4 undervalued tech stocks set to soar

Not just cheap but also dominant, these companies could ride a stronger-than-expected economy to huge gains next year.

By TheStreet Staff Dec 20, 2010 11:49AM

high tech © CorbisBy Jake Lynch, TheStreet


Technology stocks in the S&P 500 ($INX) have generated an average gain of 16% in 2010, the third-worst-performing industry group. But as the recovery ramps up next year, business and consumer spending will accelerate, and tech stocks may lead, analysts say. Value-focused Morningstar covers hundreds of technology stocks but awards its highest five-star rating to only four.


Here is a closer look at those four technology value stocks. They are expected to rise at least 53% and as much as 99%. Below, the stocks are ordered by potential return, from great to colossal.


4. Dow component Cisco Systems (CSCO) makes networking equipment. It holds the dominant position in ethernet switches, with roughly 70% market share, a stable figure. It is also the leader in routers, with Juniper (JNPR) grabbing second place.


Morningstar believes Cisco's growth forecast, at 12% to 17% long-term, is too aggressive, and its movement into the mature blade-server market is ill-advised, potentially threatening important tech partnerships with little chance of profit growth.

Still, at a forward earnings multiple around 10 and a cash flow multiple of 11 -- 43% and 37% industry discounts -- Cisco is grossly undervalued. If management can avoid overpaying for acquisitions and focus on gaining market share in emerging and frontier markets, Cisco's stock will benefit enormously. Morningstar estimates Cisco's intrinsic fair value at $30, suggesting a return of 53%.


12-Month Sales Growth: 20%

12-Month Net Income Growth: 38%

Operating Profit Margin: 22%

Debt-to-Equity Ratio: 0.3

5-Year Average P/E: 20

Current P/E: 15


3. Santa Clara, Calif., company Applied Materials (AMAT) sells manufacturing equipment and services to semiconductor, flat-panel display and solar photovoltaic companies. Like Cisco, it has a dominant market share.


Morningstar says the company has a "wide economic moat," its perception of sustainable competitive advantages. According to Gartner, in 2009, Applied held 15% of a $17 billion market. It leverages existing relationships to build custom high-tech products, thus creating a durable revenue base.


Determined to maintain its position, it invests roughly $1 billion a year into research and development. Its foray into the solar equipment business, though not currently a game changer, will likely pay dividends in the long run as alternative energy rises as a global priority.

Morningstar forecasts a fiscal 2011 slowdown for Applied, with 3% sales growth, which will likely create a buying opportunity for long-term investors. The semiconductor space is unusually cyclical.


12-Month Sales Growth: 90%

12-Month Net Income Growth: 407%

Operating Profit Margin: 24%

Debt-to-Equity Ratio: Minimal

5-Year Average P/E: 20

Current P/E: 19


2. Advanced Micro Devices (AMD) builds microprocessors for servers and computers. Its chief rival is Intel (INTC), the world's largest semiconductor company.


AMD has consistently played second fiddle to Intel, which is able to maintain market share by maintaining a performance lead with its Core 2 chips. However, AMD between 2003 and 2006 stole market share when its Opteron chips beat out comparable Intel products.


Morningstar says AMD's Interlagos and Valencia server chips, to be released in 2011, have a shot at stealing market share from Intel, which will also release new chips. Interlagos and Valencia pack more cores on a single chip, which could help boost productivity and power savings at data storage centers.


Unlike the aforementioned stock picks, AMD is the David, not the Goliath, in this investment thesis. Morningstar doesn't believe AMD has any competitive moat, placing it at a long-term disadvantage, but thinks its stock is cheap relative to near-term earning prospects.


12-Month Sales Growth: 32%

12-Month Net Income Growth: 157%

Operating Profit Margin: 7.9%

Debt-to-Equity Ratio: 3.9

Industry Average P/E: 20

AMD's Current P/E: 5


1. Vimicro International (VIMC) designs, manufactures and sells semiconductors in China. Specifically, it is the leading chip-maker for PC webcams and has enjoyed several design wins for its multimedia chips for mobile phones, which are rapidly proliferating in China.


The company also has a unit focused on surveillance-camera chips. Although recent losses have hurt Vimicro's stock (it is down 31% in 2010), Morningstar expects a return to profitability in 2011, with an operating margin in the low- to mid-teens.


A major issue is the lack of intellectual property enforcement in China, which threatens Vimicro's market share. Also, the semiconductor industry is subject to technological obsolescence and sharp cyclical swings.


Morningstar values Vimicro at $7 with a residual income model, implying the stock could nearly double. It will need to face off against American companies in China, including Nvidia (NVDA) and Texas Instruments (TXN). Vimicro has a home-field advantage.


12-Month Sales Growth: 35%

12-Month Net Income Growth: 56%

Operating Profit Margin: -22%

Debt-to-Equity Ratio: Minimal

Industry Forward P/E: 14

VIMC's Forward P/E: 52


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