KEK

2003 TECH SECTOR OUTLOOK January 7, 2003

Executive Summary

IT spending to grow a lackluster 2% in 2003, with customers’ ability to spend as important as

their desire to spend given cost cutting priorities.

Poor capital investment discipline and burgeoning commoditization pressures may hinder profit

growth in the tech sector, irrespective of demand.

As “open standards” become more common in technology, value-added may migrate from the

purveyors of IT gear to the customers that implement and customize increasingly generic

technology building blocks in proprietary ways.

Valuations and expectations for tech stocks don’t adequately reflect the prospects for slower

growth and secular pressures on profitability in coming years. Patience is warranted in selecting

entry points on most stocks since the NASDAQ will likely be range-bound, with risks to the

downside.

Chief risks to this cautious stance are threefold: 1.) a meaningful acceleration in consolidation

during 2003 could mitigate competitive pressures; 2.) investors may discount potentially

brighter 2004 prospects by mid-year; and 3.) aggressively reflationary government policies

could spur better than expected GDP growth.

Despite a generally inhospitable climate as compared to the idyllic 1990s, plenty of suitable

investment opportunities exist including: 1.) companies with differentiated intellectual

property; 2.) companies addressing performance bottlenecks where innovation is still rewarded

with premium gross margins; 3.) low cost producers driving commoditization rather than those

suffering from it; or 4.) companies moving upmarket into higher value added segments from

areas that were already commodity-like allowing for a positive margin bias.

Bubble Bath Round IV?

“Technology stocks are no longer ‘expensive’ compared to the market based on historical

relative price-to-sales ratios since 1990, though the appropriateness of overall market

valuations may be debated. With the relative price-to-sales ratio testing ten year lows, the

rate and extent of margin improvement will ultimately determine whether or not

technology stocks prove expensive on an earnings basis. With technology stocks trading

at “relatively reasonable” valuations, the NASDAQ should end its long period of sharp

underperformance (though the higher Beta will persist). If the corporate profit

improvements that are critical for a capital spending recovery don’t materialize, the S&P

and Dow should suffer along with tech stocks as money shifts into bonds.”

-- June 26, 2002 tech update

As we near the end of the third year since the March 2000 NASDAQ peak, the two most visible

vestiges of Bubble.Com – egregious relative valuations and a massive glut of excess IT equipment –

have been purged like the double chocolate mousse desserts at a bulimia benefit dinner. The 41%

decline in the Russell 1000 Technology Index’s during 2002, following 24% and 34% declines in

2001 and 2000, respectively, has deflated the technology sector’s price/sales back toward pre-

Bubble norms (median P/S of 2.6 vs. 3.0 previously). The overhang of excess computing capacity

and gray market inventory has either been rationalized or fully depreciated. But despite these

important improvements, Bubble-induced dysfunctional behaviors and unsustainable imbalances

persist, as is evidenced by the industry’s lack of capital discipline and attendant structural problems

– too many companies with too much capacity spending too much on R&D.

Demand to the Rescue?

There are three stages in a technology spending downturn and recovery; 1.) companies absorb

unused capacity and try to make existing infrastructure more efficient; 2.) they upgrade specific

infrastructure as it becomes obsolete / cost inefficient; and 3.) they return to proactively investing

in new initiatives that accelerate and automate business processes. Spending is currently stalled in

the second stage as customers focus on streamlining internal processes rather than investing in new,

“strategic” applications. In recent surveys, CIOs cited their companies’ top line performances as

the most probable swing factors for 2003 spending and budget pressures should persist until

customers’ revenue growth improves.

While S&P operating profits are expected to increase 10% in 2003, cost cutting should be the key

driver as excess capacity and continued price competition will constrain revenue growth. At the

end of 3Q02, overall capacity utilization in the US languished near a ten year low of 75% and

US Technology Spending Mix by End Market

Key Verticals % spending Sales EPS Capex Sales EPS Capex

Financials 21.0% -1% 14% -10% 6% 11% -3%

Communications 18.0% -2% 6% -38% 0% 3% -5%

Manufacturing 14.0% -1% 11% 0% 4% 11% -3%

Government 11.0% 5% 9%

% total 64.0%

Other Weighted Avg -13% -1%

Business Services 7.0%

Technology 6.0%

Retail 5.0% 2003 CIO survey results -- US and Europe

Healthcare 4.0% 2003E Budget

Transportation 3.0% Growth

Utilities 3.0% Goldman Sachs +2-3%

Education 2.0% Merrill Lynch +1%

Other 6.0% Morgan Stanley +2-3%

Total 100.0% Average 2.0%

2002E Growth -- y/y 2003E Growth -- y/y

“The 'trouble with prosperity' is prosperity to the extent that more and

greater performance in equities induces more and greater issuance of

equities… With the proceeds of the issuance… they will make the

fatal additional extra investment that will be unprofitable... So you

can't imagine a world in which stocks go up all the time because there

would be too much investment and the investment would prove

unprofitable. Companies would begin reporting unprofitable results

and the market would go down again. So in the nature of things,

prosperity is at some level its own worst enemy…”

