Technology: Strong Liquidity, Stable Operating Trends Mitigate Concerns in 2008

The debt ratings agency, Fitch says that it believes 2008 credit and operating trends will remain stable for most U.S. information technology (IT) sectors, except for electronic manufacturing services (EMS), which has a negative outlook. Total industry debt is expected to increase in 2008 exceeding a 10-year high again, surpassing $190 billion. The technology industry overall is expected to continue to achieve growth in excess of U.S. gross domestic product for 2008, with many companies benefiting from strong international growth amplified by the weak U.S. dollar.

Fitch has a cautious bias to this view (particularly for less geographically diverse companies) as U.S. growth could be constrained by the financial services vertical, which is the worldwide leader in terms of IT spending. Fitch estimates that any significant decline in IT spending by financial services companies could reduce the U.S. growth rates by more than 100 basis points, with the hardware sector being most affected.

2008 Credit Outlook

Technology companies' balance sheets are strong and industry financial flexibility remains healthy. Cash positions are near $250 billion, essentially flat since year-end 2004, and free cash flow has increased the last few years with expectations that it will be flat in 2008 with pressured profitability offsetting top-line growth. Credit concerns for the industry center on potential debt issuance, primarily for acquisitions and increased share buybacks due to difficulties accessing offshore cash in a tax-efficient manner, weakening credit protection measures mostly from higher industry debt levels, and, although declining, event risk of companies considering alternative capital structures (mostly new issuers). In 2008 Fitch believes the maturing technology industry will continue to experience strong acquisition activity from strategic buyers, particularly for the software and IT Services sectors, and potentially, though less likely, the EMS sector. Event risk around leveraged buyout activity has subsided for the intermediate term.

Debt Levels Increasing

Total industry debt is expected to increase again in 2008, surpassing $190 billion and exceeding the 10-year high set in 2007. Fitch believes a majority of 2008 technology debt issuance will be driven by three main factors: 1) many technology companies have exhausted their U.S.-based excess cash balances for share repurchases or acquisitions and are examining issuing debt in the U.S. to support share repurchases and other activities, as overseas cash levels continue to increase, 2) debt-financed acquisitions, and 3) new issuers who have historically had zero debt and are continuously examining their capital structures. Debt refinancings will also drive debt issuance, as the industry has approximately $20 billion of debt maturities in 2008. Fitch believes excess cash and free cash flow will continue to be used aggressively for stock buybacks, which are on pace to increase more than 10% in 2007 to approximately $90 billion.

Liquidity Remains Strong

Liquidity for the U.S. technology sector is generally very solid due to high cash balances and strong free cash flow, despite the lack of significant U.S.-based cash for some companies. Several companies accessed the capital markets during the favorable liquidity environment to extend revolver expirations and refinance maturing bonds. The few companies with weak operating liquidity are generally in that position due to exposure to the capital-intensive semiconductor industry or because of self-inflicted financial policy decisions that have resulted in a significant portion of cash flows being dedicated to interest expense (e.g., First Data Corp., Advanced Micro Devices Inc. and Spansion Inc.). However, Fitch believes these challenged companies do not have any material maturities coming due until after 2010, minimizing near-term liquidity issues.

2008 Market Outlook

The technology industry's revenue base is clearly correlated to general economic conditions, although some sectors have a stronger ability to withstand a downturn than others. For example, most IT services - with the exception of the consulting and systems integration business - and software companies receive a significant amount of relatively predictable recurring revenue and free cash flow from long-term contracts and/or maintenance streams, resulting in a stronger capability to withstand an economic downturn. Sectors such as EMS and IT distributors would clearly be affected by an economic downturn from a profitability standpoint, but this decline has historically been offset by working capital improvements.

Market indications and industry trends suggest the worldwide IT spending environment will remain stable in 2008 with mid- to low-single-digit growth expected. Growth will likely be led by the approximately $800 billion IT services and software sectors with hardware being most challenged to achieve growth due to pricing pressures as unit demand remains healthy. While worldwide growth is stable, Fitch believes declining macroeconomic trends in the U.S. (Fitch forecasts 1.7% expansion in 2008) could pressure the sector and participants that lack geographic revenue diversity. The combination of relatively high energy costs and a pressured housing market may potentially lower consumer discretionary spending on technology products. The small and medium business (SMB) market remains a source of growth and strong focus of the IT industry.

