By Isabelle Sender Most information-technology and telecommunication companies remain optimistic that Corporate America will loosen its belt and open its wallet in 2006. Capital investment has been anemic in 2005, particularly for enterprise technologies. We at Standard & Poor's Equity Research think that's partly because corporations used excess cash for stock buybacks and dividends, rather than making capital expenditures.
Things could change in 2006. S&P's equity analysts are encouraged by the robust capital on Corporate America's balance sheets, as companies post what we view as a healthy amount of cash. Overall, ongoing free-cash-flow generation is strong. What's more, S&P is heartened by business trends that drive tech spending in cycles, such as the enterprise implications of wireline and wireless networks' convergence. S&P favors a market weighting of the information-technology (IT) sector, which makes up about 15% of the S&P 1500 index.
Within the IT sector, S&P analysts have identified industries and stocks that appear attractive whether tech spending improves materially next year or not. What most of S&P's picks have in common is that they're ranked 4 STARS (buy) or 5 STARS (strong buy), and generally focused on growth, with strong positions in their respective markets. The story for 2006, S&P believes, is that enterprise expenditures should help offset a drop in consumer spending in IT and telecom.
SOX APPEAL. In September, IT-consulting firm Gartner Research surveyed 1,500 IT managers, whose overall view was that spending will increase by about 5.5% in 2006. Scott Kessler, group head for technology equity analysis at S&P, agrees. "Expenses on technology are more reasonable today, reflecting more conservative budgeting, more of a focus on discernible and quick return on investment, and upper management getting involved in spending decisions," he says.
S&P sees more gradual IT spending in this economic cycle than in the prior cycle in the late 1990s, which was boosted by Y2K concerns. But complying with stricter regulations, such as the Sarbanes-Oxley law, should help push tech spending. The ubiquitous use of mobile devices is also expected to boost tech spending, according to S&P, Gartner, and Forrester Research, another technology-consulting firm.
S&P equity analyst Richard Stice says S&P's fundamental outlook for the computer storage and peripherals industry is positive. He expects storage to remain a high spending priority in 2006, driven in part by an increasing emphasis on data backup and replication requirements associated with Sarbanes-Oxley. Among the stocks he follows, Stice has strong buy recommendations on EMC (EMC) and Seagate Technology (STX).
SECURE RELATIONSHIPS. Although S&P's fundamental outlook for the application-software industry remains neutral, equity analyst Jonathan Rudy expects the industry to "benefit from a number of positive trends that we see, as companies continue to use application software to leverage their earlier IT investments over the long term." The companies that garner S&P's highest ranking of strong buy, according to Rudy, are Amdocs (DOX) and Citrix Systems (CTXS). Cognos (COGN) is ranked buy.
Rudy sees specific areas of software, such as Internet security and customer-relationship management (CRM), benefiting more than other areas as IT spending likely recovers. Rudy believes the rapidly evolving Internet and e-commerce are creating strong demand for certain software applications. Many software vendors are integrating Web features into their products, and some are developing new Internet applications, including those related to the booming e-commerce market.
Systems-software companies are likely to benefit from similar trends, Rudy believes. His fundamental outlook on this industry is positive, and his strong buy recommended stocks are McAfee (MFE) and Microsoft (MSFT).
CONSULTING NEED. E-commerce remains a driver for growth in the data-processing and outsourced-services industry, for which S&P has a positive fundamental outlook. S&P has two top picks ranked strong buy in this segment: Automatic Data Processing (ADP) and Fiserv (FISV). According to S&P research, the number of U.S.-based electronic transactions is expected to grow to 47% of all payments in 2010, from 33% in 2002 and 23% in 1997.
The IT-consulting industry is also likely to continue to benefit from the effects of an increasingly global economy, deregulation, an IT labor shortage, and e-business opportunities, according to S&P. Analyst Dylan Cathers thinks Accenture (ACN), Acxiom (ACXM), CACI International (CAI), Satyam Computer Services (SAY), and Wipro (WIT) should benefit from a constant need on the part of corporations and government entities to use services and systems that can enable them to boost productivity and help cut costs.
In the electronic manufacturing services industry, Benchmark Electronics (BHE), Flextronics International (FLEX), and Jabil Circuit (JBL) are S&P's top picks as the trend toward outsourced manufacturing gains momentum.