-- James Grant, Grant's Interest Rate Observer, 1997

technology spending is disproportionately driven by several of the verticals most afflicted by excess

capacity – financials, communications and manufacturing. An expected 1% decline in 2003 capex

from the four top technology spending verticals that dominate two thirds of overall spending will

necessitate an 8% increase from the remaining third of the market to hit the CIOs’ forecasted y/y

spending growth target of +2%. For technology companies, the mediocre demand outlook is

exacerbated by substantial supply side pressures stemming from the sector’s historically low

capacity utilization of 65%. Such dual pressures imply that the Street’s lofty “bottom up”

expectation for 8% revenue growth and 35% profit growth in 2003 may prove overly optimistic.

An additional factor arguing for cautious expectations on the trajectory of economic growth and the

prospect for a material improvement in IT spending is a blatant absence of the pent-up consumer

demand that is typically present exiting a recession. In fact, the closest documented instance which

could pass for a “demand retrenchment” was when a power outage in eastern Delaware briefly

prevented the locals from accessing Amazon.com last May. New capital investments typically lag

improvements in consumer spending so there may be insufficient incremental demand to drive

capacity utilization and business capital materially spending higher during 2003 (above left; not

surprising since consumer spending drives 70% of economic growth versus <11% for capital

spending).

Consistent debt accumulation and “deficit spending” over the past decade has left consumers more

stretched than the average Krispy Kreme connoisseur’s waistline, with both gross financial

leverage (bottom left chart, top line) and total leverage (bottom left, lower line) at post-Depression

highs. Total leverage appears less inflated than financial leverage compared to historical norms

since persistently strong housing prices have bolstered the asset side of household balance sheets.

Consumer debt service payments as a percent of disposable income are at the high end of the

historical range of 12-14% and this burden, coupled with all-time high real net debt levels, should

help to curb hitherto insatiable consumer appetites… at least assuming a moderation in double digit

housing capital gains and no further stair-step increases in productivity that would allow for a

further improvement in the trend in wage gains. If these factors indeed moderate, consumer saving

will likely have to increase from its current level of 4% toward the 10% long-term trend level as

real savings replace capital gains as a source of retained wealth.

Real Aggregate asset price (1) growth vs. real credit growth Real aggregate asset growth for US/Jap/Ca/Aus

(1) Real aggregate asset prices include equities, commercial and residential real estate. Source: BIS

While US consumers’ love of leverage would make Archimedes’ blush, they are not alone in

gorging on the post-Depression cornucopia of credit. With the noteworthy exception of Japan,

debt/GDP ratios have risen to record levels for both the countries explicitly listed in the top chart

and other developed nations around the world, as well (http:// www.bis.org / publ / work114.htm;

page 39). That Japan has been able to gradually deleverage in the wake of its own asset Bubble

implosion without reforming its own financial imbalances has arguably been a “luxury” afforded by

its weak Yen policy aimed at driving exports. But propping up its economy by purchasing

treasuries to finance the US debt / consumption binge has merely amplified imbalances elsewhere.

“Most of the financial market participants I meet with don’t want to take the post-bubble

shakeout beyond the ensuing IT carnage… Consumers developed the mistaken belief that a

surging equity market had become a new and permanent source of saving… Asset-driven saving

strategies have gotten a new lease on life in this post-Nasdaq-bubble climate as property market

appreciation has taken over where Nasdaq left off… Private sector debt loads remain at record

highs to this day -- for consumers and businesses alike… The excesses of the debt cycle are

always the transmission mechanism for the extremes of wealth-related impacts on real economic

activity -- they are the principal means by which new sources of purchasing power are extracted

from frothy asset markets. The excesses of the debt cycle are a breeding ground for systemic

risks in the financial system…”

-- Stephen Roach, Chief Morgan Stanley Economist at World Economic Forum, June 2002

“I’m old, Gandalf. I know I don’t look it but I’m beginning to feel it in my bones. I feel sort

thin… sort of stretched like butter scraped over too much bread…”

-- Bilbo Baggins to Gandalf in Lord of the Rings

Bilbo Baggins was stretched “thin” after he fell under the influence of the evil Ring of Power,

which prolonged his life even as its insidiousness corrupted his heart. As per Stephen Roach’s

statement, the evils of excessive debt accumulation can similarly sap resiliency from the financial

system, though the latent threat posed by rising systematic risk may long lay dormant. But whether

or not the extent of global debt accumulation and its apparent Virtuous Cycle offspring -- rising

asset values, wealth effect-driven spending increases and rising collateral values that enable further

debt accumulation -- is warranted by lower global risk premiums and higher intrinsic values is a

moot point. What seems less debatable is that these factors are less likely to be positive growth

drivers going forward since the multi decade process of global disinflation and 60 year post-

Depression process of debt accumulation may be nearing an end (especially with real interest rates

near zero in the EuroZone , zero in the US and negative in Japan; and if the portents of a

weakening dollar and strong precious metals are to be believed, policy makers have little room for

additional accomodation). But to the extent that NASDAQ excesses were merely symptomatic of

more pervasive global asset speculation and capital misallocation, a more dire denouement to the

storied US economic expansion may lie ahead.

