Reorganizing Tech Stock Priorities

 |  Includes: ATML, BBY, MCHP, NAPS, ON
by: Zacks Investment Research

Much of the expected growth from emerging markets and technology has been scaled back in recent industry outlooks. Zacks senior technology analyst Abdul Saleh spoke with us recently to help reorganize our tech stock priorities.

Prior to the full-blown U.S. economic crisis, had the tech industry outlook been turning more positive?

The tech industry as a whole has experienced cyclical turns since the bursting of the Internet “bubble” and it has been difficult to find a sector which has provided positive investment returns on a consistent basis. Recall that in one of our earlier conversations on Nov. 29, 2007, we had broken up the share price performance for companies in my coverage area for the period Nov. 2006 to Nov. 2007. We had found that, with the exception of the companies in the Business/Application Software sector, companies in the Semiconductor, IT Services, Internet and BPO were all yielding negative absolute returns.

Similar analysis for companies in these sectors under my coverage area for a period subsequent to Nov 15, 2007 and up until the beginning of September 2008 would yield a flat to slightly higher average absolute return. On that basis, we could conclude that immediately prior to the financial market meltdown, tech stocks were trying to improve upon the growth trends, and most of the companies were relying upon growth in the emerging markets to counter the lackluster trends in the domestic markets. In other words, fundamentals for the companies in the tech sector were improving.

How about since the Wall Street difficulties have come to pass? In what way do you expect the tech stocks under coverage to be affected?

It would be difficult to conclude that the current meltdown on Wall Street has come to an end. However, given the extent of losses suffered, one can surmise that the end is probably near. The tech stocks under my coverage has already suffered significant losses.

With the Dow and NASDAQ losing 19.6% and 25.9%, respectively since the beginning of September, shares of companies in my coverage area has all fallen across the board for the same time period: Semiconductor, 13 companies, down 29.5% on average; Software 13 companies, down 28.5% on average; IT Services, 3 companies, down 33.4% on average; Internet Software/Services, 8 companies, down 31.2% on average; BPO, 4 companies, down 39.8% on average; Electronics, 3 companies, down 32.5% on average; and finally, Telecom Component, 4 companies, down 48.7% on average.

Given the current scenario, valuation metrics for all these sectors are being re-calibrated and estimates re-visited. The current earnings reporting season is vital to assess the sustainability of the growth fundamentals of these companies.

You also cover BPOs [business process outsourcing], and that market looks to be slowing, as well. Can you give us an update?

The BPOs were all under significant pressure even before the economic malaise, with a slowdown in its growth trajectory for 2008 and the Street had already discounted the 2008 slowdown. In other words, the BPO companies were all trading with a 2009 growth/recovery story in mind. The current financial market fallout adds further uncertainty to their growth picture, with roughly 35% of market cap already shaved off for the BPO companies under my coverage since the fallout.

There's no mistaking that the global financial crisis has found its way to India's shores at a time when the country is in no shape to weather it. The stock market is choppy, there's been a credit squeeze, interest rates are up, and banks continue to rein in loans as inflation hovers at 12%. Growth has slowed from the heady 9% a year ago to 7.9% for the three months ended in June, and it's forecast to grow only at 7.5% for the fiscal year ending next March. With banks in the U.S. and Europe struggling to survive, outsourcing is less likely to be a dominant theme going forward.

It is expected that the BPOs may cut their dollar revenue forecasts due to a downturn in the U.S. market, which contributes more than half their revenue. These companies have already said that customers were delaying decisions on new projects in the tough global environment.

Additionally, German software maker SAP (NYSE:SAP) warned earlier last week that its sales had dropped abruptly in the last two weeks of September as companies curtailed business software spending. This is expected to negatively affect the Indian BPOs with increasing revenue dependence in Europe.

Do you have any solid Buy recommendations at this point in time?

Existing recommendations based on pre-meltdown fundamentals and company guidance may not be viewed appropriately at this time. This is not to say that the existing recommendations are not relevant. My Buy recommendations, which are few are far between, may be revisited in conjunction with the upcoming earnings release and company guidance.

It is vitally important to pay attention to what the managements of the respective companies will say and how it will shape the estimates going forward. However, companies may exceed expectations and takeover/merger stories may begin to surface. One needs to pay attention to merger announcements already made: Microchip (NASDAQ:MCHP), along with On Semiconductor (ONNN) has already made a hostile bid for Atmel (NASDAQ:ATML) and Napster (NAPS) is set to be bought out by Best Buy (NYSE:BBY). It would be interesting to see if these announced deals are reconstructed/revalued in the face of overall market devaluation. We have Hold ratings on MCHP and NAPS, and we had recently upgraded ATML from a Sell to a Hold.

What type of tech stocks do you feel it would important to stay away from?

Although the ongoing U.S. and global financial crisis have stemmed from the housing market bubble, particularly the sub-prime mortgage markets, the thrust of the current crisis is in the availability of credit in the credit market (or the lack thereof). Companies in the tech sector are expected to be impacted negatively not only from a lack of credit availability to finance their letters of credit, but also from their customers who will have an increasingly difficult time to finance their purchases from these companies.

This implies that tech companies with high debt ratios may have a difficult time while those with high net cash in their respective balance sheets may be able to sustain the credit crunch. In other words, stay away from companies that are highly leveraged.

Abdul Saleh is a senior analyst covering the foreign tech and BPO industries for Zacks Equity Research.