The Tech Slump: Two More Years?

Rate cuts will help contain the damage, but they can't do much about overcapacity

Dallas-based Texas Instruments Inc. (TXN ) is getting a firsthand look at just how fast the tech economy is slowing down. Calling it the "sharpest deceleration the industry has ever experienced," the company reported on Apr. 17 that orders were down 32% from the fourth quarter as many customers cancelled orders. "We have not seen any indications other than weakness," says William A. Aylesworth, TI's chief financial officer.

A steady drumbeat of gloom from the tech sector appears to be a key reason why Federal Reserve Chairman Alan Greenspan moved to cut interest rates on Apr. 18. Earlier cuts had helped keep Old Economy industries such as housing and autos afloat, but tech companies kept sinking as capital spending evaporated. On Apr. 16, networking giant Cisco Systems Inc. (CSCO ) warned of a 30% decline in orders in the current quarter. A day later, chip-industry bellwether Intel Corp. (INTC ) announced that revenues for the first quarter were the lowest since mid-1998. Indeed, the Fed's worries about weakening capital spending--mentioned twice in its rate-cut announcement--seemed directed at tech, which now makes up more than half of all business investment in equipment.

Lower interest rates, though they cheer the stock market, can't do much directly about the tech sector's biggest problems, overcapacity and excess inventory. But indirectly, lower interest rates can help by buttressing Old Economy industries that buy a lot of tech equipment. In addition, rate cuts can provide liquidity to the financial system and make it less likely that tech-related defaults or bankruptcies will trigger bigger financial problems.

So are we close to the end of the tech slump? Even before the Fed's surprise cut, there were faint signs that the tech cycle had bottomed out. Despite its sales slide and an 82% drop in earnings in the first quarter, Intel reported that its personal-computer business was starting to stabilize. Then, on Apr. 18, IBM (IBM ) said that its first-quarter net income rose 15%.

But even if the tech sector has stopped deteriorating, more and more tech execs are concluding that sluggish growth will last well into 2002, rate cut or not. "Customers I talked to in January said this would be a two-quarter slowdown," said EMC Corp. (EMC ) Executive Chairman Michael C. Ruettgers. "Most people now believe recovery is out for this year, and it will be into next year before general markets recover." Intel expects that its communications and flash-memory businesses "will have a longer, slower recovery beginning later this year," says CFO Andy D. Bryant.

Given the current climate, one likely scenario is that the current slump lasts two years from the time it began in late 2000; during that time, info-tech spending will likely average about 3% to 5% annually. That would feel like a kick in the head to an industry that enjoyed gains of 18% and 23% in 1999 and 2000. But such a slowdown would just bring the industry's five-year growth rate back to the long-term average of 12% per year, according to the Commerce Dept.'s figures for business spending on information-technology gear and software. Moreover, a 3%-to-5% growth rate would not be unprecedented. The last two tech slowdowns, in 1986-87 and 1990-91, showed two-year tech-spending growth rates of 4% and 2.5%, respectively.

In the past, the Fed might not have worried much about a tech downturn, even one that lasted for two years. But today, the tech sector is a much larger share of the economy, making a rapid deceleration there a bigger danger to overall growth--and a bigger worry for Greenspan. First, the simultaneous combination of big job cuts by struggling high-tech companies such as Cisco, TI, Hewlett-Packard (HWP ), and Motorola (MOT ), the evaporation of stock-option gains, and the collapse of tech stocks in household portfolios threaten to hit consumer spending hard in the second half of the year.

In addition, the tech slump could trigger cascading problems across the financial sector, resulting in much tighter credit conditions for everyone. Telecom companies such as ICG Communications (ICGXQ ), Northpoint Communications Group (NPNT ), and Winstar Communications (WCII ) have filed for bankruptcy, and PSINet (PSIX ) has said that it will probably go the same route, which would hand big losses to junk-bond holders, the banks that lent them money, and equipment makers, such as Lucent Technologies (LU ) and Cisco, that helped finance their purchases.

"I don't think the world has seen the fallout from all this vendor financing," says Ray Burgess, chief strategist for Motorola Inc.'s semiconductor unit.

That prospect is apparently a big worry for the Fed. According to one senior bank executive, the Federal Reserve and the Comptroller of the Currency have quietly discouraged banks from lending to telecom companies in hopes of keeping the sector's problems from spreading weakness elsewhere.

