By Sam Stovall While the troubles of the stock market in 2003 have been well-documented, the performance of the Standard & Poor's Office Electronics index has been a pleasant surprise. It has been the fourth-best performer out of the 116 sub-industry indexes in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes) year-to-date through Feb. 21, rising 10.4%, vs. a 3.8% decline for the 1500. (Only 27 sub-indexes are in positive territory year-to-date.) The strong showing has enabled the office-electronics group to join the Industry Momentum portfolio, the list of industries with top S&P Relative Strength rankings.
This feat may be hard to duplicate, however. The group's strong year-to-date performance is largely attributable to gains in Xerox (XRX), which makes up approximately 75% of the index, after the outfit reported better-than-expected results for the fourth quarter of 2002. Despite this near-term strength, Richard Stice, the S&P analyst who follows computer-storage and office-electronics issues, is not optimistic about the group or Xerox, believing that the sluggish U.S. economy will continue to weigh on office-equipment purchases.
Stice's view was recently confirmed by Xerox's 2002 fourth-quarter earnings, which showed a 5% decline in sales, year to year. In addition, competition and price erosion are combining to offset the benefits of cost-cutting initiatives.
SERVICE SECTOR. Stice notes that over the last couple of years, companies have re-evaluated their information-technology spending priorities. This has resulted in a greater allocation of financial resources to data storage, particularly disaster recovery, and other security-related products. One consequence of this shift: Spending on office-electronics products, which had already been de-emphasized due to the economic slowdown, became even less of a priority for Corporate America.
However, Stice believes this environment will be less challenging for those companies that can emphasize the service and repair portion of their revenue base. As customers attempt to stretch IT budgets by extending the life of office equipment, the likelihood of breakdowns or malfunctions will increase. Stice expects office-equipment outfits' service revenues to post modest growth, even in the absence of any significant economic improvement.
In the longer term, he expects favorable product demand, due to technological advances, overseas expansion, a healthier economy, and an ongoing trend toward home offices and telecommuting. On the downside, pricing pressures will continue to have a negative impact on margins.
STAR SHORTAGE. As a result, Stice says that the profitable companies in this segment will have to balance the dual objectives of maximizing operational efficiencies and maintaining a level of R&D spending sufficient to allow successful product launches. Companies that can pull that off should be able to take additional market share from their less resourceful competitors.
Reflecting Stice's less-than-favorable outlook on the industry's prospects, none of the stocks in the S&P Office Electronics index carries S&P's highest investment rankings of 4 STARS (accumulate) or 5 STARS (buy). Stice maintains a 2-STAR (avoid) ranking on Xerox, as he says the company's earnings quality remains a concern.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the 116 industries in the S&P 1500) as of Feb. 21, 2003.
Largest Company (Market Cap.)
S&P STARS* Rank
Consumer Electronics/Consumer Discretionary
Harman International (HAR)
Distillers & Vintners/Consumer Staples
Constellation Brands (STZ)
Diversified Metals & Mining/Materials
Phelps Dodge (PD)
Newmont Mining (NEM)
Internet Software & Services/Information Technology
Metal & Glass Containers/Materials
Office Electronics/Information Technology
Oil & Gas Drilling/Energy
Nabors Industries (NBR)
Oil & Gas E&P/Energy
Philadelphia Suburban (PSC)
*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's