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Early Movers in Tech

Looking for companies that will grow faster than the economy in the next couple of years? Thomas W. Smith, group head of the Standard & Poor's analysts covering technology stocks, points out that makers of equipment for information technology, both hardware and software, meet that standard. He also notes that wireless communications and digital-signal processing (DSP) are among the hot areas. Thus, S&P includes among its buys Texas Instruments (TXN) and Analog Devices (ADI) -- both make DSP chips and the analog chips that go with them.

Another S&P buy is Intel (INTC), which has been focusing on its Centrino technology for wireless notebook computers. As the tech sector recovers, Smith sees semiconductor outfits among the early movers, while he expects telecommunications-equipment stocks, especially for wireline companies, to lag behind.

These were some of the points Smith made in an investing chat presented Oct. 7 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Thomas Smith is a Standard & Poor's Equity Analyst. He has no affiliation with or ownership interest in any companies under discussion. Other S&P affiliates may provide services to the companies under discussion. He is a registered representative of Standard & Poor's Securities, Inc.

Q: Tom, what's the feeling at S&P about the market?

A: Our view on the technology sector is positive, and we are overweighting the sector, as we believe the American economy is in the midst of a multiyear turnaround. We think information-technology equipment -- both hardware and software -- will grow faster than the overall American economy through 2005. And therefore, we generally see good things ahead.

Valuation for tech shares in particular, and the market in general, is always open to a lively debate. However, we feel that, generally, low interest rates and the prospects of an economic recovery help to justify a generally high valuation level for the market.

Q: Lucent (LU) -- up or down?

A: Lucent, as covered by my colleague Ari Bensinger, is a 2-STARS (avoid). It looks from the estimates for losses through fiscal year '03 (September) like the recovery is still ongoing for Lucent. It's representative of a number of stocks serving the wireline telecommunications equipment industry, which we believe will be one of the prominent laggards in the technology recovery. We are not yet positive on this group.

Q: Thoughts on Firstwave (FSTW), please.

A: Firstwave Technologies is not in our coverage. They offer applications that optimize the sales, marketing, and customer-service functions through Internet-based customer relationship management (CRM) solutions. While I can't add more about Firstwave, let me note that through the end of September, the Internet software and services industry, as tracked by S&P, was up 92% year-to-date, compared with a 31% increase for the information-technology sector and a 14% improvement in the S&P 1500 index. You can easily see that Internet software and services has been one of the hottest areas this year, within the hottest sector, as described by the S&P indexing system.

Q: Any pickup in IT spending? I gather you expect it to come. Has it begun?

A: My sense is that it's beginning, but has not accelerated in a strong manner so far. As I listen to the semiconductor companies on my beat, one senses that their end markets have been stabilizing for several quarters now and a better-than-seasonal pattern for PC sales appears to be at hand, according to reports from Intel (INTC).

However, we look for a more decisive improvement in information-technology equipment sales in sales will turn positive in 2003 and grow at 4%, clearly higher than the 2.4% estimated for the economy by Standard & Poor's. And equipment investment is projected to improve to 9.5% in 2004 and grow at 8.7% in 2005. Both of those figures are more than twice as fast as our projection for the overall economic growth for the U.S. economy.

I feel good about the prospect for tech spending generally. That said, the pace of tech sales in this upturn is not apt to be as strong as it was in the great heyday of the late 1990s.

Q: What's your opinion or outlook on the satellite-radio concept? And which stock would fare better -- Sirius Satellite Radio (SIRI) or XM Satellite Radio (XMSR)?

A: We do not presently have Sirius or XM Satellite Radio in coverage. Clearly, this is a product line that is capturing America's imagination, even if it has not yet fully penetrated into everyone's car and office. Radio is one of the last areas of popular communications services to go digital.

One way I think about a play on digital radio is...the semiconductors that go into that gear. And at a recent analyst day at Texas Instruments (TXN), they had several digital-radio services discussing products that they were putting out through gadgets that would include some chips from Texas Instruments, which is a strong player in digital-signal processing.

Q: You remind us, Tom, that your own beat is makers of chips and chip equipment. What stocks look best there?

A: As I was starting to mention, digital-signal processing is a prominent theme for electronics in the present decade, and we view Texas Instruments and Analog Devices (ADI) as strong players in this area because both make digital-signal processors, as well as many of the analog chips that are typically used together with the DSPs. Both TXN and ADI are buys. We're positive on the semiconductor industry overall, and we view it as a leading-edge industry within technology, as the sector makes its comeback.

