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Toward a Leaner, Smaller Tech Sector

By Jane Black

Weak links will be swept away or devoured, leaving the industry hurting in the short term but possibly more durable in the long term

NEW YORK - The prevalent sentiment after the Sept. 11 terrorist attacks is that nothing will ever be the same. This seems especially true for the high-tech sector's prospects. While the rebuilding of southern New York City and a heightened interest nationwide in improving security may provide a short-term boost to an industry that has spent much of 2001 on the ropes, the effect is likely to fade quickly. An even more brutal environment for makers of chips, computers, cell phones, and other communications gear will emerge.

"Consolidation will be accelerated by this disaster," predicts Ulric Weil, a technology strategist at Friedman, Billings & Ramsey, an investment firm in Arlington, Va. "The rich will get richer and the poor will get poorer, and may be pushed to the wall."

Indeed, Sept. 11's fallout will hit technology both directly and as a by-product of other sectors' pain. America was skirting a recession before the disasters and now may not be able to avoid it, military action of some kind is a near certainty, and market volatility is now a fact of life across the globe. All of which puts the tech sector uncharacteristically in the same boat as the wider economy. Already gone were sector's days of double-digit growth. Now, that growth will be even stingier: Market researcher IDC sees tech spending rising just 3% this year vs. 11.1% growth in 2000 and the 5.6% it predicted before Sept. 11.

NATURAL SELECTION. Clearly, whatever vestiges remained of the charmed life the high-tech industry led for a decade are likely to be swept away in the aftermath of the World Trade Center and Pentagon disasters. As many as 80% of all dot-coms could fail over the long term, according to research firm Kinetic Information, a unmistakable sign that tech companies can no longer play by their own rules.

The new motif for high-tech will be survival of the fittest, where size and scale will be the emblems of natural selection. The outlook is brightest for blue-chip techs -- the ones with brand names and balance sheets strong enough to survive a drawn-out cutback in corporate spending. They could emerge mightier as their weaker competitors succumb.

By yearend, analysts say, investor interest could be reinvigorated in top-tier tech companies, most of whose stocks took it on the chin in the wake of Sept. 11. Since then, the tech-heavy Nasdaq has fallen 14%, and tech stalwarts have stumbled. By Sept. 28, chip behemoth Intel had lost 21% of its value, closing at $20.39, down from $25.89. Bellwether Cisco dropped 13%, from $14 to $12.18, and Microsoft fell 11%, from $57.50 to $51.17. Services giant IBM dropped the least -- about 4%, from $96.47 to $92.30.

BLUE-CHIP BONANZA? Indeed, after a yearlong slide capped by their post-Trade Center declines, many tech companies are suddenly trading at reasonable prices. That's particularly true for such blue-chips as Microsoft, IBM, and even hard-hit PC maker Dell, all three of which are sporting price-to-earnings ratios in the low 20s. That's about on par with the p-e for the overall S&P 500, and it's unusually low for tech companies. Current tech p-e's are also just slightly above the 21 recorded at the trough of the last two recessions, in 1982 and 1991.

None of this bodes well for the non-blue-chip players. "Right now it doesn't pay [for investors] to dip down to a second- or third-tier company," says Patrick Adams, president and chief investment officer of Denver-based Choice Funds. "All premier tech firms are selling at reasonable multiples, and the blue chips will be the first to come out of this."

"You've got at least two more quarters of misery at the bottom"

Their strong balance sheets and cash positions will allow them to maintain critical research and development functions and give them the wherewithal to snap up smaller companies with good technology but not enough cash to survive a recession. "A lot of small firms were getting hammered anyway. Now you've got at least two more quarters of misery at the bottom. Some small firms simply won't survive," says Thomas Smith, S&P's director of technology research.

