By Joseph Radigan
S&P STARS Rank
Apple Computer (AAPL)
Lam Research (LRCX)
Novellus Systems (NVLS)
Check Point Software (CHKP)
McAfee Inc. (MFE)
RSA Security (RSAS)
Cisco Systems (CSCO
Storage Technology (STK)
Ask Jeeves (ASKJ)
Tech companies saw a good -- but not great -- fourth quarter. True, period results for many large tech concerns were in line with, or slightly better than, Standard & Poor's forecasts. Nonetheless, there was too little spending on corporate information technology, according to S&P's analysts, who believe that a full recovery calls for substantial increases in IT expenditures. Until that happens, S&P thinks modest gains are more likely.
"I would not refer to the fourth quarter as a rebound," says Scott Kessler, S&P's group head for IT equity research. "That implies a rapid acceleration in revenue growth that's based on more than seasonality. Most of these companies are talking about relatively modest revenue growth." Recent results underscore the extent to which many tech businesses slashed expenses and raised efficiency during the downturn from 2000 to 2003. "Companies were forced to reexamine their business models," Kessler notes.
SOFTER SPENDING EXPECTED. As S&P sees it, much of the revenue growth derives from strong overseas demands, a replacement cycle for aging equipment in the U.S., continued spending by consumers, and above-average revenue growth for some hot product categories, particularly consumer electronics and security software.
Kessler says continuing trends in consumer electronics, such as digital photography and digital music, ranked among the biggest developments in 2004. Popular products included cellular handsets with camera phones and portable music players like the iPod from Apple Computer (AAPL
; S&P investment rank 3 STARS, hold; recent price, $45).
But with forecasts of more moderate consumer spending this year, the question remains as to whether corporate IT departments will take over the lead from consumers. S&P thinks demand will remain strong in certain segments, such as servers and security software, but sees no large increases in corporate tech budgets.
INTEL'S IMPROVEMENT. The earnings and stock performance of the semiconductor and chip-equipment subindustries serve as a useful proxy for the technology sector as a whole, in S&P's view. Stock prices for the semiconductor and chip-equipment groups have rebounded in the past few weeks, and S&P thinks this reflects the cautiously optimistic forecasts issued by many of these companies during the fourth-quarter earnings season.
Most large chipmakers were hamstrung by excess inventories last year. But that's starting to change. "We think chipmakers and their customers have worked off most of the inventory glut during the past several quarters, and we think the inventory situation should be completely resolved by the second half of 2005," says Amrit Tewary, semiconductor analyst at S&P. A notable improvement took place at Intel (INTC
; 3 STARS; $24), which reduced inventories by $559 million in the fourth quarter and reported revenues of $9.6 billion, 13% higher than in the third quarter.
Inventory problems also took a toll on semiconductor-equipment outfits. Industrywide sales rose about 40% in 2004, and earnings were strong for several equipment suppliers, including those carrying S&P's highest ranking of 5 STARS (strong buy): Lam Research (LRCX
; $32) and Novellus Systems (NVLS
; $30). But the group's share prices fell 25% for the year.
GOOD, NOT GREAT. "There was a real disconnect in the performance of the stocks," says Colin McArdle, S&P chip-equipment analyst. "During 2004, chip-equipment stocks weren't trading on current operating earnings, but instead we think they were being discounted because of the inventory buildup." The then-bearish industry outlook could have caused some of the decline in equipment orders. Orders dropped 20% in the fourth quarter, from the third quarter.
Continuing a recovery that began in mid-2002, the hardware industry enjoyed a good fourth quarter, but growth was hardly strong enough to confirm that businesses would begin loosening their purse strings, says Megan Graham-Hackett, an S&P computer hardware analyst.
"Nobody is describing demand as robust. Customers are still very cognizant of the price war among vendors, and it doesn't look like end users have a healthy appetite for new projects," says Graham-Hackett.
SECURITY-SOFTWARE STRENGTH. Notebooks were particularly hard hit by price competition. Graham-Hackett says a year ago, this category was expected to aid the hardware group's recovery. Instead, competition ate into revenue growth. S&P's top picks in the hardware group are 5-STARS-ranked IBM (IBM
; $93) and Dell (DELL
; $40), both of which reported solid gains in most of their business lines. Dell's revenues rose 17%, to $13.5 billion, which Graham-Hackett attributes to the company's refusal to cave in to pricing pressure.
In software, results from Microsoft (MSFT
; 5 STARS; $25) were surprisingly strong, despite the absence of a new release of either of its franchise products, Windows or Office. Jonathan Rudy, S&P software analyst, says much of the expansion came from sales of server products and development tools.
The security software category also increased quickly, with most of the major vendors in that group reporting substantial growth from both consumers and businesses. S&P's picks among security software developers include Check Point Software (CHKP
; 4 STARS, buy; $22), McAfee (MFE
; 4 STARS; $23), RSA Security (RSAS
; 5 STARS; $16), and Symantec (SYMC
; 4 STARS; $22).
Business spending on security products has increased notably. "Corporations are just not willing to cut back on their security spending," says Rudy. "It's such an important part of the overall budget."
STORAGE GAINS. Revenues were up 12%, to $6.1 billion, for communications-equipment maker Cisco Systems (CSCO
; 5 STARS; $17) during its quarter ended Jan. 29. Revenue growth was toward the low end of S&P's forecast. S&P communications-equipment analyst Ari Bensinger says somewhat weak demand from federal government customers and some softness in service contracts accounted for the shortfall.
"Cisco says the best proxy for their sales is GDP [gross domestic product]," Bensinger observes. "And the economy has not been as strong as people had hoped." Cisco is forecasting modest sequential growth in its April quarter but sees 6% to 8% expansion from its April quarter to its July quarter. If those expectations are realized, Bensinger says, it could mean that corporate IT spending will have turned the corner.
Storage-equipment makers also did very well in the fourth quarter. The increased complexity of many standard applications and growing use of e-mail have driven the rising need for storage, says Richard Stice, who tracks this industry for S&P. "More people are using e-mail and also using multiple e-mail accounts," Stice says. "Plus, under the new regulatory environment with Sarbanes-Oxley, more e-mails must be archived than ever before."
CHECK OUT ETFs. In addition to the major hardware makers, such as IBM, Dell, and Hewlett-Packard (HPQ
; 3 STARS; $20), which all sell storage equipment, beneficiaries of this trend include EMC (EMC
; 5 STARS; $13) and Storage Technology (STK
; 4 STARS; $32).
Internet advertising showed perhaps the strongest revenue increases of any industry during the quarter. Many mainstream advertisers turned to the Internet last year, and the Internet services concerns recommended by S&P include several that get a large chunk of revenues from advertising and related businesses: ValueClick (VCLK
; 5 STARS; 12), Ask Jeeves (ASKJ
; 4 STARS; $22), Google (GOOG
; 4 STARS; $187), and Yahoo! (YHOO
; 4 STARS; $32). Their revenue gains ranged from 60% to well above 100%, with some of the growth fueled by acquisitions.
Investors wishing to gain broader exposure to the IT industry may wish to investigate some exchange-traded funds that track the sector. They include Select Sector SPDR-Technology (XLK), Vanguard Information Technology VIPERS (VGT), and iShares S&P Global Information Technology Sector (IXN). Radigan is a senior editor for Standard & Poor's weekly investing newsletter, The Outlook