IT Spending recovery already at hand?

Real vs. Nominal Computer Spending ($Bn) 1996-Present

Technology capital spending grew during 3Q even as the non-technology portions continued to

sputter. But this modest strength is primarily attributable to easy year-over-year comparisons from

3Q01 and the impact of hedonic pricing adjustments on reported computer sales figures.

Hedonic pricing adjustments require the calculation of price indices which are used to deflate a

nominal measures to provide “real” (constant price) estimates that purportedly reflect “quality

adjusted prices.” While real spending on hardware surged by more than 20% y/y, the nominal

hardware spending figures that actually drive IT company revenues have been trending sideways for

the past year and a half and are only modestly above 1995 levels. This is consistent with current

estimates calling for essentially flat global IT spending during 2002 (+0.1%E).

IT spending should increase a modest 2-3% in 2003 as corporations wait to see definitive signs of a

recovery in revenue growth and a corresponding abatement of margin pressures. From a macro

standpoint, extremely lean global inventories, solid productivity gains, robust real wage gains for

workers, low inflation and aggressively accomodative monetary and fiscal policies argue for a

more sanguine view of the prospects for stronger GDP growth, improved corporate revenue growth

and a re-acceleration in IT spending by 2004. Furthermore, the average age of the rapidly

depreciating IT capital stock has been on the rise and continued R&D advances are improving the

Global IT Spending by segment ($Bn) 2000A 2001A 2002E 2003E 2004E

Services

Consulting 52.1 1.8% 53.0 -1.0% 52.5 53.5 5.2% 58.1

Business Processing & transaction mgmt 83.4 7.5% 89.7 5.8% 94.9 99.5 ##### 111.7

Outsourcing and IT mgmt 111.9 7.6% 120.4 6.7% 128.5 133.5 ##### 146.8

Development and integration 155.4 2.3% 159.0 0.0% 159.0 163.8 8.5% 176.4

Total Services 402.9 422.2 434.9 450.3 493.0

Hardware

Servers

High end 11.1 7.2% 11.9 -13.4% 10.3 10.3 1.0% 10.0

Mid-range 16.7 -18.4% 13.6 -9.4% 12.3 12.8 ##### 13.8

Low-end 9.2 6.2% 9.8 7.2% 10.5 10.8 7.9% 10.8

Standard Intel servers 19.2 2.4% 19.6 2.8% 20.2 20.6 6.4% 23.0

Total Servers 56.1 54.9 53.3 54.5 57.5

Storage

Disk systems 27.4 -12.8% 23.9 -13.9% 20.6 20.6 -0.8% 21.6

Tape drives 4.1 21.0% 4.9 -4.7% 4.7 4.7 1.9% 4.9

Fibre Channel 1.4 5.2% 1.5 17.9% 1.7 1.8 ##### 2.3

Total Storage 32.9 30.3 27.0 27.1 28.7

PCs and peripherals

Personal computers 211.5 -19.7% 169.8 -9.9% 153.0 153.6 1.0% 159.1

Workstations 4.5 -16.6% 3.8 -17.8% 3.1 2.9 ##### 2.5

Printers 27.5 -6.4% 25.7 -2.1% 25.2 25.4 1.8% 26.0

Handheld devices 5.6 10.7% 6.2 15.6% 7.2 7.6 ##### 8.8

Other 13.4 -4.8% 12.8 -3.2% 12.4 12.7 6.8% 13.7

Total PCs and Peripherals 262.6 218.3 200.9 202.2 210.1

Data networking equipment 59.6 8.4% 64.6 5.0% 67.8 70.0 9.1% 75.6

Hardware maintenance and support 76.7 0.5% 77.1 -0.6% 76.6 77.4 3.0% 79.7

Total Hardware Spending 487.9 445.2 425.6 431.2 451.7

Software

System infrastructure 47.5 6.0% 50.3 4.0% 52.3 53.8 8.0% 60.8

Application development and deployment 43.5 -4.1% 41.7 2.0% 42.6 43.9 9.0% 48.5

Applications 87.1 -6.1% 81.8 3.0% 84.3 86.1 6.0% 94.6

Software maintenance and support 40.3 5.9% 42.7 5.1% 44.8 46.0 7.5% 49.6

Total Software Spending 218.4 216.5 224.0 229.8 253.5

Total IT Spending 1,109.1 1,083.9 1,084.5 1,111.3 1,198.3

y/y % change -2.3% 0.1% 2.3% 7.8%

Hardpunch

Source: Soundview, IDC, Goldman Sachs, Morgan Stanley, Mutual Estimates.