Other 5-STARS buys include Microchip Technology (MCHP), which is a maker of microcontrollers and associated specialty memory and analog chips that are used in embedded control systems that are ubiquitous in electronics applications. Microchip sells their chips into a very wide variety of end markets, from remote controls to automotive electronics, as well as to computers, consumer items, and industrial applications.

Other buys include Vishay Intertechnology (VSH). Vishay is an interesting company that makes many simple electronic components. They get about half their revenue from passive components, which are often subject to commodity price swings, and half from active components, which are typically semiconductors that have relatively more stable pricing. Overall, we think Vishay is attractively valued compared with similar chipmakers and passive component makers.

We also have a 5-STARS (buy) recommendation on Intel, which has delivered consistently strong results for this time in the semiconductor cycle. It seems to be leading the way up for the industry. We think that they have partly made their own luck by focusing on the Centrino technology for wireless notebook computers. The gross margin story has been attractive for Intel, in our view.

And we think they should do pretty well as American corporations start to hire again in 2004 and 2005, and have a need to replace PCs that may have been bought back in 1999 for Y2K-compliance reasons. The typically useful life for a PC is about three years. So as we begin to move four and five years away from Y2K, we think there will be an interest in upgrading PCs generally and moving on to wireless notebooks in particular. There are many other semiconductor companies recommended as 4-STARS, or accumulates.

Q: Is Motorola (MOT) a good buy now -- after announcing the spin-off of its chip business?

A: Motorola is certainly the story of the week so far. We think that the outlook for its shares has improved a bit with the announcement of its intention to spin off its semiconductor division. As followed by my colleague Ken Leon, Motorola was upgraded today to hold from sell, partly based on the spin-off.

We still expect weak 2003 and 2004 sales and earnings for most of Motorola's businesses. However, the spin-off could be sufficiently beneficial to outweigh our performance concerns. We have a target price on Motorola of $14 a share, based on a sum-of-the-parts valuation.

Q: How about Taiwan Semiconductor (TSM) and United Microelectronics (UMC)?

A: Taiwan Semi and UMC are the two largest dedicated semiconductor foundries. They make the chips for many so-called fabless chip companies in the U.S. and elsewhere, such as Xilinx (XLNX) and Altera (ALTR).

As you can imagine, the outsourcing trend is playing quite favorably into the hands of the chip foundries, and we observe that the semiconductor industry is cycling up. So, fundamentally, as a broad observation, business is picking up for these companies. Although we do not cover TSM and UMC from our New York office, they are covered by our Asian-based colleagues, and the last dispatches I had seen were bullish on the chip foundries. -- those two in particular, with TSM a 5-STARS (buy) and UMC a 4-STARS (accumulate).

Q: There are questions in the audience about Nokia (NOK) -- and Tom, any general observations about telecom stocks?

A: Nokia is one of the telecom equipment companies that we like. It's a 5-STARS buy, as covered by my colleague Ari Bensinger. Nokia, of course, is one of the largest handset makers, and we think they should do pretty well as handsets continue to add features that would encourage people to upgrade their phones. Based largely on our discounted cash flow analysis, our 12-month target price on Nokia is $20 per share, and we estimate earnings of 95 cents in 2004.

I would observe that wireless-telecom equipment seems to have a more open field to run in than the wireline makers. The wireline telecom equipment makers are limited in our view by the constrained capital expenditure budgets of the American telephone companies. So we would generally look for opportunities more in the wireless area than in the wireline area.

As a broad observation, we think the semiconductor industry is an early mover in a comeback for the tech sector. The computer companies, software companies, storage-technology companies are middle movers, and telecom equipment, especially the wireline telecom equipment companies, are laggards in the tech comeback. I might add that Internet service providers seem to have been early movers as well.

Q: You've named several buys in semiconductors -- can you quickly give us some of S&P's buys in other sectors of tech?

A: Taking a quick tour of the buy list out of the tech department, I would mention Cisco (CSCO) and IBM (IBM). We already mentioned Nokia. Others: DoubleClick (DCLK), InterActiveCorp (IACI), Fair Isaac (FIC), Open Text (OTEX), Nextel Communications (NXTL), Intrado (TRDO), Sybase (SY), Microsoft (MSFT), Flextronics (FLEX), Emulex (ELX), Teradyne (TER), and ATMI (ATMI). In addition, Automatic Data Processing (ADP) is a new 5-STARS today.

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