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IT Sector Analysis
Matthew JenkinsMatthew Jenkins Bhavik KothariBhavik Kothari Jennifer LambertJennifer Lambert Jeonghun LeeJeonghun Lee Jianwen LiJianwen Li David MeisterDavid Meister
Outline:
Size & Composition Size & Composition RecommendationsRecommendations Business AnalysisBusiness Analysis Financial AnalysisFinancial Analysis Valuation AnalysisValuation Analysis Review RecommendationsReview Recommendations QuestionsQuestions
Size & Composition: We are currently underweight (4.02%)We are currently underweight (4.02%)
• Market Weight: 15.96%Market Weight: 15.96%
• Portfolio Weight: 11.94%Portfolio Weight: 11.94%
Industry Composition of Portfolio:Industry Composition of Portfolio:• IT Services:IT Services:
1.2% of S&P1.2% of S&P
Concord EFS #5Concord EFS #5
1.83% of Portfolio1.83% of Portfolio
• SemiconductorsSemiconductors 2.8% of S&P2.8% of S&P Intel #1Intel #1 4.57% of Portfolio4.57% of Portfolio
• Software:Software:
4.4% of S&P4.4% of S&P
Microsoft #1Microsoft #1
4.24% of Portfolio4.24% of Portfolio
• HardwareHardware 3.45% of S&P3.45% of S&P IBM #1IBM #1 1.31% of Portfolio1.31% of Portfolio
Recommendations:
Maintain underweight position for the sector.Maintain underweight position for the sector. Strategically look at the industries within the sector Strategically look at the industries within the sector
for opportunities:for opportunities:• SoftwareSoftware• HardwareHardware• SemiconductorsSemiconductors• IT ServicesIT Services
Keep watchful eye for recovery; we believe that we Keep watchful eye for recovery; we believe that we are close.are close.
Business Analysis:Business Cycle
Yield Curve:Yield Curve: NormalNormal
Fed Policy:Fed Policy: ExpansionaryExpansionary
Economic Phase:Economic Phase: Soft LandingSoft Landing
Growth:Growth: LowLow
Best Sector:Best Sector: DefensiveDefensive
Inflation:Inflation: LowLow
IT sector, being more cyclical in nature, is clearly out of favor.
Business Analysis:Phase of Cycle
Main IndustriesMain Industries Life Cycle PhaseLife Cycle Phase
PC & Enterprise HardwarePC & Enterprise Hardware MatureMature
SoftwareSoftware GrowthGrowth
SemiconductorsSemiconductors MatureMature
Consulting ServicesConsulting Services GrowthGrowth
Business Analysis:External Factors
1.1. Technological Factors:Technological Factors: Network externalities and open Network externalities and open standards have led to constant innovation. standards have led to constant innovation.
2.2. Government:Government: Federal government defense spending has Federal government defense spending has grown at a CAGR of 6.96% in the last 5 years as compared to grown at a CAGR of 6.96% in the last 5 years as compared to 2.90% CAGR in the last 10 years. Defense spending on 2.90% CAGR in the last 10 years. Defense spending on technology has increased from 2-4% to 8-10% in recent times. technology has increased from 2-4% to 8-10% in recent times.
3.3. Social Changes:Social Changes: Minimal, mainly influenced by convenience. Minimal, mainly influenced by convenience.
4.4. Demographics:Demographics: The use of technology is spreading in The use of technology is spreading in various functions within organizations and across many various functions within organizations and across many industries. industries.
5.5. Globalization:Globalization: Outsourcing of software services and BPO Outsourcing of software services and BPO activities to India. activities to India.
Business Analysis:Demand Factors
1.1. Growth in GDP:Growth in GDP: Revenue cycle in the IT sector has been Revenue cycle in the IT sector has been following the trend in the GDP growth rate.following the trend in the GDP growth rate.
StockVal®S&P INFO TECH. SECTOR COMPOSITE ADJ (SP-45) Price 18.51993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
REVENUES YTY % CHANGE-14
-7
0
7
14
21
HI 20.5 LO -16.9 ME 9.5 CU -1.6
06-30-199303-31-2003
REVENUE-PER-SHARE YTY % CHANGE-12
-6
0
6
12
18
24
HI 18.3 LO -15.7 ME 9.3 CU 0.5
06-30-199303-31-2003
GROSS DOMESTIC PRODUCT ($BIL) YTY % CHANGE2
3
4
5
6
7
8
HI 7.1 LO 2.0 ME 5.4 CU 3.7
06-30-199303-31-2003
Business Analysis:Demand Factors
2.2. Manufacturing Index:Manufacturing Index: ISM Manufacturing activity index and ISM Manufacturing activity index and technology orders have a high correlation. Current technology orders have a high correlation. Current manufacturing index has dropped to 47, which indicates manufacturing index has dropped to 47, which indicates slowdown in technology orders.slowdown in technology orders.
