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|  | JULY 15, 2004
 INDUSTRY IN FOCUS By Thomas Smith, CFA The Tech Sector Slips a Notch S&P has downgraded it to marketweight, from overweight, on worries about a slew of weaker preannouncements and soft demand Amid weaker profit outlooks issued recently by some high-profile tech companies, Standard & Poor's Equity Research Services on July 13 downgraded its investment opinion on the S&P Information Technology sector to marketweight, from overweight. These preannouncements -- from the likes of Veritas (VRTS ; S&P investment ranking, 3 STARS, or hold; recent price, $17.60), Siebel Systems (SEBL ; 3 STARS; $7.89), BMC Software (BMC ; 3 STARS, avoid; $14.82), Emulex (ELX ; 3 STARS; $11.12), and LSI Logic (LSI ; 3 STARS; $6.53) -- make us less optimistic about the fundamentals of and price-appreciation potential for the IT group. FAILING TO REBOUND. One other possible negative we see for the sector is the extensive issuance of stock options to compensate employees, which erodes earnings quality. An additional headwind is rising interest rates, which may pressure valuation multiples for growth stocks. Seasonal factors and the expiration of some tech purchases' accelerated depreciation also factor into our analysis. Our sector index consists of 15 subindustries, including computer hardware and software, semiconductors, and communications equipment. As of July 9, the S&P Information Technology index represented 16.4% of the S&P 1500 on a market-cap basis and had dropped 5.7% year-to-date, vs. a 0.4% increase for the S&P 1500. The sector sold off in late January and has been unable to sustain a comeback. This weak performance comes despite what we see as good earnings-growth potential based on a replacement cycle expected for tech equipment bought in 1999 for Y2K compliance, a general strengthening of the U.S. economy, and a relatively low interest rate environment that's conducive to spending on business equipment. IMPROVING FUNDAMENTALS? Our relative-strength measures indicate modest negative momentum for the IT group, vs. most other sectors. Overall, we expect the sector to perform in line with the S&P 1500 in the coming 12 months. Tech-sector fundamentals are expected to show a more decisive comeback in 2004 than the more gradual recovery seen in 2003. We think recent earnings updates indicate that many tech outfits are seeing business accelerate from low revenue levels. However, revenue warnings in the storage-component and enterprise-software groups have revealed some areas of softening demand. Merger activity is up, as shown by the pending acquisition of Advanced Fibre Communications (AFCI ; 4 STARS, accumulate; $18.17) by Tellabs (TLAB ; 4 STARS; $7.71). Also on the sector's radar: Motorola's (MOT ; 5 STARS, buy; $17.09) planned spin-off of its semiconductor unit and the widely anticipated IPO of Interent-search leader Google. COMMUNICATIONS EQUIPMENT. We remain positive on the semiconductor and semiconductor-equipment industries, even though we downgraded leading chipmaker Intel (INTC ; recent price, $23.94) to 3 STARS (hold) from 5 STARS (buy) on July 14. We expect global chip sales for 2004 to surpass the $204 billion achieved in the boom year of 2000 and to move higher in 2005. The hardware and software industries are likely to perform in line with the overall IT sector, supported by steady long-term demand trends. We're positive on the communications-equipment industry, which we see showing signs of stabilization and potential growth after lagging behind other industries earlier in the tech rebound. Where should investors look within the group? Subindustries worth considering include Communications Equipment and Data Processing and Outsourced Services, which tend to perform better in the later stages of the typical technology cycle. We would also emphasize large-cap companies with S&P Quality Rankings -- a historical measure of earnings and dividend performance -- of B+ or better. Some of the names we like now include Affiliated Computer Services (ACS ; price, $52.80), Automatic Data Processing (ADP ; $40.50), and Microsoft (MSFT ; $27.70), each of which is ranked 5 STARS. Note: Thomas Smith has no stock ownership or financial interest in any of the companies in his coverage area, nor in any of the other companies mentioned in this report. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). For Required Disclosure information and Price Charts for all STARS ranked companies go to http://www.spsecurities.com, click on "Investment Research", and then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts". All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Additional information furnished upon request to Standard & Poor's  Smith heads the Information Technology analytical group at Standard & Poor's Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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