As the market appears to have already priced in a bounce in tech profits this year, share prices are unlikely to rally

The fundamentals of the technology market appear to be slowly improving. The two main issues that caused the collapse of the market in 2000/ 2001, i.e. the build-up in inventory levels and falling demand, appear to have stabilised.

Historically the time to buy into markets was when demand had bottomed and sentiment was poorest. So is now the opportunity to buy technology stocks? The answer is not clear. While demand certainly appears to have levelled out, valuation levels suggest that sentiment is very positive with a strong recovery forecast for the second half of this year. Post the lack-lustre first-quarter results season, this forecast looks increasingly optimistic.

Two main themes have dogged technology markets since mid- 2000. On the supply side, companies invested heavily in IT infrastructure (hardware, software, network equipment) over the 1998-2000 period in anticipation of continued strong economic growth. This led to the build-up of significant IT capacity within companies and as the economy slowed in the second half of 2000, companies realised that they had excess IT capacity, relative to historic trend levels (see graph).

At the same time, corporate demand for IT products was slowing as companies such as financial institutions and manufacturers cut their IT budgets as profits declined. Inventory levels in IT companies quickly built up and companies started to discount prices in order to move stock. This resulted in increased price competition and lower profits.

The graph illustrates that the inventory over-supply situation has been largely resolved after a period of depressed ICT spending. Demand, however, remains sluggish and until such time as this recovers, there is unlikely to be a sustainable rally in technology markets. So what will encourage corporates to start spending again on technology?

The main factor that will encourage a loosening of ICT budgets is higher profits, or even the prospect of higher profits in the broad economy.

The collapse in broad corporate earnings in 2000 was preceded the sharp decline in ICT spending. The S&P 500 in the US is forecasting that earnings will grow by 12 per cent in 2002, which should result in some recovery in ICT spending this year.

Assuming this is the case, will technology markets rally? Not necessarily. There is a difference between growth in spending and how quickly this gets converted into higher profits for technology companies. In addition, the performance of ICT stocks will also depend on the valuation of those stocks, i.e. how much good news has already been priced in.

Reviewing the first-quarter results of the technology sector, there is little evidence of a recovery in spending. At best, it can be implied that demand has bottomed out. How quickly it recovers is difficult to assess. There is evidence, however, of continuing price competition, particularly in the PC market and semiconductors. This will likely keep profits depressed for at least another quarter or two, which is almost year-end.

The market, however, is forecasting a strong recovery in ICT profits this year, driven by a recovery in demand in the second half of the year. Consensus earnings growth for the Davy Large Cap Tech Index (DLCTI), which is comprised of a range of industry-leading technology companies in a number of sectors (Microsoft, Intel, Cisco, etc) is 46 per cent in 2002.

In the current environment, this looks increasingly optimistic. And even assuming this level of earnings growth, the index is trading at 28 times earnings, slightly below its long-term average of 30 times (which includes the bubble period of 1998-2000). Should actual earnings growth materialise at 20 per cent this year, this implies a multiple of 33 times, 10 per cent above the historic average.

The underlying supply/demand fundamentals of the ICT market are improving, albeit gradually. The market, however, appears to have anticipated this recovery and is pricing in a sharp bounce in profits this year.

This forecast is now looking decidedly shaky, as the Q1 reporting season comes to a close. In this environment, the ICT market is unlikely to make much progress from current levels.

Barry Dixon is a technology analyst with Davy Stockbrokers