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Technology Stocks: Bad News Continues

Bill Loomis

Since my last article in Washington Technology, the bad news has continued concerning information technology spending, with the two leading e-business services companies, Sapient Corp. and DiamondCluster, pre-announcing poor results for the second time this year.

The major cause for the shortfall is a dramatic decline in North American revenue, primarily as a result of the slowing U.S. economy and its negative effects on IT spending.

IT service firms are not alone, however, as the slowing economic environment also has resulted in pre-announcements from large, well-known tech companies, such as Cisco Systems Inc., Oracle Corp., Intel, Microsoft Corp. and many others.

I estimate both Sapient and DiamondCluster will experience sequential declines in North American revenue of about 30 percent in the March quarter, while European revenue will continue to grow.

Even large companies, such as Computer Sciences Corp., have been having a difficult time. CSC's U.S. systems integration and consulting unit (I estimate at about 5 percent to 7 percent of CSC's total revenue) is potentially facing weak demand, although its international (38 percent of revenue) and federal government (25 percent of revenue) IT businesses remain strong.

Private IT service firms I speak with also seem to indicate that certain parts of Europe remain strong, though this may be negatively influenced by the apparent deteriorating spending in the United States in coming months.

Business in the second quarter of 2001 seems to be shaping up to be worse than most companies thought. While I had initially looked to a fundamental recovery perhaps beginning in the second quarter, I no longer believe this to be the case for commercial IT service companies.

Technology professional services is a sequential business that simply cannot turn on a dime. Project ramp-up time is required before services firms can begin to book substantial amounts of revenue, and unless IT spending resumes in earnest over the next month or two (looking increasingly unlikely), it will be hard to book enough revenue to show substantial improvement in the second quarter.

We believe the second quarter of 2001 is generally shaping up to look flat at best and, increasingly, more likely to be down sequentially for the e-business service companies, though probably less so than the first quarter. If trends persist, the second half of 2001 could end up much more "flattish" than many companies now expect, and could even show a continued downtrend should Europe and other international IT spending be reduced as U.S. economic woes spread globally.

Overall, I believe that 2001 for e-business service companies is more likely shaping up to be down year-over-year, possibly down as much as 10 percent to 15 percent, rather than flat-to-up, or zero percent to 10 percent year-over-year growth I had previously thought.

Traditional commercial IT service companies may be able to squeak out a flat year from 2000, as many deal with IT services that help companies reduce costs or increase the efficiency of their existing systems, such as application maintenance or enterprise application integration.

Federal IT service companies will likely be less impacted by the economy, though state and local government IT service firms may feel some pain, as several states already are talking about general spending reductions following an expected drop in tax revenue.

I remain very positive on the e-business and other commercial IT services industry in the long term, and stocks will undoubtedly move ahead of spending and economic improvement. However, the timing of this move has become less certain, and the interim risks for investors more pronounced. Investors clearly are favoring business visibility today over potential growth or profit margins in the future, evidenced by the valuation changes in the market over the past year.

For the first time that I can recall, both the publicly traded traditional and the e-business commercial IT companies that Legg Mason tracks are trading at a valuation below the government IT companies we track.

Bill Loomis is managing director of the technology research group at Legg Mason Wood Walker Inc., Baltimore. He can be reached at wrloomis@leggmason.com. Legg Mason Wood Walker Inc. makes a market in the shares of Sapient Corp. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security. Opinions expressed are subject to change. Additional information available on request.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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