Despite indications that the fortunes of the technology sector are about to start taking a turn for the better, companies are keeping a tight rein on their IT spending and earnings are still down
The global technology sector, once dear to the hearts of investors, has become the sector that we all love to hate. This is hardly surprising, given that the technology-laden Nasdaq Composite Index has fallen 65% since its March 2000 peak, and despite it having rallied more than 20% since the September low. But we believe a bottom may now have been reached.
The sectors' road to recovery from here will not be a smooth one, and, while the March 2000 peak and ' seemingly ' September 2001 trough have a number of similar characteristics, the speed and magnitude of the recovery will not match that of the collapse. Nevertheless, 2002 looks set to be a better year than 2001 for global technology investors, albeit one in which the heady returns seen in 1999 will remain but a fond memory.
Inevitably, the prospects for top-line improvement are inextricably linked to the outlook for the global economy. The chart here shows the high correlation between semiconductor revenues and GDP growth. US firms are estimated to account for more than 45% of global IT spending. With US GDP growth slipping into negative territory for the first time since 1993, and consumer confidence at its lowest point since February 1994, the prospects for a steep improvement in IT spending are remote. In past cycles, company spending has improved only three to six months after signs of an economic recovery. While disaster recovery, network access and security software have taken on an added importance in the post-11 September era, a recent Dataquest survey noted that the most important key issues for US companies remains cost-cutting and protecting their profit and loss accounts.
So, a return to strong earnings growth for US corporations as a whole is necessary to invigorate the technology sector. Current earnings estimates for the S&P 500 do not expect this to occur until the second half of 2002 and, with IT budgets likely to be held flat for some time, visibility is unlikely to improve in the near term. However, technology stocks will rise in anticipation of fundamental improvement.
The decline in semiconductor revenues, as shown in the chart, is not solely attributable to slowing GDP growth. We are now 10 months into what is arguably the greatest technology inventory correction in history. Recent data shows that, while semiconductor shipments had fallen 40% from their December peak, new orders in September have increased for the second consecutive month. Historically, semiconductors have started to make the greatest gains three quarters after the beginning of interest rate cuts.
A rebalancing of inventories will result in the sales of semiconductor companies recovering earlier than that of their customers. The chart shows that we are close to ' if not at ' a bottom for revenue growth. The pace and extent of recovery, however, ultimately depends on the effectiveness of a 4.5% reduction in interest rates and $200bn of fiscal stimulus.
Margin improvement will be vital to earnings and technology valuations in 2002. The ability of technology firms to eliminate expenses will be key when separating the winners from the losers, as pricing power will remain elusive. This year alone, the top 120 technology companies have taken more than $120bn in write-offs ' equivalent to all the net profits in the past two years. Operational restructuring and inventory write-offs, which will probably result in some benefit to profit margins going forward, account for £19bn of this sum.
Leading business software companies and foundry makers with increasing capacity utilisation should show substantial margin improvement in late 2002.
The impact of this on the bottom line will be important only in the context of how it relates to expectations. In the six out of the last seven reporting quarters, technology stocks have moved in the opposite direction to that of earnings revisions. In the third quarter, many companies finally hit what were dramatically reduced expectations. Large-cap bellwethers such as Intel and Cisco managed to maintain and achieve guidance throughout the quarter and both saw estimates rise following their earnings releases.
For the fourth quarter of 2001, consensus estimates for US technology firms are looking for a 61% drop in earnings. While this is hardly cause for great cheer, it would be the first sequential improvement in year-on-year earnings since March 2000 and comparisons thereafter become progressively easier.
Further cuts are unlikely to be of the magnitude endured by investors in the third quarter of this year. Indeed, disappointments of 5% are likely to be viewed with a sigh of relief. Estimates for 2002 have been cut but still look stretched at 49%. This is misleading, given that 20% of the top 100 global technology companies are still expected to see negative growth in 2002.
The degree of valuation upside for the global technology sector poses the greatest risk to improving returns in 2002. We believe that most investors, having been burned in 2000, will be far more cautious, and multiples are unlikely to return to these peaks. As we are not anticipating a steep recovery in fundamentals in 2002, we will look ahead to 2003 earnings for valuation support. The number of years it takes a company to return to peak earnings will be key.
The more cyclical areas such as semiconductors and contract manufacturers offer most upside potential. Capacity cuts should help the stock prices of the survivors in 2002. PC upgrades will be a distant end of 2002 event and we believe that more powerful growth will come from networking and distributed computing. Communications equipment is ripe for consolidation and this will be a prerequisite for any fundamental recovery for the group.
While telco providers have indicated that capital spending will be down 20% next year, consensus estimates for the communications equipment companies currently anticipate only a 3% decline
Overall, we are cautiously optimistic about the outlook for the global technology sector from here. As it slowly emerges from a global slowdown in IT spending, we will maintain a focus on those companies we believe will emerge with enhanced market shares and stronger product pipelines. Buying world-class companies whose longer-term growth outlook is intact, such as Cisco, Intel and Texas Instruments, will continue to reap rewards. We believe sustainable gains are likely by the middle of next year as investors discount renewed interest from corporate US in achieving technology-driven productivity gains in 2003.
Recovery of technology sector will not match speed and magnitude of collapse.
Communications equipment is ripe for consolidation.
Semiconductors and contract manufacturers offer most upside potential for investors.
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