ROI on tech investments, making a sharper recovery a distinct possibility. Customers will have to

make major, multi-year investments to achieve the Holy Grail-esque goal of establishing a

seamless, real time, global enterprise (improving information sharing and data mining capabilities

across departments and linking with suppliers and strategic partners to pare inventories and speed

time to market). Demand and IT spending growth may ultimately prove to be less of a concern

than the profitability technology companies realize from such growth.

Too much capacity and too much capital

Number of U.S. public technology companies

vs. share of profitable companies

Source: Merrill Lynch

Double digit revenue growth over much of the past three decades has masked the fact the

technology companies have consistently demonstrated less capital discipline than Ivanka Trump on

5th

Avenue carte blanche with The Donald’s plastic. The industry’s nearly universal eschewal of

returning cash to shareholders via dividends or meaningful share repurchases demonstrates

companies’ pandemic obsession with achieving growth, even if for “growth’s sake.” Such poor

reinvestment decisions unnecessarily foster hyper-competition that depresses returns and this

will become a bigger issue as the industry growth rate gradually slows. Capital indiscipline is

largely to blame for major structural imbalances that persist even as we enter the fourth year of the

current technology Nuclear Winter. Specifically, there are a surfeit of companies with too much

production capacity, spending too much on R&D to chase too few market opportunities. M&A

dollar volumes in 2002 were near 1995 levels even though there were at least 50% more public

companies and more than twice the number of private companies, with nearly 4x as many losing

money as compared to 1995 levels. There are still 10,000 software companies in the U.S. alone,

and the supply is not materially contracting since there are nearly 800 domestic venture capitalists

with $100 billion of uncommitted funds that are still devoting 20% of new investment dollars to

software investments. The paltry M&A deal flow during 2002 was dominated by HP/Compaq, IT

services deals (more deals likely) and a few niche, strategic software deals (IBM / Rational;

Veritas / Precise). Arguably, the only material deals specifically aimed at rationalizing excess

capacity were in the optical components sector (Alcatel Optronics / Kymata; Bookham / Nortel

components division; Triquint / Agere; New Focus disposal of components business).

Somewhat surprisingly, the largest tech companies have not set a good example for the industry

when it comes to exercising capital discipline. Three of the largest companies – Microsoft, Intel

and Cisco – take the prodigious profits earned in their maturing core markets and reinvest them in

highly competitive areas which afford comparatively mediocre profitability. Microsoft’s

investments beyond Windows, Office and server operating systems – including MSN internet

access, handset and cable OS software and Xbox – have yielded modest to negative incremental

profits and the company’s $54 billion of idle cash is doing little to benefit shareholders.

Intel’s 2001 operating margin was 30% in its core market of computer chips (“architecture”),

versus -29% and –12% in the peripheral markets of communications and wireless chips,

respectively. But the mediocrity of Intel’s margin performance outside of the microprocessor space

isn’t half as noteworthy as its absurdly bad investment track record outside of the semiconductor

realm during the second half of the 1990s. The company squandered billions in one of the Valley’s

worst venture capital arms (Intel Venture Capital) and in ill-advised Web Hosting initiatives that

were later written off. Intel has $12 billion of idle cash on the balance sheet and has elected not to

act as a consolidator despite intriguing M&A opportunities at attractive prices (Intel did act as a

consolidator during the boom years). Cisco’s dominance of the enterprise router market enabled it

to consistently achieve 60%+ gross margins and to amass $21 billion of net cash. The tens of

billions of stock the company issued to acquire companies in the service provider space during the

1990s have been of dubious merit, with service provider revenue stalled around 17% of total

revenue at sub-par gross margins. Cisco’s cash hoard sits idle and the company continues with its

longstanding policy of doing acquisitions exclusively for stock despite its excess liquidity. All three

companies would likely argue that they are ‘investing for the future’ and there would be an element

of truth in such a claim. But the overarching reality is that as these companies’ core markets

are maturing and they are hoarding assets and chasing growth by reinvesting in lower return

initiatives elsewhere.

If the undisputed leaders in the technology sector refuse to accept maturity and manage assets to

maximize shareholder value and returns, why should their less lauded peers? Cash rich companies

that are weakening fundamentally (e.g. 3COM, Gateway, Novell, Parametric), that have seen

endmarket demand evaporate (e.g. Metalink, Netro, Sycamore) or that are just plain “Undead”

with few competitive advantages and high cash burn rates (e.g. Cosine, Interwoven, VA Software)

should arguably return cash to shareholders in some form. Instead, they will retain the cash until

they either burn through it, spend it on acquisitions or – against all odds – actually succeed in

revitalizing themselves as growth companies. It is worth noting that dividend taxation changes

won’t alter the underlying lack of investment discipline or managerial risk aversion that

drives companies to hoard cash to invest in new growth areas when their core businesses

mature or enter secular decline. Furthermore, the lack of capital discipline in the sector is

arguably the gravest threat to returns since investment levels are discretionary and can be scaled up

or down in order to earn an “appropriate” return on capital based on realistic risk / return prospects,

which vary over time and are currently unfavorable.

