Tech Sector Outlook 2008: Part 2

What S&P's equity analysts see ahead for application software, Internet software and services, home entertainment software, and consulting and data processing services

Here's the second of a two-part rundown of Standard & Poor's information technology analysts' outlooks for tech subindustries and stocks, featuring outlooks on application software, Internet software and services, home entertainment software, IT consulting and data processing services, telecommunications services, and communications equipment. Part 1 covered semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software.

Application Software

Analyst: Zaineb Bokhari

As we enter 2008, we have a neutral outlook for the application software subindustry. We think the slowing U.S. economy will affect corporate spending on application software, although we do not think that growth in spending will slow much below a mid-single-digit rate (4% to 6%). While it is unlikely that corporations will curtail budgets entirely, we expect growth in the first half of 2008 to be muted, as firms continue to assess the impact of recent turbulence in the credit markets and of developing economic headwinds, thus likely making 2008 a back-end loaded year. The financial services sector has historically invested heavily in software to meet regulatory demands and to foster productivity. We do not think all software purchases are discretionary, but we think investors need to be mindful of this before viewing the subindustry as a "safe haven."

While we think that growth in licenses will slow as corporations delay purchases, we expect maintenance renewal rates to remain high. This will benefit companies that have strong recurring revenue bases and maintenance revenue streams, like Oracle (ORCL; $21), which carries our strong buy recommendation. Regions outside the U.S. have offset a domestic slowdown somewhat, and we expect this trend to continue, but we are not optimistic that this can continue indefinitely, particularly if the U.S. economy continues to weaken.

We recommend that investors be selective, choosing companies with broad product sets, diverse customer bases, sufficient geographic exposure, and a high degree of recurring maintenance revenues streams, as we think these companies will weather economic uncertainty.

We think Adobe Systems (ADBE; $42), which carries a buy recommendation, will continue to benefit from a well received product launch, with significant future potential to benefit from the growth of rich Internet applications and mobile media.

We also think the small and midsize business (SMB) segment, while not recession-proof, will likely continue to grow faster than the mature enterprise segment. For this reason, we recommend Lawson Software (LWSN; $9), a provider of enterprise resource planning (ERP) software and ranked buy, primarily to the SMB segment.

We expect M&A to continue in 2008, particularly of small- and mid-cap players with strong product offerings in appealing niches. We think Informatica (INFA; $18), which also carries a buy recommendation, could be an attractive acquisition.

We think the pace of M&A could moderate from 2007 as financing mega-acquisitions could become more difficult for some vendors. Partly offsetting this is our view that smaller vendors, who struggle in a slowing economy, could become easier targets for larger vendors.

Internet Software & Services

Analyst: Scott Kessler

We think Internet companies will largely reflect market realities in 2008. For example, we foresee a deceleration in U.S. growth and notable opportunities abroad. We also expect emerging areas of digital advertising, such as video and mobile marketing, to contribute more materially to revenues. We anticipate additional M&A activity, especially in the online advertising solutions segment and niche content areas.

We're going to be watching Google (GOOG; ranked hold; $675) very closely, as usual. Google has become the world's largest and most important Internet company, in our view. In part because the company has become so big, we think it will be difficult for it to continue to gain market share in the search category as it has in the past. We also believe competitors are positioned to make inroads after completing acquisitions and efforts to refocus and realign.

Many Internet companies announced and/or initiated material reconstitution initiatives in 2007, including bellwethers IAC/InterActiveCorp (IACI; hold; $27), VeriSign (VRSN; hold; $37), and Yahoo! (YHOO; hold; $23). We've seen writedowns, asset sales, and considerable M&A activity, as companies seem more focused on delivering shareholder value than ever before. Internet companies have also spent more on stock repurchases in 2007 than in any prior year, based on our estimates.

We have two strong buy recommendations in the Internet Software & Services subindustry.

Ebay (EBAY; strong buy, $32) is a brand and stock familiar to most, and we believe the shares are as attractive as they have been for some time. We think the eBay marketplace business is healthy, the PayPal operations are strong, and the Skype growth story is still intact. The stock recently traded at below 20 times our 2008 EPS estimate, and it has a p-e-to-growth ratio of less than 1.0, based on our calculations. The company has ample cash with which to make strategic acquisitions and repurchase stock.

Shanda Interactive Entertainment (SNDA; strong buy; $35) is a leading provider online games in China. We believe its diversified mix of games, varied business model, and valuation have appeal. The ADRs recently traded at a PEG ratio of below 1.0, based on our 2008 profit forecast.

Home Entertainment Software

Analyst: Jim Yin

We have a neutral outlook on the home entertainment software sector. Sales of the new generation of game consoles have been picking up, driven by the popularity of Nintendo Wii and reduced prices for Microsoft's (MSFT) Xbox 360 and Sony's PlayStation 3. We expect this sales trend to continue in 2008, as Nintendo ramps up production of Wii and console prices decline because of lower component prices.

Stronger sales and a larger installed base of game consoles should bode well for video game developers, as consumers purchase as many as 9 to 15 titles per console. Additionally, we expect video game developers to release more titles that take advantage of the new consoles' better graphics and improved playability. In particular, we think developers underestimated the popularity of Wii and have not developed as many titles for this console system as for others. However, they have allocated more resources and plan to release more video games for Wii.

Although we believe fundamentals will improve in 2008, we do not have a positive fundamental outlook for this sector, primarily due to valuations. We have a hold recommendation on Activision (ATVI; $27), THQ (THQI; $28), and Take-Two Interactive (TTWO; $19), and a sell opinion on Electronic Arts (ERTS; $59).