3.3. IT Spending:IT Spending: CIO and CFO IT spending survey results: CIO and CFO IT spending survey results:• Most business heads expect a growth of 2-3% in IT spending in 2003. Most business heads expect a growth of 2-3% in IT spending in 2003. • Spending critically depends on company performance and business Spending critically depends on company performance and business
needs.needs.• Quality service and low cost will influence spending decisions over Quality service and low cost will influence spending decisions over
innovation. This will put pressure on profit margins of IT companies.innovation. This will put pressure on profit margins of IT companies.• Hardware purchases are becoming more price driven. Lengthening of Hardware purchases are becoming more price driven. Lengthening of
life cycles and horizontally scaled architecture are the main reasons for life cycles and horizontally scaled architecture are the main reasons for this.this.
• Majority of business heads agreed that IT budget growth has slowed Majority of business heads agreed that IT budget growth has slowed from 5-7% to 2-4%. They have incentive to under invest.from 5-7% to 2-4%. They have incentive to under invest.
• Spending on storage and software expected to increase. Short of Spending on storage and software expected to increase. Short of capacity and software being a leading indicator of business needs are capacity and software being a leading indicator of business needs are the reasons for this.the reasons for this.
• Long-term growth in IT spending expected to be 5 - 7%. Long-term growth in IT spending expected to be 5 - 7%.
Business Analysis:Demand Factors
4.4. Corporate Earnings: Corporate Earnings: High correlation between corporate High correlation between corporate earnings and IT spending in the past 7-8 years, with a time earnings and IT spending in the past 7-8 years, with a time lag of 1-2 quarters.lag of 1-2 quarters.
Business Analysis:Supply Factors
1.1. Capacity Utilization:Capacity Utilization:• Utilization is low for all hardware, communications and networking Utilization is low for all hardware, communications and networking
equipments compared to industries in other sectors.equipments compared to industries in other sectors.• Semiconductor industry is currently operating at 65% capacity utilization.Semiconductor industry is currently operating at 65% capacity utilization.• Capacity utilization of storage devices is very high mainly due to delay in Capacity utilization of storage devices is very high mainly due to delay in
spending by businesses in the past.spending by businesses in the past.
2.2. Technological Innovation:Technological Innovation:• Intel plans to release the next microprocessor chip in June 2004. Intel plans to release the next microprocessor chip in June 2004.
Hence, till then prices of semiconductor chips are expected to decrease Hence, till then prices of semiconductor chips are expected to decrease at the historical rate of 7%. at the historical rate of 7%.
Business Analysis:Profitability Outlook
IndustryIndustryEarnings Earnings OutlookOutlook ReasonsReasons
SemiconductorsSemiconductors NegativeNegative Excess capacity, low demand and Excess capacity, low demand and decrease in pricesdecrease in prices
SoftwareSoftware PositivePositive Spending prioritySpending priority
StorageStorage NeutralNeutral Short capacity, expected decrease in Short capacity, expected decrease in pricesprices
Consulting Consulting ServicesServices
PositivePositive BPO and government spendingBPO and government spending
PC & Enterprise PC & Enterprise HardwareHardware
NegativeNegative Low demand, slow upgrade cycles and Low demand, slow upgrade cycles and excess capacityexcess capacity
Earnings Per Share
$0.00
$0.10
$0.20
$0.30$0.40
$0.50
$0.60
$0.70
Jun-01
Sep-01
Dec-01
Mar-02
Jun-02
Sep-02
Dec-02
Mar-03
Jun-03
Sep-03
Dec-03
Mar-04
0.000.050.100.150.200.250.300.350.400.45
IT Sector S&P 500 IT Sector / S&P 500 (Secondary Axis)
Financial Analysis:Earnings Per Share
IT Sector is expected to close the earnings gap slightly, but have prices already reacted to this expectation?
Forecast
Net Cash from Ops
01000
20003000
40005000
60007000
80009000
2002 2001 2000 1999 1998
Year
$$$
Hardw are
IT Services
Semiconductors
Softw are
IT Sector
S&P 500
Financial Analysis:CF from Operationsby Industry
Year Year HardwareHardware IT ServicesIT Services SemiconductorsSemiconductors SoftwareSoftware IT SectorIT Sector S&P 500S&P 500
20022002 4772.64772.6 1171.61171.6 3721.53721.5 5142.35142.3 7525.37525.3
20012001 4298.34298.3 1036.81036.8 3939.73939.7 8078.18078.1 4737.94737.9 6836.76836.7
20002000 4289.94289.9 873873 6217.86217.8 76707670 5118.65118.6 6759.46759.4
19991999 4119.34119.3 922.5922.5 5087.15087.1 7176.77176.7 4851.14851.1 6536.96536.9
19981998 3625.33625.3 908908 3918.43918.4 5225.25225.2 39223922 5820.45820.4
FCF Adjusted
0
1000
2000
3000
4000
5000
6000
7000
2002 2001 2000 1999 1998
Year
$$$
Hardw are
IT Services
Semiconductors
Softw are
IT Sector
S&P 500
Financial Analysis:Adjusted Free CFby Industry
Year Year HardwareHardware IT ServicesIT Services SemiconductorsSemiconductors SoftwareSoftware IT SectorIT Sector S&P 500S&P 500
20022002 2137.12137.1 881.3881.3 12321232 2319.52319.5 3737.33737.3
20012001 2138.82138.8 784.4784.4 1075.81075.8 5806.85806.8 2301.12301.1 3324.23324.2
20002000 2964.82964.8 735.5735.5 4497.44497.4 5433.85433.8 3874.33874.3 3856.23856.2
19991999 2528.42528.4 688.2688.2 3034.73034.7 5330.25330.2 33723372 3350.43350.4
19981998 1681.81681.8 542542 1813.71813.7 3432.23432.2 2162.42162.4 2822.92822.9
IT Sector overall is a cash generator, but it has fallen well behind the S&P 500 the last two years. We see a positive trend for Software.
