Innovation is at the heart of Technology, and one of the best innovators in the world has been California-based Apple Inc. The firm has a rich history of groundbreaking products, starting with the 1984 Macintosh. Apple's innovations in creating a user-friendly computer (as detailed in Chapter 2) helped propel the Mac to commercial success in a relatively new market.

But the computer industry soon became more saturated—Figure 5.2 shows US computer sales reaching a second peak in the mid-1990s (the first being in the 1980s), then moderating through the remainder of the decade. Growth has been relatively muted since, but this is the period in which Apple demonstrated its innovative strength.

Figure 5.2. US Computer Sales Growth Source: Thomson Reuters.

Apple struggled during the early 1990s, losing market share as Windows-based PCs grew in popularity. In order to mimic PCs, Apple licensed its operating system to third parties. But too late—Windows already had a stranglehold on the computer industry. And by the late 1990s, growth was slowing.

Then Apple released a new kind of computer: The iMac G3. While not completely revolutionary, some distinct characteristics differentiated it from PCs—mostly physical design. Resembling early generation Macs, it was an all-in-one machine combining the monitor, CPU, disk drives, and ports in a single encasing. It was also aesthetically unique, with rounded edges and a transparent, blue-colored outer shell. These small yet innovative design tweaks revived sales. After reporting three years of falling sales, two of which included net losses, Apple sold approximately 1.8 million iMacs in 1999—a 68 percent increase over unit sales of similar products in 1998.^[74]

Apple continued to find innovative opportunities to further expand growth in the highly competitive and saturated computer market. Next, it focused on peripheral devices that used computers as "digital hubs. " In 2001, Apple released the iPod. Similar to the iMac, the firm focused on physical design, making the digital music player sleeker than the competition. It also continued its tradition of proprietary software aimed at creating a user-friendly experience. The iPod became a runaway success, eventually driving Apple's growth back into double-digit territory. Following its original release, Apple continually upgraded the iPod with increased memory, different colors, smaller sizes, and the ability to record and play video. Each enhancement and product refresh helped maintain growth and fight off market saturation. But, realizing the iPod's astronomical growth would not last forever, Apple made another innovative leap.

In 2007, Apple entered the mobile handset market. Combining its expertise in digital media players and user-friendly software, the company released its now highly popular iPhone. The device had a sleek physical design and unique touchscreen interface that was a departure from traditional mobile phones. It was an instant success, selling over one million units in the first 74 days of its release.^[75] If fact, it was so popular that virtually every major handset producer in the world began manufacturing touchscreen devices. The iPhone eventually became Apple's primary growth driver, offsetting the slowing growth of its more mature iPods.

While Apple has enjoyed much success, overcoming product maturity is not an easy task. For example, Motorola was also considered an innovator. Its RAZR phone was revolutionary for its time, setting the standard for slim form factor mobile phones. It was highly successful, but like all phones, its growth eventually slowed. Motorola relied too heavily on the device and failed to produce innovative new models, resulting in significant market share loss and deteriorating growth. Motorola's stock was punished by investors.

So how does one invest on innovation? Unfortunately, there isn't a reliable way to tell what a firm has up its sleeve. Firms have a vested interest to keep developing products a close secret. One of the few methods investors can use is examining past performance, but this is a tricky game. Remember, both Apple and Motorola had a strong history of innovation. Only one, however, has yielded outperformance in recent years. So, while innovation can be a highly successful way of overcoming product maturity, it's highly unpredictable for investors.

Fortunately, for investors who manage their portfolios using a top-down strategy (discussed more in Chapter 7), long-term success is predicated more on getting higher-level themes right more of the time, rather than picking the right stock at precisely the right time—a very precarious undertaking. Further, when making individual stock decisions for a well-diversified portfolio, you may have the opportunity to hold several peers, increasing your odds of selecting the industry's better performers, rather than picking just one stock and hoping you get it right.