IT Consulting and Outsourcing

Analyst: Dylan Cathers

We believe IT outsourcing companies are in a position to benefit regardless of the direction the economy takes over the next few quarters. If the economy firms, we believe companies will have to increase capacity to handle the additional work, especially after the numerous downsizings that have occurred over the past few years. If the economy softens, we think outsourcing companies will benefit, first because the outsourcers generally sign long-term contracts, thus ensuring a relatively steady income stream. Second, after reducing headcount and outsourcing work, some companies are no longer equipped to perform certain tasks as they become dependent upon their outsourcing partners.

While we look for growth to continue, we remain slightly more cautious regarding the rate of growth. For example, we do not think that Indian outsourcers will be able to continue growing at their recent 40% annual pace, but we don't think growth in the 30% range is unreasonable, and we see them continuing to take market share from their U.S. competitors. There are additional headwinds for the group, including the rising rupee relative to the U.S. dollar, wage inflation in India, and the possible expiration of tax breaks in 2009.

Within our coverage, Cognizant (CTSH; $33) is one of our strong buy recommendations. We believe the company has the offshore capabilities and vertical expertise to continue to be strongly competitive. Most of its workers are located overseas (in India), but Cognizant is headquartered in the U.S., which gives it some insulation from fluctuations in the U.S. dollar/rupee relationship. We note, however, that nearly half the company's revenues are derived from financial services firms.

Elsewhere in the group, we recommend Satyam (SAY; buy; $25), based on what we view as its ability to manage margin pressures well. We think the traditional outsourcers, with the notable exception of Accenture (ACN; buy; $35), will continue to struggle.

We remain bullish on two payroll processing outsourcers, Automatic Data Processing (ADP; strong buy; $47) and Paychex (PAYX; buy; $39). Although employment growth may slow in 2008 and interest rates are declining, we believe these two companies remain attractively valued, relative to historical norms, and we expect mid-double-digit earnings growth from both in 2008.

We are neutral regarding companies in our IT services universe that are most exposed to spending by the federal government, given the divided Congress and White House. We believe there will be further legislative contentiousness. Accordingly, we have hold recommendations on ManTech International (MANT; $45), CACI International (CAI; $44), and SRA International (SRX; $30).

Telecommunications Services

Analysts: Todd Rosenbluth, Jim Moorman, CFA

Our fundamental outlook for the integrated telecom services industry is positive. We believe the telecom carriers, through broadband growth and cost savings, will generate strong free cash flow to support dividends (currently an above-average 3.1% yield) and share buybacks in 2008. While we expect to see some pressure from cable telephony, and while the housing market continues under pressure, we contend that bundled telecom services will remain core to consumers.

We expect the largest telecom providers, such as strong buy ranked AT&T (T; $40), to further roll out fiber-based video services and as a result, increase revenue per household. We expect smaller telecom providers, such as strong buy ranked Citizens Communications (CZN; $13), to hold off offering their own video services until pricing for equipment declines, but we see them increasing their spending on broadband initiatives to increase penetration.

We believe that independent wireless service providers in developed countries will have stable cash flows but should see margin pressure as competition continues to intensify through price cuts, incentives, and handset subsidies. However, we think wireless providers in emerging markets will fare better in terms of improving margins and profitability, but competition will begin to have an effect.

In our opinion, the bright spot for both domestic and emerging market service providers will be the continued proliferation of data revenue and its positive effect on revenue per user. We believe that the early 2008 spectrum auction will likely be the last chance for carriers that need capacity to enter or expand into new markets for the foreseeable future, but could hurt their cash flow as they build out networks. Therefore, it is our opinion that the true winners will be the wireless tower companies such as American Tower (AMT; $41) and SBA Communications (SBAC; $33)—both buy recommended—as the "arms dealers" to Verizon and peers as they continue to enhance their networks with better service and new product to entice subscribers to switch.

Communications Equipment

Analyst: Ari Bensinger

Increased use of the Internet is creating strong demand for broadband access equipment, as data transmission is now the overwhelming majority of traffic carried on the telecommunications network. Moreover, the growing popularity of user-generated-content Internet sites and peer-to-peer traffic is fueling an exponential increase in the transport of video over the network. Being multimedia intensive, Internet Protocol video is a significant occupier of bandwidth that can potentially strain the transport network.

To handle the sharply higher demand for data and video transmission, telecom operators are in the midst of migrating from narrowband networking of voice services to broadband networking of data services. Traditional circuit-switched networks are being rapidly replaced with packet-based systems, and they are being better equipped to handle video and mobile applications.

On top of the strong end-demand for Internet and video, an increasingly competitive environment between the telecom and cable operators is helping to push industry growth. Operators continue to rebuild and upgrade their networks to better handle triple-play offerings of voice, video, and data. Given that the triple-play package holds the key to attracting new subscribers, improving customer loyalty, and increasing the average revenue per user, each camp has little choice but to spend on the communications equipment gear that enables this service.

While we expect these growth drivers to continue for the foreseeable future, industry pricing and margin pressure are intensifying because of increased consolidation in the telecom sector. Additionally, the spending shift toward next-generation equipment, specifically for fiber access projects, has materially decreased sales visibility for equipment providers.

In light of these factors, our fundamental outlook for the communications equipment industry is neutral. Overall, Standard & Poor's forecasts mid-single-digit growth for the communications equipment market for 2008.

Our top pick is networking gear supplier Netgear (NTGR; $34), which carries our strong buy recommendation. We see the company benefiting from increasing broadband penetration, particularly in emerging countries, as well as a growing number of interconnected networks, with computers being increasingly connected to home entertainment and storage devices. While industry competition remains intense, we believe Netgear will continue to gain market share by successfully introducing new products at attractive price points.

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