Financial Analysis:Net Profit Margin
CFO and CIO IT spending survey suggests NPM will face continued pressure for the remainder of 2003.
Net Profit Margin Adjusted
-
2.00
4.00
6.00
8.00
10.00
12.00
14.00
1995 1996 1997 1998 1999 2000 2001 2002
%
IT Sector S&P 500
Return on Average Common Equity
-
5.00
10.00
15.00
20.00
25.00
30.00
35.00
1995 1996 1997 1998 1999 2000 2001 2002
%
IT Sector S&P 500
Financial Analysis:Return on Equity
The bubble has burst, and we do not expect significant IT Sector recovery within the next three months, because…
Financial Analysis:Dupont Analysis
We expect margins and asset turnover to remain low, holding ROE down.
Financial Analysis:ROE by Industry
Based on the ROE analysis, there appears to be some opportunity within the industries to increase return on IT stocks even though the sector appears much worse than the S&P.
Year Year HardwareHardware IT ServicesIT Services SemiconductorsSemiconductors SoftwareSoftware IT SectorIT Sector S&P 500S&P 500
20022002 13.2213.22 21.5921.59 4.244.24 2.452.45 15.8715.87
20012001 19.8119.81 21.9121.91 7.347.34 24.2624.26 13.3313.33 19.0119.01
20002000 31.231.2 22.4222.42 29.2729.27 27.4727.47 24.9624.96 24.2924.29
19991999 30.5730.57 22.8622.86 22.0322.03 33.6133.61 26.8726.87 24.9524.95
19981998 36.4136.41 20.6120.61 20.5220.52 35.535.5 28.9328.93 24.1824.18
ROE
0
5
10
15
20
25
30
35
40
2002 2001 2000 1999 1998
Year
%
Hardware
IT Services
Semiconductors
Software
IT Sector
S&P 500
Valuation Analysis:Sector P/E, P/B, P/S vs. S&P 500
Valuation Analysis:Sector P/B, ROE Relative to SP5A
Valuation Analysis:Sector P/S, NPM Relative to SP-5A
Valuation Analysis:Software P/E, P/B, P/S
Valuation Analysis:IT Services P/E, P/B, P/S
Valuation Analysis:Hardware P/E, P/B, P/S
Valuation Analysis:Semiconductor P/E, P/B, P/S
Valuation Analysis:Price Momentum
Valuation Analysis:Crossover Index
Valuation Analysis:Sector Dividend Yield
Valuation Analysis:Summary
P/E, P/B, P/S, P/CF point to industry opportunities, but not overall sector short-term P/E, P/B, P/S, P/CF point to industry opportunities, but not overall sector short-term value:value:
• Low (relative to median) ratios suggest value, high suggest overvalued industry Low (relative to median) ratios suggest value, high suggest overvalued industry prices.prices.
Technical Analysis suggests sector is close to reaching its resistance price, but has Technical Analysis suggests sector is close to reaching its resistance price, but has remained flat for the past six months.remained flat for the past six months.
We will make specific industry recommendations during the company presentation.We will make specific industry recommendations during the company presentation.
IndustryIndustry P/EP/E P/BP/B P/SP/S
SoftwareSoftware LowLow LowLow LowLow
Consulting/ServicesConsulting/Services LowLow LowLow LowLow
HardwareHardware HighHigh HighHigh HighHigh
SemiconductorsSemiconductors HighHigh LowLow HighHigh
Recommendations:
Maintain underweight position for the sector.Maintain underweight position for the sector. Strategically look at the industries within the sector Strategically look at the industries within the sector
for opportunities:for opportunities:• SoftwareSoftware• HardwareHardware• SemiconductorsSemiconductors• IT ServicesIT Services
Keep watchful eye for recovery; we believe that we Keep watchful eye for recovery; we believe that we are close.are close.
Questions?References: Fed Beige report, Merrill Lynch and Bearn Stein CIO survey and Gartner surveys on defense spending.
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