Policy Blunders Put U.S. Tech Companies at a Substantial Disadvantage

American technology companies have long been the dominant market leaders on the Internet. But, as government policy puts these companies' services at risk, can they sustain their leadership positions both at home and abroad?

Apr 29, 2014 at 11:59PM

Internet hosting has become one of the most dependable income streams for companies like Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and for good reason. These companies have a substantial footprint worldwide and are capable of deploying content for customers anywhere in the world, from providers anywhere in the world.

Global jurisdiction: The new reality
A Friday ruling in a U.S. Federal Court could change all that, as a judge ruled that Microsoft must turn over customers' private content in response to U.S. search warrants, even when that content is stored overseas.

It's no small change in U.S. jurisdiction, as the judge asserted that, as long as the content is being managed by an American company, wherever it is physically located doesn't matter. The courts have never made such an assertion on physical property, and the ruling applies only to online content.

This amounts to a huge disadvantage for American companies like Microsoft and Google in hosting sensitive content online, and means that hosting services within favorable countries like Ireland and the Netherlands will still be saddled with the risk of U.S. government snooping, so long as the hosting is done by a U.S.-based company.

As hosting grows increasingly commoditized, who is doing the hosting and where is less important to customers than security and privacy. Customers who prefer overseas-hosted private content not be subject to U.S. jurisdiction will transition to service providers based elsewhere.

This is not an isolated incident either, as NSA scandals and the Pentagon's Cyber Command are turning the Internet into less of a global marketplace and more of a battlefield, painting a lot of American companies into an uncomfortable corner.

Avoiding U.S. companies
It's already having some obvious effects, too. The European Union is continuing to move forward with a proposal by Deutsche Telekom to create an EU-centric communications network for businesses as a response to evidence of industrial espionage by the NSA.

A huge, high-tech telecommunications network would usually be the sort of thing companies like IBM (NYSE:IBM) and Cisco Systems (NASDAQ:CSCO) would be in the front-running to build. Instead, much to the chagrin of the administration, those companies aren't even eligible.

The Obama Administration has argued that excluding U.S. companies is an unfair violation of international trade laws. That argument isn't particularly persuasive in this case, however, because the whole goal of this network is to avoid U.S. espionage, and that goal would be severely undermined by letting American companies build the thing.

What this means for investors
The big problem is that none of these companies seems to have priced in the danger they face, and Friday's ruling suggests that U.S. policy is liable to get more onerous as time goes on. Microsoft seems the most vulnerable to this in the near-term, as it is directly involved in the latest verdict, was heavily involved in the NSA Prism scandal, and has substantial exposure to Europe. It is also trading around its 52-week high, suggesting these new, substantial risks have not yet been reflected in its price. 

Google is harder to figure, with a higher P/E than the rest, based on its impressive growth going forward. It is also a market leader in some enviable segments (search engines, Internet advertising, and video) that, so far, no one seems able to touch. Ironically, while the company seems, on the surface, the most affected by the jurisdiction ruling, it might also be the hardest of the four to replace, and reasonably priced at these levels.

IBM looks particularly vulnerable in the long-run, having the most debt and lowest cash balance of the bunch. A current ratio of 1.1 also makes it the least able to make adjustments if and when this starts impacting the bottom line. On the other hand, it is trading at under 10 times its estimated forward earnings, making it a potential rebound candidate if and when these policies start getting rolled back and reformed.

Cisco, with a forward P/E not much higher than IBM's, has a much better balance sheet. The company can probably weather the loss of some overseas contracts without much problem and continue to pay its generous 3.3% dividend until the storm blows over.

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Jason Ditz has no position in any stocks mentioned. The Motley Fool owns shares of Google (C shares), International Business Machines, and Microsoft. 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.

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