Tech's Mostly Steady Outlook


When will the technology industry resume its boom? It's not likely to happen in 2005. As in 2004, Standard & Poor's Ratings Services expects the current year to be one of moderate growth in spending on tech products and services, rising at a rate in the mid-single digits. Growth likely will continue to be uneven, both between and within the various tech sectors.

How are key groups likely to fare? Following several years of extremely strong growth, semiconductor revenues have slowed since the summer of 2004 and likely will be flat to modestly down in 2005. Telecommunications equipment likely will be modestly positive, continuing the stabilization that began last year, following the severe decline from the 2000 peak.

BOLSTERED MEASURES. Unlike these two cyclical sectors, software and services should continue their steady, moderate growth. Technology shifts, like the early transition from circuit-based telephony to voice-over-Internet protocol (VoIP), from 200mm to 300mm semiconductor wafers, and to third-generation (3G) wireless standards, will create above-average growth opportunities in equipment manufacturing, handsets, flash memory, and logic chips.

The general trend of stabilization to moderate sales growth should help bolster tech companies' financial measures. This was evident in the modestly positive credit trend in the first quarter of the year, as the number of companies whose ratings outlooks were upgraded to positive outstripped the number moved to negative by a wide margin. A balanced credit trend for the year also is anticipated, because a focus on cost reductions over the preceding three years is helping to offset pricing pressures across almost all sectors.

Of course, not all tech companies are in the same financial shape. The stronger players have built up substantial excess liquidity during the recovery from the collapse of the tech bubble in 2000, and companies like Hewlett-Packard (HPQ), IBM,(IBM), Intel (INTC), and Microsoft (MSFT) have begun to return this cash to shareholders in the form of stepped-up share repurchases and increased or special dividends. Standard & Poor's

credit ratings on those four companies were affirmed, despite the substantial size of the repurchases and dividends.

WHAT'S AHEAD? Also, we expect consolidation in both the software and the services sectors to continue in 2005. The ratings impacts could vary -- Oracle's (ORCL) $10 billion acquisition of PeopleSoft and its pending $700 million deal to buy Retek (RETK) had no ratings impact, nor did IBM's recently announced $1.1 billion purchase of Ascential Software. SunGard (SDS) already was on CreditWatch with negative implications because of a planned split-off of one of its units when reports of a possible $11 billion private equity deal surfaced. The deal would have a downside impact on SunGard'S investment-grade ratings if successful.

What does S&P Ratings see ahead for key sectors within the technology group? Here's a sector-by-sector look (also see S&P's Tech Company Report Card, Pt. 1 for company-by-company outlook summaries).

Computer manufacturers. Our outlook for U.S. computer hardware spending remains moderately optimistic. Unit volumes are expected to grow at double-digit rates, but highly competitive industry pricing conditions will dampen sales growth in dollar terms. Corporate spending on computer hardware should grow in the mid-single digits in 2005. Although demand for Intel- and Linux-based servers is expected to be stronger than overall spending growth, outlays for high-end systems -- especially for UNIX platforms -- are expected to be flat to slightly lower in 2005.

The need for continued investment in e-commerce and Web-based technologies should continue to support a positive spending outlook over the intermediate term. But once again, highly competitive industry conditions will continue to pressure computer hardware profitability for most original equipment manufacturers (OEMs).

Electronics distributors. Revenue trends for distributors of electronic components and computer products are expected to track growth in technology spending. Industry growth is expected to be in the 5% to 10% range, with rates at the upper end of the range for broad-line, global distributors participating in multiple sectors that benefit from a presence in higher-growth regions.

While earnings continue to improve on a year-over-year basis in the components sector, it's hard to predict the timing and magnitude of the next industry downturn. As a result, the rating outlooks in the components sector remain negative, reflecting our view that these companies need to build additional financial cushions. Rating outlooks are stable in the computer products distribution sector, reflecting these outfits' consistent profitability and less leveraged financial profiles.

Communications equipment manufacturers. This sector continues to stabilize, as it recovers at a moderate pace from a severe downturn. However, the technology transition to digital voice transmission continues to challenge suppliers, while consolidation among the service providers could lead to shifts in market share. Equipment companies may undertake selective acquisitions to gain scale and broaden their ability to penetrate key customers.

Equipment suppliers' cost structures are about right for current business levels. Our corporate credit rating for Ericsson (ERICY) was raised to investment grade, reflecting improving operating and financial performance and a very strong balance sheet. Nortel (NT) remains on CreditWatch, pending the release of its audited financial results and a better assessment of its near- to intermediate-term performance.

Semiconductor manufacturers. The chip sector's slowdown has continued into early 2005, although the decline is expected to be moderate compared with past down cycles. Still, 2005 likely will be weaker overall than 2004, as inventories in the distribution chain and at electronics manufacturers remain above desired levels. Long-term industry growth is expected to be in the 8% to 12% range.

Modest outlook improvements and selective upgrades are likely as companies stabilize their financial profiles in the recovery, but major rating changes are unlikely.

Contract manufacturers. Growth expectations for players in this group in the first half of 2005 are modest. That's because visibility from key end markets -- computing, networking, and telecommunications -- is poor. The sector continues to experience improved operating leverage -- albeit gradually -- as benefits from restructurings and low-cost manufacturing translate into higher margins on an EBITDA basis -- that is, earnings before interest, taxes, depreciation, and amortization. Balance sheets remain strong, with most companies generating positive cash flow, indicating the market likely will remain fragmented and intensely competitive through the next business cycle.

Acquisition activity has been muted, with the exception of Jabil Circuit's (JBL) $195 million purchase of the business and assets of Varian Electronics Manufacturing, the production business of Varian Inc., based in Palo Alto, Calif.

Software service providers. The relative stability of this sector is supported by a high proportion of service revenues under long-term contracts. These deals provide software makers with a solid recurring revenue base and a better degree of visibility than other high-tech sectors. Based on recent trends and earnings announcements, it appears corporations are loosening their purse strings and beginning to reinvest more in IT infrastructure. But even with their customers' increased willingness to spend, most rated software and services companies remain cautious and continue to realign their cost structures. Most of these outfits maintain adequate financial flexibility to cushion any near-term volatility.

Overall business fundamentals remain strong, the industry is still highly fragmented, and well-entrenched companies should continue to perform well over the long term. Consolidation, M&A, and divestiture activity have accelerated recently, and we expect this trend to continue as companies expand critical mass and technical expertise, and divest noncore operations to add liquidity to balance sheets. There are a host of examples: Oracle's deals to buy PeopleSoft and Retek, the acquisition of Veritas by unrated Symantec (SYMC), SAIC's sale of its Telcordia unit, Computer Sciences Corp.'s (CSC) divestiture of select units of DynCorp, and SunGard's announcement that it will be acquired by a private equity group in a transaction valued at over $11 billion. From Standard & Poor's Ratings Services


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