S&P's Top Tech Picks for 2001

Standard & Poor's analysts tell what to expect for key technology groups in 2001 -- and offer their favorite stocks in the sectors they cover

Unless you've just returned from that desert island along with Tom Hanks, you know that 2000 was a difficult year for investors in the technology sector. Highflying favorites like Cisco Systems and JDS Uniphase saw their stock prices drop sharply as Wall Street fretted that a slowing U.S. economy would have a sudden and severe impact on earnings. And the damage to those companies was minor compared to the bloodbath among Internet stocks.

Maybe 2001 will be kinder to tech investors. One hopeful sign, according to Standard & Poor's Director of Technology Research Megan Graham-Hackett: the likelihood that interest rates will decline further. She believes the size of the Jan. 3 rate cut by the Federal Reserve, and the Fed's decision to move earlier than expected, means that second-half 2001 earnings per share growth for techs looks less vulnerable than it did at the end of December.

We asked Graham-Hackett and other S&P technology analysts for their outlook for key technology groups in 2001 -- and their top picks in the sectors they cover. Here's what they had to say:

Megan Graham-Hackett, computer hardware and networking equipment

The year 2000 told two distinct stories. One is that major tech companies like Cisco Systems and Sun Microsystems saw revenues accelerate to growth rates not seen in years -- and remarkably, the growth came on top of a much larger revenue base (both have annual sales approximating $20 billion!) than in previous years. Yet the tech-heavy Nasdaq composite told another story, posting a terrible performance. It was down nearly 40% for the year.

Reflecting the proliferation of the Internet, the demand environment for the computer hardware and computer networking industries remained quite healthy. Servers and networking equipment (such as routers and switches) continued to sell at a healthy pace as the build-out of Internet infrastructure continued, as it had in 1999 - a year in which the Nasdaq soared some 85%. But fears of a slowing economy and the resultant impact on tech earnings have weighed on the tech sector as it looks to 2001.

While the slowing U.S. economy indeed poses risks for technology spending in 2001, we believe mission-critical infrastructure investments will continue to witness solid demand. We think plays on this technology subsector are most compelling.

The best example? Cisco Systems (CSCO ; S&P STARS rank *****, buy) best represents a company that is well positioned in this environment. First, investments in networking have consistently ranked as a top category by corporations as far as allocation of technology spending for 2001. In addition, Cisco has capitalized on Web-based technologies itself to achieve a nimble and efficient cost structure. Cisco estimates that Web-based technologies saved the company some $1.4 billion annually, which it can then invest in R&D to better compete with its peers for the long run.

Ari Bensinger, communications equipment

S&P expects spending for communication equipment to be strong over the next few years, with growth above 15% annually. Based on estimates from a number of major companies, over the next three years, communications providers will spend over $1 trillion on equipment and services.

What's driving the growth? Telephone companies' insatiable need to increase the capacity of their communications systems and to improve the quality and breadth of their service offerings. The most sought-after products: equipment that can enhance the capacity of service providers' networks, from the core of the network to the end user. Carriers are seeking to establish broadband networks in both wireline and wireless forms. When this additional bandwidth is brought online, carriers can then offer new and compelling services in an effort to outpace the intense competition.

The solution for wireline carriers has been to move toward optical systems, which have the potential to transmit billions of bits of information per second via a single strand of fiber-optic cable. This technology offers the fastest transmission and the greatest capacity, but because of its expense, it's initially being deployed for long-distance carriage. Other equipment providers are focused on cracking the bottleneck that exists in the "last mile" -- the distance between a carrier's central office and the user's home or office -- through offerings like digital subscriber lines (DSL) and cable modems.

Our current favorites in the group include global communication equipment supplier Nortel Networks (NT ; *****), which dominates the high-speed optical networking market and leading optical component supplier JDS Uniphase (JDSU ; *****), which has the most comprehensive portfolio of active and passive components in the industry.

Jim Corridore, contract manufacturing and storage

Contract manufacturing: Though the stocks of companies in the electronics manufacturing services (EMS) industry were battered in late 2000 on fears of an economic slowdown, investors are not fully realizing that the pressure on original equipment manufacturers to outsource production of printed circuit boards, subassemblies and full product lines will only increase. These companies are pushing to cut costs, increase efficiencies and get rid of costly plants and equipment.

For this reason, we feel that the contract manufacturing industry is a good hedge against an economic slowdown and a relatively safer way to play technology stocks. After all, investing in an EMS company is a roundabout way to participate in telecom, datacom, networking, computers and consumer electronics , as these industries are expected to continue to outsource production.

Our favorite stock in the industry right now is Sanmina (SANM ; *****), which mostly makes high margin telecommunications equipment -- a good place to be, as we don't expect demand to slow down, due to pressures on telecom companies to continue to expand their networks. With the highest margins, return on assets and return on equity in the industry, Sanmina is undervalued relative to our fiscal 2001 (Sep.) EPS estimate of $1.15 (as adjusted for a pending stock split).