Criticisms of industry spending levels aren’t intended to imply that high R&D expenditures are bad,

per se. To the extent companies are truly pioneering innovations that create unique value for

customers with the potential to generate attractive risk-adjusted returns, such investments are

warranted. The problem is that spending is near all time highs despite a reduced opportunity set

because balance sheets are awash in cash and the industry hasn’t consolidated to reduce spending

pressures. Take the DSL chipset space, dominated by Globespan. Globespan has 40% market

share and the by far the best technology in the industry, yet the stock trades at a mere 1.5x trailing

twelve month R&D expenditure and 1.4x net cash (currently free cash flow positive) because the

already crowded competitive field (over 10 other players of note) is still seeing new entrants (most

recently, Broadcom; Broadcom likely spent R&D equivalent to Globespan’s enterprise value for

the privilege of challenging Globespan’s dominance of the niche). As another example, Agere and

Intersil controlled over 90% of the $800MM wireless LAN chipset market and their early

dominance should have deterred some new entrants, at least in a rational world. Instead, at least

30 other companies are entering the market with others slated to follow in a violent bout of insanity

rivaled only by that of Nicholson in “The Shining.” The irony is that much of the discrete wireless

LAN functionality provided by this gaggle of chipset competitors will migrate onto general purpose

processor chips produced by the likes of Intel, Texas Instruments and Broadcom (…so the

Lemmings rushing into the space may be destined for the proverbial cliff).

Net net, the Night of the Living Dead 3 ½ hour Director’s Cut had less zombies than the

overpopulated, moribund tech landscape. I recently performed an internet search using the

keywords “shakeout, survive, technology, company,” to locate a quote from John Chambers on

the need for an industry shakeout. Instead, I found a superb November 11th Forbes article

appropriately dubbed “The Undead,” with some choice quotes that highlight the absurdity of the

current situation (http: // biz.yahoo.com /fo / 021024 / the_undead_1.html )…

Customer Quote

“David Guzmán…is chief information officer for medical supply distributor Owens & Minor…and gets

hundreds of pitches every week from a mind-boggling array of vendors. Some 549 publicly held

software makers market their wares, plus hundreds more private shops that few people ever hear of. In

the past year Guzmán has quadrupled the size of his voice-mail in-box to 140 calls--and still it jams up

with unsolicited come-ons. He gets another 500 e-mails a day, mostly from software outfits that are

unknown to him. His assistant spends most of her time clearing out the clutter… He adds: ‘Nothing will

get through to me. It's a stack every day--I ignore it every day.’ “

Quotes by Potential Strategic Acquirors (?)

“Even the professional dealmakers are loath to take a gamble on buying trouble. ‘Can you spot value in

this morass of carnage? The truth is, most of these companies should die,’ says James Davidson of Silver

Lake Partners, a private equity firm in Silicon Valley.”

“ ‘The fact that they (potential targets) have cash doesn't help," says Bernard Liautaud, chief executive

of Business Objects. ‘If they're losing a lot of money, they're virtually unacquirable. We don't want to

ruin our profitability.’ ”

“ Dell Computer Chief Executive Michael Dell. ‘The rational thing to do would be for the [software]

companies to just return their money to the investors,’ he says. As for the rest, he says, ‘You've got

8,000 to 10,000 companies out there, just ticking away. They'll just clip coupons, or whatever, until

this ends.’ ”

Quotes by Potential Strategic Sellers (?)

“Interwoven has almost $200 million in the bank. ‘Our cash can last a decade or longer,’ boasts CEO

John Van Siclen… Nice, but Interwoven hasn't been profitable in two years and similar stuff is peddled

by at least two dozen rivals, including Microsoft and Oracle; five smaller direct entrants have a total of

$776 million in cash. ‘You size the company appropriately to be able to run for many years,’ he added.”

“(Voice recognition software maker)… Nuance Communications, Chief Executive Ronald Croen ticks

off a partial list of other players: ‘…I could give a list of 50 companies in the same business, but I can't

follow them all,’ he says. But he is undaunted: Nuance has $150 million in cash from its two public

offerings. ‘Without market development or doing anything intelligent, we can still last four more years,’

says Croen, who recently announced he is looking for a successor.”