Another strategy Technology firms use to fight product maturity and slowing growth is acquisitions, and there are few Tech consolidators as successful as Oracle. The firm began and still dominates in database software—Oracle had a 44 percent share of the market in 2007.^[76]

In 1995 and 1996, Oracle was growing sales by over 40 percent annually.^[77] But naturally, as the market matured, growth slowed. After modest but healthy single-digit growth in 2004, Oracle purchased PeopleSoft for a final value of $8.4 billion.^[78] The acquisition more than doubled Oracle's 2005 sales growth to 16 percent and broadened the firm's offerings in application software^[79]—and kicked off an acquisition spree. In 2006, the purchase of Siebel Systems pushed sales even higher, and by 2007, growth was over 25 percent.^[80] In just four years, the firm doubled annual sales, operating income, and net income. And Oracle's significantly expanded product portfolio generated cross-selling opportunities and helped reignite growth in its core database offerings.

Oracle's acquisitions have been successful overall, but offsetting product maturity through acquisitions can be risky. Integration can be costly, time-consuming, and potentially distracting to management. However, if done correctly and well, this strategy can bolster growth and strengthen a firm's competitiveness.

How does M&A impact the sector? It depends on how deals are transacted. When one firm acquires another by paying cash (either with cash on hand or with borrowed funds), the acquired firm ceases to exist as an independent, publicly traded firm. Those shares are removed from the market and sector share supply declines. Because stock prices are ultimately dictated by supply and demand, this should have a positive impact on prices if the demand for Technology shares remains constant or rises. This bullish force becomes more powerful if the sector as a whole experiences a high level of cash-based mergers.

But mergers can also be transacted in stock. For example, Firm A is worth $20 billion and Firm B is worth $10 billion—that's $30 billion in total stock supply. Say Firm A wants to buy B. Usually it'll pay a premium, maybe 20 percent—paying $12 billion. Firm A issues $12 billion in new Firm A stock, and B ceases to exist. Except, where we once had $30 billion in total stock supply, we now have $32 billion. If this happens broadly, it can have a negative impact on prices sector-wide if demand for Technology shares doesn't keep pace.

Deals can also be transacted partially in cash, partially in stock. For example, Firm A might pay a hybrid of $6 billion in cash and $6 billion in stock for B. But most cash/stock deals tend to result in lower overall supply, which can be a bullish factor.

How do you know when cash-based deals or cash/stock hybrid deals are more likely to occur? Watch bond yields and earnings yields. A bond yield represents a firm's borrowing cost. The earnings yield is the reverse of the P/E ratio—the E/P (earnings per share over price per share). When earnings yields are higher than bond yields, a firm can borrow cheaply and buy a higher earnings yield—the difference between the higher earnings yield and the lower bond yield is profit. Done right, the deal finances itself and is immediately accretive to the acquirer's earnings. The acquirer's earnings per share rise, and, all else being equal, share price should follow. This is powerful incentive for CEOs to transact acquisitions (or buy back their own shares—the same concepts apply). Periods likely to see a higher rate of mergers and acquisitions are when interest rates are generally benign and bond yields are lower than earnings yields—just as we saw in 2005, 2006, and 2007.

That's the sector-wide impact, but the affect on individual stocks can be subject to other considerations entirely, at least in the short term. In the very near term, sometimes Wall Street reacts favorably to deal news, sometimes negatively. As an investor, it's critical you understand how a deal impacts a firm for the longer term and don't get swayed by near-term knee-jerk reactions. For a deal to work, firms should find targets that fit well into their existing business or somehow introduce a new, competitive value proposition.

Another strategy to battle mature or increasingly obsolete markets is shifting business models. This is more radical than the kind of innovation we've talked about so far. Instead of a PC maker innovating a new feature for computers, we're now talking entirely new product lines. However, doing this can be dangerous if it's a journey into the unknown.

