Markets & Finance

Part 1: S&P's 2007 Tech Sector Outlook


Part 1 of a rundown of analysts' expectations for key IT industries in the coming year—and their top stock picks

Things generally happen pretty quickly in the technology sector. Market positions shift rapidly (consider the PC segment, for example) and tech stocks can move quickly as well. However, 2006 was marked by things that didn't happen as fast as some had expected, namely the introduction of several major new products and services. Microsoft's (MSFT; ranked 3 STARS, hold) Vista and Office, Sony's (SNE; ranked 3 STARS, hold) PlayStation 3, and Yahoo!'s (YHOO; ranked 3 STARS, hold) Panama search-technology upgrade are a few noteworthy offerings that were delayed during the year.

While the postponements hurt the 2006 results of associated companies, these and other offerings from the likes of Apple Computer (AAPL; ranked 4 STARS, buy) and Adobe Systems (ADBE; ranked 3 STARS, hold), among others, should contribute to notable revenue and profit growth in 2007.

Nonetheless, we at Standard & Poor's Equity Research continue to recommend market-weighting the Information Technology sector. Despite underperforming the S&P 500 since 2003, the sector's outperformance since mid-2006 has resulted in what we consider full valuations based on price-earnings and p-e-to-growth metrics.

Here is the first of a two-part rundown of our IT analysts' outlooks for selected tech sub-industries and stocks, covering semiconductors, semiconductor equipment, computer hardware, and electronic manufacturing services, and computer storage and peripherals. Part Two, featuring outlooks on application software, systems software, home entertainment software, IT consulting and data processing services, and Internet software and services, will follow at a subsequent date.

Semiconductors

Analyst: Clyde Montevirgen

We have a neutral opinion on the semiconductors subindustry. While 2006 witnessed healthy growth, reflecting sold demand from the cell-phone and consumer-electronics markets, we think current inventory congestion, possible erosion in average selling prices for certain chip types, and questionable end-market demand will likely present difficult year-over-year comparisons for the first half of 2007. However we believe that stocks are trading at relatively low levels and note that share prices could quickly rise on anticipation of improving industry fundamentals.

We project industry sales to grow 8% in 2007, lower than the Semiconductor Industry Assn.'s estimate of a 10% increase, based on our view of slower sales growth across a broad variety of chips. Economic growth is decelerating, and many companies have pared down capital expenditure plans for 2007 in the face of reduced demand visibility and inventory buildup. Although we see certain chip types experiencing substantial unit growth, we think that the combined average selling price may erode due to potential overcapacity, price wars, and unfavorable sales mix.

Year-to-date through Dec. 15, the S&P Semiconductor Index declined approximately 6%, vs. a gain of roughly 13% for the S&P 1500. We believe that shares of semiconductor producers are somewhat inexpensive based on historical relatives, and still see potential outperformance for companies that produce faster-growing chip types, such as high-end analog, graphics, and high-end microcontrollers, as well as for those that have market leadership in broad end-markets. We currently have strong buy recommendations on Texas Instruments (TXN) and Microchip Technology (MCHP).

Semiconductor Equipment

Analyst: David Kaplan

Following an estimated 25% rise in sales of semiconductor equipment in 2006, which we view as unsustainably above our long-term growth projection of around 10%, we see a period of digestion in the first half of 2007. Furthermore, with elevated semiconductor inventories and forecasts for a slowing global economy, we expect sequential declines in revenues for the first two quarters of 2007.

However, we see industry sales picking up in the second half of 2007, resulting in full-year sales being roughly flat with 2006. Our forecast incorporates our view that this slump will be less severe than historical downturns.

We view the shares of most semiconductor equipment companies as fairly valued, reflecting our expectations for a recovery in the latter half of 2007. However, we believe some stocks in this group are undervalued.

We have a strong buy recommendation on Axcelis Technologies (ACLS), which lost favor with investors after market-share losses in recent years. We see a turnaround for Axcelis in 2007 as the company's Optima HD tool gains traction. We believe these shares offer compelling value, as they recently traded at around 12 times our 2007 earnings per share estimate of 50 cents, and 12.8 times the consensus EPS estimate of 47 cents.

We also like the shares of Brooks Automation (BRKS), which is ranked buy. We expect the company to benefit from the increasing need for automation in 300mm-semiconductor manufacturing facilities.

