Easy Days for Tech Rally May Be Over
The good news about this quarter’s technology earnings: it appears that conditions have reached a bottom and investors have better near-term visibility. The bad news: that near-term outlook isn’t so great.
“You’re seeing a tough comp versus 2008,” says John Bright, technology research director at Avondale Partners. “We expect you’re going to continue to see those at least through the September quarter, probably through the December quarter.”
The technology sector has been a pillar of strength—the S&P 500 Technology Sector Index is up 10 percent year to date compared with a 4.8-percent decline in the S&P 500. Companies such as Intel and Nokia have indicated seeing signs of demand stabilization, but it doesn’t appear that will translate into revenue growth. For the rally to continue, Bright says tech companies are going to have to begin showing some results.
“You can only say so many times that it’s going to be bad,” Bright says. “The newness of that thought process is starting to wear off. Investors are recalibrating expectations, recalibrating their valuation metrics and are looking more to where is spending going to shake out for the medium and long term.”
The PC industry is navigating through a shift in consumer preference that could keep revenue under pressure. Demand is showing signs of recovery. In its first-quarter earnings statement, Intel said that PC sales had “bottomed out” and that the sector is returning to normal seasonal patterns.
But Ashok Kumar, senior analyst at Collins Stewart, says revenue in the sector will continue to be sluggish as customers flock to netbooks. The low-priced mini-laptops typically run on Intel’s Atom chip, which carries a lower profit margin than the company’s processors used in mainstream personal computers. Intel said it expects revenue and gross margins to remain flat in the second quarter.
“If you assume that 2008 was the revenue high-water mark for the cycle, we’re not likely to visit those levels for the industry in aggregate until 2012,” Kumar says. “This year we expect a 10- to 15-percent unit decline in PCs, but the value decline will be closer to 20 percent.”
Kumar notes that the upcoming release of Windows 7 will likely continue to fuel the flight to lower-cost PCs.
“Windows 7 will not require hardware upgrade cycles,” Kumar says. “It can more than adequately run on netbooks. It’s configured so that it can run on the lowest common denominator in terms of configuration. This is a complete break from past [Windows upgrade] cycles, which have always necessitated a hardware upgrade.”
Like Intel, Microsoft takes in less money for bundling Windows with netbooks than it does with more powerful personal computers. In its fiscal third-quarter earnings announcement, Microsoft’s revenue fell well below analysts’ estimates, and the company said it “expects the weakness to continue through at least the next quarter.” Tellingly, revenue in its Windows Client division fell significantly from the year-ago quarter.
“At a minimum, things are not getting worse,” Kumar says. “That’s the prominent message across the hardware food chain. The March quarter likely marks the bottom of the cycle, but the recovery’s going to be fairly tepid. We’re basically setting the stage for a gradual recovery.”
Changes in consumer preference is also a key driver in the mobile devices arena. It’s what Tavis McCourt, managing director at Morgan Keenan, calls the “barbell dynamic.”
“We’re seeing relative strength at the high end, relative strength at the low end, and relative weakness in between,” he says. “It’s a disaster for vendors like Sony Ericsson and Motorola, who historically have been reasonably strong in mid-range phones. You’re seeing Research in Motion and Apple take some share because they play only in the high end of the market. Nokia’s been a mixed bag. Their low-end sales have been okay, but they sell a lot everywhere, so if there’s weakness somewhere, they’re going to feel it.”
Steady demand at the high end certainly fueled Apple’s strong fiscal second-quarter results, as shipments of 3.79 million iPhones trounced analyst estimates. McCourt says the pure-play smartphone vendors—Apple, RIM, and, if the soon-to-be-release Pre smartphone is a success, Palm —are in the best position in this climate.
Like Intel, Nokia made the point of noting that it sees signs of demand stabilizing, despite a 90-percent drop in its first-quarter net profit. So while global demand for mobile devices has declined significantly from a year ago, investors are reassured by gaining any visibility into the near term.
“You’re talking 15- to 20-percent year-over-year declines, so it’s not good,” McCourt says. “But three months ago, you had no idea if that number was going to be a 20-percent or a 40-percent decline. Now at least we know what the decline is, so companies can right-size their cost structure to that and investors can right-size their expectations.”
Compared with offline advertising and shopping, the online business is relatively strong as consumers increasingly turn to the Internet in search of bargains, says Steve Weinstein, senior research analyst at Pacific Crest Securities. But the slow economy is still taking its toll on the sector.
Google is a prime example. For the first time since going public in 2004, Google posted a revenue decline on a consecutive-quarter basis in its first-quarter results. Yahoo’s struggles continued with a 78-percent drop in first-quarter net income, including a 3-percent decline in search-ad revenue. And it doesn’t look as if the online advertising business is primed for a real recovery in the current quarter.
“The economy is still slowing substantially,” Weinstein says. “[Market conditions] may get less bad, or get bad at a slower rate, but as far as actual improvement, not really.”
On the e-commerce front, Amazon reported better-than-expected first-quarter results, including revenue that topped analyst forecasts.
“It looks like e-commerce really surprised in price strength in Q1,” Weinstein says. “It’s not necessarily a change in trend, it’s more of a lot of offline problems driving people online, where people are looking for more value. I don’t know if it’s a sustainable uptick, but Q1 should be pretty good.”
Indeed, Amazon’s guidance for the second quarter was tepid, as the company expects operating income to come in below Wall Street estimates.
“Even though growth is slowing and momentum isn’t what it once was, on a relative basis to the respective industry—whether it be advertising or retail—online is still doing much, much better.”