Upturn? What Upturn?

Tech execs expect their customers to keep a lid on spending until next year

By rights, the engines of a high-tech turnaround should be starting to roar, speeding toward a recovery in the last half of 2002. Domestic production of such high-tech gear as computers, chips, and electronic components has surged 12% since the start of the year. Excess information-technology inventories have been whittled down 4.5% since then too. And corporate profits are again rising in some sectors of the economy, meaning companies should have the cash to upgrade their systems.

But the high-tech bounceback--which tech execs and analysts widely expected in the second half of 2002--is behind schedule. More than half of chief information officers who took part in a June Morgan Stanley survey don't see the economy improving until 2003. Only four months before, only 16% of CIOs felt that way. Moreover, more than half of corporate IT buyers say they will conserve their tech budgets for the rest of '02, according to a survey released July 11 by Goldman, Sachs & Co. And on July 23, Merrill Lynch & Co. downgraded the stocks of 11 chip companies because it felt they had been too bullish about potential orders. "The change in sentiment has been dramatic," says Michael Shulman, director of research at ChangeWave Research. "It even calls into question the kind of growth you'll get in the first half of 2003."

With the economy on the mend, why the trouble in Techland? Because demand for high-tech products simply hasn't materialized as expected. The uncertain economy and continued market woes are prompting companies and consumers alike to put major buys on hold. "There is just not a lot of business being done in the IT market," says Thomas M. Siebel, CEO of Siebel Systems. "We don't see any reason why it should get better in Q3 and Q4."

Of course, tech execs have a history of incorrectly forecasting demand--particularly when the underlying trends shift. The same could be happening now. Despite predictions of brisk back-to-school and pre-Christmas sales that prompted many tech companies to gear up production during the past few quarters, the long-awaited turn isn't materializing. Merrill Lynch says orders for chips used in PCs, cell phones, and home-networking gear peaked in June. It cut the sector's growth target for the fourth quarter, from 7% to 5.4%, as inventories at some chipmakers, such as Nvidia Corp. (NVDA ) have grown. "Customers have clearly started to cut orders and will take less inventory risk given weak end-markets," says Merrill analyst Dan Heyler.

Meanwhile, software and server makers are waiting for customers to install and optimize the products they purchased during the late 1990s. That could take a while. AMR Research Inc. estimates that only half of the business software bought since 1998 is in use. The Goldman Sachs IT survey found that replacing aging hardware is a low priority for CIOs. Indeed, to cut costs and complexity, companies ranging from Eastman Chemical (EMN ) to General Motors (GM ) to IBM (IBM ) are consolidating the number of servers and software applications they run. IBM, for example, was running 1,500 e-mail servers in 2000; thanks to improved efficiency, it aims to have 500 by the end of the year.

To be sure, the positive news about the economy should not be ignored. If slowing wage growth allows corporate profits to continue picking up, that could mean more cash to invest in new equipment and systems. Even though 62% of the Morgan Stanley CIO respondents said a near-term rise in profits won't translate into bigger IT budgets, some will boost spending. And technology imports as a whole have inched up over the past three months, topping the year-ago level. This all points to tech spending slightly outpacing nominal gross domestic product in 2003, according to Goldman Sachs. But hopes for a recovery any earlier than that are fading fast.

By Ben Elgin, with Jim Kerstetter and Cliff Edwards, in San Mateo, Calif., and Faith Keenan in Boston

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