Moreover, the 50% decline in the Nasdaq over the past year inflicted massive losses on venture-capital investors. "It's going to take two to four years to find out how bad returns will be for venture," says Clifford Higgerson, a partner at ComVentures in Palo Alto, Calif., with 35 years in the venture industry. He expects venture capital to decline for at least that long. Given the importance of venture capital to the New Economy boom of the 1990s, this could dampen the rise of innovations needed to fuel the next wave of growth.

Certainly, it's no longer disputable that a pervasive tech slowdown is well under way. Production of computers, semiconductors, and communications gear rose at only a 5% rate in the first quarter of 2001, the slowest rate since 1991. New orders for tech equipment are plunging at a 19% annual rate, also the worst performance since the last recession. And computer prices are falling sharply as well. In the past, falling prices signaled faster, better models--but now, it reflects a drop in demand.

Add it all up, and there's plenty of reason for the Fed to worry. The three forces that drove the tech boom--venture capital, telecom spending, and corporate investment--are all sagging at once. Venture spending is down 32% just since the start of 2001, according to VentureWire, though its rate of decline seems to have slowed for the moment. Spending on telecom gear is expected to decline 15% for 2001, followed by no growth in 2002. And corporate IT spending is being restrained by the slowing economy. At Cleveland plastics manufacturer PolyOne Corp. (POL ), for example, less critical IT projects are being delayed. "Demand is way down. That's the fundamental issue," says David Honeycutt, PolyOne's director for e-business.

Skepticism about some of info-tech's bigger claims could also slow new orders. "Manufacturers think they have had too much hyperbole about products, such as e-commerce changing the face of the world, when in reality it was just another tool for improving efficiency," says Jerry Jasinowski, president of the National Association of Manufacturers. And doubts about online commerce coupled with the slowing economy spell trouble for the B2B software market. It may take until at least yearend before demand perks up, according to Vivek Y. Ranadivé, CEO of Tibco Software Inc. (TIBX ), in Palo Alto. "The tactic a lot of people used was: `Your competitor is doing this, so you damn well better do this as well,"' he says. That line stopped working months ago.

That has left many equipment and chip makers with much of the stuff they built in 2000. Motorola's Burgess figures that by and large, chip makers booked two years' worth of sales last year. The market for communications and networking chips grew 37% in 2000. But Burgess says "we got 12% last year that we shouldn't have had" because those sales were simply moved up from 2001. The result will be a decline in sales this year and continued slow growth next year.

When the tech sector eventually works through its excess inventory, the critical question will be what rates of growth will return. Optimists such as Pradeep Jotwani, president of the $16 billion Hewlett-Packard Co. division that handles PCs, thinks overall tech spending by consumers will continue to grow at an annual rate of over 15% from 2000 to 2004 due to healthy growth in emerging categories such as digital cameras and MP3 music players. "The long-term trend still holds," says Jotwani. "Consumers will bring technology into their lives for another decade."

Others share his view. Michael S. McQuary, president of EarthLink Inc. (ELNK ), an Atlanta-based Internet service provider, thinks growth in the ISP market will again reach 15% to 20% after the slowdown has weeded out weaker players. Cisco CEO John T. Chambers predicts that his company, despite its recent weakness, will rediscover 30%-to-50% growth rates.

But many analysts believe the days of even 20%-to-30% annual revenue growth are over for the foreseeable future. In telecom equipment, "we are going to see a lower longer-term growth rate," says Tom Lauria, a telecom-gear analyst at ING Barings. Salomon Smith Barney's Tobias M. Levkovich argues that there will never again be the same combination of Y2K spending, near-free equity driving a dot-com boom, and the initial move of all kinds of companies to the Net. "It's a one- time event," he says.

That's why the Fed's latest rate cut will have little effect on tech's long-term growth rates. Nor will it be able to lift tech out of its slump anytime soon. But it will lessen the chance that tech's troubles will pull down the rest of the economy--and that's enough for now.

By Michael J. Mandel in New York, with Peter Burrows and Linda Himelstein in Silicon Valley, Andrew Park in Dallas, and bureau reports

Before it's here, it's on the Bloomberg Terminal.