Tech Stocks: No Safe Haven

(page 2 of 2)

Tech stocks are likely to suffer more amid consoldiation and disarray in financial services, a major market for IT services. On Sept. 14, Bank of America (BAC) agreed to buy Merrill Lynch (MER). The following day, investment bank Lehman Brothers (LEH) filed for bankruptcy protection from creditors, and insurance giant AIG (AIG) struggled to line up financing and stave off credit-rating downgrades.

Hurt by the Street

The firms, like many on Wall Street, are big buyers of computer hardware and software. "IT spending for the financial sector for sure is going to be lower," says Avi Cohen, head of research at Avian Securities. "A lot of technology plans are either being terminated or put on hold."

Goldman Sachs (GS) now says U.S. IT spending will grow just 4% this year, down from its previous forecast of 6% growth. "IT managers appear to be increasingly bearish," Goldman said in the Sept. 8 report, which will "have a tightening effect on budgets."

Worse, tech stocks could still be overpriced. Corporate IT spending typically follows corporate profit trends by six to nine months, and declining capital investments trail tighter credit by about nine months, according to Citigroup's Levkovich. The trends are not yet fully baked into shares, he says.

Currency Benefit Diminishing

Meanwhile, the U.S. dollar rebound isn't helping tech stocks. After steadily falling for more than two years, the dollar hit an all-time low of $1.604 per euro on July 15. Revenue at HP, Oracle, IBM, and other tech companies with substantial overseas sales was buoyed by the weaker dollar, since sales denominated in foreign currencies amounted to more dollars when translated back for bookkeeping purposes.

The foreign exchange benefit is diminishing. The dollar, boosted by declining crude oil prices, hit a nearly 12-month high against the euro on Sept. 11, and was trading late on Sept. 15 at $1.426 per euro. Bill Whyman, head of technology research at International Strategy & Investment, a research and investment firm, estimates that revenue at technology companies in the S&P 500 has been boosted by about one-third over the past six months because of currency gains. But he expects the gains to ebb in the fourth quarter, and for currency conversion rates to sap tech-company revenues by the first quarter of 2009. Currency effects "could go from a boost to tech to a drag by the end of the year," he says.

Analysts are starting to adjust their expectations. American Technology Research analyst Shaw Wu trimmed his 2008 and 2009 revenue estimates for HP in part because of the stronger dollar. On Sept. 15, he lowered his 2008 revenue outlook for IBM (IBM) for the same reason. Wu has a "buy" rating on both companies.

Slump in Chip Prices

The dollar's rise could reduce Apple's fourth-quarter revenue by $105 million, to $8.11 billion, according to a Sept. 12 research note from Pacific Crest Securities analyst Andy Hargreaves, who rates Apple "outperform." Apple's currency hedging could reduce the earnings impact, he said.

And although currency benefits lifted Oracle's revenue 6% for its fiscal year ended in May, the database and application software company will likely get less than the 5% currency benefit it predicted for its first quarter, due to be outlined Sept. 18, says Brent Thill, Citigroup's software research director, who has a "buy" rating on the shares. By the second quarter of 2009, currency effects could lower reported sales. "You start subtracting out these currency impacts and you have the potential for lower growth," says Thill. "Currency has been an enormous tailwind that's inflated the revenues of software companies. Now it's becoming a stronger headwind."

Other tech companies are victims of slow demand, too. A yearlong slump in the price of memory chips sent the Philadelphia Semiconductor Sector Index (SOXX) to a 5½-year low on Sept. 9. As memory chipmakers have cut back production, vendors of semiconductor manufacturing equipment saw fewer orders.

A Challenging Autumn

To be sure, some technology companies have been protected from the forces whipping the tech market. Microsoft's broad product line and many dollar-denominated revenues could lend it some immunity; Microsoft shares are up 6.6% since July 15. Cisco Systems (CSCO) has hedged against the dollar's rise; its stock is up 5.1% in that period.

Still, investors expect a difficult fall season. In software, stocks typically move higher from September through November, as vendors sign late-year contracts, according to Thill. "Investors are willing to pay up for that certainty," he says. "This year, that's essentially been tossed out the window."

For more on the recent performance of tech stocks, see BusinessWeek.com's slide show.

Ricadela is a writer for BusinessWeek.com in Silicon Valley.