Pru on IT (primary motivating thesis) IT HARDWARE:
INITIATING COVERAGE WITH AN UNFAVORABLE SECTOR RATING -
POSITIONING FOR A SLOWDOWN
HIGHLIGHTS
• Initiating coverage of the IT hardware sector with an Unfavorable sector rating. We believe that IT
demand, and consequently earnings for IT hardware companies, will fall short of investor
expectations over the next several quarters.
• Meaningful changes in real GDP growth act with a multiplier of approximately 4x on IT spending
growth rates. Even a soft landing for the economy would represent a material change to growth and
signal slower IT spending ahead.
• Our industry checks point to slower corporate IT spending. Businesses have shown reluctance to
spend budgets and are ready to react to a downturn, as indicated by selective spending, longer
approval times, and scaled down purchases.
• An inventory build has begun at select stages of the supply chain. We expect pricing to be used as a
lever to trim inventory levels.
• In a slowing environment, we favor companies with low fixed costs and demand volatility, and with
product cycles that will lead to share gains. We think these companies have the best chance for
earnings upside.
• Our Overweight names include Dell and Lexmark International. Our Underweight names include
Hewlett-Packard, Seagate, Sun Microsystems, and Western Digital. Our Neutral Weight name
includes Apple Computer.
DISCUSSION
We are initiating coverage of the IT hardware sector with an Unfavorable sector rating due to our belief
that IT demand, and consequently earnings for IT hardware companies, will fall short of investor
expectations over the next several quarters. There are three primary reasons for our below consensus view
on IT spending: 1) the “multiplier effect” on IT spending from slowing GDP growth, 2) signs of slowing
corporate IT spending, and 3) inventories building at select stages of the supply chain.
Sector Framework: IT Demand and The Multiplier Effect
The key driver of earnings power for IT hardware companies is IT demand, and IT demand is highly
dependent on the health of the global economy. As shown below, growth of IT spending has exhibited a
strong correlation to worldwide GDP growth over time with IT spending typically growing at 1-3x the
rate of real GDP growth (Figure 2).
However, changes in the growth rate of IT spending resulting from changing economic conditions are
often of greater magnitude than projected. This trend, herein referred to as “The Multiplier Effect,” can be
explained by the highly discretionary nature of IT spending.
As illustrated in Figure 2, over the past
decade, IT spending growth rates have changed with a multiplier of approximately 4x to the change in
real GDP growth. That is to say for a 1% change in real GDP growth, the IT spending growth rate on
average exhibits a 4% change. This relationship is most evident when yearly GDP growth rates change
meaningfully (change of approximately 0.5% or greater), as such a change is beyond the noise level and
signifies a true change to the macroeconomic environment.
Figure 3 further demonstrates the high degree of variability in IT spending, as growth rates seldom fall
within 2% of that of the prior year.
Figure 4 further demonstrates the high degree of variability in IT spending, as growth rates seldom fall
within 2% of that of the prior year.
Source: IDC.
The multiplier effect is further amplified for IT hardware companies. For example, PC revenue growth
rates are clearly more variable than IT spending growth rates, as indicated in Figure 5 below. In half of
the years over the past decade, PC revenue growth rates have changed by 6% or more.
The multiplier phenomenon is easily explained, as when conditions worsen, businesses and consumers
pare back or delay IT spending to focus their budgets on more critical items. Conversely, when
conditions improve, budgets allow for more discretionary spending, especially for big ticket IT hardware
purchases.
Given that IT hardware stock prices are usually driven by changes in earnings expectations, we think it
essential to consider not only current IT spending trends, but also macroeconomic conditions and the
multiplier effect when investing in IT hardware stocks.
Sector Rating Unfavorable: Cautious IT Outlook
We are initiating coverage of the IT hardware sector with an Unfavorable sector rating due to our belief
that IT demand, and consequently earnings for IT hardware companies, will fall short of investor
expectations over the next several quarters.
Worldwide IT demand and GDP have shown solid growth over the last few years, as consumers and
corporations reaccelerated spending following the post-bubble recession.
Consensus expectations are for US GDP to slow in 2007 due to myriad of factors including record energy
prices, higher interest rates, and a cooling of the housing market. Even a soft landing for the economy
would signify a material change to recent growth patterns.
However, it appears that 2007 IT spending expectations do not reflect a significant deviation from current
levels. In contrast, we are projecting a more pronounced slowdown in IT spending, which we believe will
lead to downward earnings revisions for IT hardware companies.
