The recent spate of high-profile profit warnings from technology companies has resulted in an increasing realisation that a recovery in the technology market is unlikely until well into 2002. There are two main factors driving this view - slowing revenue growth and declining margins. These negative trends are forcing analysts to reduce earnings estimates for this year and next. Investors do not like declining earnings and therefore are likely to continue to sell the market.
Why has revenue growth slowed? Over the 1999/2000 period, companies spent significantly more than normal on IT equipment for various reasons, including anticipated strong growth in such areas as online business and data communications. When this did not materialise over the past year, companies decided that they had over-invested and therefore have pulled back from further spending. The extent of the over-investment has been estimated at between $100 billion and $200 billion (€118E 236 billion) in the US alone over the period.
The graph illustrates our estimate of overspending at $130 billion, based on statistics from the Bureau of Economic Analysis in the US. This reflects the difference between the actual level of IT equipment built up over the 1999/2000 period and what it would have been, had spending on IT continued at its long-term trend growth rate of 9 per cent per annum. It also assumes a depreciation rate of 34 per cent per annum. Based on this analysis, in order to revert to a "normal" level of IT equipment, spending by companies needs to decline by 37 per cent this year, continuing at the trend rate thereafter. Such a decline is unlikely to occur in one year and therefore spending growth in 2002 is also likely to be negatively impacted. This will curtail the revenue growth prospects for many IT companies over the next 12 months. Thereafter, spending is likely to revert to its long-term trend rate, which has actually been increasing over time as the impact of technology on productivity growth is realised.
A consequence of the slowdown in top-line growth is margin compression. As many IT companies are valued on a multiple of sales, it is important that superior levels of revenue growth are achieved or maintained. Companies have been cutting the price of their product to maintain or gain market share, resulting in falling profit margins. This trend has been most apparent in the PC market with a vicious price war being waged between Dell, Compaq, and Gateway. More recently, however, price competition has extended to the server, software, and semiconductor markets. As gross margins decline, companies are being forced to cut costs in other areas in order to maintain operating margins, and job cuts are the result. With conditions unlikely to improve over the next six to 12 months, further job cuts are inevitable.
So far, one or both of these trends have impacted on a number of the Irish technology companies - Baltimore, Trintech, Horizon and Datalex. The others have survived (so far). Riverdeep's revenue growth is being driven by US government spending on education, which increased by 18 per cent this year. Iona claims that its products help companies improve the productivity of their existing IT asset base, an area that, to date, appears relatively unaffected by the slowdown. Parthus reassured the market about its Q2 numbers last week but some of its peers have been subject to slowing revenues.
The outlook for the tech market remains very uncertain over the next year. It will take some time for the over-investment of 1999/2000 to be cleared and, until then, revenue growth prospects will be limited. This will continue to negatively affect profit margins and thus company earnings. As earnings forecasts inevitably decline, so will the market. The fat lady hasn't even cleared her throat yet!
Barry Dixon is a technology analyst at Davy Stockbrokers
