Tech Sector Plagued by Uncertainty

Tech companies lack a killer app, and that's why consumers and companies aren't buying, says S&P's Scott Kessler. Still, there are some stocks he likes

Tech stocks have had a rough time lately. A few major bellwethers, including chipmaker Advanced Micro Devices (AMD), storage giant EMC (EMC), and software maker SAP (SAP), warned that second-quarter results would be weaker than they originally thought (see, 7/13/06, "Why Dell, Apple Declined").

The main problem dogging the sector is uncertainty, according to Scott Kessler, technology analyst and group head at Standard & Poor's Equity Research. The question is the strength of spending by both businesses and consumers. Plus, Kessler says, the group is missing a "killer application," or must-have gadget or software that will lure customers to buy tech products this year. On July 13, S&P downgraded the information-technology sector to underweight from marketweight (see, 7/13/06, "S&P Cuts IT Sector, Boosts Consumer Staples").

Ahead of earnings reports coming from heavyweights Yahoo! (YHOO), eBay (EBAY), IBM (IBM), and Google (GOOG), to name a few,'s Karyn McCormack spoke with Kessler about what he expects. Edited excerpts follow.

Some tech companies have already reduced their earnings outlook for the second quarter, including EMC and AMD. What do you expect for the sector's earnings?

There have been a handful of negative preannouncements, perhaps nominally more than we've seen in past quarters. The most notable among them have been AMD, EMC, and SAP. It seems there's a different story for each of them. However, it's pretty obvious that all three companies are bellwethers, and indications of unfavorable specifics probably don't bode well for at least the related companies.

Among the ones that warned, AMD is engaged in a pricing battle with Intel (INTC), particularly regarding low-end PCs. EMC was largely due to inventories and issues related to a product transition. We reduced our 2006 earnings estimate on July 14 for EMC, based on less encouraging guidance than we had hoped for, which was one of the considerations in downgrading the stock [to buy from strong buy].

SAP indicated that their software revenue growth was well below our expectation because of the company's inability to recognize revenue from some larger deals. But the company kept its guidance for the year because it expects to close those deals sooner than later.

These three preannouncements are from companies in disparate industries. I think the one theme is uncertainty. In the case of both EMC and SAP, they had a hard time closing deals in a timely fashion. A lot of times, that's a harbinger of skittish customers. EMC says their quarter was particularly back-end loaded. Generally, that's not healthy and introduces risk, particularly if a company misses the estimate because of one week's worth of business. AMD's warning is related to pricing, which is tied to the consumer.

All of these companies indicated that revenues or earnings would be lower than expected. That reflects uncertainty in terms of customer purchasing.

Do you think Wall Street's revenue and/or earnings forecasts for tech bellwethers like IBM and Apple (AAPL) are too high?

I've seen some forecasts come down recently, particularly for Apple and IBM. The uncertain economic backdrop is impacting the purchasing behavior of both corporations and consumers.

Also, the third quarter tends to be seasonally weak regardless of economic underpinnings. Nonetheless, we think that the fourth quarter could still shape up nicely for results and the stocks.

In terms of the big names, one theme that seems to be pervasive across a lot of big tech stocks is the quest for growth and focus on cost-cutting. When Microsoft (MSFT) reported last quarter, it talked about investments it's making to generate long-term growth. Intel recently announced the sale of its communications business, and that it will let go a number of executives as part of a restructuring plan.

The stocks have been beaten down so much that the expectations are negative, and this could provide upside potential for some of the names.

What are the trends you're watching for when companies report and issue outlooks for the coming quarters?

One thing that we're looking for is commentary or data or any kind of indication about the demand environment. In a lot of cases, companies are struggling with market share. We'll look to see if companies are sacrificing some revenues for higher-margin sales or if they're committed to maintaining or capturing additional market share. Dell (DELL) and Intel are good examples of why that could be tough, because both of them have lost market share recently, and it's not clear if they're focused on the most profitable revenues.

Also, many companies are buying back a lot of shares. In fact, a large number of big tech stocks have notable buyback programs in place. We're going to look to see how aggressive these companies are, and if they've actually been buying back their stock.

The last thing is, I'm curious to see how recent geopolitical developments have impacted the spending and operating environments for these companies.

Why have so many tech industry stocks been down this year? What will it take to get investors interested in the sector again?

It's been surprising to me how much these companies have underperformed. One reason is options have really adversely impacted perceptions related to the tech sector. On one hand, you have fundamental analysts making assessments based on earnings and earnings per share growth. Because a lot of tech companies' earnings and EPS are being negatively impacted by stock options in 2006, the comparisons appear very unfavorable in many cases. Plus, the backdating of options has played a role in getting people uncomfortable about the sector, and giving people legitimate reasons for selling the stocks.