ADDED URGENCY. The consolidation may already have begun: On Sept. 24, Internet security software provider and online payment processor VeriSign announced that it will pay $1.2 billion in stock for Illuminet, a company that helps telephone carriers route voice calls across disparate networks. VeriSign CEO Stratton Sclavos told reporters that the two companies had been exploring a partnership for about a year but that VeriSign began to consider an acquisition only within the past two weeks. A shakeout trend could be a reprieve for a company like Cisco, which during the boom years had an increasingly difficult time keeping up with the innovation at well-funded startups.

Another thing in the blue chips' favor: Once corporate customers start buying again, those that once might have chosen smaller vendors to save money may be more intent on finding a supplier perceived as more reliable. "The disaster is going to cause people to go back and go for what they know," says Zack Shafran, portfolio manager for the Waddell & Reed Science & Technology Fund. "People aren't looking for technology that will save them 10%. They'll pay that 10% just to know that it works 24/7 and the company isn't going away," he asserts.

For instance, though many analysts have touted disaster-recovery companies such as Comdisco and Sungard since the Sept. 11 attacks, many others believe that old-line services and equipment provider IBM will be the ultimate beneficiary of increased spending to secure and maintain company data.

DELAYED SPENDING. Exactly when the blue chips will begin to prosper again is unclear, however. The earliest that tech spending could revive is the middle of 2002, according to research firm IDC. But its chief research officer, John Gantz, notes that while 2002 IT budgets will be higher than this year's, spending against these budgets will be postponed until businesses sense that the economy is turning around.

Lack of historical precedent makes it hard for economists to offer projections

The uncertainty is understandable. On the political front, President Bush is issuing daily reminders that the protracted battle against terrorism will be unlike any war the U.S. has ever fought -- not exactly comforting to economists who like to base their projections on historical trends. The economic data are also in flux. Corporate demand looks set to remain weak, and consumer spending, which heretofore had propped up the economy, plunged 14% in September -- its largest monthly drop since October, 1990, according to a Sept. 25 Conference Board report.

Thus, despite a renewed interest in security, communications infrastructure, and storage, "the majority of [tech] companies' long-term prospects haven't changed," says Christopher Bonavico, fund manager of TransAmerica Aggressive Growth Funds. That said, some sectors will do better than others as the economy struggles through the next few months. Here's the outlook for several key tech industries:

Telecommunications:
Increased use of bandwidth-intensive communications such as videoconferencing in the wake of the terrorist attacks have had some analysts hoping for an uptick in the battered telecom sector. But higher sales of such equipment can't offset an anticipated lack of spending by carriers on new infrastructure. That's bad news for equipment providers of all kinds. Broadband-gear maker Redback Networks announced on Sept. 25 that it expects revenues to plummet 35% in the third quarter. Wireless equipment maker ONI Systems also just reduced its revenue outlooks after customers lopped orders.

One bright spot is wireless communications. Providers such as Cingular say they've already seen improved sales for both phones and service in the aftermath of the attacks. The country's largest wireless provider, Verizon, says its traffic has increased by 40% over normal levels in the wake of the attacks.

And there's much room for growth. Only about 40% of the U.S. population has mobile phones, vs. around 70% in most European countries. Eventually, increased demand for mobile communications could hasten the build-out of more reliable next-generation networks that have been postponed as the economy has slowed. "People are thinking differently now. They want to be in touch anywhere all the time. The level of service available today won't be acceptable anymore," says Wadell & Reed's Shafran.

Personal Computers:
Even before the Sept. 11 attacks, the PC market was expecting negative growth. Now, hopes of a boost during the Christmas selling season or following the release of Microsoft's new XP operating system have been all but abandoned. Pre-attack, research firm IDC estimated that the industry will shrink to $67 billion in 2001, down 5.6% from 2000. Now, analysts believe PC sales will decline even more, by about 6%, and won't move into positive terrain until next year. IDC expects sales to grow to $68 billion in 2002, an increase of 2%.

Though such figures are mainly guestimates, analysts say they're gaining more visibility into the PC market. Their projections are based on trends they saw after the Gulf War in 1991, says IDC's John Gantz. "After Desert Storm, hardware got hit the worst, and the PC market worst of all. PCs are most tied to consumer spending and capital investment, and that's what gets hit hardest by uncertainty," he says.

