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Predictions for PC Makers

Although some technology stocks have staged a nice rally recently, computer hardware has lagged behind the market for the year. Year-to-date through Dec. 2, the S&P Computer Hardware index rose 1.4%, vs. the 4.4% gain in the S&P 500-stock index.

This marks a reversal of a trend established late in 2004, as investors felt enthusiastic about the strong computer demand during last year's holiday season and helped push computer hardware stocks to a 13.7% gain for the year, compared with the S&P 500's 9% rise.

FIGHTING FOR SHARE. "It has been a rather long cycle for a PC refresher cycle," says Megan Graham-Hackett, who follows computer hardware stocks for Standard & Poor's Equity Research. She figures unit growth will come in around 15% this year, but then she sees the rate slowing to 9% in 2006.

Graham-Hackett has a neutral fundamental outlook for the computer hardware group, and she has a hold recommendation on shares of Apple (AAPL), Dell (DELL), Hewlett-Packard (HPQ), IBM (IBM), and Sun Microsystems (SUNW).

She continues to see signs of steady demand for technology products, given the need for companies to produce more due to a competitive global market and the growing use of the Internet. But her enthusiasm is tempered by the potential for difficult comparisons for hardware growth rates in 2006 and continued pricing pressure as vendors fight for market share.

"SELF-HEALERS." Given that this pressure has remained intense, hardware vendors are trying to offset the negative impact on profits by offering services, servers, and storage that carry wider margins, Graham-Hackett says. In particular, she says hardware companies are focusing on automated and "self-healing" features and single-button functions.

BW Online's Karyn McCormack recently spoke with Graham-Hackett about what hardware companies are doing to boost sales. She also discusses her stock picks. Edited excerpts from her remarks follow:

Note: Megan Graham-Hackett is an S&P Equity Research analyst. She has no ownership interest in or affiliation with any of the companies on which she writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

What are the next-generation hardware products to look for from the major computer companies like Sun, Hewlett-Packard, and IBM?

For the corporate side, the major category for computer hardware companies would be servers. The focus is on ways to improve the return on capital outlays for these servers. Companies are looking for automated features, to almost self-diagnose if some kind of fault occurs.

This helps give companies better response time and better processing -- and essentially helps companies streamline their staff. That's where the industry has evolved over the past couple of years, introducing features that had been the domain of mainframes and offering what's been described as "self-healing" features. Sun has introduced products in this area (see BW Online, 12/7/05, "Sun's Super Servers"), and so have HP and IBM. They're all pretty much going after the same market.

At the same time, the industry has always focused on faster and cheaper devices. As corporations have deployed a horizontal architecture in their data centers, the issue has been heat dissipation.

In data centers, companies have a lot of smaller servers stacked in a rack-mounted chassis. This helps to have a more modular approach to save space, and that helps reduce the price-per-square-foot cost for data centers, particularly in high-price cities such as New York.

One product is blade servers -- they're very thin servers. IBM has taken charge in this area. The constant balance is to have very high processing power in a small server, while also addressing the heat dissipation. Striking an optimal balance has been a focus of computer-hardware companies, while continuing to push the envelope on processing power.

What about products for the consumer?

IBM sold its PC division to Lenovo but still has a stake in it. Lenovo is striving to differentiate itself from the competition. This is to offset the fact that all the PC vendors are competing on price, due to the highly commoditized nature of the mature PC industry.

One area Lenovo is focusing on is having a one-button function to attack a virus. I don't know if this will actually kill the virus, but potentially, it isolates the virus from the rest of your computer, so that if you're attacked by a virus, at least your computer may not be rendered useless. That's a very interesting area.

IBM (through Lenovo), Dell, and HP are looking at the common issue for users -- trying to find single buttons that will make using a computer easier for those novice users. A few years ago, some PC makers made a button to access the Internet. The analogy here is computer makers are trying to get the PC to be like your TV -- just plug it in and go.

They want to make it as simple as possible so people don't become frustrated. This could enhance the opportunity, so that if users have a positive experience, there will be follow-on purchases or upgrades. This is a page out of the playbook that Palm used for its operating software for the Palm device. Apple's iPod pitch also played to the simplicity of the device.

Are there any smaller niche players to watch?

We recently brought into coverage a company called Logitech (LOGI). It has greatly expanded its product lineup in consumer electronics. It makes iPod speakers, and its universal remote has gotten very favorable reviews. It has a number of tech products that you would describe as peripherals -- a gaming mouse, speakers for the iPod, universal remote, Internet video camera -- that are playing to the trend in home entertainment. We think the company won't rise and fall with just one product or market.

In the home-entertainment market, or consumer electronics, margins can be challenged, and you can always have a new competitor take away your share with a hot new item. But we believe Logitech benefits from a series of new products targeted at specific new growth markets in consumer electronics -- and offered at a wide range of price points. We have a hold ranking on the stock, mostly because we believe it is reasonably valued.

What are the best plays if you want to invest in computer hardware?

We have a hold recommendation on IBM, Sun, and Dell. Pricing pressure has become very intense over the past year. There has been new penetration from Acer. While we've had pretty solid unit growth, the dollar amount of sales growth has been low.

However, we've found companies innovative in acquisitions, taking market share, and showing margin improvement. One company is Ingram Micro (IM), which is ranked 5 STARS (strong buy). It's a leading tech products distributor (See BW Online, 12/6/05, "Ingram Micro's Maxi Prospects"). We feel the valuation is low on a p-e basis on a historical range.

As the market goes through this relative instability, at some point, things stabilize. As things stabilize, we might see better revenue traction, and those companies that have witnessed margin expansion could benefit from better operating leverage compared with peers.

Do you think Apple's stock has peaked? Is it worth buying now?

Revenue growth for Apple has peaked, we believe. There can be a period after revenue-growth peaks [during which] stock price can appreciate. Right now we have a hold opinion on the stock. From what we saw last quarter, the expectations for the iPod are so high that it's very difficult for Apple to beat them. The bar has increasingly moved up.

Apple has introduced new offshoots to the iPod that should drive sales, but we see growth rates slowing down. Given the new product momentum, however, we don't think the shares are overvalued, even though they're trading high relative to historical p-e and price-to-sales. We think investors should hold the stock.

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