The Technology Sector, From the Buyer’s Perspective
By Dick Formichella
The reduction in capital spending so often referred to in the financial news has been widely accepted to be one of the primary causes of the current economic downturn. In particular, the significant drop in corporate spending for information technology products and services has severely impacted the earnings projections for the Nasdaq 100 and put many of the smaller technology firms in danger of continued survival. Their stock values have fallen to levels we haven’t seen in years and it seems that a single digit is all it takes to show the price of most of them.
As an investor interested in the technology sector, you obviously view this phenomenon with great despair. Having watched your technology stocks drop by 70% or more is enough to put anyone around the twist, and many of our readers have probably considered throwing in the towel and liquidating their technology holdings altogether. Even those clairvoyant souls who got out early enough to have preserved some of their gains from the previous tech run-up have to be content with the meager yields on money market funds or other cash equivalents while they look for signs that it’s safe to get back in the game. Going from 30% average annual returns to 3% kind of puts a damper on a person’s wealth perception as well as their early retirement plans.
The 64 dollar question is: Are those days gone forever? Better stated, when will it be over, at least for the Nasdaq, and will the tech sector ever recover to the growth and return trajectory we saw in the latter half of the nineties?
Obviously, the first part of the question is difficult to answer other than to say that at the end of last week, when the DOW was falling over 5% and the S&P 500 was making new lows, the Nasdaq, and in particular the Nasdaq 100, seem to have been less severely impacted than the other indices. That could be interpreted to mean that the bear market loss leaders (the Techs) have finally settled and as often happens when you approach the capitulation stage of a bear market, cyclical large caps are finally getting their due pulled down more by emotion than reason.
However, even if the Tech Sector has fallen as far as it’s going to, what events will induce corporate buyers to loosen their purse strings and start buying again, and thereby allowing tech firms to post some positive earnings surprises for a change. Avoiding a recession is nothing but a phyrric victory if the GNP grows at no more than 1% -2% per year and corporations decline to invest in IT at anywhere near the rate they were doing before Y2K.
Having served as a Chief Information Officer in four different industries over the past twenty years and having lived through enough economic cycles to have an experience base to draw on, I can think of two major reasons that spending on IT products and services are likely to outpace other expenditures in the competition for corporate capital, particularly during a period where earnings-challenged corporations are struggling to find ways to boost returns above the ho-hum level.
1.“You’ve got to spend money to save money.”
If you believe the economic projections, CEO’s and CFO’s are going to be faced with major challenges growing their top line over the next few years. That will leave them with little choice but to focus on cost improvement to achieve the kinds of returns that investors will be expecting.
Having spent a large amount of my career at GE, I consider myself an expert at cost cutting and none less than my spouse (also a CIO) has said that I can squeeze more out of a dollar than anyone she knows. [By the way, that sentiment wasn’t offered in a complimentary tone.] So, as a self-proclaimed expert on the subject, I can unequivocally state that virtually every major corporate cost savings effort I have ever witnessed has ultimately resulted in more spending on IT, not less.
Most people think that cost cutting involves layoffs and the elimination of supposedly non-essential things such as travel, etc. However, except when the people are part of variable cost (e.g., manufacturing), there is little real opportunity with those kinds of actions. If a corporation already has an efficient cost structure (and shame on their management if they don’t), simply eliminating headcount has to result in lower quality or customer service.
Since impacting quality or customer service is rarely a viable option, if you’re going to reduce cost, you must make sure that you don’t “throw the baby out with the bath water.” The goal is not really cost cutting but, as I learned so clearly at GE, improved productivity. And the most effective way to improve productivity is through higher levels of automation. I know the techno-phobe’s disagree but I firmly believe that the major productivity improvements we saw at US corporations during 90’s were principally the result of improved application of information technology. And I can also state categorically that there is still plenty of room left to go. Probably less than 25% of the total automation opportunity has been realized at most corporations (more on this subject will be coming in future columns).
The bottom line here is that economic and competitive pressure will force corporations to once again seriously address productivity improvement efforts over the next several years. And as they do so, the demand for IT products and services will only increase.
2.“As much as it hurts, I have no choice but to upgrade.”
For decades, it seems that organizations that make their money selling IT hardware and software have used a “carrot and stick” approach to induce their customers to purchase their new-and-improved models. The carrot obviously was improved functionality, faster throughput, lower cost per transactions, etc., etc. And in most cases, the products were, in fact, improved.
However, corporate IT leaders, although acknowledging the improvement, often saw little compelling need to buy. Their current systems worked just fine, thank you, and they would rather spend the money, if they had it, on other things. That’s where the stick came in to play. As it turned out oh so often (surprise, surprise) the products were bundled in such a way that if you wanted to use any of the new functionality, you were compelled to purchase it all, or perhaps other products that you didn’t already have. Or (the sharpest stick of all) even if you didn’t want to upgrade at all, you were forced to because the vendor informed you that they would be withdrawing support for the old version of the product by a certain date in the near future.
During the hey day of the corporate mainframe, IBM played that game exceedingly well. Today, when no vendor (even Microsoft) has the same chokehold on corporate IT as IBM did then, the game often involves multiple vendors rather than just one. I’m not suggesting collusion or anything like that but it’s amazing how the industry as a whole pushes us all along and benefits holistically as a result.
A simple example is Microsoft’s new Windows XP operating system. If you want to really be able to use it to it’s true advantage, you’ll need to have a PC with a minimum of a Pentium 300 MHz chip and at least 128 megs of memory. There are countless home PCs and corporate workstations in use today that are below that spec. So, it seems likely that lots of new PCs (and lots of new DRAMs) will be purchased as a result of Windows XP (Michael and Carly said to tell Bill “thanks.”). Additionally, much of Microsoft’s older Office software, and most third party software, will probably not work well (if at all) running under XP. Therefore business and consumer users will also be forced to buy those upgrades as well. The bottom line is that the introduction of Windows XP will have a trickle down effect that will benefit many other companies in the technology sector.
For these reasons, I believe those who are predicting earnings stagnation for organizations that provide technology based equipment and services are being overly pessimistic. Increasingly effective utilization of technology is the only way businesses will be able to stay competitive in the future, particularly during periods of slower economic growth. And their absolute dependence on their installed base of technology products will force them to upgrade as their vendors push them along. All of this will provide ample market growth opportunities for successful firms in the Tech Sector and will enable them in due time to regain the investment stature they held before March, 2000.
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