Some interesting reading from morganstanley.com
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United States: Will Capital Exit Fast Enough in IT?
Richard Berner (New York)
It's earnings season, and earnings so far are beating expectations --expectations that analysts admittedly have reduced several times in the past few months. That performance broadly reflects improving profit margins, but unfortunately, margins aren't rising across the board. Companies that have trimmed capacity to be in line with normalized business growth can exploit the operating leverage inherent in their operations (readers will note that this is a time-honored theme; see "Who Will Benefit from Leverage in Recovery?" Global Economic Forum, June 19, 2001). But where capacity is excessive, as in many segments of technology, there truly is no pricing power, and margins remain under pressure. I believe that pressure on IT margins will persist until capital and thus capacity exit, either through significant cuts in capex below depreciation levels or shuttering of facilities.
There's no mistaking the earnings revival, despite the modest character of recovery. Our strategy team notes that with 134 of the S&P 500 companies reporting through October 16, operating income in the third quarter rose by 11.1% (assuming consensus estimates for those companies that have yet to report). Since sales excluding utilities probably rose by 3% or less in the quarter, that earnings performance reflects improving profit margins. Cost cutting is part of the margin improvement story, but more fundamentally, it is strong evidence of operating leverage -- leverage that many companies are able to exploit even in a moderate recovery. Indeed, earnings in seven of the ten major S&P sectors -- including IT -- appear to be up by at least 14% from a year ago. Especially in IT, however, those earnings increases probably aren't sustainable because utilization rates are so low that virtually all the benefits from that leverage go to the consumer.
Demand growth isn't the problem; at least the way economists look at it, the IT recovery is real. Adjusted for inflation, we estimate that US computer and software outlays posted their first double-digit year over year gain last quarter -- rising by 11.5%. And it appears that investment in computers alone may have risen even more strongly, with nominal shipments up 11.6% in the year ended in August. This spending is strong evidence that the "overhang" of IT investment is largely gone, and companies are at least replacing fully depreciated gear. For their part, consumers are also contributing: Real consumer purchases of computers and peripherals rose by 32% in the year ended in August.
But there are three hurdles to strong growth in nominal IT company revenues. First, IT prices generally are falling as fast as volumes are rising, so IT revenues are barely increasing. For example, producer prices for computers and related equipment fell by 20.5% in the year ended in September. In addition, telecommunications companies glutted with capacity continue to slash capex. In the year ending in August, telecom equipment shipments fell by 20%, and new orders fell by 11.6%. Finally, overseas demand is faltering, adding to the pain. My colleagues Joe Quinlan and Rebecca McCaughrin note that the real culprit in the widening US trade gap this year is not so much rising import penetration but fading US exports, especially to Europe and Latin America (see "America's New Trade Villains," Global Economic Forum, October 18, 2002).
But demand would have to be growing much more strongly to offset the fundamental problem in technology: excess capacity, and by implication, little concern with the return on invested capital. Many IT companies keep investing as if a boom lies around the corner, and all they need is a healthier economy to bring back 1990s-like growth rates. Consequently, IT utilization rates are so low -- 10 to 20 percentage points below other industries' -- that they truly have no pricing power. For example, according to Federal Reserve data, operating rates in computers and office equipment in September fell back to 65.4%, fully 15.3 percentage points below the 1967-2001 average. And in communications equipment, the utilization rate fell to an all-time low of 49.9%, 30.2 percentage points below the '67-'01 mean. And the Fed estimates that while capacity growth outside IT is essentially zero, in IT industries, it is running at a 10% annual clip. So the real IT overhang lies in the IT companies themselves, and, except in telecom, not with their customers.
I doubt strongly that vigorous IT demand growth will return quickly, so more capital exit -- at the very least, in the form of capex cutbacks -- seems likely at IT companies. Morgan Stanley semiconductor analyst Mark Edelstone noted last week that Intel's disappointing third quarter earnings mainly reflected excess capacity and high fixed costs that depressed gross margins by more than expected (see Underutilized Capacity Is Adversely Impacting Margins, October 16, 2002). As a result, Mark is reducing his 2002 revenue projection for the company by $200 million or 0.8%, but is paring his per-share earnings estimates by six cents, or 10.9%. That's clear evidence of excess capacity and operating leverage working to the downside. In response, Intel has finally announced a $400 million cut in 2002 capital spending. Whether that will trim capacity by enough is unclear. Mark doubts it, and I strongly agree. The same holds true for many other IT hardware companies. |
