones Led by firms such as Apple, maker of the iphone, the recent growth of smartphones has been particularly striking, with sales rising at a much faster pace than traditional handsets. According to ISI, smartphones share of the total handset market jumped from 12% in the fourth quarter of 2008 to 22% in the fourth quarter of 2010 and is likely to keep growing. Gartner predicts that by 2013, premium smartphone devices costing more than $300 will capture a little over 40% of the handset market, illustrating an evolving pattern that could eventually be replicated in the underpenetrated emerging markets. Many consumers in developing markets such as the BRIC countries Brazil, Russia, India, and China have already begun to embrace mobile devices. According to ISI and Gartner, 61% of the incremental growth in handsets over the 12 months that ended December 31, 2010, came from such countries, yet their penetration levels are still quite low. As these markets mature and handset usage continues to spread, it stands to reason that a natural transition toward smartphones and other, more data-intensive mobile devices would take hold at some point, bolstering the growth profile of select IT firms with an emerging-markets presence. Supporting this outlook, some industry experts predict that by 2015, 50% of all mobile phone users in China will own a smartphone. Chart Developing markets remain underpenetrated U.S. Brazil Russia India China 162% Market penetration per 100 people % 39% 42% 29% 97% 90% 45% 56% 20 0 Internet users 5% Cell phone users Source: The World Bank (as of ) 10

11 Conclusion We view the information technology sector as a powerful secular growth story that is likely to remain intact for years to come. However, it is essential to note that the rewards will not be shared equally across the sector, meaning that skilled individual stock selection will be critical to investor success. Currently, we think the most attractive investment opportunities lie in fundamentally sound, reasonably valued IT companies that are moving swiftly to capitalize on long-term trends in cloud computing, virtualization, and mobile devices. In our judgment, many of these firms are poised to take market share from competitors and achieve further growth in sales and earnings, potentially pushing their stock prices higher perhaps dramatically higher in some cases. While there are many possible ways to gain appropriate exposure to such stocks, a well-diversified, actively managed domestic mutual fund may allow investors to both mitigate the downside risk and participate in the potential upside gains. 11

12 Strength. Expertise. Partnership. Wells Fargo Advantage Funds skillfully guides institutions, financial advisors, and individuals through the investment terrain to help them reach their financial objectives. Everything we do on behalf of our investors is built on the standards of integrity and service established by our parent company, Wells Fargo & Company; the expertise of our independent investment teams and rigorous ongoing investment review; and the collaborative level of superior service that is our trademark. More information about Wells Fargo Advantage Funds is available free upon request. To obtain literature, please write, , or call: Wells Fargo Advantage Funds P.O. Box 8266 Boston, MA Institutional investment professionals: Retail investment professionals: Website: wellsfargo.com/advantagefunds Important disclosure: The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Portfolio manager comments are as of June 2011 and are subject to change. Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Funds that concentrate their investments in a single industry may face increased risk of price fluctuation over more diversified funds due to adverse developments within that industry. Some funds, including nondiversified funds, small- and mid-cap stocks, and/or more volatile segments of the economy, entail additional risk and may not be appropriate for all investors. Consult a fund s prospectus for additional information on these and other risks. Carefully consider a fund s investment objectives, risks, charges, and expenses before investing. For a current prospectus, containing this and other information, call or visit wellsfargo.com/advantagefunds. Read it carefully before investing. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Advantage Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA/SIPC, an affiliate of Wells Fargo & Company Wells Fargo Funds Management, LLC. All rights reserved. FAWP