Tech Outlook 2005 -- Part 1


The tech sector lost some shine in 2004, as worries about economic growth and weaker demand persuaded investors to look elsewhere for growth. So far this year through Dec. 17, Standard & Poor's Information Technology index edged up just 0.3%, vs. a 7.4% gain in the broader S&P 500.

The tepid gain isn't too surprising after the 47.2% jump for Info Tech in 2003. However, telecommunications stocks have fared much better this year, climbing 16%, after rising just 3.2% in 2003, amid consolidation news and more focus on dividend-paying stocks. The strongest performers in 2004 were Internet software and services (up 61%), followed by wireless telecom services (up 53%). Semiconductor-related shares were the big losers.

For clues about what to expect from info tech and telecom, BusinessWeek Online asked S&P analysts about their 2005 outlook for key industry segments, along with their favorite stocks. Overall, S&P has a market weight recommendations on both the Info Tech and Telecommunications Services sectors. This means investors should be particularly choosy.

TOP NAMES. S&P has its top ranking on a few familiar names, including software makers Microsoft (MSFT) and McAfee (MFE) and hardware giants IBM (IBM) and Dell (DELL). In Internet advertising, S&P's favorite pick is ValueClick (VCLK).

S&P also has strong buy recommendations on two analog chip outfits, Maxim Integrated Products (MXIM) and Linear Technology (LLTC); electronic manufacturing services provider Sanmina-SCI (SANM); storage provider EMC (EMC); and outsourcing companies Affiliated Computer Services (ACS), Automatic Data Processing (ADP), and Computer Sciences (CSC).

In telecom services, S&P's top picks include Verizon (VZ), CenturyTel (CTL) and Canada-based BCE (BCE). Among wireless-telecom equipment, Qualcomm (QCOM) and Motorola (MOT) get the top ranking.

COMING ATTRACTIONS. Part 1 of this two-part series provides outlooks from S&P chip analyst Amrit Tewary, semiconductor-equipment analyst Colin McArdle, computer-hardware analyst Megan Graham-Hackett, information-technology services and data-storage analyst Richard Stice, software analyst Jonathan Rudy, and specialty software analyst Zaineb Bokhari.

Part 2 of this report will offer overviews from Scott Kessler, who covers Internet software and services, consulting and outsourcing analyst Stephanie Crane, wireline telecom services analyst Todd Rosenbluth, wireless-equipment analyst Ken Leon, and communications-equipment analyst Ari Bensinger.

Amrit Tewary, semiconductors

Standard & Poor's maintains a neutral outlook for semiconductor stocks over the next 12 months. Despite the significant year-to-date decline in chip-stock prices (the S&P Semiconductor Index fell 24% through Dec. 17), we think current valuation multiples are warranted in most cases, given some lingering inventory concerns, some macroeconomic uncertainty, and our expectation for moderating sales growth for the chip industry in 2005.

We think significant gains are unlikely for most chip stocks in the near term, given our belief that we're entering the latter stages of the current industry upcycle. We expect chip industry sales growth to moderate from a projected 30% this year to about 8% in 2005, before weakening to a flat-to-down year in 2006.

Despite our overall neutral outlook for the industry, we do have 5-STARS, or strong buy, opinions on two chip stocks that we believe will outperform peers during the next 12 months: Maxim Integrated Products (MXIM

; recent price: $42) and Linear Technology (LLTC

; $40), two high-end analog chip outfits that have similar businesses. We think the high-end analog business has more attractive long-term growth prospects than most other chip segments.

HEALTHY BALANCE SHEETS. Also, we believe Maxim and Linear are both well-run companies that have a diverse customer base in a number of end-markets such as automotive, consumer, communications, data processing, industrial, instrumentation, and medical. We believe this diversity results in a lower risk profile for these companies, as it limits exposure to weakness at any one customer or end-market.

Both Maxim and Linear are highly profitable companies with well-above-average gross and net margins. In addition, with no long-term debt and plenty of cash, they have what we see as healthy balance sheets. Furthermore, we think both stocks are attractively priced at current levels, based on price-earnings and price-to-sales analyses.

For Maxim, we see fiscal year 2005 (ending June) earnings per share advancing 45% to $1.74, on sales growth of 25% and significant operating margin expansion. Our 12-month target price of $60 is based on our p-e model, and values the company at 34.5 times our fiscal year 2005 EPS estimate, which represents a premium to most peers but a discount to the stock's historical average multiple.

PEER LEADER. For Linear, we see fiscal year 2005 (ending June) EPS advancing 32%, to $1.35, on 29% sales growth and continued margin expansion. Our 12-month target price of $50 assumes a forward p-e of 36, above most chip peers but below historical averages.

We believe both Maxim and Linear merit premium valuations to most peers, given our view of their above-average prospects for growth and profitability, and below-average risk profiles.

Risks to our opinions and target prices for the semiconductor companies mentioned here include semiconductor industry cyclicality, increased competition, the risks of wafer-fab ownership, and an above-average reliance on stock-based compensation.

