Online Extra: Tech Investors: Learning to Live with Less

Thanks in large part to lagging spending from telecom carriers, the sector can expect a slow recovery in 2002

Picture a prize terrier in a swimming pool, paddling furiously to keep its head above water. Not a pretty sight, right? Well, that's basically what the tech sector is going through right now. While earnings for the second half of 2001 may well improve, here's the bad news: Second-quarter profits are likely to be worse than the first quarter's.

Yes, the rest of 2001 and much of 2002 will likely provide a period of slow recovery in the tech sector. But nobody is going to be breaking earnings records.

The most positive news is that the Nasdaq could well end the year about where it started last January, in the 2500-2600 range. That's 21% up from where the index is trading now and nearly 60% up from April's low of around 1620. Savvy investors will have to be satisfied with that and start thinking about 2002. They just better think modestly. There are no 1990s'-style trends like deregulation, privatization, or the emergence of the Internet to whip up hot growth.

DELAYED REACTION. The biggest buyers of tech -- the telecommunications carriers -- will be preoccupied for the rest of the year with an industry consolidation to soak up overcapacity. Alas, more Fed rate cuts or an economic recovery won't have an immediate effect on their capital spending. That means the tech sector will likely drag in 2001 and may well be beat out by Old Economy stocks that can benefit more quickly from a turnaround next year.

So what about investors who want to stick with tech? They should be thinking long-term and be keeping an eye on good business fundamentals that will prove themselves over the next 12 to 18 months. Truth is, there's plenty of evidence that investors still cling to false hopes. In part, these are spurred by analysts' overly optimistic projections. "The [earnings-per-share] consensus of late May for S&P 500 tech earnings was higher than that for 2000," points out Steven Wieting, senior U.S. strategist at Salomon Smith Barney. "Investors have to base their valuations on realistic 2002 numbers."

The consensus estimates show S&P tech earnings dropping by 22% this year and rising by 35% next year, says Wieting. But if that happens, they would surpass the record year 2000 by about 13%. Let's be frank: That's unlikely.

Why? Last year's earnings were the result of a culmination of what analysts refer to as "secular" trends -- factors that can affect earnings but have nothing to do with the fundamentals of a sector -- such as the global deregulation and privatization of the telecommunications industry during the 1990s. These trends fostered competition that helped create a first-mover frenzy around new product areas like data transmission and the Internet.

"TAKE A BREAK." But data and the Internet won't fuel the kind of tech growth they have in the past, largely because the investing community will no longer fund the network buildouts of large telecommunications carriers. When the Nasdaq peaked at 5048 in March of 2000, money for network building that would enable faster data transmission and better Internet access was easy to come by. "We thought everything was secular and not cyclical, and we started to fund things in that fashion," says Pip Coburn, tech analyst at UBS Warburg.

Now, with network overcapacity, the climate has completely changed. "Investors are telling the service providers that they should just take a break from [network building] and watch their cash flow and their balance sheets a little more closely," says Coburn.

Last year, telecom carriers led the tech-spending boom, with increases in capital expenditures of some 25% over 1999. This year they are leading the downturn. Coburn estimates that carriers' consumption of technology will come in flat to negative for 2001.

TENACIOUS CONSUMERS. But telecoms aren't the only ones pulling in their horns. Last year, nontelecom companies increased IT spending by 10% to 14% over 1999. This year, Coburn estimates they'll spend only 3% to 5% more than they did in 2000. Although least important to the overall tech picture, consumers will be the most tenacious in their tech spending. In 2000 they spent about 7% to 9% more on tech than they had in 1999. This year, they might spend 5% more than they did last year, according to Coburn.

Small wonder why most analysts like the segments of tech whose end users are consumers and nontelecoms. These end users will respond to the Federal Reserve's rate cuts and the economic recovery by spending on tech, among other things. Companies whose sales will benefit include manufacturers of low-end semiconductors used in all kinds of consumer goods, particularly in consumer electronics. As the prices of digital cameras and TV set-top boxes with disk drives come down, companies such as Zoran (ZRAN ), which makes the encoder chips for DVDs and digital cameras, should fare nicely.

Tech companies that sell to corporate end users may see some benefits from increased corporate spending in the second half of this year. That could help software manufacturers like BEA Systems (BEAS ), Microsoft (MSFT ), Oracle (ORCL ), and Veritas (VRTS ).

FOREVER BEHIND. The stocks that could be trouble may be last year's stars -- companies like Cisco, Intel, and Sun Microsystems. "We think the old leaders are still overpriced," says Milton Ezrati, senior analyst and strategist at Jersey City (N.J.) money manager Lord, Abbett. "If you look at past bubbles from tech to energy, the stocks that led the inflation and then collapsed never recover their relative value."

For investors, that means getting back to business fundamentals, ignoring the hype, and hanging in there for the long haul. "You have to have a long-term perspective. You don't want to get jerked out of a good company because they have a couple days when they are down 15% or 20%," says UBS Warburg's Coburn. "That's par for the course in technology."

But even with an 18-month investment horizon, don't set your sites too high. Since telecom carriers have lost their appetites for new technology, tech investors are going to have to learn about moderate growth.

By Margaret Popper in New York

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