The Outlook for Tech

Slower growth but still strong


It was a stomach-churning reversal of fortune. On Aug. 28, the stock of No. 1 chipmaker Intel Corp. (INTC) hit 75 and yet another new high. The good times, it seemed, were never better. Then came a report forecasting slower growth in PCs, followed by Intel's Sept. 21 warning that third-quarter revenue growth will likely come in just 3% to 5% above the second quarter, half what analysts expected. In a couple of weeks, the stock of one of the skyscrapers of the computer industry lost more than 40% of its value--$215 billion. Poof.


Was Intel's news really that rotten? Have investors lost their minds, or are they rightly losing their courage to invest in technology? For decades, makers of chips, computers, software, and all manner of whizzy tech gear have been on a roller-coaster, riding three- and four-year booms and busts. But for the past record-setting 37 quarters, the tech sector has defied gravity, becoming the most powerful force in the longest and strongest economic boom in postwar history. Surely, says conventional thinking, this can't go on much longer. So does the news out of Intel, a presager of past tech stumbles, signal a widespread downturn?


The short answer: no. Dozens of analysts, economists, industry CEOs, and technology buyers say a general tech-industry meltdown is highly unlikely--unless Wall Street or the worldwide economy dive into a panicky tailspin. Growth is slowing, but remains healthy. Indeed, experts say we're still in the early stages of an explosion of technology innovation and adoption brought on by the Internet. ''I went through teenie-weenie technology changes for 20 years. Now you're talking about the biggest change in the global economy in 50 to 70 years,'' says Alberto W. Vilar, head of money manager Amerindo Investment Advisors Inc. ''You're looking at the biggest productivity change ever.''


ESSENTIAL GEAR. Not that there aren't ominous signs. Since January, more than three dozen Internet startups have shut their doors, and some 17,000 dot-commers have lost their jobs, says outplacement firm Challenger, Gray & Christmas Inc. The growth of PC revenues is expected to slow dramatically--from nearly 17% this year to 12% in 2001 and may actually decline in 2002. A host of telecom companies, including AT&T (T), Sprint (FON), and Verizon (VZ), say they'll miss their financial targets for this year. And earnings shortfalls are stacking up. The latest: On Sept. 27, Priceline.com Inc. (PCLN), the Internet discounter, said its revenues would be about $30 million less than expected in the third quarter. Its stock sank 42%.


Still, the evidence of tech's overall well-being is substantial. Having increased from 2.5% of gross domestic product in the 1980s to 5.3% today, the information-technology economy is growing at a strong clip. Total worldwide computer, networking, and software spending is expected to top $975 billion this year, up 10.4%, according to market researcher International Data Corp. While the rate of growth is slowing slightly--it's expected to tally 10.1% next year--increases of more than $100 billion a year are now coming on top of a huge base. Carleton ''Carly'' S. Fiorina, CEO of computer maker Hewlett-Packard Co., expects to deliver on her promise of 15% revenue growth this year. ''The only surprises will be upside, not downside,'' she says.


In the new era of e-business, tech gear is no longer the extra purchase but the essential purchase. Using the global, instant reach of the Net, companies are finding the Web is an easy way to communicate with suppliers, contractors, and customers, collapsing time and space and saving oodles of money. That's why James A. Yost, chief information officer at Ford Motor Co. (F), says the carmaker is investing heavily in technology. ''I don't see any near-term reduction in our tech spending, nor do I see anything coming that would change that dramatically,'' he says.


Competitive pressures are so intense that, even if a recession hits, many analysts expect tech won't lose as much ground as it did in past downturns. Normally, when corporate profits come under pressure, capital spending gets slashed across the board. Not this time, predicts Richard B. Berner, chief U.S. economist for Morgan Stanley Dean Witter. Corporations can't afford to scrimp on technology--or they risk losing out to competitors. ''The pressure on profit margins will slow things a bit, but tech spending will hold up better than capital spending in general,'' says Berner. Michael D. Capellas, CEO of Compaq Computer Corp., agrees: ''Will information technology slow at the same pace as the rest of the economy? No. The Internet is too fundamental.''


JITTERS. Much of the must-have corporate spending is going to e-business projects, upgrading networks to handle the storm of data, voice, and video coming across the wires, or the deployment of wireless technology. Spending on optical-networking gear, which speeds data, is projected to soar from $31 billion last year to $89 billion in 2003, according to researcher Dell'Oro Group (page 144). IDC expects companies to shell out $119 billion this year and $284 billion in 2003 on Web initiatives--up from $86 billion last year. And there's no end in sight. In a Salomon Smith Barney survey of 50 CIOs in August, 78% said they expect to increase their computer hardware and software spending in 2001--mostly because of Web and wireless plans.


