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As the tech industry girds for third-quarter earnings, analysts are turning their attention to next year. Many don't like what they see
At Alaska Airlines (ALK) in Seattle, Senior Vice-President of Information Technology Services Robert Reeder is crafting his 2008 technology budget with one eye on competitors and the other on the economy. So he's got to account not only for rivals, including Delta Air Lines (DAL), but also lofty oil prices and lingering fallout from the summer stock slump and real estate malaise.
"As the economy goes, so goes spending across the board, including IT," says Reeder. As a result, Alaska will increase its information technology budget by only 4% in 2008, the same as 2007. "We've noticed a softening in revenues," he says. "We're not scaling back IT; we're just not going to grow by as much" as in the past, when increases each year were larger.
Chief information officers aren't the only ones striking a cautionary note on technology spending. Goldman Sachs' (GS) early look at 2008 IT spending is "less than comforting," analyst Laura Conigliaro said in an Oct. 10 report. Despite healthy spending on new computer equipment and software in the third quarter, IT spending in 2008 could fall by 1% compared with 2007, according to Goldman's survey of 100 information technology managers. "Macro concerns may ultimately cap spending," Conigliaro said.
Eye on Earnings Reports
The upshot for tech companies is potentially slowing sales and profit growth, while for investors, it may mean tech stocks become less of a haven. Stocks including Amazon.com (AMZN), Cisco Systems (CSCO), and VMware (VMW) yielded solid returns during the stock market's wild swings (BusinessWeek, 8/27/07). So tech stocks look like safe bets at the moment: Most hardware, software, and networking vendors expect healthy third- and fourth-quarter earnings as CIOs drain budgets that are set for the year.
But will the good times carry over into 2008? That concern will be top of mind for investors as the tech industry's quarterly earnings season kicks off with reports from Intel (INTC), IBM (IBM), and Yahoo! (YHOO) on Oct. 16.
It's still early to gauge with certainty whether falling house prices, losses at financial-services companies tied to subprime loans, and signs of trouble in other sectors of the economy will take a toll on corporate tech spending. But the picture that's emerging doesn't look rosy. "We're hearing some caution" on IT spending, says Colleen Graham, an analyst at consulting company Gartner (IT). Companies aren't feeling confident enough to exceed their 2007 budgets, and Graham expects light spending through the first half of 2008.
Modest Growth Forecast
One company that could feel the squeeze is Red Hat (RHT), a provider of the Linux operating system and other open-source software widely used in corporate data centers. Red Hat Chief Executive Matthew Szulik said in a Sept. 25 conference call that he doesn't see sizable increases in tech budgets in 2008. "We continue to see pressure on IT spending," he said.
Bill Whyman, senior managing director at economic research institute ISI Group, forecast in a Sept. 10 report that technology vendors' revenues could increase by 9% in 2008, only "modestly" better than 2007's projected 8% growth. "The uninspiring '08 growth outlook centers on the broader economy," he said. By contrast, revenues had grown by 10% in each of the two previous years and by 13% in 2004.
To be sure, stocks have rebounded from the August rout, and evidence shows technology spending and online advertising remain robust. Oracle (ORCL) had a bang-up first quarter (BusinessWeek, 9/21/07) ended Aug. 30, and it flexed its dealmaking muscles on Oct. 12 with an unsolicited $6.7 billion bid for BEA Systems (BEAS) (BusinessWeek, 10/12/07).
Not All Gloom and Doom
Shares of software maker VMware, the industry's hottest initial public offering since Google (GOOG), have doubled since their Aug. 14 debut. Meantime, shares of Google, the Web search provider that reports earnings Oct. 18, go from strength to strength (BusinessWeek, 10/11/07). JPMorgan (JPM) semiconductor analyst Christopher Danely on Oct. 2 raised his 2007 and 2008 earnings estimates for Intel, citing among other advantages a healthy PC market.