One of the most successful transitions in business history was IBM's. After more or less creating the PC, IBM failed to recognize the market's potential and gave up control of the operating system and microprocessor to third parties in the early 1990s. Thanks in part to the rising strength of Microsoft and Intel, PCs gained significant momentum while sales of IBM's core mainframes fell. Corporate computer systems evolved, and, instead of the traditional all-in-one model, they were being pieced together with hardware and soft-ware from multiple vendors. This fundamental shift caught IBM off guard, bringing the firm to the brink of obsolescence.

Results suffered greatly. Between 1990 and 1993, IBM's gross margins fell from about 56 percent to 39 percent, with operating margins falling from 16 percent to 0.5 percent.^[81] Mainframe sales were declining at a precipitous rate. The firm posted a net loss of almost $3 billion in 1991, which widened to over $8 billion by 1993.^[82] The technology giant was nearing destruction, and its stock price fell almost 60 percent from the end of 1990 to mid-August of 1993.^[83]

Many believed the firm couldn't survive as a vertically integrated organization, and then-CEO John Akers planned to split IBM into multiple independent companies—aiming to make them more nimble. However, after two straight annual net losses, Akers stepped down and the firm searched for a new CEO. In 1993, Louis V. Gerstner, Jr. became IBM's first ever executive from outside its own ranks, leaving his role as Chairman and CEO of RJR Nabisco.^[84]

His first job was to return IBM to profitability, which meant significant cost reductions. In total, these cuts amounted to $8.9 billion, with 35,000 layoffs.^[85] The firm reengineered operations, lowered expenditures, sold real estate and other assets, and reduced its dividend. By 1994, operating margins were back up to 7.8 percent.^[86] However, this was only the beginning. Gerstner needed to make IBM relevant again, so he made a series of very large bets that challenged the way IBM previously operated.

The first bet was keeping the firm together instead of breaking it into pieces. Gerstner believed one of IBM's core strengths was its breadth of customer solutions.^[87] The next two bets were on the future direction of the entire Technology sector. The growing industry trend was to build corporate computer systems with pieces from multiple manufacturers. A firm could use PCs from Dell, servers from IBM, and storage systems from EMC. However, it would be up to the firm's IT staff to figure out how to integrate the products, many of which operated on different standards. As a result, IBM bet Technology's future was in solutions helping customers build, integrate, and maintain these complicated piecemeal IT systems.

This last change didn't come easily. IBM now had to recommend competitors' products over its own if those products better fit the customer's needs. However, keeping the firm together proved a smart decision. IBM's deep expertise in so many fields of technology enabled it to offer a broad range of solutions. The firm also bet networked computing would overtake stand-alone, and that such a shift would require more open industry standards. As a result, IBM "opened" its products to interoperate with other industry platforms, which prepared it for the coming Internet revolution.^[88]

IBM's turnaround did not occur overnight, but Gerstner was able to return the company to profitability in 1994 and increase net income almost 170 percent over the next 5 years.^[89] Fast forward to 2008—IBM is now the largest IT services firm in the world. Operating mar-gins are even back to 15 percent.^[90] Though the firm was caught off guard, it successfully regained its footing by transitioning business models.

Because they all differ, there's no standard way to invest in new business models. Transitions can also take years to implement, which can reduce accuracy of forecasts. Also, as we'll cover in Chapter 7, it's impractical to make forecasts for more than the next 12 to 18 months, yet a wholesale change in a company's business model assuredly will take at least as much time, usually more.

However, performing high-level analysis on how a firm's strategy fits into wider industry or sector trends is always important. If you've determined the new strategy is a smart one, your next bet should be on execution. Can the company successfully make the transition? Can they do it faster than most expect? Answering these questions is difficult. Similar to the innovation example, looking at past performance is one of the few, albeit unreliable, ways to gauge competence. Experience is another. Who is leading the effort and is their background relevant? In IBM's story, Louis Gerstner had extensive experience running customer-centric organizations, which was particularly helpful as this was the quintessential focus of IBM's new strategy.

