Three Plays from the Beaten-Up Tech Sector

Times of economic difficulties make for difficult investing. And one of the most difficult sectors is tech. A slowdown in the economy generally means companies rein in any spending, making investing in technology companies especially hard. However, not all companies get pulled under, and I have three I think are worth a look.
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A tightening credit environment and slower consumer spending are likely to reduce the amount companies are willing to invest in new technology, which represents about half the total amount companies spend on new property, plant and equipment.

No matter how difficult the spending environment, however, there are always a handful of companies that buck the trend. Finding such opportunities can provide highly successful stock picks. I think I have discovered a few that are worthy of consideration.

Software

Given our current economic uncertainty, I especially like the relative defensiveness of the software names. Since software design does not require investments in factories, it is not subject to the boom-and-bust cycles associated with more capital-intensive areas like semiconductors and storage. Although customers may forgo an upgrade in tough times, the companies generally remain profitable, flush with cash and virtually free of debt.

My favorite software company is

Ansys

(ANSS). Ansys designs engineering-simulation software used in such industries as aerospace, automotive, manufacturing, electronics, biomedical and defense. This software reduces the time it takes to move products from the design stage to manufacturing because it allows for much of the necessary product testing to be simulated rather than tested on prototypes. The company licenses its technology to businesses, educational institutions and governmental agencies.

In the not-too-distant past, simulation software could be run only on the most powerful workstations. As a result, it was available only to senior-level engineers in any given firm. As computing prices have come down, companies are finding it more efficient to put Ansys on more workstations for more engineers, dramatically expanding the potential base.

Ansys shares have soared more than 62% over the last year, and it's about 15 times its price from 2000. I don't expect that kind of performance in the future, but I think investors can still find pleasing results. Earnings have exceeded analyst estimates by a wide margin for several consecutive quarters, and over the last 60 days, analysts have boosted their earnings estimates for 2008 from $1.47 to $1.62, and their 2009 estimates from $1.74 to $1.92.

Ansys is currently trading right in line with its five-year average P/E ratio of 29. If that average holds, the stock could rise another 15% to $56 over the next year based on current analyst estimates.

Another software stock with strong momentum is

Symantec

(SYMC), which provides security, storage and systems-management solutions. The company has been expanding its product portfolio via acquisitions over the last few years, and the strategy may now be paying off.

On the latest conference call, CEO John Thompson said "we saw CIOs of large enterprises purchase more products from Symantec as they strive to reduce the number of vendors they much manage. This is a trend we expect to continue, particularly during these more challenging economic times."

The numbers seem to back up that statement. Earnings per share of $0.40 beat the consensus estimate by a nickel in the June quarter. Over the last four quarters, the total earnings surprise has been $0.14, and analysts have continued to raise their estimates for 2008 and 2009 earnings. Those estimates now stand at $1.50 and $1.63, respectively.

The current P/E ratio of 14.6 times 2008 earnings is at the low end of the five-year P/E range for Symantec. Meanwhile, analysts expect the company to post 12% growth in earnings per share for the next three to five years, and over the last 12 months, the company has generated $1.54 billion in free cash flow.

I see no need for a company growing 13% per year to offer investors an 8.4% free cash flow yield. I believe that 6.3%, which is twice the yield on five-year Treasuries, should more than suffice. If cash flow grows in line with earnings expectations, that yield could justify a 45% gain to $32 per share over the next year or so.

Though I am not a technical analyst by trade, the stock has been stuck in a $15-$22 trading range for nearly three years. A decisive move above $22 could signal more to come. Based on my valuation analysis, I think such a move is possible.

Semiconductors

Although the high capital requirements of semiconductor companies has traditionally caused them to be more cyclical, I think the time may be right to make some selective bets in the group. For six consecutive quarters, semiconductor companies have shown remarkable constraint in ordering new equipment. Despite showing revenue growth themselves, they are spending less on new capacity.

The spending restraint should improve capacity utilization and margins for all semiconductor firms, but one name seems to stand out above the rest:

Amkor

(AMKR).

Amkor is one of the world's largest subcontractors of semiconductor packaging and test services. Packaging and testing are integral steps in the process of manufacturing semiconductor devices. Amkor provides these services for a laundry list of semiconductor makers, including

Intel

(INTC),

Qualcomm

(QCOM) and

Texas Instruments

(TXN).

Since it services a broad range of semiconductor manufacturers, I think Amkor can participate in a semiconductor sector recovery, regardless of which manufacturers are most successful.

Analysts don't seem to be giving the company much credit. The consensus estimate for 2008 is $1.34, and earnings are barely expected to rise to $1.38 in 2009. This seems overly pessimistic for a company that has beaten consensus estimates by a cumulative $0.34 over the last four quarters.

Investors seem even more skeptical than the analysts, valuing the company at just 6.5 times the current year's expected earnings, despite 10% annual growth expectations. The $388 million in free cash flow the company has generated over the last 12 months is nearly 25% of the company's market capitalization.

Though Amkor has more debt than I'd like to see, it has been aggressively paying it down. Since the end of 2005, total debt has been reduced by nearly $500 million, and it now stands at $1.67 billion. If the debt reduction continues, I think investors will finally reward the company with a higher valuation. A good starting point, in my opinion, would be a still fairly miserly P/E multiple of 10. That alone would justify nearly a 50% increase in share price.

To summarize, while the economic environment may prove difficult for the technology sector as a whole, I think there are several worthwhile opportunities for selective stock picking.

Ansys Software's stock is up more than 62% in the last year, and given a broadening customer base, I see no reason for that growth to stop.

On a technical basis, a break above $22 for Symantec should unleash the stock for a nice upside move.

Amkor seems to be getting an unfair shake from analysts, as they are projecting slowing growth, but the company has beaten estimates considerably over the last four quarters.