SEMI NEUTRAL. Another service area that's likely to benefit from a potential uptick in IT spending is the Internet software and services industry, for which S&P has a positive fundamental view. Four companies -- RealNetworks (RNWK), VeriSign (VRSN), and WebEx Communications (WEBX) -- are likely to benefit from increased online transactional activity, in S&P's opinion. Kessler believes the online-content business has been particularly strong since the summer of 2004.
S&P has a neutral fundamental outlook for the semiconductor and semiconductor-equipment industries, but does favor a few stocks. The summer of 2004 marked the low point for semiconductor-equipment stocks, according to S&P equity analyst Colin McArdle. At the end of 2004, factory utilization rates, a key metric for the equipment industry, were only at 80%, McArdle notes. But he believes semiconductor factory utilization rates remain above 90% now.
McArdle likes the prospects for Brooks Automation (BRKS) and Lam Research (LRCX) -- both ranked strong buy. "We see industry growth of 8% to 10% in 2006. PC unit shipments remain soft, in our view, and we believe there's some reluctance on the part of companies to commit to corporate IT spending," McArdle says. "However, we see potentially strong operating leverage in the event of an industry upturn."
CHIP DEALERS. Likewise, S&P's semiconductor equity analyst Tom Smith believes stocks of chipmakers are poised for 9% industry sales growth in 2006. "We think the industry will avoid a negative sales growth year during the current semiconductor cycle due to disciplined supply chain management and increased end-market diversification," Smith says. S&P's top semiconductor picks include Cree (CREE), Marvell Technology (MRVL), and AMIS Holdings (AMIS).
S&P has a positive fundamental outlook on another chip-related industry, technology distributors. This group includes companies that distribute semiconductors, computer parts, and other electronic components. Like the wider IT sector, these companies have been affected by a boom-bust cycle, and initially faced a long and deep downturn after 2001.
The largest distributors are building global networks of warehouses and software. Cathers' positive outlook for this group partly reflects reports of an uptick in demand for semiconductor components from major chipmakers. His top picks -- Ingram Micro (IM) and CDW Corp. (CDWC) -- are poised to benefit, he says.
RURAL ADVANTAGE. In the telecommunications sector, new generation technologies are having an influence on companies that provide wireline telecom services. Increased pricing pressures, industry consolidation, and the growth of wireless services have taken a toll on the integrated telecommunication services industry, for which the fundamental outlook is negative. However. rural incumbent carriers should, in analyst Todd Rosenbluth's view, "continue to operate in a less competitive arena, as wireless and cable competition is more muted there than in metropolitan markets."
Rosenbluth's favorite stocks in this industry include CenturyTel (CTL), BCE (BCE), Chunghwa Telecom (CHT), Citizens Communications (CZN), Commonwealth Telecom Enterprise (CTCO), Deutsche Telekom (DT), Philippine Long Distance Telephone (PHI), and Telefonos de Mexico (TMX). The analyst notes that growth in the wireless units was relatively strong in the third quarter and should continue to be into 2006.
Wireless telecommunication services analyst Ken Leon believes American Tower (AMT), China Mobile (CHL), and Sprint Nextel (S) are best suited to outperform. "We see the 2005 upgrade to enhanced data networks and to third-generation (3G) handsets with Web-based capability boosting average revenue per user (ARPU) and revenue growth," Leon notes.
PRIORITY SHIFT. Another driver of growth for telecom companies is the need for enterprises to upgrade and replace relatively old network equipment. Communications-equipment analyst Ari Bensinger thinks that a round of equipment replacements should create a multiyear spending cycle within the market for enterprise communications gear. His top picks are Motorola (MOT) and Powerwave Technologies (PWAV), which are ranked strong buy.
Companies ranked buy include Cisco Systems (CSCO), Commscope (CTV), Comverse Technology (CMVT), Harris (HRS), Qualcomm (QCOM), and Research in Motion (RIMM).
Telecom carriers are shifting spending priorities to broadband digital service line and fiber-to-the-premise equipment, thereby turning to products supplies by communications equipment providers, Bensinger believes. Equipment companies are also needed in order to implement next-generation access technologies like Wi-Max (worldwide interoperability for microwave access) and IPTV (Internet Protocol Television), which are gaining acceptance.
Sender is a reporter for S&P MarketScope