Colin McArdle, semiconductor equipment

The S&P Semiconductor Equipment Index declined 26% year to date through Dec. 17, vs. a gain of 8% for the S&P 1500. In the three months through October, 2004, the North American semiconductor equipment industry's preliminary book-to-bill ratio was 0.96, the first time it has been below 1.0 in 2004. But this is up from a low of 0.78 in October, 2002.

We believe near-term uncertainties will persist in the first half of 2005, as semiconductor manufacturers defer incremental capital spending, though we expect a stronger second half. We currently have a neutral outlook on the sub-industry.

We continue to favor diversified front-end equipment suppliers with economies of scale, as global demand continues to shift outside North America. We expect business in Asia, particularly China, to continue to grow at a significantly faster pace than the rest of the world over the next few years.

TWO WINNERS. As the industry's largest supplier by a wide margin and a leader in what we see as cutting-edge technology, we believe Applied Materials (AMAT

; buy; $17) has a compelling risk/reward profile. The stock is trading at 19 times our fiscal year 2005 (ending October) EPS estimate of 91 cents, below relevant peers. We maintain our 12-month target price of $21 based upon peer-group p-e multiples.

A second stock we like is Lam Research (LRCX

; buy; $28). With Lam reporting September-quarter results that were stronger than we anticipated and our belief that the company's earnings will grow faster than the industry average, we raised out 12-month price target to $32, representing appreciation potential of 14% from Lam's recent price.

Risks to our recommendations and target prices include a prolonged slowdown in demand for chips worldwide, as well as pricing pressure due to potentially increasing competition.

Megan Graham-Hackett, Computer Hardware

We have a neutral opinion on the computer hardware sub-industry for 2005. While we do believe 2004 witnessed healthy units growth in PCs (our forecast is 12.5%), we think easy year-over-year comparisons helped, as well as stronger-than-expected demand from consumers.

In 2005, we expect the demand for PCs to ease to a 7% to 10% rate of growth in global unit shipments, assuming a relatively stable economic environment, as the demand surge following a two-year dearth of spending on PCs in 2001 and 2002 unwinds. We anticipate pricing pressure to remain intense.

On the server side, we forecast a 2% to 5% increase in server revenues in 2005. Although we believe there were some stronger signs of corporate IT demand late in 2004, we expect the focus of IT spending to continue to be on areas that enable customers to make better use of infrastructures already built -- such as software and services-related spending which raise the efficiency and productivity and return on invested capital of current data centers.

PRICE ADVANTAGE. Given these two scenarios, our 5-STARS, or strong buy, recommendations are IBM (IBM

; $98) and Dell (DELL

; $42). Our investment thesis for IBM is predicated on it having larger software and services assets than its peers that, in our view, are strategically well positioned and enable the company to differentiate its products and solutions.

For Dell, our recommendation reflects our assumption that its competitive advantage lies in its direct-selling model, which enables the company to have a lower cost structure than peers and take market share. We expect the scrutiny on IT budgets to remain intense, and believe Dell's ability to price below peers, based on structural efficiencies in its business model, should enable these share gains to be sustainable.

Richard Stice, electronic manufacturing services and data storage

We believe demand for electronic manufacturing services (EMS) should improve in 2005 as more businesses look to outsource the production of their merchandise. In addition, we think EMS companies will benefit from their efforts to reduce costs, streamline operating models, and better manage inventory levels. We anticipate further penetration into design-related activities, which feature a collaborative relationship with respect to the creation and development of a product, and see revenue growth for this type of service continuing to accelerate.

Our top pick in this sector is Sanmina-SCI (SANM

; strong buy; $8). We view Sanmina-SCI as being in the final stages of a significant financial turnaround, following a slump in IT spending and integration issues associated with its acquisition of SCI Systems in 2001. Steps taken to combat these factors include shifting production to lower-cost locations (with a particular emphasis on Asia), reducing headcount, and broadening service offerings. This strategy has paid off, in our opinion, as the company's quarterly operating income has more than doubled over the same period just two years earlier.

SMART BUYS. We believe the data-storage industry possesses several favorable trends as it heads into 2005. Storage remains a top priority for corporations due not only to the growing amount of data being created and managed but also as a result of more stringent regulatory requirements for record keeping. Companies in this industry are increasingly focusing on a total package that emphasizes software and services, in addition to hardware offerings. On the downside, we are concerned with the potential of more aggressive pricing tactics by competitors, as well as the limited amount of visibility into overall demand trends.

Our favorite name in this group is EMC Corp. (EMC

; strong buy; $15). The company maintains an industry-leading market-share position and has, in our view, adroitly built its product portfolio through acquisitions. EMC's push into the storage software area has helped gross margins to widen for eight consecutive quarters. We believe the company's balance sheet is another attractive feature, containing close to $3 a share in cash and investments and a long-term debt-to-capital ratio of 1%.

Jonathan Rudy, software

We anticipate that the overall software industry should grow in the low to mid-single digits in 2005. However, we like certain areas of software better than others. We have a positive outlook on the systems-software group as we enter 2005, but are neutral on the application software and home-entertainment software groups. Specific areas such as security, data backup, and recovery software are positioned to do well in an economic expansion, in our opinion.