Another stock on which we have a buy recommendation is photomask producer Photronics (PLAB), which is out of favor with investors, in our view, following lackluster performance in recent years. Photronics recently traded at 14 times our fiscal year 2007 (ending in October) estimate of $1.16 and 13 times the consensus EPS projection of $1.25. The company recently entered a joint venture with Micron Technology (MU; ranked 5 STARS, or strong buy) in a strategic shift toward selling higher-priced and higher-margin, leading-edge photomasks.

Computer Hardware

Analyst: Richard Stice

We have a neutral fundamental outlook on the S&P Computer Hardware subindustry. We anticipate PC unit growth of 10%-12% in 2007, in line with our 2006 forecast. Growth should be aided by the release of Microsoft's Vista operating system, as well as continued expansion in emerging geographies. Within the server market, we also believe unit growth in the low double-digit range is likely over the next 12 months as companies continue to build on the trend toward lower-end and bladed systems. However, we think profitability for both product lines will be somewhat inhibited by ongoing pricing pressures and a slowing U.S. economy.

Our favorite stocks within this sub-industry are Apple (AAPL), which carries a buy recommendation, and IBM (IBM), which is ranked strong buy. In the case of Apple, we believe the shares will benefit from new product introductions in early 2007, including a new operating system, its iTV offering, and an expected iPhone device. In addition, we anticipate further gains in the PC market and a sustained market share in the MP3 player category.

For IBM, we view its market leadership position in a variety of sectors, improving business mix, and significant research and development expenditures as favorable catalysts. Moreover, the shares trade at a discount to the S&P 500 on a p-e basis.

Electronic Manufacturing Services

Analyst: Jawahar Hingorani

Our outlook for the electronic manufacturing services (EMS) group is neutral for 2007, as businesses balance the need to cut costs with the need for greater flexibility in pricing and delivery, as well as help in managing their supply and distribution channels. Key differentiators in this group, in our view, include maintaining a global footprint, adapting to a continually declining cost structure, collaborating in design and development, and providing superior services across the customer's supply chain. Execution is also key, as companies winning new programs are required to demonstrate superior cash conversion cycles—that is, the time taken to convert orders into collected cash—while delivering high levels of quality and service to their customers.

One buy-ranked stock in this sub-industry is Flextronics (FLEX). We view Flextronics as the leader among the publicly traded EMS providers in the U.S. not just due to its size, but also due to the breadth of its offerings and its ability to compete across the board. Recent program wins, and strategic moves like the acquisition of International DisplayWorks and the divestiture of part of its software group, demonstrate in our view, the ability of this EMS leader to continually focus on growth. Organizing itself around a core of sound design, manufacturing, and supply-chain management services enables Flextronics to maintain that focus. We believe the company has the ability to gain market share on many of its competitors and maintain its leadership position in the EMS space in 2007.

Our other EMS picks (ranked buy) are Jabil Circuit (JBL) and Benchmark Electronics (BHE).

Computer Storage & Peripherals

Analyst: Jawahar Hingorani

We believe data-storage continues to be a top priority for large enterprises, as well as small and midsize businesses, particularly relating to regulatory compliance. We are encouraged by several favorable trends as the industry heads into 2007. Increasing amounts of data and content and the proliferation of broadband access have necessitated the need for greater capacity across the storage infrastructure. Faster transport has required network infrastructure for storage to evolve, and companies in this industry have achieved this through a combination of R&D spending, as well as strategic acquisitions. Aggressive pricing practices due to competitive pressures could squeeze margins, and long-term visibility will likely be a key to picking winners and losers in the group.

One company in this group that we favor is Western Digital (WDC), on which we have a strong buy recommendation. We believe Western Digital is positioned to increase its market share and compete with large rivals without having to invest immediately in technology or acquisitions. The company aims to take its successes in the traditional computing markets and capitalize on its ability to provide long-term quality and service to address new markets like portable media players and mobile handsets. We believe Western Digital's balance sheet is another attractive feature, with close to $3.40 a share in cash and investments and negligible long-term debt.

We also have a strong buy opinion on Emulex (ELX), due to what we see as the company's demonstrated ability to execute on its strategy, as well as grow faster than the market in many of the segments it serves. Additionally, we note Emulex's consistent record of cash generation, and its attractive valuation relative to peers.


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