Semiconductors:
Like PCs, the semiconductor sector was already heading south long before the Sept. 11 attacks. Weaker end markets, such as PCs, mean a delay for any recovery in chip orders -- which could keep the industry near rock bottom for at least another two quarters, according to S&P analyst Tom Smith. Analysts expect global chip sales to plummet 25% in 2001, from $204 billion to about $153 billion, marking the industry's steepest decline since 1985, when global semiconductor sales tumbled 17%, to $21.4 billion, according to the Semiconductor Industry Assn.

Still, sales should start to improve by this year's fourth quarter. "I believe inventory reduction has accelerated over the past several months. Combining that with even slightly improved order levels means that the inventory correction will be largely completed by the end of the third quarter," says George Scalise, the SIA's president. Before Sept. 11, sales were expected to rise as much as 10% sequentially from the third to the fourth quarter. In light of the attacks, the SIA has cut that number to 1% to 5%.

Security:
Without doubt, this sector is the near-term winner in the new world order. Until now, corporations spent just 0.4% of revenues on security according to technology consultancy Gartner. Best-positioned are the managed-security providers, such as privately held ServerVault, that corporations can use to outsource their security operations. ServerVault President Patrick Sweeney says he has seen a 50% rise in customer inquiries since the attack.

Biometric companies, which sell devices that authenticate individuals by scanning unique identifiers such as fingerprints or retinas, are also expected to do well. The uphill public-relations battle that before Sept. 11 afflicted such outfits as Visionics, which makes controversial facial-recognition software, is easing. Visionics stock has skyrocketed nearly 150% since Sept. 11. But while the upside for this industry is huge, the dollar figures remain small. By 2006, the entire sector is expected to deliver sales of $520 million, according to Cahner's In-Stat. The key will be selling large orders to government agencies and transport hubs such as airports and train stations.

Software:
This is a mixed bag. All subsectors of software are going to be hit in the short term: Witness the round of profit warnings since Sept. 11. Bellwether Oracle announced that in light of the terrorist attacks its license sales would drop 15% this quarter, vs. previous estimates of an 8% to 10% decline. Analysts believe that system-infrastructure software, such as database software, middleware, and operating systems, will be hit hardest because it's tied so closely to new hardware sales -- which are likely to remain weak. IDC expects growth in sales of systems software to slow to 6% in 2001, compared to 9% in 2000.

By contrast, sales of tools to develop software will grow by 10%. Granted, that's half the growth the sector saw in 2000 but still respectable. Application-development software includes products such as customer-relations-management and supply-chain software. Unlike systems software, it must be upgraded continually, points out IDC's Gantz. "The value you get from improved versions is enough to get you to buy even in tough times," he says.

Security software has the brightest future. Companies that provide firewalls, intrusion-detection systems, and antivirus software all are expected to prosper. In particular, S&P analysts recommend firewall maker Check Point and antivirus company Symantec. Network Associates and TrendMicro, also makers of antivirus and other security software, are also expected to enjoy revenue growth.

NO QUICK FIX. As an investor, if you bet on blue chips or an industry that is profiting from post-attack lifestyle changes, you should plan to be in for the long haul. Just because tech tocks are more reasonably priced at the moment doesn't mean that they won't slip more in the short term. In fact, the uncertainty ahead will likely only increase market volatility. Technology strategist Weil believes tech stocks could fall further as third-quarter earnings uniformly come in below consensus estimates. These shares could be further damaged by tech executives' inability to predict fourth-quarter sales. "The mantra of no visibility looms again. That's a bad background for tech stocks in the short term," Weil warns.

Over the long term, though, what could be only a slight recession could help put the technology sector back on track, with the wheat being separated from the chaff. "This is damaging in the short run, but we were already weakening," says Michael Davey, a technology analyst at Investec Ernst. "Now it has everyone coalesced on finding a solution." When the economy rebounds, the result may be a leaner, stronger tech sector ready to rise again.

. . . watch for more stories coming soon  

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