The IT 'Recovery': Here's What's Ahead

IT spending “recovery” is merely an “echo boom” with higher volumes, lower prices

It’s difficult to play the hardware stocks; in part, because there is no real “recovery” trend to play. It’s a stock picking sector – Dell, the superior performer, on continued share gains; Hewlett-Packard a potential turnaround play on its new management team; Sun a “poor mans” turnaround play. Recovery of IT spending just isn’t a catalyst… yet.   

The first thing I ask when folks mention "tech recovery" is: "Recovery from what?" There's been some degree of "bounce back" from the lows of 2002, and I expect we'll see more, albeit modest, increases going into 2006 over 2005 and 2004.

I view the up-tick in tech spending since the lows of 2002 as having two aspects.

First, I see a bounce back from untenable IT spending lows. To use one metaphor, we've re-filled the gas tank after running it down to fumes -- but we aren't driving all that more than we were a year ago, and we're certainly not buying a new car.

Second, I see it as a replacement spending cycle, particularly replacement of PCs. Many people haven’t seen this "echo boom" happening because pricing is weak, but PC processor unit volumes are higher than pre-Y2K. However, some financial analysts have suggested that when profitability returns, companies would spend more on technology. They seem to believe that there is a de-facto, causal relationship between the two. While profitability has always been a key criteria for large IT purchases, in my experience as a tech analyst, and in the experience of most folks I know in IT management, it has largely been a gating criteria. Even in the best of times, other things need to fall into place, and the big one is a demonstrated (or at least perceived) business need for the new technology.

That is an important difference between this “recovery” period and all previous ones.

Cycle of Upgrades Has Changed

The PC business is a good example of what's going on today and how it differs from past cycles. In the 20 years since the introduction of the PC, we have seen cycle after cycle of upgrades. Each of these upgrade cycles has been driven by new and compelling capabilities that made new hardware a necessity. Not only that, but most of these cycles also introduced new capabilities that made PCs more essential to more people leading to an ever-widening installed base. In each of these cycles, companies tended to replace everything they had, and they also tended to buy more. Most of these upgrade cycles were driven by new software. Over the years, Intel's upper management has recognized and openly spoken of this "software spiral" as being the driving force behind PC upgrades and the addition of new PCs to the installed base. So long as Microsoft (and others) continue to writer hungrier and hungrier applications, with more and more compelling uses, people continue to buy more and more capable PCs.

Today the software spiral is not driving an upgrade cycle in hardware. Although there is an "echo bubble" in PCs, this is, for the most, part, a replacement cycle -- not upgrading to substantially more powerful hardware. In large part, companies are still running current office suites and other applications on PCs that are four years old, or on new PCs that are not substantially different from their old Y2K hardware. There are few new applications that would require companies to upgrade their hardware and certainly little reason to deploy additional PCs, because everybody in the organization who needs one has one -- or inherited one from someone who was laid off.

The major reason for companies to replace PCs right now continues to be that some of the oldest ones -- usually 4- to 5-year old boxes -- have become cheaper to replace than to keep repairing. (I need to draw a distinction between a replacement cycle, of old hardware with units of approximately the same capabilities, versus an upgrade cycle, which is to more powerful hardware).

But even these replacements have a very different character than previous cycles. Many of the computers being replaced are quite capable of doing the job, and anything on the market today is more than capable of replacing them. So we are replacing old or broken boxes with new, inexpensive, bottom-of-the-line ones. My sense is that if companies could save money buying even less-capable boxes, they would.

So we are seeing an "echo boom" in PC unit sales -- not business revenues and profitability from PC sales. Dell Inc. is one exception; it has increased share at the expense of other companies, largely HP and IBM / Lenovo – and, due to its superior expense management has eeked out some improved profitability.

I think this mini-boom will last for a few more quarters.

Killer App Needed to Spur Hardware Sales

Eventually some new application will come along to require more hardware resources, and at that point companies at large will need to think about a real capability upgrade, rather than a replacement program. Meanwhile, companies are likely to continue to replace things on the cheap and will probably hold off on major hardware upgrade programs until there is some compelling reason to do so. Companies also need a clear idea of what they need in terms of upgrades.

The impact of all this is clear: Hardware manufacturers, semiconductor makers, storage and disk drive makers, and all their suppliers are likely to continue to sell more low-end, lower-margin products. That's an anathema to companies such as Intel, Sun Microsystems, Hewlett-Packard, and the like, which make the lion's share of their profits from sales of their high-end product lines.

Some financial analysts believe that the introduction of new wireless notebooks will somehow stimulate demand for new PCs that previous software cycles did. I don't doubt that in some sectors this may be accurate. Certainly in the highly mobile world of Wall Street analysts, investment bankers, hedge fund and mutual fund analysts, lawyers, journalists, and the like, the utility of such devices is indisputable. But even they need to go no further than their own trading floors or operations departments to recognize that a large number of workers will never be able to be mobile in the same way.

In many American companies, less than 10% could probably have a reason to use a PC away from their regular work stations; i.e., less than 10% of employees are mobile. The vast bulk of employees are on the phone taking orders, resolving customer issues, entering data, making payments, shipping product, or in administrative roles. These are not activities that would tend to make wireless PCs a compelling investment for their companies. And in truth, the bulk of these lower-wage employees would never be trusted with taking home a $2K to $4K piece of equipment in any case. That is not my view, rather, it's the view of many IT spending decision makers.

Companies Using More Software Capabilities

In enterprise software, I am aware of many organizations using more of the features in their enterprise software suites, rather than upgrading their software. Many companies never learned the full capabilities of their software when they installed it during the Y2K boom. Now they are increasingly taking advantage of what's already there, rather than buying more. These packages are so multi-faceted that few people I know claim to be using them to their fullest ability, and many are walking away from huge "upgrade" projects in favor of making better use of what they already have. This process is having a substantial impact on large systems integrators who, having historically made their money on large implementation projects, are now bidding for minor "enhancement" projects at cut rates.

In summary, I see no compelling reason to believe that many companies will start throwing large amounts of extra money at new, upgraded technology, even if profits do recover substantially in the coming months. Although I do expect the replacement cycle we have seen the last couple of years to continue with comparable, low-priced units. That said, while there should continue to be replacement spending, I don't see a substantial absolute dollar increase in IT spending for 2006, beyond 2005 spending levels, absent a robust, broad-based economic recovery -- even if unit sales do continue to increase.

Melanie Hollands
melaniehollands@yahoo.com