Tech stocks could suffer from excessive expectations in '08

Seems like it was only yesterday when the technology sector was beckoning as a refuge from the subprime mortgage hurricane. Well, September, anyway. How times have changed. After Cisco Systems (Symbol: CSCO) warned last month that it was seeing a slowdown in orders from its biggest U.S. customers, investors have reassessed. Now they see at least some vulnerability to the deteriorating financial conditions, if for no other reason than the fact that the crumbling financial services sector is a major customer for IT goods and services. Cisco’s down 17% over the past month, while broader tech measures, like the Technology SPDR Exchange-traded Fund (XLK), have bounced around sharply but remain off 5% to 10% since the beginning of November.

So what next for tech? The detective work has to go beyond just guessing at future business conditions. It’s also a matter of investor expectations. Have tech stocks been beaten up enough in the past month to provide a cushion if business should slow next year? Cowen & Co. analysts Arnie Berman and Greg Niss ask that very question in their monthly review of the tech sector, out today. Unfortunately, their answer isn’t a happy one if you’re loaded up on Cisco and its brethren. Looking at the average analyst forecasts for the almost 400 tech companies they track, Niss and Berman discovered that expectations for next year depend on the IT business getting substantially better than it has been in 2006 and 2007.

For example, analysts expect 94% of companies will increase revenue in 2008 from 2007. That compares with an estimated 74% that will have increased revenue in 2007 or the 87% which increased revenue in 2006. With the credit crunch biting, consumers on the defensive and financial sector IT spending hit, is it reasonable to expect revenue increases from more companies next year? Similarly, analysts expect almost 85% of the tech companies will show higher profit margins next year versus 49% that improved margins in 2007 and 54% in 2006. The combined profits of all the companies are projected to increase 22% in 2008 versus a 15% gain this year and 14% improvement in 2006.

Berman and Niss are particularly disturbed by the narrowness of the year’s earlier tech rally. Most of the gains came from just a few stocks, particularly Apple (AAPL), Google (GOOG), RIMM (RIMM) and VMWare (VMW). They point out that RIMM has substantial exposure to spending cutbacks by financial services firms while Apple and VMWare are trading at extreme valuations on top of sky-high expectations. “The narrowness of the tech tape is troubling — in part because 3 of the 4 top contributors…appear susceptible to controversy in 2008.” Troubling, indeed.

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