Markets & Finance

Tech Sector Outlook 2008: Part 1


What S&P sees ahead for semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software

Technology stocks have had a nice run in 2007, largely thanks to healthy demand for PCs with new software products, and exciting new gadgets like Apple's (AAPL) iPhone. The sector moved up in the first half of 2007, then retreated during the summer and autumn, along with many other sectors, amid worries about the U.S. economy caused by the subprime mortgage meltdown. So far this year, through Dec. 13, the Standard & Poor's Information Technology index gained 15.9%, handily beating the 4.9% rise in the S&P 500-stock index.

Standard & Poor's Equity Research has an overweight opinion on the information technology sector and an associated positive fundamental outlook. We believe technology companies and stocks should benefit from healthy domestic spending from enterprises and on consumer electronics, strong international demand, and new product and upgrade cycles.

We also see valuations as attractive, especially on a price-earnings-to-growth basis. Moreover, we believe many technology companies are rightly focused on delivering shareholder value, and are employing buybacks, strategic mergers and acquisitions, and restructuring/realignment efforts to provide it.

Here's the first of a two-part rundown of our IT analysts' outlooks for tech subindustries and stocks, covering semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software. Part 2, featuring outlooks on application software, Internet software and services, home entertainment software, IT consulting and data processing services, and telecommunications services and communications equipment, will follow on Dec. 24.

Semiconductors

Analyst: Clyde Montevirgen

We have a positive fundamental opinion on the semiconductor industry. Although strong unit demand in 2007 was balanced by less favorable average selling prices (ASPs), plant utilization rates rose and inventory levels burned off, providing a good starting point for the industry, in our view. We see memory chipmakers reducing manufacturing equipment orders and microprocessor producers benefiting from server and higher-end notebook demand, leading to better ASPs ahead. We expect sales to increase by 5% in 2008, moderately above the estimated 4% in 2007, and believe that this acceleration, combined with more favorable operating leverage, will lead to relatively high earnings growth, compared to that of other S&P industries.

But unlike 2007, when we saw various supply and inventory problems, we are somewhat concerned about the demand side of the equation. Economic risks stemming from the credit and housing markets could possibly limit enterprise and consumer spending ahead. Although we project sales advancing at a faster pace next year, our growth projection is lower than it was a few months ago due to higher economic risks we foresee and limited end-market demand visibility. Because of our increasing risk view, we have a more cautious opinion on the industry's relative valuations.

We are positive on companies we think will be able to advance in the face of possible economic headwinds by gaining market share in their respective segments, or on companies with very attractive valuations and solid growth prospects. We currently have buy recommendations on Intel (INTC; $26), Broadcom (BRCM; $26), Cypress Semiconductor (CY; $35), On Semiconductor (ONNN; $8), and Volterra Semiconductor (VLTR; $12).

Semiconductor Equipment

Analyst: Angelo Zino

Our outlook for the S&P semiconductor equipment industry is neutral. We envision a decline in semiconductor equipment spending in 2008, based on our opinion of unwillingness by chip manufacturers to increase capital expenditures during a period of uncertainty for the global economy. We think depressed prices of computer memory chips, known as Dynamic Random Access Memory (DRAM), and poor end-market demand visibility will also contribute to our projection that orders will remain weak over the next several quarters.

We have a more favorable outlook for the second half of the year, as we see fundamentals improving for the industry. The rebound, in our opinion, will be driven by the steady transition to faster and more efficient semiconductor devices, a stabilization of memory chip prices, and an increase in capacity by customers, as utilization rates are near peak levels. Additionally, we see significant growth opportunities from solar technology, the flash memory market, and higher demand for flat-panel displays.

Although we expect fundamentals to deteriorate in the near term, we view investor sentiment as low, and believe most of the weakness is already reflected in stock prices, as semiconductor equipment stocks fell substantially during the second half of 2007. We view valuations for the industry as attractive, based on price-to-earnings multiples, applying our 2008 earnings forecasts.

