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Tech Stocks: Powering Up?

On July 13, Apple Computer (AAPL) and Advanced Micro Devices (AMD) tantalized tech investors with better-than-expected earnings for their second quarter. The surprise results helped set off a market rally, with the Nasdaq composite closing on July 14 up 4%, to 2,152.82 -- its best performance in over six months. But will the surprises continue from the big tech names as earnings season rolls on?

Scott Kessler, director of information technology equity research at Standard & Poor's, believes the answer is yes. Kessler says, "From a stock-appreciation perspective, there's great potential for growth in the technology sector." Indeed, on July 14, S&P raised its recommendation on the sector to overweight from underweight.

Kessler expects strong reports from Google (GOOG) and Yahoo! (YHOO) in the next two weeks, and predicts pleasant surprises from certain companies that stand to benefit from the growth of converged devices such as cell phones that can play music.

BusinessWeek Online reporter Jeffrey Gangemi recently caught up with Kessler and asked him about his outlook for the tech sector. Edited excerpts follow.

Note: Kessler has no ownership interest in or affiliation with any of the companies under discussion in this interview.

Q: AMD and Apple announced good news last night. Do you expect other big tech companies to follow suit?

A: The Apple story is largely specific to that company and certain offerings they have that aren't replicable. The fact that Apple was able to ship 6.2 million [iPod] units in a quarter where many folks were expecting a sequential decline from 5.3 million shipped in the March quarter is a good indication of their success.

AMD is probably a greater indicator of the good things to come from the technology companies reporting over the next two weeks. AMD largely benefited from an improvement in pricing, which is an indication of more favorable demand in general for the product that they sell.

Q: What does the success of Apple and AMD mean for Intel?

A: Our analyst said that, rather than picking up share from Intel (INTC), AMD's profitability was due to more favorable pricing. Favorable pricing indicates good demand for the category of products that both AMD and Intel sell. I'm not sure to what extent Intel's relation to Apple will affect their forecasting at this point [Apple is switching to Intel chips for its computers].

Q: What does Apple's success mean for other players looking to get into the MP3 player or music-download market?

A: Last month, Best Buy (BBY) named two factors that were responsible for favorable sales last quarter, and one was MP3 players. Around the same time, Creative Technology, which is one of the major producers of MP3 players, reported disappointing revenues and profitability. Apple is really driving growth in the category and continues to gain share, at least compared to Creative Technologies (CREAF).

That's not to say there aren't challenges. We're not expecting declining growth in the MP3 player market, but rather, decelerating growth. The notion of converged devices and their ability to download and play music is going to have an impact on those sales.

Q: Can you recommend any recent stock upgrades that might be good to buy now?

A: We initiated Shanda Interactive Entertainment (SNDA) as a strong buy about a month ago. The stock is actually down since we initiated it, so we think there are significant opportunities. The company is the leading provider of online games in China.

Another upgrade that came soon thereafter is Seagate Technology (STX), which is going to be the beneficiary of things like converged devices. They're responsible for making hard-disk drives for laptop and desktop computers. But we're seeing smaller versions being used in MP3 players, DVRs [digital video recorders], PDAs, and cell phones. We see that as a nice opportunity for them.

Another that isn't classified in the technology sector but is still a technology stock is Audible (ADBL), which is the largest provider of spoken-word audio over the Internet and other digital networks.

Just this afternoon, we upgraded a semiconductor company called Cree (CREE). We think the fundamental outlook for Cree is positive. They produce light-emitting chips and power chips. Wireless broadband is going to be a nice opportunity for them.

All of these stocks are "strong buys," which is considered the most favorable recommendation from S&P.

Q: Any other big tech companies reporting that you've been watching?

A: The three big companies in the Internet space are reporting next week: Yahoo, eBay (EBAY), and Google. My sense is that Yahoo and Google are going to have very good quarters -- pricing remains favorable. Google is growing faster, so maybe they're taking marginal share from Yahoo, but really the two of them are taking share from everyone else. They're both growing substantially faster than anyone else in the industry.

Right now, the expectations for Google are much higher, which is why we have a hold recommendation on their stock. [And] we have a buy recommendation on Yahoo. [Note: An earlier version of this story incorrectly gave the recommendation as hold.] We've had a hold on eBay since November, 2004, in part because of issues related to slowing growth in the U.S. and Germany.

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