“…Altiris knows it could be a long wait for the pack of rivals to thin out. ‘I've got a database that says I

have 104 competitors, from Marimba to Alohabob,’ says John Epeneter, Altiris' technical marketing

director. ‘A lot of them don't have the capital to expand out of their little niche, but they're not shrinking

very fast. You think they'd shrink more, but the barriers to en-try are low. These guys,’ he says, ‘are like

gnats.’ ”

“ ‘We've been going to the smaller companies to see if they'd consider putting themselves up for sale, but

there's no sense of urgency,’ says Revell Horsey, managing director at Banc of America Securities.”

Commoditization pressures intensifying

“Functional Overshoot”: Leading edge products exceed customer needs

User demands and innovation trajectories don’t scale in parallel. When rapid innovation

causes product functionality to “overshoot” what users need, the basis of competition

increasingly turns toward price. For example, the number of transistors that can be produced on

a semiconductor wafer for an equivalent cost doubles every 18 months (as per Moore’s Law; 60%

CAGR) while chip designers ability to create more complex chips increases at a mere fraction of

that pace. End customer performance needs for various applications eventually slow, as well, an

issue Intel is facing in the PC market since few applications require the abundant processing power

characteristic of the latest premium priced microprocessors. As Intel’s microprocessor sales mix

has shifted from leading edge to “lagging edge” chips, the company’s return-on-invested capital

has plummeted due to intense price competition with AMD. Such problems for Intel diffuse to

other parts of the semiconductor food chain, as well. Semiconductor capital equipment providers

are seeing decreased demand for leading edge tools since older generations of chips produced on

depreciated PP&E can meet the demands in an ever-increasing percentage of the market (as long as

cost is more important than performance, large transistors produced with old process technologies

are more cost effective than smaller transistors produced with newer equipment that entails higher

fixed costs). In the upstream, UNIX-based server vendors like Sun are being pressured by LINUX

and Microsoft-based server vendors since their comparatively low reliability has been improved

enough to be acceptable in a widening array of applications.

Industry profitability is likely remain under pressure as the market for leading-edge

technologies stagnates. New, high performance applications should eventually revitalize demand

for premium technologies that command superior margins but that isn’t likely to happen until

broadband technologies proliferate, spurring an acceleration in replacement demand. In addition,

growth in most international markets will be for less advanced, lower ASP equipment than is

typical in the U.S. and Western Europe. As these “price sensitive” markets increase as a percentage

of the total market, an ongoing negative mix shift away from the sale of leading edge equipment

will pressure industry sales growth and profitability.

On the supply side, Asian manufacturers – particularly the Taiwanese and Chinese – will rapidly

take market share to the extent that performance requirements continue to mature. Historically,

Asian companies dominated the production of labor and capital intensive, commodity-like products

such as PCs (e.g. Compal, Hon Hai), flat panel displays (e.g. AU Optronics, Quanta), computer

motherboards/PCBs (e.g. Asustek, Compeq) and memory chips (e.g. Samsung, Winbond, SMIC),

partly due to their willingness to accept lower ROICs in order to advance long-term “strategic”

agendas. These companies are now making inroads into previously sacrosanct areas characterized

by higher levels of intellectual property such as semiconductor chip design (e.g. Mediatek, Sunplus

and Novatek in consumer electronic chips) and networking equipment (e.g. ZTE, Huawei,

Accton). Western companies that can’t differentiate products based on defensible Intellectual

Property will likely face severe margin pressures in the face of rampant capital indiscipline by

the market share-driven, emerging market players.

Shift to open standards

Standards are critical enablers of technology proliferation since they allow for easier deployment,

improved reliability and for software to be written in fewer flavors, reducing both development and

IT personnel training costs. Several of the titans of the technology industry became such because

their products came to define de facto standards in the industry – IBM’s System/360 & Z series

operating system for mainframes, Intel’s x86 instruction set for microprocessors, Microsoft’s

Windows and Cisco’s IOS operating system for data networking. By the mid-1990s, IT buyers had

an epiphany that while standards are important, they should be specified in advance as “open”

industry standards so that IT vendors wouldn’t gain supernormal profits as their products became de

facto standards. This change in mentality represents a rational buyer reaction aimed at curbing

“excessive” profits that were accruing to IT vendors and most cutting edge technological

deployments currently underway incorporate a heavy dose of open standards (e.g. web services,

wireless LAN, storage area networking). While open standards may ultimately help to spur

better IT demand by lowering implementation and integration costs, they will lower barriers

to entry and impair industry profitability as product differentiation becomes harder and

customer switching costs are lowered.

Open Source software

Open source software is software whose source code can be obtained, viewed, changed and

redistributed without royalties or other limitations (save for the requirement that if a company

changes the core LINUX kernel, it must publish the changes if it plans to distribute the code

externally; most non-LINUX open source software has no such clause). In the open source model,

the user community publishes code for improving and debugging software at a central cite and a site

administrator takes the best code improvements and incorporates them into the core version of the

code. The LINUX OS is the best known and most mature flavor but there are a spate of other open

source initiatives including Apache internet server, Tomcatt and Jboss application servers, MySQL

databases and the Java enterprise development tools. Open source software is already pervasive in

core internet infrastructure applications and is making initial inroads to the enterprise, where it

threatens to cannibalize UNIX and Windows NT. At the desktop level, Walmart recently

introduced a $200 PC with a LINUX OS which is achieving “impressive” sales and China and

Norway have each stated that they would promote LINUX as the dominant computing OS in their

countries over the long term (the folks in Redmond may not be invulnerable, after all).

