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.