Fitch: The Return Of Demand, The Question For Technology In `02
NEW YORK--(BUSINESS WIRE)--Dec. 13, 2001--The unprecedented technology downturn in 2001 along with a deteriorating worldwide economy resulted in weaker credit protection measures for Fitch's technology portfolio and caused a significant number of negative rating actions. With extraordinary speed, end product demand dramatically slowed in 2001, as the decline in the telecommunications market caused a domino effect throughout the technology sector with almost all segments, especially equipment makers, reporting significant deterioration in financial results and limited visibility regarding future order patterns. Rapid growth of the internet over the past couple years resulted in service providers aggressively expanding networks and increasing computer and communications capacity and the subsequent failure of many Internet businesses created over-capacity for service providers. As a result of this and a weakened economy, companies experienced sudden and drastic declines from, in many cases all-time high revenue levels. In addition, companies have taken significant write-downs to goodwill as a result of overly aggressive acquisitions in recent years, which has negatively impacted their capital structures.
Companies have reacted with significant cost restructuring programs which included headcount reductions and closing of facilities as well as aggressive working capital management to offset deterioration in profitability. While Fitch believes these expense and capital savings programs should continue to have a significant impact on operating results in 2002 the bigger question is when will end product demand return for the Technology Sector? Fitch's expectations for 2002 are for Corporate information technology (IT) budgets to be flat to slightly down as most companies will continue to operate below optimum capacity utilization levels, pricing pressures remain severe, the outlook for the telecommunications market is projected to be weak, and the timing of a recovery in demand is uncertain. Therefore, the resultant credit outlook for technology companies remains uncertain. For companies currently on negative outlook, a prolonged recession and an inability to achieve improved profitability and balance sheet improvement could lead to additional rating actions. However, it is important to analyze specific segments within the technology sector as each exhibits specific credit attributes.
Hardware:
With uncertainty ahead for at least the next few quarters, the computer hardware industry continues to experience severe price competition as well as negative unit growth in most sectors. This is resulting in headcount reductions, closing of facilities, and restructuring charges. However, much of the excess inventory from the first half of 2001 has been worked down. The few hardware manufacturers that have material service capabilities have experienced a greater degree of financial stability during this economic and IT spending downturn due to the long-term, albeit lower margin, contracts that produce stable recurring revenue streams. The combination of a diversified product line, software, services, and a financing unit will distinguish the current hardware manufacturers in the long-term as far as credit strength and stability.
The industry continues to experience a difficult pricing environment in the high-volume, low-margin personal computer (PC) segment, driven mainly by the aggressive pricing behavior of Dell Computer Corporation. In addition, the decrease in end market demand has resulted in the PC industry suffering its first unit growth decline and the timing of recovery remains uncertain. Participants must cut costs dramatically to be able to offset margin erosion to weather this pricing and lower demand environment. The risk for hardware manufacturers is that commoditization will extend beyond the PC segment to low-end servers such as 2-way, 4-way and possibly, the 8-way server products. There is less risk of commoditization in the high-end server segment, where companies compete on capability and value-added services rather than price.
Communications Equipment:
The severity of demand decline that the telecommunications equipment industry suffered in 2001 is not expected to stabilize in the first half of 2002. Most estimates indicate that this segment will shrink by 15-20% in 2002 as demand remains pressured resulting from service provider overcapacity, especially in North America. Additional concerns include a lack of capital availability for start-up telecommunications providers and a continued weak economy. More so than the other segments, Communications Equipment companies have been forced take significant write-downs to goodwill as a result of overly aggressive acquisitions in recent years which has negatively impacted their capital structures.
The negative outlook for this segment reflects the uncertainty regarding the timing or magnitude of an economic recovery and a recovery of end-market demand. Similar to other segments, Telecommunications equipment makers are weathering this downturn with reductions in capital expenditures and headcount, and inventory management. However, Fitch expects more pricing pressure in 2002 which may further depress margins, continued product line consolidation, limited financial flexibility, and event risk associated with significant internal restructurings .
IT Services:
Despite the technology downturn of 2001 and the weaker overall economy, companies in the IT services industry continue to perform better than other technology segments due to the industry's long-term contracts, which support a recurring revenue base. Currently, IT services companies are considered to be a safe haven in the technology industry as volatility remains low, the strong cash-generating capabilities are increasing overall financial stability in the face of an economic and industry recession, and there is a robust pipeline for contracts, especially from the government sector. Fitch expects the credit trends for the industry to remain relatively stable in 2002 and possibly improve as contracts get booked and as the economy recovers.
However, companies with higher exposure to consulting or systems integration have experienced weaker credit fundamentals due to soft demand in 2001 as IT budgets declined and are expected to remain flat or decline slightly in 2002. Consulting services and systems integration are more involved in the installation of new computer hardware or software which tend to be shorter term contracts and less resilient to economic swings. Companies positions in the sector will benefit from higher exposure to the higher margin and longer term strategic outsourcing and Business Process Outsourcing (BPO) contracts, which involve taking over the management of a customer's data center and desktop equipment/applications.
Electronics Manufacturer Services (EMS):
The prolonged, significant reduction in demand from the EMS industry's existing customers weakened the financial profile of the sector in 2001 and will likely continue in 2002, as limited visibility in the marketplace persists. The deep downturn in the market for electronic end-products, has resulted in continued negative revenue and profitability revisions, along with multiple restructuring attempts to resize the industry appropriately, delaying anticipated improvement in credit protection measures. Despite the downturn, EMS companies have continued to make modest acquisitions to strengthen their portfolio of capabilities for an eventual industry recovery. Adverse market conditions are expected to continue, especially if outsourcing contracts do not materialize from new customers or industries. If companies in the EMS industry are unsuccessful in the execution of planned cost reductions, facilities rationalizations, and restructuring actions, credit ratings may be further negatively impacted.
Semiconductors:
It is not clear that the semiconductor industry has yet bottomed. Regardless of the timing of the recovery, Fitch believes that it is important for semiconductor vendors not to focus solely on near-term operations through the downturn, but also to plan strategically for the inevitable turnaround. The first priority for these vendors is to deplete remaining excess inventories, and the second is to recalibrate production to a more rational expectation of demand. Key considerations as to how well companies will emerge from the downturn center on the strength and proactiveness of the management teams, the strength of their capital structure, financial flexibility, security of product positioning, intellectual property position and ability to reduce commoditization..
The increasing costs and complexity of semiconductor manufacturing has led to vendor specialization, such as integrated device manufacturers, fabless semiconductor companies (design shops), and foundries. As the market continues to mature and competition intensifies, which will result in ongoing price and margins pressures, the successful semiconductor companies will continue to be those that can innovate, whether through more complex system-on-chip designs, niche design contributions, or advanced manufacturing processes.
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Contact:
Fitch
Brendan Buckley, 212/908-0640 (New York)
Nick Nilarp, 212/908-0649 (New York)
P. Martin Ressinger, CFA, 312/368-5470 (Chicago)
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