Tech Stocks: Look, Don't Touch

Yes, prices are low and there may well be better days not too far ahead. But in the meantime, the earnings outlook remains grim

By Thomas Smith, CFA

It has been a rough month for the technology sector, as third-quarter earnings season nears. For every example like Texas Instruments (TXN , ranked 3 S&P STARS (hold) that confirms guidance for the third quarter, many other tech companies speak of softer demand, such as Cisco (CSCO , ranked 3 STARS) and JDS Uniphase (JDSU , 2 STARS (avoid).

One of the biggest surprises was the earnings warning from Electronic Data Systems (EDS , ranked 2 STARS) on Sept. 18. The shares plummeted 50% the next day, and then fell further on Sept. 24, after an analyst at Merrill Lynch sparked speculation that EDS might face a sizable charge for losses in derivatives trading.

The shares of companies in every tech industry -- from semiconductors to storage and software -- are suffering big declines amid persistent worries about weak profits and sluggish economic growth. The S&P Information Technology index has tumbled 45% through Sept. 20, while the broader S&P 500 index was down 26%. And on Sept. 23, the tech-dominated Nasdaq composite fell to 1,184.93, its lowest level since September, 1996.


  We at S&P are keeping our underweight recommendation on the IT sector. With little chance for upside 2002 earnings surprise, some high valuations, plus uncertainties about options compensation, investors have reason to be cautious.

Lower share prices and an approach to a 2003 earnings recovery could foster optimism, but we think investors should wait for evidence of stronger demand first. Technology earnings should improve in 2003 and 2004 for a few reasons: equipment bought in 1999 for Y2K compliance will become obsolete, next-generation wireless handsets are coming to market, and the economy is expected to improve. Right now, some tech revenue estimates for 2003 are being softened in the light of reduced growth forecasts, but 2003 results should still look better than 2002.

Though we are cautious on the tech sector overall, there are a few names we recommend. Companies with 5-STARS (buy) rankings include video-game software maker Electronic Arts (ERTS ), security-software maker Symantec (SYMC ), microcontroller maker Microchip Technologies (MCHP ), and semiconductor-circuit software maker Cadence Design Systems (CDN ) (see BW Online, 9/6/02, "Tech Stocks: Be Picky and Patient").

Smith is the technology group head analyst at Standard & Poor's

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