Within these particular areas, we like certain companies that have leading market shares, strong balance sheets, and high profitability. In systems software, we remain bullish on Internet security, and one of our top picks is McAfee (MFE); strong buy; $28), a leading provider of anti-virus and Internet security solutions under the McAfee brand name. We also like Check Point Software (CHKP

; buy; $24), the leader in firewall and virtual private network (VPN) software.

Another top pick in systems software is Microsoft (MSFT

; strong buy; $27). The company continues to execute extremely well, in our view, and with its recent $32 billion special dividend and ongoing $30 billion stock repurchase program, we believe that the company continues to deliver value to shareholders.

HIGH SCORERS. Other picks in systems software include Sybase (SY

; buy; $19), and Oracle (ORCL

; buy; $14).

SAP AG (SAP

; buy; $44) is the only application software company that we rank as a buy. We believe that SAP continues to benefit from enhanced product offerings, in addition to the protracted Oracle/PeopleSoft (PSFT

; $26) takeover battle.

In home-entertainment software, we continue to like Electronic Arts (ERTS

; buy; $62), and Activision (ATVI

; buy; $19), because of their market leadership, strong balance sheets, and diversified brand libraries.

Zaineb Bokhari, specialty software

Extracting value from existing corporate investment in information technology will be a key theme for 2005, in our view. As widely reported, the freewheeling spending in the mid-90s, particularly in anticipation of Y2K, is a thing of the past. Shelf-ware issues still persist and return on investments (ROI) from hefty spending on customer relationship management (CRM) and enterprise resource planning (ERP) applications has been slow to materialize.

IT is fast evolving from being viewed as a cost to a revenue/productivity enhancer, driven largely by the need of chief investment officers and other IT executives to justify spending to meet operational goals. This has resulted in spending on an as-needed basis and a preference among customers for smaller deal sizes or subscription-based licenses. In this tight corporate spending environment, we look for a shift in emphasis favoring technology companies whose products either extend the value of the IT investment or enhance the ability of decisionmakers to allocate resources effectively.

Two software segments that play to this theme are systems management software (SMS) and business intelligence (BI). We expect mid-single-digit revenue growth for the SMS companies that derive a significant portion of sales from mainframes, such as BMC Software (BMC

; hold; $18), Computer Associates (CA

; hold; $31), and Compuware (CPWR

; hold; $6). While these companies are attempting to rejuvenate growth by entering new markets like security, asset management, and application-lifecycle management, we believe it will be difficult for them to gain critical mass in these growth areas because of their size and competition from super-niche outfits.

INTELLIGENCE AGENTS. We expect SMS vendors to use their sizable cash and balance sheets for acquisitions or mergers and fill out their product offerings in the next several quarters. Vendors with attractive customer bases in asset-management and security administration are likely targets, in our opinion.

The importance of mainframe revenue, however, isn't likely to diminish soon and has come under attack. The fiercest competitor, in our view is IBM, which has leveraged its natural advantage over the SMS vendors by bundling hardware, software, and services and competing on price to lower its customers' total cost of ownership. Given our outlook for moderate growth and increasing competitive pressure, we have hold opinions on shares of mainframe-centric SMS vendors BMC Software, Computer Associates, and Compuware.

Business-intelligence software involves reporting and query, data integration, and performance analysis. While the overall BI area is growing at a 5% long-term rate, according to market researcher IDC, it is under-penetrated, in our view. Market leaders Business Objects (BOBJ

; hold; $25) and Cognos (COGN

; buy; $43) have been increasing share in the mid-teens, due largely to acquisitions and growing business momentum.

READY FOR EMBEDDING. We like the fundamentals of BI because it coincides with our view that technology with lower price tags, quick deployments, and immediate ROI will be less vulnerable to spending slowdowns. The key to success and ultimately greater revenue streams, in our view, is for corporate customers to standardize on a single BI product. Standardization affords vendors the opportunity to cross-sell and up-sell into an organization and makes competitive replacements difficult.

Business Objects and Cognos are pursuing vastly different strategies to achieve the same goal. Business Objects is employing a "built to embed" strategy in which it offers BI tools that allow users to build custom software, and relies heavily on partners like PeopleSoft and SAP to sell restricted versions of its products. Cognos, which we recently upgraded to buy, offers a packaged application, which is ready to go out of the box. While it may ultimately boil down to a build-vs.-buy decision, we think it's too early to say which strategy will ultimately win or if there's room for both to be successful.

Other large software makers see the attractiveness of BI. Oracle has built additional BI capabilities into its Oracle 10g release, and Microsoft has enhanced the reporting functionalities of its SQL server.

We look for continued consolidation in the BI area in 2005 and for database vendors to acquire smaller-niche companies specializing in the data integration and query and reporting areas, as we view it as a natural extension to their product functionality. We believe the positive business trends discussed above are adequately reflected in current stock valuations, and we have hold opinions on shares of Business Objects and Cognos.

Note: S&P analysts have no stock ownership or financial interest in any of the companies in their coverage area. All of the views expressed 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. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com.


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