We also like Solectron (SLR ; *****), the largest EMS company in the world (and it's still growing rapidly). We expect revenues to rise 64% in fiscal 2001 to $23 billion, and cash EPS (EPS before amortization of goodwill and other intangibles) to rise about 42% to $1.20. After amortization charges (reflecting in large part the recent deal to acquire NatSteel Electronics), SLR should earn about $1.02, reflecting 31% growth over fiscal 2000. We think the shares are undervalued relative to our fiscal 2001 cash EPS estimate.

Storage: We still expect growth in the enterprise storage industry in 2001. Enterprise storage is no longer a discretionary purchase for information technology managers -- it's essential. We fully expect that if IT managers decide to cut spending next year as many forecast they will, storage will be the last area that they cut, as all information technology trends still point to an exploding need for data storage. However, the rapid growth rates we have seen in the past few years for EMC and Network Appliance could come down somewhat, as this industry, while recession-resistant, is not recession-proof.

Investors have already foreseen this possibility, which we think is factored into the stock prices of EMC (EMC ) and Network Appliance (NTAP ), both of which we rate accumulate (****). With the future potential for the storage industry virtually unlimited, we like the stocks of these two industry leaders. However, given the current economic environment and investor skittishness regarding high p-e technology stocks, we do not think these stocks deserve our top-pick status.

The hard disk drive sector should have a challenging start to 2001, with continued component constraints making it tough for drive makers to get unit volumes up to the area needed to make a profit. In addition, PC companies are currently seeing some slackening in demand, and with the economic picture clouded, PC demand and consumer storage device demand could be weak to start the year. For this reason, we rate both Quantum HDD (HDD ) and Western Digital (WDC ) as ***, hold.

Scott Kessler, Internet

The past year was the worst in the history of the Nasdaq. The Internet sector has fared even worse, plummeting over 70%. However, despite a significant decrease in the value of most Internet companies, over the last 12 months, the Internet itself became increasingly important to the more than 407 million people using it worldwide. Notwithstanding a slowing global economy, strong growth of the Internet in terms of users and usage will continue to be driven by:

--More affordable online connection options from multiple electronic devices

--Additional deployments of broadband via cable modem, DSL, wireless and satellite connections

--Continued build-outs and upgrades of telecommunications infrastructure, particularly internationally

Regardless of how or where the Internet is accessed, people predominantly use it to find relevant, useful and exciting information. However, traditional and online content businesses face significant challenges in achieving and maintaining consistent long-term success. Thus, our favorite Internet companies are those that provide the platforms to create, distribute and experience engaging online content and benefit simply from the continued growth of the Internet.

Adobe Systems (ADBE ; *****), Macromedia (MACR ; *****) and RealNetworks (RNWK ; ****) are the top developers of software used to produce online content. In addition, Adobe's portable document file (PDF) format, Macromedia's Flash software, and RealNetworks' RealSystem G2 solution have become the standards for the transmission of documents, dynamic graphics, and multimedia content, respectively, over the Internet. Adobe's Acrobat Reader, Macromedia's Flash and Shockwave players, and RealNetworks' RealPlayer are the most widely used consumer software products used to experience such Internet media.

Not only will these companies benefit from the growth of the Internet in 2001, but they also could actually benefit from a slowing economy, as organizations look to more efficiently communicate with their constituencies and cut costs. Our featured Internet software companies will be tapped to enable new and existing customers to provide greater amounts of information and interactivity on their websites and reduce expenditures for paper, postage and traditional conference calls, for example.

Despite significant challenges, Adobe, Macromedia and RealNetworks are poised to perform nicely in 2001.

Jonathan Rudy, computer software and services

Our outlook for 2001 is very positive for industry leaders in select areas of software and services. RSA Security (RSAS ; *****) and Symantec (SYMC ; *****), two of our top sector picks, are Internet security software companies. Despite the recent earnings warning from Network Associates, we continue to believe that the fundamentals of these two companies remain strong. We are also positive on another internet security software company, Check Point Software (CHKP ; ****), which, despite its excellent business execution, has an accumulate rating primarily due to its high valuation.

Rational Software (RATL ; *****) is another of this sector's five star stocks. This company remains a leader in software development. While concerns over technology in general will continue to impact the volatility of this stock, we believe that Rational will be the long-term winner in its space, justifying its current above-market premium. We also believe that, while no area in technology is completely immune from an economic slowdown, certain mission critical areas, such as software development tools, will perform better than others.

Other areas of computer software where demand remains strong are customer relationship management (CRM), supply chain management (SCM), and storage software. Leaders in these three segments include Siebel Systems (SEBL ; ****), I2 Technologies (ITWO ; ***), and Veritas Software (VRTS ; ***), respectively. While business remains robust for all three companies, we are concerned over the current valuation levels of Veritas and I2, and thus rate these two hold. Siebel continues to execute flawlessly, and we currently rate the stock an accumulate.

Computer services will likely remain strong as companies continue to outsource certain areas of their information technology departments. Our top pick in this segment is Computer Sciences (CSC ; *****), which should continue to benefit from company specific, as well as governmental outsourcing.

Other companies that will likely benefit from continued outsourcing of vital services such as payroll processing, direct deposit, and other financial services are Paychex (PAYX ; ****) and Automatic Data Processing (ADP ; ****).

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