In spite of the overall growth, not all technology sectors are being treated equally. Most worrisome is the future of telecom. Analysts fret that equipment spending by phone companies could decline because their growth is falling short of expectations and isn't high enough to justify the huge outlays. Already, investors are nervous about providing more capital to telecom players because of the sector's profit problems. The amount of debt and equity raised by telecom companies shriveled to $895 million in August, vs. an average of $7.6 billion per month in the rest of 2000, according to Thomson Financial Securities Data. ''People will think harder about capital expenditures,'' says Robert C. Taylor Jr., CEO of Focal Communications Corp., a Chicago provider of phone services to businesses.


The economy is the wild card. Observers worry about the potential for a global economic slowdown spurred by rising interest rates and an energy crisis. Analyst Vadim Zlotnikov of Sanford C. Bernstein & Co. already thinks profit growth for the tech sector next year will be lower than the consensus of 24%--closer to 18%. And, he cautions, ''If we get any kind of economic shock, single-digit growth is more likely.''


LOTS OF DEMAND. The last major tech industry downturn was in 1985. Slugged with a sudden drop in demand for PCs and a resulting glut in chips and disk drives, the industry fell into a full-blown recession. In Silicon Valley alone, 12,000 electronics workers were on the street--a shocking number for that time. Survivors caustically renamed the area the Valley of Death.


But that was then, when Silicon Valley's fate was hitched to the nascent PC business. Now, the technology industry is far bigger, more diversified, and harder to hurt. Indeed, there's little evidence of a broad-based demand problem. Intel blames its revenue growth slowdown on the weak euro--not fundamental demand. Samsung Electronics Co. (SSNHY), the world's largest memory-chip maker, has seen no slowdown. ''We are meeting only about 70% of our client needs,'' says Lee Seoung Bak, a manager at Samsung Electronics' semiconductor unit. U.S. contract manufacturer Flextronics International (FLEX) and Taiwanese chip suppliers Taiwan Semiconductor Manufacturing Corp. (TSM) and United Microelectronics Corp. (UMC) are running full-bore, too.


And there's no shortage of cash to fund more innovation--which will ultimately spur demand for new tech products. According to the National Venture Capital Assn. and Venture Economics, venture capitalists invested almost as much money in the first half of this year--some $54 billion--as they did in all of last year. The number of companies funded in the first half also grew by 70% compared with the first half of 1999, and the size of the average investment soared as well. VC firms also seem to have no trouble latching onto new money. New Enterprise Associates, for instance, just raised an all-time record $2.2 billion fund.


Here's a snapshot of some of techdom's key markets:


Telecom Services


Telephone companies have been hearing static in recent months. The key issue is that telecom players are investing so much money to get into new markets like wireless and the Net that their returns on assets are skidding. Capital spending has soared 26% annually over the past five years, to a projected $106 billion in 2000, while revenues have increased 11%, to an expected $327 billion, according to Lehman Brothers Inc. That has dropped return on assets from 12.5% in 1996 to 8.5% in 2000. ''Players in the industry have been spread way too thin,'' says Lehman analyst Blake Bath.


Now, there is concern that the telecom sector's growth may slow if the economy hits turbulence. On Sept. 20, Sprint Corp. revealed that its quarterly revenues were going to rise 4% from a year ago, instead of the 7% analysts had been expecting. And some top execs say corporate customers are curtailing spending. ''Everyone we have worldwide is going slower making [spending decisions],'' says William L. Schrader, CEO of PSINet Inc., which provides Internet connectivity and other services. ''Instead of a super-high-speed circuit, customers buy a high-speed circuit. Instead of a $10,000 buy, it's $8,000.''


Telecom and Networking Gear


For years, investors believed that communications-equipment companies were immune to the ups and downs of the economy. They were the arms dealers in a war among telecom carriers and would profit regardless of which side won. Now for the reality check: If the carriers start wiping each other out, the arms dealers won't sell as much.


Fears of collateral damage are growing. Shares in telecom equipment giant Lucent Technologies (LU) have sunk 64% since their peak in December. Even Nortel Networks (NT) and Cisco Systems (CSCO), whose revenues are rising smartly, have seen their stocks dip 30% from their highs earlier this year. ''There's a lot of concern'' that phone companies' won't continue big spending, says U.S. Bancorp Piper Jaffray analyst Ted Jackson.


Even before telecom players started getting pinched, their growth in spending on equipment was projected to slow a smidge. After increasing 20% last year, to $316 billion, capital expenditures are projected to rise 19% this year and 17% in 2001, says Merrill Lynch & Co. Now, telecom companies may ratchet that down in the years ahead--and communications equipment suppliers could suffer.


