Part 1: S&P's 2007 Tech Sector Outlook

Part 1 of a rundown of analysts' expectations for key IT industries in the coming year—and their top stock picks

by Scott Kessler

Things generally happen pretty quickly in the technology sector. Market positions shift rapidly (consider the PC segment, for example) and tech stocks can move quickly as well. However, 2006 was marked by things that didn't happen as fast as some had expected, namely the introduction of several major new products and services. Microsoft's (MSFT; ranked 3 STARS, hold) Vista and Office, Sony's (SNE; ranked 3 STARS, hold) PlayStation 3, and Yahoo!'s (YHOO; ranked 3 STARS, hold) Panama search-technology upgrade are a few noteworthy offerings that were delayed during the year.

While the postponements hurt the 2006 results of associated companies, these and other offerings from the likes of Apple Computer (AAPL; ranked 4 STARS, buy) and Adobe Systems (ADBE; ranked 3 STARS, hold), among others, should contribute to notable revenue and profit growth in 2007.

Nonetheless, we at Standard & Poor's Equity Research continue to recommend market-weighting the Information Technology sector. Despite underperforming the S&P 500 since 2003, the sector's outperformance since mid-2006 has resulted in what we consider full valuations based on price-earnings and p-e-to-growth metrics.

Here is the first of a two-part rundown of our IT analysts' outlooks for selected tech sub-industries and stocks, covering semiconductors, semiconductor equipment, computer hardware, and electronic manufacturing services, and computer storage and peripherals. Part Two, featuring outlooks on application software, systems software, home entertainment software, IT consulting and data processing services, and Internet software and services, will follow at a subsequent date.

Semiconductors

Analyst: Clyde Montevirgen

We have a neutral opinion on the semiconductors subindustry. While 2006 witnessed healthy growth, reflecting sold demand from the cell-phone and consumer-electronics markets, we think current inventory congestion, possible erosion in average selling prices for certain chip types, and questionable end-market demand will likely present difficult year-over-year comparisons for the first half of 2007. However we believe that stocks are trading at relatively low levels and note that share prices could quickly rise on anticipation of improving industry fundamentals.

We project industry sales to grow 8% in 2007, lower than the Semiconductor Industry Assn.'s estimate of a 10% increase, based on our view of slower sales growth across a broad variety of chips. Economic growth is decelerating, and many companies have pared down capital expenditure plans for 2007 in the face of reduced demand visibility and inventory buildup. Although we see certain chip types experiencing substantial unit growth, we think that the combined average selling price may erode due to potential overcapacity, price wars, and unfavorable sales mix.

Year-to-date through Dec. 15, the S&P Semiconductor Index declined approximately 6%, vs. a gain of roughly 13% for the S&P 1500. We believe that shares of semiconductor producers are somewhat inexpensive based on historical relatives, and still see potential outperformance for companies that produce faster-growing chip types, such as high-end analog, graphics, and high-end microcontrollers, as well as for those that have market leadership in broad end-markets. We currently have strong buy recommendations on Texas Instruments (TXN) and Microchip Technology (MCHP).