More importantly, consensus expectations for IT hardware companies are for an acceleration of earnings
growth to more than 20% per year in 2007. We believe that such acceleration is unlikely even with the
consensus IT spending forecasts.
There are three primary reasons for our below consensus view on IT spending and the sector in general;
these are 1) the “multiplier effect” on IT spending from slowing GDP growth, 2) signs of slowing
corporate IT spending, and 3) inventories building at select stages of the supply chain.
The Multiplier Effect
As previously discussed, the discretionary nature of IT spending makes it highly sensitive to changing
economic conditions. History shows that meaningful changes in real GDP growth act with a multiplier of
approximately 4x on IT spending growth rates. We are not in the business of predicting GDP, but we
believe that consensus expectations for a slower economic environment in the coming years signal
slowing IT spending ahead.
Signs of Slowing Spending - Corporate Lull or Something More?
Over the course of the past few months, we conducted interviews with dozens of companies and industry
contacts across the IT supply chain to gauge the health of the overall IT spending environment. Our
industry checks point to signs consistent with slower spending patterns across various IT product lines in
the corporate sector. Namely, businesses have shown reluctance to spend budgets and also display
readiness to react accordingly to a downturn, as indicated by selective spending, longer approval times,
and scaled down purchases. While it is difficult to distinguish between a short-term spending lull and the
beginning of a slowdown, these signals make us cautious regarding IT demand. Note that businesses
account for ~65-70% of total IT spending by our estimates.
While we are also concerned about IT demand on the consumer front, we have yet to hear evidence of
material changes in spending behavior. However, given the headwinds that the consumer already faces
(energy costs, housing price declines, etc), we think that slower business spending adds risk to the
consumer and the overall IT demand environment.
Inventories Building
Our models suggest that inventories have begun to build at select stages of the supply chain. While our
retail and systems distributor models show normal inventory levels, a build has begun at PC OEMs,
contract manufacturers, hard disk drive distributors, and hard disk drive OEMs. We expect pricing to be
used as a lever to trim inventory levels in the light of the slower demand environment.
Excuses, Excuses
While not part of our core framework, we feel compelled to note the host of supposed “short-term”
reasons we have heard to explain the slower IT spending environment. These include Intel’s new product
introductions, microprocessor price cuts, the upcoming launch of Microsoft Vista, the World Cup,
European Union Restriction of Hazardous Substance (RoHS) directive, and the list goes on. While each
of these may carry some merit, we can’t help but be skeptical given the wide assortment and concurrent
timing of such excuses.
But Aren’t the Stocks Cheap?
One could argue IT hardware companies are cheap, as valuations have compressed in recent years while
cash balances have expanded. In aggregate, IT hardware stocks are trading at a multiple of 15x consensus
earnings estimates for the forward-looking year. While we would certainly agree that IT hardware stocks
appear inexpensive relative to the recent past, we believe they are trading on par with historical median
valuations (excluding bubble years). Moreover, our cautious view on IT demand lead us to believe that
consensus expectations for earnings growth are likely to be ratcheted downward, justifying a lower
multiple.
Positioning for a Slowdown
In light of our Unfavorable sector rating, we prefer companies that rate well with respect to both our
market cycle framework (lower fixed cost structure and lower demand volatility) and our product cycle
framework (differentiated via superior functionality or cost leadership). We view these companies as
having the best chance to post upside to consensus expectations. Conversely, we believe companies that
rank unfavorably on our market cycle and/or product cycle scales are at risk to miss consensus estimates.
We are initiating coverage of seven stocks. Our Overweight names include Dell and Lexmark
International. Our Underweight names include Hewlett-Packard, Seagate, Sun Microsystems, and
Western Digital. Our Neutral Weight name includes Apple Computer.
Industry Risks
Risks to our Unfavorable industry investment thesis include:
IT Demand - We are forecasting slower IT spending growth over the next several quarters. Should the
rate of IT spending be above our forecasts, there could be risk to our industry rating.
Pricing - We are forecasting increased price erosion over the next several quarters. Should supply
constraints arise and deflationary pressures subside, there could be risk to our industry rating.
Inventories - Our supply chain models suggest that inventories are building at multiple stages of the
supply chain. If companies draw down inventories due to stronger demand, there could be risk to our
industry rating. |