Open source software could ultimately displace many proprietary flavors of software provided by

the likes of Microsoft, Oracle, BEA, IBM and Adobe, though cannibalization is likely to be slow

at first and targeted at low end applications for which an inferior (immature) software is good

enough. As improvements enable programs to attack more demanding applications upstream,

technology companies selling proprietary solutions will likely be forced to cut licensing prices to

stem the advancing tide, even though such cuts could impinge on their ability invest in the R&D

required to maintain technological superiority. Value creation will increasingly shift from the

proprietary software vendors to their customers, who will do more programming in-house

(and with Indian programmers) to optimize the general purpose open source solutions for their

own IT infrastructures. While Bill Gates and Larry Ellison aren’t likely to have to pump gas for a

second source of income before 2007-ish, the “Democratization of Software” via open source

initiatives could cause major secular pressures on software industry profitability and few will be

immune.

The Revenge of the buyer?

Source: Soundview Technology.

The extraordinary gap between the average ROA of technology providers and their customers

indicates that the key beneficiaries of new technological deployments have likely been the IT

providers and end consumers, as productivity benefits were competed away (with rare exceptions

like Dell and Charles Scwhab). But as increasingly generic, interoperable technology building

blocks proliferate due to open standards, more value should migrate toward those companies

that can add value by rapidly deploying and exploiting such technologies. This is particularly

true since corporations are only in the early stages of harnessing the business process re-engineering

opportunities that an Internet computing paradigm should ultimately allow. The exploitation of

"Productivity gains are fine if there is a

monopoly. If productivity is shared with

everybody it flows right through to the

consumer." -- Jeremy Grantham,

Barron's Interview 8/6/01

“…IT customers are now the principal source of

new IT value creation. Indeed, the value that

customers are creating for one another now

exceeds the value created by even our most

important IT suppliers. In other words, customer

activities are now the largest and most influential

portion of the IT industry value chain …”

-- David Moscella, previewing his soon to be

released book, Customer Driven IT

technology for competitive advantage has long been core to the biotechnology and defense sectors,

but it should become an increasingly important tool in more mainstream sectors, as well (Zandi’s

comment below is intriguing, in that light). The improved “value capture” potential stems from the

fact that technology costs will fall as use the use of increasingly generic technology components

diminishes gross margins paid to technology suppliers, while open source software will enable

users to develop and customize proprietary in-house work flows that differentiate capabilities vis-à-

vis those of competitors.

“Banks are technology companies wrapped in a balance sheet. Scale allows for the

development of better technology for automatic execution via custom algorithms and for the

development of proprietary in-house work flows. (In the future,) the traditional IT

department will be ‘commodity people’ focused on exploiting ‘generic’ technology and

there will be vertical domain experts in-house that will increasingly create value-added,

proprietary applications.”

-- Richard Zandi, Deutsche Bank software analyst

Valuation and Expectations

Revenue growth has been slowing for some time… …yet growth expectations still well above pre-Bubble norms

Profits coming from record trough… …yet Tech Value vs. IT spending still well above pre-Bubble norms

Technology sector revenue growth has been in a modest downtrend for decades, which is hardly

surprising given its inevitable though gradual maturation as a trillion dollar industry that represents

4.5% of U.S. GDP. But the effect of moderating revenue growth on profit growth will be amplified

by overcapacity and commoditization pressures, so while profit expectations probably overestimate

the trajectory of a recovery in the short run (+35% in 2003) they clearly overestimate long-term

growth potential. The “bottom-up” analysts’ consensus forecasts calls for a 17% five year growth

CAGR and the chances of that happening are “Slim” and “None” with Slim having just left town in

a zero percent financed SUV. After the personal computer related tech Bubble burst in 1983, long-

term growth estimates of 20% were revised steadily downward over the next four years to 12% as

excesses were purged, where they remained until a cyclical resurgence in expectations commenced

as the recession ended in late 1991. The current situation is analogous to that of the mid-1980s so

patience is warranted in selecting entry points in light of high absolute valuations and still buoyant

expectations. With the Russell 1000 Technology Index up 41% from admittedly oversold October

lows and 10% during the first weak of 2003 on modest news flow, the Beta Chasers may be setting

up a partial repeat of 2002 wherein tech stock prices surged in early January on the crest of

seasonally strong fourth quarter results and struggled mightily thereafter as optimistic estimates

were cut.