Semiconductors (Stable Outlook)

Fitch's 2008 outlook for the semiconductor industry is stable, mostly driven by the aforementioned expectation of solid unit growth for PCs and mobile handsets. As the semiconductor industry continues to expand its total available market while pursuing a lower-capital-intensive profile, Fitch believes the industry will experience less volatility and relatively more predictable free cash flow. Similar to the overall technology industry, Fitch expects several semiconductor companies will continue to evaluate their mostly equity-dominated capital structures as potential opportunities to alter these balance sheet profiles, via debt-financed acquisition activity and/or potential stock buyback actions. From a business and operating profile standpoint, semiconductor companies continue to be subject to the highest technology risk within the technology industry.

Fitch believes the global semiconductor industry will grow in the low-single-digit range in 2008, following modest revenue growth for 2007. Embedded in Fitch's expectations are that unit demand will remain solid, semiconductor content within an ever widening range of applications will continue expanding, and increasing consumer spending in developing economies will partially offset slower spending anticipated in the U.S. and Western Europe. However, offsetting Fitch's expectations for solid unit demand are significant pricing pressures, excess manufacturing capacity for the memory segments, which aggressively added capacity in 2007 to meet strong NAND demand, and slightly elevated inventory levels (albeit still within manageable ranges), which will weigh on otherwise solid growth drivers.

EMS (Negative Outlook)

Fitch's negative credit outlook on the EMS industry largely reflects continued operational challenges in addition to continued event risk, arising from additional consolidation or acquisitions to bolster vertical integration capabilities. End-market demand trends remain positive, despite a pressured economy, as OEMs outsource additional manufacturing particularly in non-traditional industries such as defense, automobile components and medical instruments. However, Fitch expects profitability in the EMS market to remain challenged by continuing competitive pressures from both Asian ODMs (original design manufacturers) entering traditional EMS markets and EMS vendors forgoing typical margins to fill excess manufacturing capacity. Although 2008 could prove to be a turning point for the industry if Flextronics' acquisition of Solectron reduces a significant part of the overhang from excess manufacturing capacity leading to a more stable pricing environment. Debt issuance in 2007 was driven primarily by acquisition activity, which will likely continue to be the primary driver in 2008.

Flextronics' ratings could be stabilized if it succeeds in integrating Solectron's operations, improves profitability and uses the expected resulting free cash flow to reduce the incremental $2 billion in debt which partially financed the acquisition. Celestica and Sanmina are both expected to face continued operational challenges but could utilize positive free cash flow, particularly resulting from reduced working capital requirements, to reduce debt which could lead to a stabilization of the ratings.

Communications Equipment (Stable Outlook)

Fitch believes credit profiles for the global communications equipment providers will be stable in 2008 with the expectation that wireless spending will essentially be flat to slightly up due to subscriber growth and technology upgrades, while wireline spending will be flat. Fitch's overall market view on the medium-term outlook for the communications equipment sector is cautiously stable with relatively flat to slight growth in expenditure expected in developed markets, while emerging territories such as Latin America, China and India will continue to see sizeable investment in infrastructure over the next 2-3 years. Near-term visibility has weakened however, with concerns over carrier consolidation in developed markets and geopolitical uncertainty in some emerging markets affecting the outlook for investment in 2008.

General trends across both the developed and emerging markets include convergence and multi-media, with these developments offering the prospect of continued investment in equipment spend. However, uncertainties remain, including the potential for more efficient use of existing spectrum, which could reduce the need for capacity- and/or expansion-related investment. While Fitch believes communications investment is driven primarily by strategic considerations, current economic uncertainties and credit conditions could slow investment in 2008. Fitch does not, however, draw parallels with the spending crisis of 2001, while investment postponements should lead to pent-up demand in 2009.

The Fitch full special report 'Segmenting Technology Risk: Strong Liquidity, Stable Operating Trends Mitigate U.S. Tech Concerns in 2008,' will be published in early January 2008.

Posted to the site on 6th December 2007