Another method of combating slowing growth is to restructure operations and reduce costs. This, however, is usually a temporary solution—getting leaner can improve profits, but it can't grow revenue. Without any catalyst to reignite sales, it may only slow bottom line bleeding. But if done in the face of increasing sales, it can add a significant earnings boost.

In recent years, Hewlett-Packard has been successful at cutting costs. While the firm has always made efforts to keep expenses in line, everything changed when Mark Hurd took the helm in 2005. Through an aggressive multiyear program, the firm cut its work force, overhauled its retirement plan, and continually streamlined operations. The results were impressive. After a 12 percent increase in 2005, operating income grew over 36 percent the following two years.^[91] Margins expanded from 5.7 percent to 8.9 percent.^[92] More notably, HP's stock price increased over 140 percent between 2005 and 2007.^[93]

This stock appreciation was due to more than just cost cutting. In recent years, demand for notebook PCs skyrocketed, particularly from emerging markets. This benefited many firms, but HP was positioned particularly well with its better scale and superior global distribution network. Its stronger presence in regions with high demand led to market share gains over its closest rival, Dell.

Stiff competition and overly crowded markets have commoditized certain semiconductors (i.e., there's little product differentiation other than price). Demand for these chips often goes through boom and bust cycles, leading to wild gyrations in sales and earnings for the manufacturer—similarly impacting stock valuations. Typically, stock prices will tend to follow the same direction of the underlying commodity's price—in this case, the semiconductor. Hence, in an ideal scenario, product demand outstrips supply. This generally leads to higher chip prices—and stock prices—for all industry players, with some exceptions. The opposite can be said for periods of falling demand or chip prices. These periods, however, can cause irrevocable damage to certain manufacturers' sales and earnings and force them out of the market.

In recent years, one of the most volatile and fiercely competitive markets has been memory, specifically DRAM. The madness began with the announcement of Microsoft's Windows Vista in 2005. The new operating system required significantly more internal memory to function, leading many to believe its release would bolster DRAM demand. As a result, virtually all DRAM manufacturers increased production in order to meet this future surge in demand. There was just one problem: It never occurred—at least not at the level chip manufacturers expected.

The market flooded with DRAM chips and, naturally, prices fell. The decline was pronounced. As shown in Figure 5.3, from January 2007 (when Vista was officially released) to January 2008 the average price per unit fell 61 percent, with an additional 28 percent drop the following year.^[94] This is despite an upward trend in unit shipments that lasted until the Lehman collapse and sharp stock market sell-off in September 2008.

Figure 5.3. Global DRAM Prices vs. Unit Shipments Source: Thomson Reuters.

DRAM manufacturers were posting dismal results and stock prices suffered. Figure 5.4 shows performance of four global memory manufacturers. With the exception of Korea's Samsung Electronics, each company's stock price was down more than 40 percent from January 2007 to September 2008, before the Lehman collapse. Over the same period the MSCI World Index was down less than 10 percent.

Samsung outperformed its peers due to a few strategic attributes. First, it's the world's largest memory manufacturer with the widest economies of scale, allowing it to better withstand the negative pricing environment. Its stronger financial resources also helped it maintain higher levels of capital expenditure despite weaker profits. But perhaps the most important attribute was its diversity. Samsung also happens to be the world's largest manufacturer of LCD panels and the second-largest mobile handset producer, behind Nokia.

Figure 5.4. Stock Performance of Top Memory Manufacturers Source: Thomson Reuters.

Among many other macroeconomic factors, the severe pressure on memory manufacturers led to insolvency fears for certain players, some of which were realized. German memory producer Qimonda filed for bankruptcy in early 2009. (Counterintuitively, this led shares of remaining DRAM makers higher on speculation the supply decrease would drive prices for DRAM chips higher.)

Investing in volatile markets like DRAM is closer to investing in Materials or Energy firms than Technology. Stock performance is generally driven by price movements of the underlying product. In other words, you would expect the stock of DRAM producers to increase if prices for DRAM chips were rising (or expected to). Hence, the best method to invest in these types of markets is to generate forecasts on future product supply and demand.