Not everyone is feeling bearish on budgets either. "It's full steam ahead" for tech buying, says the CIO at one telecom carrier. Harry Debes, CEO of Lawson Software (LWSN), a maker of business applications for the Mayo Clinic, Polo Ralph Lauren (RL), and others, says he hasn't seen a slowing in demand. Standard & Poor's, which, like BusinessWeek.com, is owned by The McGraw-Hill Companies (MHP), said in a Sept. 26 report that while third-quarter earnings for the Standard & Poor's 500-stock index are expected to rise by just 2.4%—the smallest gain since the first quarter of 2002—earnings for information technology companies are expected to increase by 10.4%.
Why the concern then? For one, it could take a while for problems in the housing sector and credit markets to work their way onto companies' books. "No company is immune from global economic shifts," says Steve Mills, the senior vice-president in charge of IBM's $19 billion software group. "I'm struggling myself to calibrate what the implications are." Still, even amid summer market turmoil, IBM didn't see a letup in software volume, Mills says. The company is expected to report third-quarter earnings of $1.67 a share, a 24% increase from a year earlier. Analysts expect a 19% earnings increase for the fourth quarter.
Lots of Interest in Cost-Cutting
But as companies come to terms with debt losses, they may be tempted to curtail spending on new technology, especially in the financial, housing, and home improvement sectors. Consider Skanska USA Building (SKAB), a commercial builder working on projects including a new NFL stadium at New Jersey's Meadowlands sports complex.
Skanska IT director Allen Emerick says his 2008 budget likely won't change from this year's. The commercial builder hasn't seen a slowdown in construction, and it can stave off the effects of curtailed residential building for as long as a year because of the size and duration of existing projects, Emerick says. But a slower market in 2008 and an IT budget decrease in 2009 could be on the horizon. "Knowing the market may slow down next year, we may keep the budget the same and tackle some projects this year while we have the capital," he says.
Joshua Greenbaum, principal of Enterprise Applications Consulting, says there's "tremendous interest" inside IT departments to cut costs. Some CIOs are paring back in anticipation they'll have their budgets sliced. But others want to be able to show CEOs, CFOs, and their boards that they're cutting spending on maintaining older technology to make room for new projects. "I'm seeing a lot of interest in projects that can free up budget," Greenbaum says.
Chipmakers' Conservative Q4
For software companies, a pullback could translate to slower growth in sales of new licenses, a predictor of future revenue. UBS (UBS) analyst Heather Bellini said in an Oct. 5 report she expects SAP (SAP) and Oracle new license sales, measured on a sequential basis, to grow more slowly in the fourth quarter than they have in the past three years. Corporate demand for PCs could also be slowing. In a Sept. 27 report, Citigroup (C) analyst Richard Gardner forecast 11% growth in worldwide PC unit shipments in 2008, vs. 14% for 2007, and said Hewlett-Packard (HPQ) canceled some orders from its manufacturers for desktops and notebooks in August.
Citigroup analyst Glen Yeung said in an Oct. 8 research note he expects chipmakers including Intel and Advanced Micro Devices (AMD), which reports third-quarter earnings Oct. 18, to issue conservative guidance for the fourth quarter, given the uncertain economic outlook. Analysts expect Intel to earn 30¢ a share in the third quarter, an increase of 76%, on $9.61 billion in sales. In the fourth quarter, Wall Street is looking for earnings of 37¢ a share, an increase of 48%.
For now, investors may need to wait for more data. If anything goes seriously wrong with computer-industry results, curtailed spending in the financial-services sector could be an early warning. Financial companies buy about 13% of all U.S. technology products, according to ISI Group, and they tend to buy new technology earlier than companies in other sectors. During Oracle's Sept. 20 conference call, Co-President Charles Phillips said he anticipated layoffs in the sector but hadn't seen any cutbacks in IT budgets yet. As third-quarter results start coming in, Wall Street will be on the lookout for any indication that '08 won't be a banner year for tech.