Dawn of a Computer Hardware Revival
By Martha Toll-Reed
Amid very cautious commentary from industry members, the signs of growth in the U.S. computer hardware industry -- makers of PCs and servers -- are modest and sporadic. But they're starting to build. Consumer spending on PCs and electronics has been the primary bright spot to date, but a full hardware recovery hinges on growth in corporate spending. While it's still too early to declare a bona-fide recovery for the U.S. computer industry, it's worth looking at some of the early signs of growth -- and which companies are expected to benefit first.
Standard & Poor's Ratings Services expects the early beneficiaries of improved info-tech hardware spending -- in order of magnitude -- will be Dell (DELL ), Apple Computer (AAPL ), IBM (IBM ), and Hewlett-Packard (HPQ ). Spending on high-end systems is likely to lag behind in the early stages of an IT spending recovery, thereby also suppressing the near-term growth prospects of Sun Microsystems (SUNW ) and Silicon Graphics (SGI ).
A recovery in U.S. computer hardware spending should lead to revenue and profitability growth for the rated issuers, but it isn't expected to have any near-term impact on the companies' credit ratings. The rating profile of the four issuers in the U.S. computer hardware sector with stable outlooks is constrained by S&P's view of their business-risk profile. Although all four have largely maintained consistent profitability and strong liquidity and financial flexibility, the conservative balance-sheet structures and sizable cash balances typically held by these computer makers have helped offset more volatile, and highly competitive, industry conditions.
The negative outlook on Sun and SGI reflect heightened business risk, weak profitability (for their rating levels), and -- for SGI -- limited financial flexibility.
While U.S. economic data continue to be positive (gross domestic product grew a solid 3.1% in the second quarter of 2003, the sixth consecutive quarter of positive growth), IT spending has been held back by a persistent atmosphere of caution. After what in hindsight was overspending during the dot-com boom of the late 1990s, corporations have been limiting IT investments to those with a well-defined, near-term return. In addition, no compelling advances in technology are spurring new IT spending. Nevertheless, indications of growth are beginning to accumulate.
In fact, the Commerce Dept. reported that June saw the highest increase in IT spending -- 7.6% -- since 2000. U.S. PC unit shipments (including low-end servers) were up 11% in the June, 2003 quarter, the first return to double-digit growth in almost three years, according to International Data Corp. Although not at robust levels, the Gartner Technology Demand Index also showed signs of strengthening demand through July, 2003.
On a more anecdotal level, Intel (INTC ) recently raised its September quarter revenue forecast. The positive revision comes from unexpectedly strong demand across all geographic regions in Intel's core business -– microprocessors, chipsets, and motherboards. Intel is widely viewed as a tech-industry bellwether.
Dell, Apple, and IBM are all expected to be early beneficiaries of improved IT spending. The prognosis for HP is less clearly positive and more dependent on management execution, while revenue improvement for Sun and SGI is expected to lag behind the other rated peers.
DELL. Clearly leading the list of early beneficiaries is Dell (corporate credit rating A+; outlook, stable). Given its strength in desktop PCs and its growing position in the small-to-medium business (SMB) market, Dell is well positioned to benefit from future employment growth and associated PC and hardware spending. Nevertheless, at the current rating level, the potential for rating improvement remains limited by Dell's hardware-centric business-risk profile.
Dell has thrived during the IT downturn because of consistent management execution, an efficient operating cost structure, and market strength in PCs and low-end servers. Reflecting improved market position and notably consistent financial performance, the corporate credit rating on Dell was raised to A- from BBB+ in October, 2002.
APPLE. New product introductions and signs of improvement in its core "creative" markets (advertising, graphic, and corporate design) have positioned Apple (BB; stable) to benefit from an upturn in U.S. computer hardware spending. Recent PowerMac G5 desktop product introductions are targeted at Apple's primary buyers. Surveys indicate recent strengthening in the creative markets, which are among the first to benefit from a resurgence in corporate advertising.
In addition, new server and storage products represent incremental upside for Apple, which historically has had a minimal presence in the server market. However, its rating is constrained by its limited global market share and dependence on a relatively narrow product base for most of its earnings.
IBM. The A+ corporate credit rating on IBM (stable) reflects its broad product and customer base and strong financial profile. Small and midsize businesses -- which are expected to lead an IT spending recovery -– account for almost 25% of IBM's revenues. It reported strong and improving revenue growth in the SMB sector in the first half of 2003. In addition, in the June quarter IBM reported accelerating year-over-year growth rates (in constant currency) in four out of its top five largest industry sectors, indicating improving end-market demand.
Although IBM is well positioned to profit from increased computer hardware spending, rating improvement is limited by highly competitive industry conditions and a business-risk profile that's somewhat lower than the rating level.
HEWLETT-PACKARD. With a leading market position in printers and a broad computer hardware product line, HP (A-; stable) will clearly benefit from increases in consumer and corporate IT hardware spending. The A- corporate credit rating on HP reflects an improved market position and strong financial profile. However, rating improvement is limited by HP's predominant earnings reliance on its printing and imaging segment, as well as significant operational execution risk inherent in HP's hardware-dominated business profile.
HP's Personal Systems group (which includes PCs) is engaged in fierce competition, primarily with Dell. HP reported an operating loss in its Personal Systems division in its July, 2003, quarter, down from a modest operating profit in the prior quarter. The extent to which HP's Personal Systems division (about one-third of total revenues) benefits from improved IT spending will be more dependent on HP's competitive position and improvements in its cost structure.
The timing and magnitude of an improvement in HP's Enterprise Systems Group is also likely to be somewhat mixed. HP is well positioned in the "Wintel" server market, but its UNIX servers have suffered from the decline in that market, as well as product integration issues from the Compaq acquisition.
SUN AND SGI. Sun Microsystems (BBB; negative) and Silicon Graphics (CCC-; negative) have both posted more than eight consecutive quarters of year-over-year revenue decline, partly reflecting highly competitive market conditions and weak spending on high-end servers. Material revenue improvement for both companies isn't likely in the absence of growth in IT hardware spending.
The decline in IT hardware spending has been most severe in mid- to high-end UNIX servers, where Sun's market position is strongest. Its recent strategic expansion into the lower-cost Linux-based server market should help offset secular declines in the Unix market. However, to the extent Sun's growth occurs in low-cost segments such as Linux running on Intel-based machines, revenue and profitability improvement will be weaker. An industry recovery -– and sustained revenue and profitability improvement for Sun -- could lead to a stable outlook over the intermediate term.
SGI has struggled over the past couple of years to align its product base and cost structure with those markets where it can profitably add value. It has a good technology position but a historically niche-oriented market position in high-end computing and graphics solutions. SGI is trying to broaden its market position and growth potential, but that effort has been hampered by the weak IT spending environment. The negative outlook reflects SGI's limited liquidity and a material debt maturity in September, 2004.
Toll-Reed is a credit analyst covering the computer hardware industry for Standard & Poor's Ratings Services