We have a strong buy recommendation on Teradyne (TER; $10), and it is our only such recommendation in the subindustry. Despite Teradyne recently reaching a four-year low, we see valuations nearing a trough, expansion into the high-growth flash memory test market, potential for market-share gains, and a recently announced $400 million stock repurchase program as compelling reasons to buy the stock. We expect sales for test equipment to increase 7% in 2008, outperforming the overall semiconductor equipment market.

Computer Hardware

Analyst: Tom Smith

We have a positive outlook for the computer hardware subindustry for the next 12 months, based on our projection for personal-computer unit growth of about 10% for 2008. This would represent a slower pace than the 12% we estimate for the not-quite-finished year of 2007, but nevertheless would be a solid year for the industry.

We see PC sales driven by the ongoing rollout of updated operating systems from Microsoft (MSFT; $35) and Apple, consumers' desire to upgrade to notebook PCs from desktops, and the usual need to upgrade a PC within a three- to five-year period merely to avoid creeping obsolescence and breakdowns. The trend toward notebooks, in order to gain advantages of portability, access to new Wi-Fi networks, and to simply lose the tangle of wires around the house, is a welcome one for the PC industry, as it encourages sales of higher-end products. Another side of a push toward higher-end PCs is consumer interest in multimedia PCs used for video, audio, and telephony purposes in addition to computing.

Thinking about this trend toward more variety in usage patterns for PCs, we like computer peripherals maker Logitech (LOGI; ranked strong buy; $35), as it makes the accessories that permit personalization of PC setups.

Among the PC makers, we expect the lively battle for market share to continue in 2008. A key question for the industry is whether Hewlett-Packard (HPQ; buy; $52) can continue to gain market share over Dell (DELL; hold; $24). We view HP's revitalization as further along and delivering results better than Dell's, and we think that trend will remain intact in 2008. That said, should Dell succeed in reaching consumers effectively through new distribution channels including major retailers, while keeping its margins under control, it has a chance to deliver one of the more dramatic comeback stories of the industry.

Apple also has a shot at improving its market share, based in part on additional store traffic spurred by rising customer interest in the iPod and iPhone products. The effects of consolidation should also weigh on the industry, with Acer becoming a bigger player since having acquired business from Gateway in the U.S. and Packard Bell in Europe during 2007. Lenovo remains a major player, and one eager not to lose share to Acer and the others.

We similarly see a good year for server sales in 2008, based on ongoing global economic growth in most major markets, with perhaps a stutter in server sales in the U.S. related to weakness in the housing market and related industries, including finance. We like the prospects for industry heavyweight IBM (IBM; strong buy; $107), which we believe is using its global scale advantages in hardware, software, and services, and is likely to continue a big share buyback program that should support per-share results.

Computer Storage

Analyst: Jawahar Hingorani

We believe storage continues to be a priority for IT managers at companies of all sizes, and is increasingly becoming a consumer need due to the creation of large amounts of personalized digital content (audio and video) on various social networking sites. Our outlook is tempered slightly by the weakness we perceive in the U.S. market, and the likely effect it will have on spending on storage hardware in some important verticals such as financial services, manufacturing, and the U.S. government. However, we think that in 2007, hardware has decreased proportionately in terms of overall storage spending relative to prior years, and we are seeing a rise in the amount of software shipments as a percentage of total revenues for many storage systems vendors.

The advent of virtualization as a major trend in storage stems from the need to manage the secure access to increasingly complex applications and data, as well as to improve data center efficiency, by reducing server footprint and lowering energy consumption. The drive to be "green" is accompanied by very real cost savings, making virtualization attractive to enterprises. The reduction in server count is offset by the need for richer, more robust servers across all price ranges, increasing the need for components and network infrastructure. The trend in increased demand for software for storage replication and archiving/hierarchical storage management (HSM) reflects the increasing importance of business continuity/disaster recovery strategies.

These, in turn, are driven by the compliance and risk-management needs for a long-term storage strategy for certain types of information, particularly in data mining, analytics, and reuse in the context of archiving. We also see the spread of broadband wireless services and infrastructure driving the need for additional storage infrastructure build-out.

