Sector Outlook: Technology

Tech giants with substantial business outside the U.S. should enjoy a boost in demand this year

It all started on Nov. 7 with John Chambers. While announcing quarterly results, the Cisco Systems (CSCO) CEO told investors the company's business of selling networking equipment to big U.S. companies would be "lumpy" in coming months. Shares of Cisco fell 16% over the next several days, taking a major bite out of the 18% gain it had racked up for the year. The decline was contagious, affecting even stars such as Google (GOOG) and Apple (AAPL). The tech-heavy Nasdaq composite index fell 5.9% in the three trading days following Cisco's announcement.
The good news: Following this latest beating, analysts say the sector is attractively valued. The subdued earnings expectations of Cisco, Qualcomm, Texas Instruments, and others means there's room for pleasant surprises, says Keith Wirtz, president and chief investment officer of Fifth Third Asset Management. "Things may start out mixed, but estimates could rise up again, lifting stocks in the first half."
Analysts are betting healthy fundamentals will make the sector's blue chips a relatively safe haven from the credit and housing crises roiling the financial markets. Worldwide, the tech outlook appears upbeat: Strong demand for computers, software, networking equipment, and semiconductors is expected to continue and even accelerate, especially outside the U.S., in 2008. On Dec. 4, a Merrill Lynch (MER) research report identified tech as one sector likely to be a strong performer in 2008.
A lot could go wrong with the optimistic picture. Most tech companies do significant chunks of business in the U.S., where the economy is slowing and, some believe, could descend into recession. The deeper any recession, the more corporate customers in areas including financial services and autos could cut back tech spending. On Dec. 6 research firm IDC (IDC) projected U.S. companies' tech spending will grow by 3% to 4% in 2008, down from an earlier projection of 5.5%. In 2007, U.S. tech spending rose at a 6.6% rate, says IDC.
UNDERVALUED MEGA-CAPS
Indeed, investors who have been selling off tech are probably spooked by the macroeconomic news. But they may be overlooking the strong points of these companies.
Large-cap tech stocks as a group have higher growth rates, better margins, and healthier returns on invested capital than the Standard & Poor's 500-stock index, says Tony Ursillo, tech analyst at Loomis Sayles (LSBRX), which owns big slugs of Cisco, Microsoft (MSFT), Intel (INTC), and other tech giants in its funds. Ursillo considers the big tech stocks to be undervalued given that they're trading at a price-earnings ratio that is a 10% to 15% premium to the S&P 500, based on 2008 earnings estimates. He figures the premium should be closer to 30%.
Investors should also look for companies that do a substantial chunk of business in fast-developing emerging markets, where spending on technology is expected to grow at double-digit rates. Those markets include not only the so-called BRIC countries of Brazil, Russia, India, and China, but also smaller nations in the former Soviet Union and Eastern Europe.
Which companies fit the bill? Ursillo and others point to Cisco, the very outfit that set off chills in November. Cisco's sales in emerging markets are expected to jump from $2.5 billion in 2007 to $10 billion in 2010, or about 20% of Cisco's total. Overseas, the company is replicating the dominant position it holds here at home. "Despite its cautious outlook, it's balanced with international growth," says Kenneth A. Smith, manager of the Munder Technology Fund, where Cisco is a top holding. "As the Internet grows [overseas]," he says, "they'll grow, too."

PITCHING WINDOWS AT BRICS
Analysts also say IBM (IBM) and Microsoft will continue their overseas momentum. At IBM, revenue in the first three quarters of 2007 grew 25% in the four BRIC countries combined, far faster than the single-digit growth rate of its businesses in the U.S. In India, the increase was a hefty 39%.
Microsoft, meanwhile, is aggressively targeting BRIC countries with low-cost versions of Windows, and sales should benefit as more countries, especially China, begin to better enforce copyright law, says Smith. In its most recent fiscal year, Microsoft rang up about 39% of its $51.1 billion in revenue outside the U.S., up from 36% the prior year.
Even in developed nations, sales will get a boost, thanks in part to the weak dollar. More important, though, are the fundamentals: Developed markets are seeing rising demand for certain kinds of hardware, particularly laptop computers, sales of which are expected to rise 25.6% next year. That's great news for PC makers since laptops on average sell for more than desktop computers and are replaced more frequently. Analysts say Hewlett-Packard (HPQ) is prepared to ride the laptop boom, thanks in large part to its well-established retail and distribution network around the world. In the most recent fiscal year, HP saw revenue from laptops jump by 47%, compared with an 8% rise in desktop sales.
With rising sales of all kinds of tech products, from personal computers to servers to new mobile devices and video gadgets, some analysts are betting on companies that make the innards for those devices. Makers of semiconductors, including Maxim Integrated Products (MXIM) and chip king Intel, are expected to see a jump in demand. In 2008, Intel plans to launch new chips for mobile devices and home-video products.
Those devices, of course, now have people churning out massive quantities of data, video, and music. The need for more storage has created yet another demand, says Scott Kessler, an analyst at Standard & Poor's (like BusinessWeek, a unit of The McGraw-Hill Companies (MHP)). Two companies aiming to supply it are Seagate Technology (STX) and Western Digital (WDC).
From good old computers and chips to newfangled gadgets, as the world goes digital, there are lots of ways for investors to get in on the action.