In the midst of a raging storm on a dark night, people will draw courage from almost any ill-formed thought or ill-founded piece of information that gives hope of some respite. So it is, at present, with the global technology sector.
For some 18 months, ever since a February 2001 Cisco profit warning illogically brought to an end a period of irrational over-exuberance, almost everyone with a professional interest in the technology economy has been trying to second guess when the recession will be over. With the exception of a few isolated pessimists who predict seven to 20 lean years, there has a been clear and rolling pattern to the so-called expert analyses: those in good heart say, and have been saying since early 2001, that recovery is two quarters away; most of the rest say it is four quarters away.
In recent months, a few shards of light have made their way through the storm clouds, putting the industry in the former, more optimistic frame of mind. Cisco, a bellwether, briefly lit up the stock market, not only by bettering the 2001 equivalent, dismal quarter, but by beating deliberately downplayed expectations. And Dell Computer again released strong figures, although partly at the expense of rivals.
There has also been some heartening research. Influential organisations such as venture capital firm 3i and the CSSA (now Intellect) in the UK, as well as research company IDC at a European level, have all taken polls that suggest that more and more vendors are seeing signs of recovery.
Bruce Temkin, principal analyst at Forrester Research, probably typifies such sentiments: "Almost every economic indicator you look at is either neutral or positive, so we are clearly out of a slump." He expects a "dramatic increase in the funding for IT projects" and pinpoints the first quarter of 2003 for clear recovery.
Such optimism is encouraging, but it can also be misleading. The overwhelming weight of evidence, whether based on short-term figures or historical experience, supports a different view – that the technology sector is still a very long way from complete recovery.
What is this evidence? First, the industry has lost, and is losing, so much revenue, so fast, that a sudden recovery against the trend lines seems absurd. This is shown by Infoconomy's global 200 IT company index and by its Euroindex. On a global level, the industry is some 14% smaller than a year before, representing a real loss of revenue for the top 200 companies of some $30 billion over the past 12 months. In Europe, revenues are plummeting fast and growth is just turning negative. It is not suddenly going to jump up; in fact, it is still getting worse.
The more informed executives know this; they have looked at their order books, talked to their customers and reached a gloomy conclusion. Hewlett-Packard's CEO Carly Fiorina, for example, said that "the spending environment remains tough around the world" and warned there would be no immediate recovery. Sam Palmisano, the CEO of IBM concurs: "It is clear that the industry is not bouncing back this year… and it is not going to be growing at 10%-11% next year."
To put this in perspective, even the most optimistic executives at IBM and HP expect their companies to shrink substantially – by billions of dollars for at least a year, and that they will not make up this ground for a further two or three years. And these are not isolated cases: as recent financial results show, the technology slowdown has engulfed almost all the so-called 'gorillas' of their sectors – IBM, SAP, Intel, Cisco, HP/Compaq – and has spread far beyond the small, the vulnerable and those heavily exposed to the Internet infrastructure sector.
An analysis of IT sector results shows companies falling into one of three camps. The largest group by far are suffering from a precipitous collapse in sales; the second group, consisting of companies such as SAP and Cisco, have grown revenues but have done this against a background of falling licence or core product sales; and a much smaller group, led by Dell, have continued to thrive, usually for sub-sector or product-specific reasons.
Ultimately, of course, only resurgent demand among IT buyers can trigger recovery. But this is very unlikely to happen in 2002. OvumHolway and Gartner Group, for example, have both said that IT spending will be depressed until mid 2003 at least.
These slightly more bearish indicators, however, are misleading in themselves, since they only tell a fraction of the story. There is, for example, a built-in assumption that an increase in capital spending will translate into an immediate IT industry recovery – rather than a delayed, drawn out and low margin one. And, furthermore, they say nothing about the balance of supply and demand, margins and profitability, company valuations, or of stock market sentiment.
In fact, most published research takes a simplistic view: that too much was spent, that optimism got out of control, and that now it is being corrected.
All this may be true – but what kind of a correction is needed? Figures supplied by the US Federal Reserve Board and investment bank Merrill Lynch provide little succour: technology capacity utilisation in the US, they say, is at about 60% – its lowest ever figure by far. On the two previous occasions when utilisation dropped below 70%, the fall was triggered by deep industrial and consumer recessions. This time, excess technology capacity is not just a result of falling economic activity, but is itself a key driver of the recession. There is far much too much IT out there – especially in certain once free-spending sectors such as telecommunications.
This leads to three simple conclusions: First, that demand for almost all commodity and replacement equipment, including basic services, network bandwidth and raw computer power, will struggle to recover whatever happens. Second, that for almost all technology products and services, there will be sustained pressure on prices as many buyers, having over-provisioned and over-extended themselves, seek to negotiate before buying as never before. And third, it means that the IT industry ideally needs yet another wave of innovation to stimulate growth.
A second set of problems relates to the supply side of technology industry. First, there is a problem of over-supply; the venture capital wave of the 1990s and the associated public bull market, and especially the excesses from 1999 to 2001, has left a legacy that still needs to be worked through. There are still too many suppliers – especially in certain sectors where the hype was greatest and the technical barriers to entry the lowest – web hosting is a good example.
Until these suppliers consolidate – and the depressed level of merger and acquisition activity shows that they have not – then prices and profits will struggle to recover. But consolidation is not happening as fast as it might, because suppliers are not running out of money as fast as they once might have. This is because so much money was channelled into venture capital (VC) funds, and into technology sector IPOs, that troubled and unprofitable companies have been able to resist the pressure to merge. In fact, while VCs in US and Europe are almost all struggling to raise new funds, their existing funds are still mandated to invest their many millions, and to not be too long about it.
An associated concern is that technology sector valuations still remain very high, with price/earnings ratios still in their 30s or 40s. In fact, the so-called Internet bubble was simply a big spike in what has been a decade long upward trend. It is difficult to see how, in the context of supply and demand, of pricing pressure and over capacity, of worldwide economic fragility, and the inevitable failure of many, many smaller companies, these valuations are justified.
While some industry executives and analysts remain optimistic that demand will simply recover as supply and demand is corrected, others are pinning their hopes on the emergence of a powerful technology – or perhaps some economic development such as e-government – that will drive growth and spark a new industry of innovation. In the IT world, there are several interesting developments, but, for a big economic hit, that can only be mobile data communications – whether it is 3G UMTS or Wi-Fi Ethernet, or some combination.
In the early stages, the impact of major new technologies is never clear. But one thing is: the revolution driven by mass market, wireless data communications is only at the very beginning of a very long cycle. Its early years – certainly until 2005 and probably until 2010 – will be characterised much more by investment than by the returns, even if these eventually turn out to be great.
Does all this add up to a grim prediction of sustained economic woe? Not at all. First, if IT sales people believe their own words, then the whole of the business world will benefit from increasing productivity and wealth as it gradually makes its IT investments pay. And against a background of fragile recovery, some companies will fare extremely well, especially if they can take market share
But for most technology company executives, it won't be easy: they should realistically expect at least two more years of tough times and turbulence, and plan accordingly.
Note: This article is loosely based on a presentation that Infoconomist editorial director Andrew Lawrence gives to CSSA (Intellect) members once a quarter. For more information, email email@example.com.