Chips


Despite the warning from Intel, signs are still positive for most chipmakers. Every month, the Semiconductor Industry Assn. (SIA) reports a new revenue record, and factories worldwide are still operating at near-100% capacity. ''We don't see any signs of a slowdown,'' says Thierry Laurent, executive vice-president of Philips Semiconductor.


The picture isn't quite as rosy next year, though the industry is still in the pink. The SIA projects industry revenues will climb 25%, to $244 billion, following 31% growth this year. That figure could go lower, though, if the vast amounts of capacity set to come online next year drive the industry into oversupply.


Financial results for chipmakers next year will vary widely based on their niches. Older types of memory won't grow much. Intel, still largely dependent on microprocessors, should see 16% growth, thanks in part to its push into high-powered servers. But the really big winners will be suppliers of specialty parts used in networking and communications gear. Revenues at Analog Devices Inc. (ADI), for instance, will grow 52%, to $3.9 billion, predicts brokerage Thomas Weisel Partners.


Personal Computers


After a decade in the limelight, PC industry revenue growth is dimming. Due to falling prices, PC revenues are expected to grow just 12% this year, despite unit growth of 17%, says analyst Roger Kay of IDC. Still, the home PC business remains full of vim and vigor as consumers rush to get onto the Net. Sales to consumers are expected to grow 34% this year and 18% in 2001, to $86 billion, says IDC's Kay. That leaves plenty of headroom for home PC powers such as Gateway (GTW), HP (HWP), and Compaq (CPQ).


The corporate PC market isn't faring as well. Despite the introduction earlier this year of Microsoft's vastly improved Windows 2000 operating system, revenues of corporate PCs are expected to grow just 9% this year and next. While corporations have tended to buy new desktop machines every two or three years, those habits appear to be changing. Glassmaker Pilkington North America, for example, may hold on to most PCs for four years rather than the three years it uses them today--a move that would save $1 million a year, says CIO Bill McCreary.


Computer Servers and Storage Sales of higher-powered back-office gear that handle a company's big Net jobs keep growing at a blistering pace. ''I'm not seeing any decline in demand,'' says Daniel J. Warmenhoven, CEO of Network Appliance Inc., a maker of storage computers.


The market for powerful Unix-based servers grew 23% in the second quarter, over the year-before quarter, says Chase H&Q analyst Walter J. Winnitzki--a far cry from the single-digit growth of recent years. New souped-up servers running Windows 2000 should take off as well in 2001. And storage is the latest money eater for corporations. While they used to spend just 25% of their hardware budget on storage devices, that figure has risen to 50% and should hit 75% by 2003, says Gartner Group Inc. Bottom line: The good times should continue to roll for market leaders. Sun Microsystems Inc. (SUNW) is expected to grow around 40% for the next two quarters. ''I think this Net boom is in the first third of a nine-inning ball game,'' says Salomon Smith Barney analyst John B. Jones Jr.


The biggest risk facing server makers is one that's hard to combat: perceptions. This year's brisk market growth will be tough to match in 2001. For starters, it's artificially high, given low spending by corporations in late 1999 as they waited for Y2K to come and go. ''The easy compares become much more difficult in 2001,'' says Sanford C. Bernstein analyst Zlotnikov.


Software


The software industry is going strong, thanks to the Web. It's a case of keeping up with the Joneses. An old-line company can't afford to fall behind on new technology. ''We have to go out and improve our wireless-customer access because there's no question the other guys in our market are going to do it,'' says Peter Dupre, chief information officer at W.B. Mason Co., an office-supply company in Brockton, Mass.


Internet credentials are vital to software players. The stocks of companies such as SAP (SAP) and Microsoft (MSFT) have been hit partly because they're seen as being behind on the Net. Although the stock price of database giant Oracle Corp. (ORCL) dropped when its applications revenue growth for the first quarter came in at 42% rather than the expected 65%, it is still considered a key supplier of software to companies streamlining their businesses via the Net. ''Right now,'' says W.B. Mason's Dupre, ''we're spending money to lower costs. I figure you've got to make hay while the sun shines.''


Those that do are betting that the millions of dollars they're risking now will pay off many times over. If so, the virtuous cycle of tech spending and productivity gains will continue to feed off itself. And--barring any economic shocks--this industry can thrive with slower growth without the devastating crashes that have followed previous booms.


By Andy Reinhardt, with Peter Burrows and Jim Kerstetter in San Mateo, Calif., Steve Rosenbush and Peter Elstrom in New York, Joann Muller in Detroit, and bureau reports