It’s hard times for tech
stocks and it may be
getting worse

NEW YORK » Technology stocks have underperformed the rest of the market so far this year, and professional investors have reduced their commitment to the industry as a growing number of analysts question the outlook for what was once Wall Street's flashiest sector.

Among its more vulnerable areas is the computer manufacturing industry; although Dell Inc., Hewlett Packard Co. and Apple Computer released solid third-quarter earnings, a recent report from Gartner Group, an information technology research firm in Stamford, Conn., predicts massive consolidation as a current wave of corporate PC-buying tapers off.

There's a strong probability that three of the nation's top 10 PC makers could be out of business by 2007, Gartner said. The report, released Nov. 29, did not speculate which companies might be affected by the consolidations, but suggested there simply would not be enough business in the future to support the current number of vendors.

"None of the companies is immune. Any one of them could have a problem," said Leslie Fiering, a research vice president with Gartner. "With the lowered demand, you're going to have a lot of vendors competing for smaller numbers of shipments and smaller amounts of revenue. To meet this, we think they'll have to take what could be as much as 2 percent out of their operating expenses ... and some companies will be able to meet that and others, it may catch them by surprise. We believe they are all vulnerable at this point."

A report that International Business Machines Corp. is selling its PC business give credence to that point of view. The New York Times said yesterday that IBM is negotiating with the Lenovo Group, China's biggest PC maker, and at least one other unidentified prospective buyer for the unit.

Fiering said 2005 may turn out to be a decent year for PC makers, since corporate America is still in the process of replacing the computers it bought during its last spending spree, when the Y2K bug prompted a wave of buying. But once that tapers off, things will get more difficult; she foresees single-digit growth in 2006 and more dismal times after that, until the next replacement cycle starts. From 2006 to 2008, emerging markets are likely to account for more than 60 percent of market growth, she said.

The PC maker in the best position, analysts say, is Dell, in part because its build-to-order business model helps it avoid undesirable inventory stockpiles. Dell has also won praise for carefully watching expenses, which may give it more leeway in a tougher environment.

"The best profit model in the industry is Dell. They can really wring profits out of the business," said Walter McCormick, head of value equities at Evergreen Investments in Boston, while noting the stock is not cheap enough for his portfolios. "If you want a company that reflects what's going on in the PC space, Dell is the premier company."

For most of 2004, Evergreen has maintained a modestly underweight recommendation for the tech sector, mostly out of concern that its lofty stock valuations are not supportable in the current climate.

"In general, we're not in an environment where businesses are spending in an important way on their IT budgets. It looks to be very sluggish," McCormick said. "There could be some year-end spending related to tax incentives ... but as we look forward and look at surveys and talk to companies' management, we're not getting a sense that this is a business that's about to surge. It seems to be a business that is more closely tied to the economy, and maybe not quite as able to outpace overall economic growth as it once did."

The tech stocks of the Standard & Poor's 500 have risen about 5 percent so far this year, versus a 7 percent advance for the index as a whole. Only health care and consumer staples have produced slower returns, yet tech stocks still sell at higher valuations than the rest of the market -- a premium of about 35 percent, by some measures. With tech apparently heading into a difficult patch, analysts say this valuation gap should start to narrow, and as it does, share prices are likely to fall.