Technology Sector Trends That Investors Cannot Ignore

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Most of the technology titans have already reported financial results. The landscape is changing at extremely rapid rates, and now more than ever before, investors have to be agile.

The tech giants as a whole

<img alt="" height="433" src="http://g.fool.com/editorial/images/61056/7-26-13-tech-pic-1_large.png" width="753" />

Source: Ycharts

So the past earnings season has been extremely interesting. The above chart depicts the price increases in the past month that we have seen. Why did Apple (NASDAQ: AAPL), and Facebook (NASDAQ: FB) perform so well? Why did Intel (NASDAQ: INTC) bomb so badly?

Apple guidance was the key

Going into the quarter, investors and analysts were concerned about Apple and whether or not the company could meet its own guidance targets. The way it usually works on Wall Street is that forecasts are built around what the management team thinks it can do. So when we go from one quarter to the next, we see trends in whether or not the management team is meeting expectations, and if it will raise or lower guidance.

The guidance that was provided by Apple was good because the sales figures were slightly higher than the ones in the previous year. This, of course, is only possible if the management team believes that it can ship all of its next-generation products on time. If it cannot do this, then obviously it will miss. The guidance had a favorable impact on sentiment, and we could be due for a surprise as a lot of customers may make the switch to an iPhone.

Phone contacts are going to be ending, and this could be the quarter that Apple gets to switch Android loyalists to the iPhone. Remember, the iPhone wasn’t on Sprint, and T-Mobile until recently, and with older contracts ending, there is still some pent-up demand.

Can we justify owning Facebook?

Facebook jumped by an astonishing 40% the past month. I have been a permanent bull on the company for a while. It doesn’t always make sense to others that I am a growth investor. I believe in the future, but I also believe in value investing. How can you believe in the future and look for undervalued stocks at the same time? The short answer is to look for stocks that are less valuable than what others perceive them to be in the future.

Going into the quarter ,no one was expecting Facebook to beat analyst expectations by 28.5%. The stock is undervalued because investors had the prevailing notion that monetizing mobile isn’t very feasible. But with Facebook launching advertising within a user’s news feed, the company was able to counter the negativity surrounding its strategic shift to mobile.

But it doesn’t necessarily end there. Facebook operates at ridiculous economies of scale and currently has 819 million mobile monthly active users. Technically speaking, running a website doesn’t really require that much. The beauty of a social network is that there are no content costs as users do all the generating. Companies like Yahoo! and Netflix have to purchase content to attract users, but Facebook doesn’t have to.

Operational expenses may continue to fall as the cost of servers has gone down significantly in the past couple of years. In fact, building a super computer that can handle the data of 819 million mobile users is far cheaper than it has ever been before. Those geniuses at Intel are brilliant. Facebook went from a negative 69% gross margin to a positive 31% gross margin. While we can’t blame all of Facebook’s success on gross margins due to servers, there’s no denying that data-center costs have fallen significantly over the past couple of years.

Research and development costs fell, and never should have been so large in the first place. Technology companies have to spend their research and development budgets intelligently. Smart spending is all about finding world-class talent and pushing them into positions of responsibility. Smaller teams tend to do most of the heavy lifting. The best strategy for innovation has been to keep teams small, and find the best talent. Talent will multiply profits.

What went wrong amongst tech companies?

The Intel and Microsoft duo, for the most part, under-performed. Intel had to lower its guidance, and its server segment reported flat year-over-year revenue growth. This is weird isn’t it? Almost everyone is talking about big data, and changes in demand. The prevailing argument is that the cloud will grow, and grow at rapid rates. What some do not know about the cloud is that there are some winners and some losers in this story.

The side that seems to be doing most of the losing is hardware and other equipment manufacturers. In the second-quarter earnings reports from Oracle and IBM, both companies reported year-over-year declines in systems and hardware. The good news is that a server tends to have low gross margins anyway, so the effects on profitability for IBM and Oracle can be largely mitigated through software and service sales, which have high margins.

So there are varying ideas about how the cloud will grow. Some believe in platforms as a service (which allows people to create web applications using software tools in the web). Others believe that the growth will come strictly from software as a service (stuff like Office 365, and Salesforce.com).

The idea, however, is that growth in cloud revenue is likely to come in the form of subscription fees. Services, rather than infrastructure needs. After all the brilliant geniuses at Intel have continued to improve the power of computers, which have allowed companies like Facebook to spend even less on data centers.

<img alt="" height="418" src="http://g.fool.com/editorial/images/61056/7-26-13-tech-pic-2_large.png" width="747" />

Source: YCharts

Notice the correlation in higher profit margins for Facebook, and falling revenue growth in Intel’s server segment? This is because Facebook can run fewer servers thus having higher margins; Intel cannot sell more processors, so it results in falling rates of sales growth.

Conclusion

Going forward Facebook and Apple are the way to go. Avoid Intel, because there are serious structural issues that the company is currently facing.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Apple, Facebook, and Intel. The Motley Fool owns shares of Apple, Facebook, and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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