The Tech Earnings Hangover
By Jim Corridore
We are now mostly through the June quarter earnings cycle, which is a good time to review some of what we've heard and try to give you some insight on what we are expecting for the rest of 2001 and early 2002.
Unfortunately, there has not been a lot of positive news, and thus far it looks like the current downturn will persist through the third quarter and likely through the rest of the year. Of the companies in our coverage universe that have already reported earnings through July 27, the vast majority of them lowered guidance for the third quarter and the rest of the calendar year. There were a few nice earnings reports, but far and wide, most of the news was that the economic picture had not yet cleared, visibility was still poor, and it was uncertain when things would pick back up.
However, the current downturn is largely factored into share prices. We would argue that once the economic picture starts to improve, industry leaders in the data storage and electronics manufacturing services (EMS) sectors will see a nice acceleration to their revenue and EPS numbers. After identifying the leaders in attractive segments, we would not wait for the upturn to happen before investing in these stocks. The current low share prices, plus the inevitable improvement (for the leaders in well-positioned industry segments only), make now a good time for selective acquisitions.
STORAGE SLUMP. Companies in the data storage sector were largely supposed to be immune to a slowdown due to the explosive growth in data creation fueled by virtually every technology -- from e-mail, to the Internet, to spreadsheet creation, to the convergence of voice-data-and video. However, we learned that spending on storage can be delayed in the near-term, which has impacted the demand for storage products.
The largest and most well-known company in the industry, EMC (EMC ; 4 STARS, accumulate), surprised analysts when it preannounced a large EPS shortfall for the quarter and declined to give guidance for the rest of the year. EMC's Chairman, Mike Ruettgers, said it was the toughest selling environment he had ever seen, and that hundreds of millions of dollars in sales had been deferred. The desire to push sales and "help customers make the purchases they need" led to large-scale price declines, which hurt gross margins. Direct attached storage took the biggest hit, while networked storage, software and services performed relatively well. We lowered our EPS targets for the company, and now expect $0.30 in 2001 and $0.45 in 2002, sharply lower than the $0.79 EMC reported in 2000.
So why do we still like the stock? EMC is the dominant company in data storage, is well positioned in the areas of networked storage, storage software and services, and should return to a more historical growth pattern once the economic picture improves. We would tend to like a company that is dominating what should be a strong growth category in a normal operating environment. Trading at 44 times our 2002 EPS target, we see the shares priced at an attractive entry point for a company of this caliber.
Demand for storage networking products has also slowed. However, due to cost advantages and quick payback periods on investments in this sector, network attached storage (NAS) and storage area network (SAN) products are still growing, albeit not at the torrid pace of a year ago. For the longer term, we like Brocade Communications (BRCD ; 5 STARS, buy) the leading maker of SAN switching products. The company should continue to gain market share in this challenging environment, and should put those share gains to good use once technology spending improves. Trading at 62 times our FY 2002 (Oct.) EPS target of $0.50, the shares are pricey, but you are paying for a dominant player in a rapid growth sector that should grow EPS at a 45% CAGR over the next 5 years.
NO ESCAPE. Another sector thought to be protected from a slowdown is the electronics manufacturing services (EMS) industry, which makes electronics products for OEMs in telecom/datacom, PC, computer peripheral and consumer electronics. The argument was the additional penetration of new OEM outsourcing projects along with a diversified customer base by industry segment would help offset any slowdown in one or more industries.
The problem turned out to be that almost all technology sectors slowed simultaneously, and new projects, while still coming along at a nice pace, could not ramp up fast enough to replace shortfalls from mega companies like Cisco, Lucent, Motorola, Dell and others. As a result, all of the leading EMS companies have reduced guidance for the next couple of quarters. In particular, telecom demand has fallen off to such an extent that companies highly exposed in this area had huge sequential drop-offs in revenues in the June quarter, and will be flat to down again in the September quarter.
We still like several companies in this sector. We carry accumulate (4 STARS) recommendations on Flextronics (FLEX ), Sanmina (SANM ), Celestica (CLS ) and SCI Systems (SCI ), which is being acquired by Sanmina.
Why are we still relatively bullish on this sector? We strongly feel that the current economic turmoil is only making the prospect of outsourcing manufacturing by the OEMs more palatable. Over the next 18 months, we believe you will see an acceleration in the number of OEM asset sales and strategic agreements with the largest EMS companies. All of the companies we are recommending are of sufficient size and scale to take on a new large-scale program, and should benefit from this upcoming wave of new outsourcing deals.
The current penetration rate into electronics manufacturing is still only about 20%, and widely expected to reach up to 70% of all electronics manufacturing worldwide, providing enormous growth potential. This, combined with lower valuations, makes it a good idea to accumulate the shares, despite the current negative tone to business. Once the economy starts to pick up, there will be a rapid re-acceleration in growth of revenues and earnings at these top-tier EMS companies.
BLURRY PICTURE. Demand for office imaging products (copiers and printers) has clearly slowed. Xerox (XRX , 3 STARS, hold), Ikon Office (IKN , 3 STARS, hold) and Electronics For Imaging (EFII , 4 STARS, accumulate), all had lower revenues in the quarter. In a shrinking revenue pool, the only way to grow is through market share gains, which had led to a fierce competitive pricing environment in office imaging.
Xerox also has the challenge of trying to dig out from under the operational and financial mess the company has gotten itself into over the past couple of years. While not out of the woods, the company has made significant progress in improving its balance sheet and cutting costs.
We sill like EFII, which works with all the major copier and printer makers (with the exception of Lexmark), and should not be hurt by the competitive environment. The company's products are used in color and high-speed printing, areas that should rebound nicely when the economy improves. Trading at 19 times our 2002 EPS target of $1.20, we find the shares attractive.
Corridore is a technology industry analyst for Standard & Poor's