Broyhill Letter (q2-09)

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THE BROYHILL LETTER “If GM had kept up with technology like the computer industry has, we would all be driving $25 cars that got 1,000 MPG.” – Bill Gates

Executive Summary There has been a dramatic change in capital markets since the turn of the millennium, but the Technology industry in particular has undergone a metamorphosis over the last decade. At the height of the go-go nineties, the sector sold at over 50 times peak earnings and at an average free cash flow yield of less than 2% while the long bond offered almost 6%. Implied growth expectations were questionable at best. Since those exhilarating days the sector has been rationalized, and today’s survivors offer a current free cash flow yield of 9%. After a long stay in growth stock purgatory, a different beast has emerged, and now the numbers are skewed in investors’ favor. While the growth outlook isn’t what it was in the heyday of the 90s, the fundamentals rest on a much stronger foundation.

The Lost Decade Technology’s long stay in growth stock hibernation has, in all likelihood, come to an end as the bottom in fundamentals looks to have been around the turn of the year. Considering the depth of the current cycle, margins have held up extraordinarily well. Following the bubble bust, businesses tightened their budgets to a point where investment dramatically undershot its long-term trend. As a result, earnings should prove less cyclical than prior cycles when investment in technology had overshot. The survivors offer strong operating leverage, global franchises and unparalleled financial flexibility. The consensus neither anticipated nor believed the underlying shift in the sector, and despite their rhetoric, current yields tell us that skepticism has yet to be extinguished. While no longer trading at depression extremes, the sector still offers a free cash flow yield more consistent with those seen at major cyclical troughs. More than any other sector, Technology offers what interests us most: an under-represented (see Chart I) and under-valued opportunity with improving fundamental trends. Chart I :: Investors still suffering from a bubble hangover

A Switch Hitter? Our favorite macro theme for this year has been cyclicality. We believe government efforts to reflate will be successful and see stocks discounting a brighter outlook over the course of the year (particularly those with high foreign sales exposure, i.e. Technology). Of course the longer-term is an entirely different ball game as the deleveraging process which began last year looks set to last for a very, very long time; but that is a story for another time. Today, we believe the most important theme is operating leverage versus financial leverage. And on that front, there is no better expression of this dynamic than Technology. Technology stocks are typically a

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group that trade coincident with economic prospects of the Chart II :: An indication of pent-up demand? global economy. And most of the indicators we are monitoring today are already at or below the lows reached during the bust, in terms of both time and magnitude. As a result, U.S. tech spending in Q1-09 fell to its smallest share of GDP since Q4-94 (near the start of the bubble) and more than 20% below trend (see Chart II). We believe levels this low suggest we have seen the worst and tend to coincide with stabilization in the performance of the industry. The stocks have been rising in the face of negative news, suggesting investors have only just begun to discount a recovery. Valuations are coming off historic lows (well below the 2002 trough) and it is common for valuations to rise as economic prospects find a footing. The most appealing aspect of the sector given the macro backdrop is that it seems poised to do well under various economic outcomes. Traditional “defensive” segments of the market present specific risks in the current investment landscape: healthcare faces tremendous regulatory risk; consumer staples face stiff valuation headwinds; utilities carry tremendous levels of debt. However, the Technology sector is sheltered from many of the issues facing the market today. The stocks in the group have little debt, lots of cash, and few unfunded liabilities. With lower debt levels (median debt/equity for S&P Tech is 40 versus 70 for S&P 500) the sector is less exposed to the credit crisis, not to mention management’s ongoing experience dealing with deflationary price levels.

Ripe for Consolidation After an expensive education in 2008, we expect investors will become more “leverage-sensitive” in their future endeavors. Technology is the least leveraged sector of the market (see Chart III), and as a result, companies in the industry are better positioned to sustain rising dividend payments. At year end, the Tech sector had $244B or 31% of the cash in the S&P 500, ex-Financials. Was it that long ago that institutional investors were throwing temper tantrums because of the cash sitting on the industry’s balance sheet? $30B Chart III :: Tech boasts healthier balance sheets than most consumers special dividend anyone? Turns out that a conservative capital structure - a protective cushion against rapid product cycles, competitive shifts and technical risk - wasn’t such a bad idea after all. Unfortunately, this is not part of GE’s Six Sigma Black Belt curriculum. The decline in the market cap of Tech shares combined with large cash positions makes a good deal of the sector ripe for industry consolidation . Large parts of the Enterprise Technology industry are maturing as growth slows, competition increases and core computing resources commoditize. Consolidation is the likely result. CSCO’s entry into computing and ORCL-JAVA are catalysts. EMC and NTAP’s battle for DDUP and BRCD’s bid for ELX are evidence. We believe that the industry is in the early stages of a 2

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significant consolidation cycle that should last years. We expect activity to pick up substantially as there are too many players in highly fragmented industries and potential acquirers are sitting on mountains of cash. We recently came across an interesting statistic in reading the work of another manager we highly respect: the top fifteen companies in the industry have enough cash on hand to acquire almost every other public software company! Lender financing is not an issue.

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Chart IV :: Prices have trended sideways as management has hoarded cash for a rainy day

Bottom Line This year’s rally in the NASDAQ has increased investor apprehension that the bull case for Technology and cyclicals in general has been fulfilled. We don’t yet share their concerns. The sector generates nearly a quarter of the entire market’s free cash flow on revenues that are about 10% below their 2008 peak. We are maintaining a pro-cyclical portfolio stance and are reluctant to abandon our winners just yet. Today’s gradual movement of economically sensitive stocks from the value camp to the trend-driven one looks similar to comparable points in earlier cycles. Rather than lose sleep over “missing the boat”, we believe this year’s outperformance, the best since 1999, may signal an inflection point after a lost decade. - Christopher R. Pavese, CFA

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