The Russell 1000 Tech Index performance last winter and this winter sport chilling similarities…

Summary and Investment Strategy

“The function of recessions is to clean the excesses of the previous boom… But the Fed

policy of credit expansion has allowed capacity to grow, not in the U.S. but in China. Each

time they inject money into the U.S. economy, consumption grows and industrial

production grows in China, which is wonderful for Asia but not the U.S.”

-- Marc Faber, Global Boom and Doom Report

The current economic malaise that is passing for a recovery is a business capex-led downturn in a

world still beset by excess capacity and a lack of corporate pricing power. Historically low inflation

is amplifying real interest burdens in a highly leveraged global economy, even as geopolitical

concerns, high energy costs, soaring healthcare costs, pension costs and state budget deficits

impinge upon confidence, profits and spending. Ultimately, it is hard to envisage a successful

reflationary scenario in which GDP growth would recover sharply without fueling further

imbalances based on the tired formula of US-consumer centric global GDP growth (according to

Morgan Stanley, the US has accounted for 64% of the cumulative increase in global GDP since

1995). The weakening dollar may presage a multiyear phase of sub-par global GDP growth as U.S.

consumers increase savings rates toward historical levels of 10% (from 4% currently and zero

percent during 2001) as asset value growth stagnates and positive wealth effects moderate.

Pressures will mount on Europe and Japan to restructure to improve their competitiveness and to

revitalize their anemic domestic demand.

While the thirty year growth CAGR in IT spending is 10-12%, a 6-8% rate in spending is more

likely going forward due to 1.) a slower GDP growth environment; 2.) a moderation in the growth

of IT relative to GDP (currently 4.5% of GDP in U.S.); and 3.) increasing price pressures as many

mainstream technologies commoditize. IT spending is expected improve modestly in 2003 (+2-3%)

and before converging toward “trend” growth in 2004 (8%) as the aging IT capital stock and benefit

of continued R&D advances commands greater investment. But poor capital discipline and the

specter of increased commoditization in key subsegments may limit the ability of IT vendors to

translate improved demand growth into robust profit growth. Lingering structural imbalances could

ultimately be diminished by consolidation and lower cash flow reinvestment while commoditization

trends could be partially reversed if demand for leading-edge technologies improves as a new wave

of high performance applications arise as broadband communications proliferates. This is likely a

multi-year process.

“Since revenue growth should be modest over the next few years in most segments, the

extent of margin recovery should be the dominant driver of stock prices… This is

particularly true since intensifying competition should increasingly polarize the returns of

commodity oriented producers and those with differentiated products based on defensible

intellectual property…”

-- June 26, 2002 tech update

The current downturn in the technology sector is analogous to that of the mid-1980s after the

personal computer Bubble imploded. Broadly speaking, technology stocks struggled during the

period and exhibited high volatility even though a small group of eventual “winners” like Dell and

Compaq fared much better. In the current Bear Market, technology stocks have shown

remarkably high correlations in the short to intermediate term so disappointments in the

broader sector will likely lead to sell-offs in both poorly positioned and well positioned

companies, alike. And disappointments are likely given the high expectations and lofty absolute

valuations extant as we enter the seasonably weak first quarter. Investable themes?

Problem excessive competition

Solution emphasize companies with differentiated intellectual property and high barriers to entry

Examples high end analog semiconductors, programmable logic devices; companies in these

niches have seen little or no gross margin pressure in the downturn so profitability will be fully

intact as their top lines ramp

Solution find companies addressing performance bottlenecks where innovation is still rewarded

with premium gross margins

Examples storage area networking software; storage and server I/O; low power chips for

portable devices

Problem lingering excess capacity

Solution emphasize buyers of excess capacity rather than sellers

Examples fabless semiconductor companies rather than foundries; data networking companies

outsourcing production rather than electronic manufacturing services companies

Solution find areas that have undergone structural change and a rationalization of excess supply

Example optical components

Problem commoditization

Solution emphasize low cost producers driving commoditization rather than those suffering from

it

Examples Dell the obvious answer; Samsung rather than Nokia; Seagate

Solution emphasize companies moving upmarket into higher value added segments from areas

that were already commodity-like allowing for a positive margin bias

Examples International Rectifier in power semis; National Semiconductor in analog semis;

Skyworks in wireless components; Hon Hai in EMS

Problem open standards and open source software

Solution value added shifts to implementation and exploitation, with increasingly “generic”

infrastructure more vulnerable than applications

Example Services companies benefit (especially low cost, offshore programming locales like

India)

Problem heightened systematic risk in global financial system and slower GDP growth

Solution focus on companies with high free cash flow yields and low capital intensity;

prefer variable to fixed cost business models that provide resiliency in case of

further demand degradation

Examples fabless semiconductors, software, services

Note – I will be handing out spreadsheets highlighting specific companies and recommended buy-in

prices based on 2003E and 2004E FCF yields, business model characteristics and competitive

positioning.