In fact, we have downgraded a number of stocks of companies that have been embroiled in backdating matters.

Another point is, and people have been telling me this: Economic growth likely peaked in 2006. Typically, during periods where the Fed has completed its cycle of raising rates, higher growth areas like technology tend to underperform. That's related to the high beta nature of the sector.

Also, the tech sector is in dire need of a killer product or service. At the beginning of this year, the perception was it could be here, whether it be PlayStation3 or Vista, but these were delayed. So really, there's no prospect for a major killer offering, a must-have, if you will, until 2007. New products are likely from Apple, but there’s talk of delays as well.

What are your favorite stocks in tech now?

We have strong buy rankings on a number of stocks. One stock that has done well is FactSet Research (FDS). It provides data services to primarily financial-services companies and has a strong organic growth story. I think they're riding this wave of mergers and acquisitions and asset-gathering that's been taking place over the past couple of years. The company's unique position, coupled with its growth and business model, are appealing, especially in this environment.

Another stock that's done well and is less known is Axcelis Technologies (ACLS), a small-cap semiconductor equipment company. We believe the company experienced some missteps last year related to product rollouts and related efforts. We think they've gotten their act together this year and are poised to gain market share in their niche. The stock also looks attractive on a valuation basis. It recently traded at $5.50 and we're forecasting EPS of 43 cents, which yields a price-earnings ratio of 12-13, which is not only below peer levels but below our long-term growth rate for the company.

The third company I would mention is Microchip Technology (MCHP)—we recently upgraded it to strong buy. In terms of diversification, quality of management, and execution, Microchip is among the best in our semiconductor coverage. We also think it has an appealing business model, and it has a sizable yield of 2.5%.

Are there any stocks investors should avoid?

We have strong sell and sell recommendations on a number of stocks. One of our four strong sells is Avaya (AV). We foresee less demand for the company's products and more competition. Telecom equipment has been a tough segment. We've seen a lot of consolidation in the equipment area that follows a lot of M&A activity among service providers. The customers are combining, which results in fewer customers and gives purchasers more leverage to get better pricing. So it's a challenging environment for these companies.

Next is Creative Technology (CREAF)— it's an American depositary receipt, and the company is based in Singapore. Creative is probably best known as a developer and maker of various types of media players with an emphasis on music, so their MP3 players compete with iPods and recent entries from SanDisk (SNDK). There's talk that Microsoft is looking to enter the segment this year. Ultimately, we feel that not only is this a competitive segment and getting more crowded, but Creative's offerings don't offer any compelling differentiation. Moreover, the company has been losing money— this is worrisome to us.

Creative shares have actually bounced a little bit because the company and Apple are involved in some patent lawsuits and we think that buyers and holders of the stock might be awaiting some type of resolution. Our take is that Apple consistently takes a hard line when it comes to intellectual property, and we think that this doesn't necessarily suggest to us that a resolution or settlement is forthcoming. Lastly, we expect Creative to lose a substantial amount of money this year and achieve minimal profitability next year.

The next one is Hitachi (HIT). The issue is its exposure to flat-screen televisions. Recent data from a variety of companies indicate there's been some demand and pricing pressures. We don't think these issues have been fully played out when it comes to Hitachi. One of its businesses is hard disk drives— we think that area is experiencing more temperate demand and has notable competitive pressures.

Last, but not least, is Marvell Technologies (MRVL). Marvell has been in the news lately because it will buy Intel's communication business for more than half a billion dollars. We have a number of concerns about Marvell. Its main area of generating revenue is hard disk drives, which we think is delicate at this point.

The acquisition from Intel completely changes the profitability profile of Marvell. The shareholder base is probably going to change notably as a result. We also believe Intel had substantial difficulties generating value from this particular segment. We think it's obvious that Marvell will have some challenges as well. The stock has gotten hit in the last few weeks following news of the acquisition. The stock trades at roughly 25 times our estimate for fiscal year 2007 earnings— a notable premium to its peers.

What do you see coming from Yahoo and Google?

One of the good stories Yahoo has to tell is international. This has been one of the planks of our investment platform for Yahoo since we upgraded the stock. In Asia, it is gaining share, especially in China. In Europe, we think the World Cup was a boon for Yahoo, which was a sponsor and purveyor of the World Cup official Web site.

Google is the stock that most analysts are most keen on. Consensus estimates have been rising and Google did gain market share in the quarter. It's not if they will beat estimates, but by what degree, and that's something to watch.

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