Taking Tech's Temperature
With a relatively stable operating environment, credit trends in the global technology sector have shifted from negative in 2006 to fairly balanced, but positive, in 2007, despite the recent credit crunch and the spate of leveraged buyout (LBO) announcements earlier in the year.
Through September, Standard & Poor's ratio of upgrades to downgrades was 1.2 for the sector. Liquidity in the high-technology sector should be sufficient to weather an expected stretch of market turbulence. Standard & Poor's Ratings Services is looking for the mid-single-digit IT spending growth of the past couple of years to continue in 2007 and expects that the modestly positive rating trend will continue.
The positive underlying credit trends from solid operating performance and cash-flow generation are being offset partially by the increasingly aggressive financial profiles in the sector. Technology companies are more willing to take on debt. The past year's $17 billion LBO of Freescale Semiconductor has been eclipsed by the recent $29 billion LBO of First Data. Meanwhile, CDW (CDWC), Affiliated Computer Services (ACS), Avaya (AV), and Alliance Data Systems (ADS) all have announced their own multibillion-dollar LBOs. CDW and Alliance currently are unrated.
Many Investigations Likely to Be Resolved
However, given the ongoing credit crunch, we do not expect many companies to announce sizable new deals until the current backlog works its way through the credit markets. In fact, Acxiom's (ACXM) deal was terminated, and there is market speculation about whether other already announced technology deals will also close.
Many of the negative CreditWatch listings related to option investigations and late filings of corporate financials likely will be resolved without a negative ratings impact. Fortunately, liquidity is very strong at many of the companies undergoing investigations. The rating impact from the option investigations and late filings has varied from CreditWatch listings and downgrades to affirmations, depending on the individual circumstances. We are monitoring all related events.
In light of U.S. companies' current uncertain access to financial markets, we have been reviewing the liquidity of all rated companies. In the high-tech sector, similar to all industrials, companies rated BB and higher are positioned to weather a stretch of market turbulence, while companies rated B and lower generally are more vulnerable.
Liquidity Remains Strong
The technology sector's proclivity to maintain large cash positions as an offset to the volatility and rapid technology changes inherent in the industry also is serving as a liquidity cushion during this period of credit market uncertainty. Companies with more than $5 billion of cash on their balance sheets include Hewlett-Packard (HPQ), Oracle (ORCL), Dell (DELL), Cisco Systems (CSCO), and IBM (IBM). Despite stepped-up share repurchases and drawdowns of excess liquidity among many investment-grade technology issuers in recent years, liquidity remains very strong at many of these companies.
Given the ongoing moderate growth of the sector, free-cash-flow generation generally has been strong for the investment-grade companies. In addition, most have a lot of discretion in their spending on mergers and acquisitions, share repurchases, and even capital expenditures.
Liquidity in the non-investment-grade space of the technology industry generally is less robust, as expected. However, even here, liquidity often is strong relative to ratings. The increase in leveraged transactions over the past several years has been focused in the more stable and predictable software and services segments. Many of these are fairly recent transactions, so refinancing risks typically are of less concern than potential covenant violations because of weaker-than-expected operating performance.
Improving Financial Measures
Standard & Poor's continues to expect growth in IT spending in 2007 to be moderate overall, with growth estimated in the mid-single digits, similar to the past two years. Technology shifts, such as the transition from circuit-based telephony to voice over Internet protocol (VoIP) and from 200mm to 300mm semiconductor wafers, and new consumer products will create above-average growth opportunities in equipment manufacturing, handsets, flash memory, and logic chips. However, an unanticipated revenue slowdown may weaken chip profitability, especially for commodity flash and DRAM memories.
The moderate overall technology sales growth should support generally improving financial measures. A focus on cost reductions over the preceding three years is helping to offset continuing pricing pressures across almost all sectors.
Despite favorable underlying trends, semiconductor revenue growth for 2007 will be modest, in the very low-single digits, down from earlier estimates of high-single-digit sales growth. Excess inventory in the first half of the year, combined with dramatic average-selling-price erosion in memory chips contributed to the slowdown. Reflecting the high fixed-cost nature of the industry, short-term profitability has been negatively affected as companies absorb lower volumes.
A long anticipated industry consolidation in telecommunications equipment has begun, following the late-2006 merger of Lucent Technologies and Alcatel (ALU) and the joint venture of the telecom equipment divisions of Nokia (NOK) and Siemens (SI), while Nortel Networks (NT) sold its 3G wireless business to Alcatel.
The contract manufacturing sector also may be in the early stages of a long awaited consolidation. Flextronics International's (FLEX) $3.6 billion acquisition of Solectron created a $30 billion company, which still lags behind industry leader Hon Hai Precision Industry.
Unlike these cyclical sectors, software and services should continue their fairly steady, but moderate, growth, with more spending focused on application development, systems integration, and best shore capabilities. Consolidation has accelerated in the software sector, as Oracle purchased Hyperion Solutions for $3 billion, Hewlett-Packard purchased Mercury Interactive this past summer for $4.5 billion, and Intuit (INTU) purchased Digital Insight.
IBM bought a number of software companies this past year, including FileNet for $1.6 billion, and is expected to continue its software acquisition strategy this year. Although none of these transactions by investment-grade acquirers affected ratings, a number of niche software companies recently have announced leveraged transactions that resulted in low-speculative-grade ratings.