One company in this group that we favor is Seagate Technology (STX; $28), on which we have a strong buy recommendation. We believe Seagate, the largest maker of hard-disk drives, has been reaping the benefits of size and scale and, along with a history of strong execution, growing revenues and profits. Following its acquisition of Maxtor in 2006, the company has succeeded in rationalizing costs and expenses to gain production efficiencies, while maintaining its position as the leader in the hard-disk drive industry.

Together with its rival, Western Digital (WDC; buy; $29), Seagate is benefiting from strong demand, stable pricing trends, and tight inventories, and has structured its operations to remain profitable. We think past investment in technology and product development, and a strong balance sheet position Seagate to stay on top of emerging trends in the disk-storage space, and to take advantage of new opportunities for growth and investment.

We also have a strong buy recommendation on EMC (EMC; $19). As the leader in the external-disk storage systems market, EMC has continued to grow sequentially through the first three quarters of 2007, while some of its rivals have struggled. After trading at a 52-week high of over $25, EMC shares have pulled back considerably without a significant change in fundamentals, in our view.

We think EMC's content management and security offerings complement its storage products, and we believe having its finger on the pulse of developments in the fast-growing virtualization space, through its 86% ownership in industry leader VMWare (VMW; $95), gives it a competitive advantage. In our opinion, the shares are undervalued relative to peers, based on the company's growth prospects and what we view as its history of strong execution. We believe a strong balance sheet and majority ownership of VMW are additional reasons for investors to own the stock.

Electronic Manufacturing Services

Analyst: Tom Smith

We have a neutral outlook for the electronic manufacturing services (EMS) industry for 2008. The industry should see moderate growth ahead, based on global economic growth and the continued adoption of the outsourcing model by manufacturers.

We see advantages for industry participants that can deliver scale advantages, including global sourcing and delivery, low production costs, and a broad production skill set so that customers can get one-stop shopping advantages. We believe Flextronics (FLEX; buy; $12) gained ground toward successfully working the big-player role in 2007 by its acquisition of Solectron.

For EMS players outside the top tier by size, the key to success in 2008, in our view, will be the development of skills in a niche market or geographic area. Medical equipment is one such niche, where experience with FDA and other regulatory standards can help expedite production and product approval. We anticipate midsize and small EMS companies to be able to have occasional success within niche categories, but to have a harder time competing in non-niche businesses over the years ahead. We believe the trend toward consolidation in EMS will continue in 2008 and beyond.

Systems Software

Analyst: Jim Yin

We have a positive fundamental outlook on the systems software sector as we enter 2008. Our positive outlook reflects our view of continued robust PC sales, driven by stronger expected growth in laptop, consumer, and international markets. Although enterprise adoption of Vista has been slow, we expect the adoption rate to accelerate after Microsoft releases Service Pack 1, which we think will occur in the first half of 2008. We see additional growth coming from the growing prevalence of mobile devices such as smartphones. Increased demand in PCs and mobile devices outweighs our concern of a possible slowdown in the U.S. economy.

We believe one company that will benefit from strong PC sales is Microsoft, which is ranked strong buy. We believe the company is in the midst of a faster growth stage, driven by stronger sales of portable computers and in emerging markets including Brazil, Russia, India, and China. Sales should also benefit from a product upgrade cycle that includes Windows Server, SQL Server, and Visual Studio scheduled to be released in February, 2008. We also think Microsoft is executing better. We project that the Entertainment and Devices Division will become profitable and online advertising revenue will increase 30% in fiscal year 2008 (June).

Another company we rank as strong buy is Citrix Systems (CTXS; $37). We expect Citrix to benefit from increased worker mobility, which requires remote connectivity from home and mobile devices. We believe the company significantly increases its market opportunity with the acquisition of XenSource, a provider of server virtualization software. Its main product allows servers to run multiple operating systems, thus enabling enterprises to reduce infrastructure costs. We believe the server virtualization market is in its early stages of growth and forecast it to increase 30% per year for the next three years. We also like that Citrix derives almost half of its revenue from international operations and should benefit from further weakness in the U.S. dollar.


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