Tops in Tech for 2002

S&P analysts tell what to expect for key technology groups in the new year -- and offer their favorite stocks in the segments they cover

After a dismal 2000, investors hoped against hope that 2001 would bring better times for the technology sector. It didn't happen. The S&P Information Technology index fell 23.5% in 2001 through Dec. 20.

Why? It's all about demand. Customers simply aren't buying software, chips and PCs the way they did in previous years amid the worst economic conditions in a decade.

Will 2002 bring better news? We asked S&P's team of technology analysts for their outlook for key industry segments in 2001 -- and their top picks among the stocks they cover. Here's what they had to say:

Megan Graham-Hackett, Computer Equipment & Networking

There are two things to watch in these segments in 2002: The budding technology spending recovery, and M&A (mergers and acquisitions) activity. The year 2001 saw a dramatic decline in IT (information technology) investment. IT spending, according to market research firm International Data Corp., is expected to rise just 1% in 2001, down from 12% in 2000. Most industry forecasters expect IT spending to rise roughly 5% in 2002, reflecting the anticipated economic recovery.

Since the bulk of the recovery should come in the second half of the year (due to the fact that seasonal spending patterns on technology typically support this scenario, as well as the fact that most economists look for the third and fourth quarters to be the strongest during 2002), it will likely be six to nine months before the industry knows how strong a recovery there will be in IT spending.

While demand should be boosted by the healthier economic environment, the amount of excess capacity available in IT infrastructures is still the unknown. But most computer hardware and networking companies have emphasized they will continue to invest in new technologies to gain a competitive advantage over peers (and gain market share), and we believe this to be true whether IT spending grows 5% or 10%.

However, if the growth is more muted, S&P believes computer hardware and networking companies will likely try to home-grow new technologies in their labs. If tech companies foresee a more dramatic recovery in tech spending, they will likely acquire companies to gain the advantage of a faster time-to-market. Thus, M&A activity among computer hardware and networking companies could be a pretty good indicator pointing to the pace of a recovery in tech spending.

We recommend IBM (IBM ; S&P rank 5 STARS, buy), since the company is already well positioned in some key technology areas (middleware, storage and services), and thus does not need to rely on a risky acquisition strategy to gain a competitive edge.

Jonathan Rudy, Software

With an economic recovery widely expected in 2002, some segments of the software industry should outperform. Specific categories such as security, entertainment and customer relationship management (CRM) software are all positioned to do well during a rebound. Within these particular groups, we like companies that have leading market share, strong balance sheets, and high profitability.

Within security software, we continue to like Symantec (SYMC ; 5 STARS), a leading provider of anti-virus software, and Check Point Software (CHKP ; 5 STARS), the leader in firewall and virtual private network (VPN) software.

In the field of entertainment software, we like Electronic Arts (ERTS ; 5 STARS). This market leader is well positioned to benefit from the recent rollout of next generation hardware consoles such as Sony's PlayStation 2, Microsoft's X-Box, and Nintendo's GameCube.

CRM software will be more dependent on an economic recovery for significant growth in 2002. However, we believe that market leader Siebel Systems (SEBL ; 5 STARS) will emerge as a stronger competitor as many smaller CRM companies have struggled to stay alive during the current recession. With a new product rollout, Siebel 7, $1.5 billion in cash and short-term investments, low debt levels, and solid profitability, Siebel is poised for strong growth in 2002.

Richard Tortoriello, Semiconductor Equipment

Chip equipment makers will experience their second-best year ever, with world-wide equipment spending forecast at about $28 billion.

Although revenue is expected to fall 41% in 2001, S&P believes spending will be only flat to slightly down in 2002. Still, chip manufacturers continue contend with a glut of manufacturing capacity -- utilizing only 64% of their capability in the third quarter of 2001.

Despite the glut, equipment purchases that add leading-edge technology will be increasingly important, as chip makers realize that they must begin purchasing these products to stay ahead of the technology curve. Companies with leading positions in copper interconnect (wiring) tools and 300mm wafer-processing equipment will likely see disproportionate growth. In particular, S&P sees strong demand for copper deposition equipment, advanced wafer metrology and inspection tools, advanced photomasks, deep-ultraviolet light sources, and factory automation tools and software. S&P also sees a rapid shift to 300mm wafer fabs in the second half of 2002, leading to significant equipment purchases, and predicts capacity additions beginning in 2003.

