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Don't Sweat Tech's Small Stuff

On the surface, things looked pretty good for technology companies Apple Computer (AAPL) and Advanced Micro Devices (AMD) after they posted solidly higher quarterly results after the close of trading on Oct. 11. Cupertino (Calif.)-based Apple said its net income for the quarter ended September was $430 million, compared with $106 million in 2004. Sunnyvale (Calif.)-based AMD reported microprocessor sales growth of 44% compared with the third quarter of 2004.

But the growth appeared to disappoint investors, who drove the shares of both companies lower on Oct. 12. AMD's price was down about 2.29%, to $21, in late trading on Oct. 12, while Apple shed 2.3%, to trade at $49.25. Should technology investors be worried about upcoming earnings reports for other big names as well?

Scott Kessler, director of information-technology equity research at Standard & Poor's, is waiting for more evidence before jumping to conclusions about the sector. "There are reasons to have some questions," he says, citing uncertainty from factors such as Hurricanes Katrina and Rita and the expiry of technology companies' stock options starting next year.

But Kessler says the sector's fundamentals are solid, and valuations are relatively attractive. S&P's investment portfolio recommendation on the sector remains at overweight, after it was upgraded from underweight on July 14. BusinessWeek Online spoke with Kessler on Oct. 12 about S&P's outlook for the tech sector -- and two 5-STARS (strong buy) picks in the group, EMC (EMC) and Citrix Systems (CTXS). Edited excerpts from the discussion follow:

Note: Kessler has no ownership interest in or affiliation with any of the companies under discussion in this interview. Standard & Poor's, like BusinessWeek Online, is a unit of The McGraw-Hill Companies.

After Apple and AMD announced their quarterly results, investors sold the companies' shares Wednesday. Does this shed any new light on the outlook for the tech sector as a whole?

I think it's fair to say that both companies had relatively encouraging results, but I think there definitely is trepidation relative to the market in general, and technology specifically. So far in October it has been a tough time in terms of how the stocks have performed in technology, and again we saw some profit-taking [in] stocks that had done well over the previous four to five months.

I also think that people have been concerned about preannouncements and forthcoming third-quarter results and forward guidance. Recent comments from companies such as Compuware (CPWR) and Xilinx (XLNX) are indicative of a trend that may or may not have any kind of staying power.

It's still unclear what the full impact the recent hurricanes will have on companies, and people are uncertain about some of the near- and maybe even intermediate-term fundamentals for tech companies. And perhaps most important, they see the stocks falling, and that has caused a degree of trepidation. Putting all those things together, people are inclined to take profits.

Apple brought in $1.21 billion of revenue from iPods during the quarter, compared with $537 million during the same quarter of 2004. Do you see Apple still leading the race this year in the MP3 player or music-download market?

The MP3 player market right now is Apple's to lose. No company has been able to challenge them, and one of their primary competitors, Creative Technology (CREAF), is struggling. There's a relationship between the popularity of iPods and the success of iTunes -- the relationship is symbiotic for the most part, since you can't play a music download from any other service on an iPod.

But several other well-known companies have successful subscription services like Napster (NAPS), RealNetworks (RNWK), and most recently, Yahoo! (YHOO). All three of those are pretty notable players in this area...and as part of their recently announced settlement, Microsoft (MFST) is providing RealNetworks about $300 million or more for promotions or more. Napster's entire market cap, as we speak, is less than $200 million.

Do you think technology stocks are a good buy right now? If so, why? And which are your favorite picks?

Yes. Currently, our fundamental outlook on the technology sector is neutral. We think the fundamentals are solid, and the valuations are relatively attractive. And a lot of the companies have strong balance sheets.

In the last couple years, companies have accumulated a lot of cash as they came out of a challenging period. There are reasons to have some questions, but notwithstanding those, we're recommending a wide variety of tech stocks at this point. I think it's fair to say that right now, there's a lot of worry [about the coming quarters], and my experience is that sometimes that is a good time to get involved in some of these names.

It would take a long time to go through all of the stocks we recommend, but one is the software and services company EMC (EMC). We think the stock is attractively valued and has a strong balance sheet. And we like how the company is faring. We think its partnership with Dell (DELL) is going to be beneficial for both companies.

Another pick is Citrix Systems (CTXS). As more people do work outside their offices, Citrix allows them to connect remotely to corporate networks and get their work done whether on the road or from home. They also recently completed an acquisition with the privately held application-networking company NetScaler, and that'll enhance the kind of products and services they offer.

How much do you think consumers will be spending on high-tech accessories this year? If their spending slows, which technology companies are going to survive the best?

A lot of companies tend to be pretty well-diversified. Dell, for example, has a major consumer franchise but most of its revenues are actually generated from corporations and governments. Technology companies are directly impacted by consumer spending, but their exposure is more limited than you might think.

Q: We've seen a string of technology companies linking up, merging, or buying one another in recent months. In the latest example, Microsoft and Yahoo announced an alliance agreement on Wednesday that includes the sharing of their free instant-messaging services. Should we expect any more of these deals soon? If so, which companies are likely to do them?

There have been some deals, and there could be more in areas like software, where there are too many companies and products. We expect to see them continue to snap up companies.

We would also expect more in the semiconductor and semiconductor equipment area. And I guess lastly, communications equipment is an area where I think there has been some consolidation, but there could be more.


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