Semiconductor equipment is not commoditized in the same way as memory chips, but demand is heavily dependent on capital expenditures by semiconductor firms. When the semiconductor industry experiences volatility, so do equipment manufacturers. These capital expenditures are generally massive, so shifts in equipment demand can be violent. However, this volatility is cyclical and can act as both a headwind and tailwind at different points in the cycle. As covered in Chapter 3, semiconductor equipment stocks tend to perform best following deep troughs in the industry book-to-bill ratio.

DRAM market imbalances also impacted semiconductor equipment manufacturers. In 2006, chip makers were producing memory as fast as possible to boost supply in anticipation of Windows Vista. Many were even expanding production capacity by building new fabrication plants, leading to a significant increase in equipment demand. Top player Applied Materials posted 31 percent sales growth and 25 percent net income growth in its fiscal year 2006.^[95] Moreover, 2006 fourth-quarter profit was up 82 percent, with memory manufacturers accounting for over 50 percent of total semiconductor equipment bookings.^[96] It wasn't just Applied Materials that benefited—this was an industry-wide trend.

But DRAM prices started falling in 2007. To stem the decline, chip producers scaled back production and reduced supply growth. They reined in capital expenditures and ran plants at higher utilization rates, leading to a sharp fall off in equipment demand. After more modest growth in 2007, Applied Materials reported a 17 percent drop in sales and a 44 percent drop in earnings in fiscal year 2008.^[97] The memory supply/demand imbalance had gone from a tailwind to a significant headwind in approximately two years, underscoring the importance of being mindful of potential supply and demand disruptions when analyzing Technology.

Piracy is a common threat, most prevalent in emerging markets like China and Russia, where property rights enforcement is weak. The software industry has been one of the hardest hit—41 percent of all installed PC software in 2008 was illegally copied, a 3 percent increase over 2007.^[98] This represents $53 billion in potential sales lost. It gets more expensive if you factor in legal costs to prosecute violators.^[99] Companies like Microsoft have attempted to increase security features on products, but they never work perfectly. It is usually just a matter of time before violators find ways to circumvent protections.

Piracy can also be found in developed markets. While there is less actual counterfeit software, many take advantage of the "honor system" under which real software is sold. Businesses often pay for licenses on a per seat basis—a fee is paid for each terminal the software is installed. But in many cases, the software provider can't physically track the number of installations. They can only trust the customer will use it in a legal manner, which is not always the case.

Another challenge is property protection in Technology is less distinct than other sectors like Health Care, where small changes in chemistry yield completely different results. Technology competitors can more easily engineer around rules and emulate successful products. For example, Yahoo! built its search engine using a substantial amount of intellectual property, but the firm still couldn't keep Google from entering the market with a new, slightly different search engine. Apple's iPhone touchscreen is another example. Shortly after its introduction, almost every handset manufacturer introduced a similar touchscreen phone.

There are Technology firms that have successfully defended intellectual property, but success is never guaranteed. Until intellectual property rights are better defined, protecting them will be a continuing challenge for Technology firms.

Chapter Recap

• Innovation is a primary lever of organic growth and market share expansion.

• There is no great way to forecast future innovation success other than by relying on past management performance and reputation. Buy innovation champions when you can get them at a cheap price.

• Mergers and acquisitions are common in the Technology sector. The best deals involve targets that are complimentary to current operations from a product or geographic perspective, come at a fair price, offer myriad synergy opportunities, and are margin accretive.

• Sometimes, firms in the Technology sector find themselves irrelevant and on the brink of obsolescence. In these cases, a complete shift in business strategy may be warranted, but it is one of the riskiest bets a company can make.

• Certain areas of the Technology sector have become increasingly commoditized. This has resulted in volatile demand and prices, which can act as both a headwind and a tailwind to Technology firms.

• Protecting intellectual property is a challenge for many firms in the Technology sector. This trend will likely continue in the absence of better defined property rights and enforcement.