Stealth Rally for Computer Hardware Stocks

S&P's Tom Smith sees more strength for computer hardware stocks, thanks to healthy demand for PCs and wireless gadgets

Juiced by stocks such as Apple (AAPL), the computer hardware group has had a remarkable run. So far this year through Oct. 12, the S&P Computer Hardware index has soared 34%, making it the best performer in the S&P Technology sector and blowing past the 10.1% rise in the Standard & Poor's 500-stock index. That's on top of last year's 17.3% gain for the industry.

Strong demand for more high-powered PCs and innovative gadgets could keep pushing stocks such as Apple, IBM (IBM), and Logitech (LOGI) higher, says Tom Smith, who follows computer hardware stocks for Standard & Poor's Equity Research. As the latest earnings season shows, companies selling higher-margin and jazzy new products are poised to stand out from the rest, he says.

BusinessWeek.com's Karyn McCormack spoke with Smith on Oct. 24 about what has been driving the group and his favorite stocks. Edited excerpts of their conversation follow.

How is the September-quarter earnings season shaping up for computer hardware companies?

The September-quarter season is shaping up fairly well for computer hardware companies, especially those with more innovative and new products. Of the six that have reported so far, they're clearly grouped into the good, the mediocre, and the ugly.

We had good results from Logitech, a maker of peripherals including mice, keyboards, and game consoles. It had strong revenue, margins, and outlook, built on a healthy quarter for PC unit volumes. It was able to capitalize by selling new products that consumers want and are priced at levels that are not daunting for consumers. We were positive going into the report with a strong buy. The stock moved up a lot that day, and we backed off to a buy based on valuation.

The other strong reporter was Apple, sharing the story of strong PC sales generally. But, of course, Apple plays into a higher-end, higher-margin part of that story and seems to be continuing to gain market share from a relatively low base.

The mixed reports, in my view, were from IBM, Xerox (XRX), and Flextronics (FLEX). IBM is progressing as I expected: It was strong in services and weak in the hardware segment. I think its hardware segment will continue to be weak until new products arrive in the first quarter of next year. And software was middling. Some software deals were not closed in the quarter as the company expected. I expect the company will get that business in the fourth quarter. So I think there's a chance for hardware and software to catch up in the coming quarters. The company also has cash to buy back more shares. The overall picture at IBM still looks strong. I had a strong buy going into the report and a strong buy coming out.

Flextronics' earnings were in line, and it had 15.5% revenue growth. It completed the acquisition of Solectron on Oct. 1. Flextronics is steady-as-she-goes and meeting expectations. It didn't give guidance pending an analyst meeting that will describe what the newly combined Flextronics-Solectron operations will look like. The electronic manufacturing services (EMS) industry is based on scale. Solectron added some expertise in higher-end computing and telecom equipment that Flextronics can use to widen its product line and customer base in a low-margin game. It was a buy going into the call, and a buy going out.

Xerox also had a steady report, but there's a lot of competition out there. It's progressing as expected.

You upgraded Apple shares on Oct. 23 after its very strong results. How come?

Apple has the opportunity to grow faster than others, because they're smaller and they can grab share. Of course, it has a strong secondary set of products with the iPods, which has strong unit growth and also supports music sales, making that dual endeavor worthwhile.