Computer Hardware: Recession-Proof?

Demand for PCs is holding up even as the U.S. economy slumps, says S&P analyst Tom Smith

When the U.S. economy slumps, computer and other hardware sales usually follow suit. That's not happening this year. "It's surprising that PC sales have held up," says Tom Smith, who follows computer hardware stocks for Standard & Poor's Equity Research. "There's something strong about people and their connection to their laptops."

The latest evidence came from the Aug. 19 earnings report from Hewlett-Packard (HPQ), which said unit shipments of PCs rose 20% from a year ago. This indicates the strong trends in the industry are continuing, Smith says, as consumers and businesses keep buying new laptops with more power, memory, and battery life to manage even more tasks, including storing photos, movies, and music. Faster growth in developing countries is helping offset weakness in U.S. sales for most hardware makers, he adds.

"PC sales just didn't falter in the first half of 2008," Smith says. "They should have failed already if they were going to."

In turn, shares of computer makers are not suffering as much as the broader market this year. Year-to-date through Aug. 15, the S&P Computer Hardware index fell 2.1%, vs. an 11.6% decline for the S&P 500 index. In 2007, the sub-industry index jumped 32.6%, compared with a 3.5% rise for the S&P 500.'s Karyn McCormack spoke with Smith on Aug. 21 about the outlook for computer makers and his favorite stocks. Edited excerpts follow.

Hewlett-Packard reported a good July quarter. What does that indicate for other computer hardware makers in the coming quarters?

It was a pretty strong quarter—a key thing for HP is that unit sales for PCs were up 20%. What I see here is a continuation of some trends. Overall unit shipments of PCs globally remain strong, with almost 15% growth last year and projected to be as strong this year. With average selling prices falling, the dollar revenue rise should be less than that, nearly 10%, according to IDC. The U.S. economy has moderated, and sales of PCs have been slower. But in far-flung geographies—such as Asia-Pacific, Middle East, and Africa—sales are stronger, and it seems that is helping to offset weakness in the U.S.

In PCs, notebooks continue to grow faster than desktops. In its July quarter, HP said notebook revenue rose 26% from a year ago, while desktop revenue grew 6%. HP's unit shipments rose 20%, while revenue rose 15% for its personal systems group.

In HP's printers and imaging business, revenue grew 3% from a year ago to $7 billion—to me it's a hopeful sign that it grew at all. It's surviving a slowdown in the U.S. economy and managed to show positive growth. In this area, the hardware revenue fell for both consumer and commercial customers, while supplies revenue grew 11%. So even if hardware sales go down, people still need ink and supplies.

In HP's enterprise storage and servers, revenue was $4.7 billion, up 5% from a year ago. So it hasn't really slowed down. Blade servers are a huge growth area—they're a smaller, more energy-efficient way to perform certain server tasks.

HP software revenue grew 29%, which may reflect some consulting business. For HP, overall, you can say that all segments contributed to growth, which is a powerful statement considering the U.S. economy slowing. Cost cuts helped the company beat the consensus EPS forecast by a few pennies.

My principle takeaway from HP is that PC unit sales remain strong, and my summation from the rest of the industry is that all PC makers are participating. We've seen very strong growth from Apple (AAPL), but you've also seen Dell (DELL) growing from a new distribution plan that includes partnerships with a few retailers. Dell reports results on Thursday, Aug.

28, so we'll get more information then.

Why are PC sales so good?

I think there's strong consumer demand for laptop computers. Consumers can do a lot more with a PC now than 10 years ago, when it was mainly word processing and spreadsheets. Now you can handle your images, your movies, your music. That has broadened the market. There's also smaller sizes, better batteries, and a number of other improvements.

Recent updates in operating systems from Microsoft (MSFT) and Apple might also be spurring sales. People don't want cords all over the place, so they're buying a cordless mouse, and perhaps a camera, which is driving sales for peripheral makers including Logitech (LOGI). And in developing economies, there's first adopters and faster economic growth.

With price competition staying intense, how can computer makers gain an edge and increase market share?

One way is through product differentiation, like Apple's operating system as a difference from Microsoft's on the high end. On the low end, it might be simply making a color on the PC—they all don't have to be dull gray or black. And in design, Apple has the MacBook Air for extreme portability—it's small enough to fit in an envelope. They're making different models for various audiences.

Dell has a different approach for its design strategy. Dell tries to customize computers for certain large audiences. For instance, they have partnered with companies like Wal-Mart (WMT) to figure out what's the most typical format or computer set-up that Wal-Mart customers would want. That way it can limit the number of computer types and avoid building up inventories of PCs that might not sell—that was a big threat when they went from the direct-sales model to the store model. Customizing PCs by knowing your customers well might give Dell an advantage.

Apple has its own stores. It tries to create an elite aura and assure people they're buying a well-thought-out electronic device. You feel like you're getting the best equipment out there, and you're not settling for price.

Which stocks do you like?

We have strong buy opinions on HP and IBM (IBM). A U.S. slowdown is only a partial slowdown for IBM because it's so large and global. We have a buy on Dell.

Apple is ranked a sell—it's a valuation call. Why? On its latest earnings conference call, Apple took some pains to tell everyone how they had many product launches, but to make these new products it's going to spend money. It guided lower for gross margin for this quarter and coming quarters, as it goes toward a larger mass market. This is not uncommon for a tech company that targets an elite group. At some point, they may say we're going after the mass market and will see lower gross margin. Then there can be several years where EPS growth gets flattened out.

If EPS growth is flattened, I wonder why I should be buying a stock at a 34 price-earnings multiple. My 12-month target price for Apple shares is 140. The risk to my thesis is that Apple's revenue could turn out to be bigger than I think and erase potential harm from lower gross margin. And investors might still pay a higher p-e for Apple. Some positives for Apple are it has a lot of cash on hand, no debt, and several product lines.

I like the big computer hardware makers and their valuations—HP, IBM, and Dell are trading around 15 to 18 times trailing earnings. Then you have Apple's p-e at 34. Is it that much better? Maybe. I say no right now.

Before it's here, it's on the Bloomberg Terminal.