Back-end equipment makers (test, assembly, and packaging) have been so battered by the downturn that S&P expects the best-positioned companies to gain significant market share at the expense of weaker competitors. Equipment stocks have had significant run-ups since early October lows and valuations have become extended for this early phase of the cycle.

S&P would use this weakness as a buying opportunity for equipment makers. S&P's current 5-STAR recommendations are Photronics (PLAB ) and FEI Co. (FEIC ).

Thomas Smith, Semiconductors

We expect 2002 to be a year of modest recovery for the semiconductor makers, following a huge bust in 2001. The Semiconductor Industry Association (SIA) forecasts growth of global dollar sales of chips at 6% in 2002, and near 21% in both 2003 and 2004. We recommend overweighting the sector as the new expansion takes hold.

Fundamentals for the group hit bottom in the summer and autumn of 2001. Chipmakers with exposure to broad end-markets beyond computers and communications have rebounded earliest. These include analog and DSP chipmakers, which cater to wide variety of end-markets including automotive, industrial instrumentation, consumer electronics, and aerospace/satellite.

Some of our favorites include the pure-play high-end analog companies Linear Technology (LLTC ; 5 STARS) and Maxim Integrated Products (MXIM ; 4 STARS, accumulate). We also like the two big plays in analog and DSP chips, Texas Instruments (TXN ; 5 STARS) and Analog Devices (ADI ; 4 STARS).

Another chipmaker we like that has some similarities with the high-end analog companies is Microchip Technology (MCHP ; 5 STARS), with makes inexpensive embedded control systems for all sorts of electronics systems based on its microcontrollers and related analog and specialty memory chips.

Scott Kessler, Internet Software & Services

While layoffs, company losses and closures have strained Internet companies over the last 12 months, the Internet itself has become a more essential tool in the daily lives of its users. A case in point was September 11, a day that Americans relied upon e-mail to facilitate heartfelt communications and on news sites for crucial information surrounding the terrorist attacks.

The Internet will become even more embedded in people's lives in 2002, and solid growth will continue despite global economic woes. Two companies that will benefit in this sector are DoubleClick (DCLK ) and Citrix Systems (CTXS ). S&P has a 5 STARS ranking on both stocks.

DoubleClick, a leader in online advertising solutions, should benefit from greater market share, better operational efficiency, and a healthy balance sheet. Citrix Systems develops software that facilitates a variety of remote computing solutions including branch office access, telecommuting and mobile computing. Demand for associated software and services should drive a notable increase in revenue in 2002.

Ari Bensinger, Communications Equipment

The health of the communications equipment sector depends on growth in capital spending by telecom service providers. Following an estimated 15% decline in 2001, carrier capital spending is expected to decrease over 20% in 2002, hurt by a tight capital market and excess capacity issues. Cost containment has become the major industry theme during this spending downturn, as vendors realign their business models to the lower demand by cutting workforces and disposing of non-core assets.

While we strongly believe in the long-term picture that the sharply increasing demand for bandwidth will spur healthy spending on data-driven networks, the near-term outlook remains weak. Therefore, we would remain on the sidelines until visibility improves. What to look for? Investors should examine key industry metrics, like a return to more normal inventory levels, an acceleration in order bookings, and an upturn in sequential revenue growth as signs of improving industry fundamentals.

Despite the challenging environment, we currently like wireless communication equipment supplier UTStarcom (UTSI ; 4 STARS), which should benefit from robust telecom spending growth in China.

Richard Stice, Contract Manufacturing

The continued trend for outsourcing operations will have a positive impact on the electronic contract manufacturing group. The larger companies in this sector should win the lion's share of new business. S&P's top picks are Flextronics (FLEX ), which has a 5 STARS ranking, and Celestica (CLS ) and Sanmina (SANM ), both of which S&P ranks as 4 STARS.

In the data storage sector, S&P is less optimistic because most stocks have risen substantially in the past few months, without any corresponding change in business fundamentals. While S&P anticipates that demand for data storage will improve in 2002 -- particularly for disaster recovery products -- S&P believes stronger demand already has been reflected in current stock prices. S&P also thinks the office equipment and photo/imaging sectors will struggle amid near-term economic weakness and a shift in IT spending priorities.

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