Technology Outlook For 2005, Plus, Longer-Term Tech Drivers

• December 27, 2004
• Melanie Hollands

Technology Sector Overview: Outlook for
2005

 

Technology stock valuations
are high. Particularly in light of the relatively modest revenue growth rates at
many technology companies. Valuations look especially high in the smaller cap
tech stocks despite that, during 2004, as a group they fell around 3 percent
after surging around 65 percent in 2003 (helping drive the Russell 2000 Index up
45 percent in 2003). Valuation in technology didn’t matter much in 2003,
although it mattered some during 2004. But I think it will matter more in 2005
since the top-line growth rates aren’t there to justify many stock prices.

 

The tech sector looks like
having a flattish year during 2005. While there will be some good tech plays in
2005, a big up move in the technology group at large seems less likely. However,
providing some downside comfort I don’t see erosion in tech company business
trends leading to a sizeable fundamental pull back in tech stock prices.

 

Recent media indicates that
some are expecting a strong up year in 2005. But I just don’t see it that way
for tech stocks: in part due to high valuations, and in part due to earnings
growth rates not being sustainable at post-trough, 2003-to-2004 levels. During
the first half of 2005 we could see the dollar continuing to weaken at the
expense of tech stocks in general. Although at this stage, the broader market
doesn’t seem to care as much about the weakening dollar as it should.

 

A good slice of the
fundamental return is embedded in current technology stock valuations. But
within the tech sector, there are select opportunities. I could be more bullish
on semi’s, for example, in the latter part of the first half of 2005; in part
because fundamentals should look more encouraging, and in part after a
substantial rotation out of semi’s into software and into non-tech areas like
energy. Oracle is one name I like for the next few weeks, and Symbol
Technologies (SBL) looks OK for a longer-term long in 2005. Linux should
continue to strengthen and VOIP (voice over Internet protocol) and related
stocks could do well (but excitement in these names could be shorter lived than,
say, RFID (radio frequency identification) stocks like SBL or Linux stocks like
RHAT).

 

There’s been a solid
improvement in (or, put another way, a slowing of erosion in) technology stock
fundamentals during 2004. First, in 2003 the tech sector traded up from its
trough lows in 2002. So the growth in 2003 was coming off of an unsustainably
low base driven by essential maintenance and replacement spending, rather than a
real increase in end-demand. Second, during the 1990’s the technology industry
had evolved from having been more vertically integrated to being composed of
more technology-specific industries. Two or three firms are now established as
leaders of a sector with scale and low cost advantages (think Microsoft, Dell,
Intel, Applied Materials etc.). Consolidation and share shifts helped propel
some of the larger caps higher in 2003. Bug going forward, opportunities for
market share shifts between companies in these more mature sectors are smaller.

 

The five main technology
drivers that propelled growth during the last seven years are now mature:
TCP/IP, GUI Interfaces, microprocessors, relational Databases, and the Internet
(www). However, emerging growth in technologies such as VOIP and Linux should
provide some growth in the Mid-and Smaller cap techs during 2005. Other growth
themes in 2005 include companies with a dominant leadership position that can
leverage that position with continued market share gains.
Examples I wrote about in the media at the beginning
of 2004 included Dell and Qualcomm and both companies’ stocks significantly
outperformed the S&P 500.
Companies that can leverage the Internet in delivering new services to customers
should do well; in particular, companies that facilitate bill remittance and
payment via the web.

 

Lastly, IT services
companies should begin to see budgets loosen up modestly, allowing for some new
contract expenditures. This should benefit RFID deployments, likely to occur in
the back half of 2005 and into 2006.
Bear in mind
that the supply chain management folks are hurting and may not have the cash to
invest in an RFID solution for their product.
Symbol Technologies is one
company to watch in this area; but there are others too. Symbol’s
“monopoly-like” domination of the AutoID Bar Coding segment will likely be
extended with growth in its RFID business.
If companies
like Oracle and SAP jump onto RFID for their largest customers that would be
unlikely to propel those stocks since revenue growth rates could be slow to
ramp.

 

As mentioned above, I don’t
expect either deterioration in tech fundamentals or a surge in fundamental
strength across the board. Tech stocks can move on economic benefits at
companies or on new technology business drivers, or a combination of the two.
For 2005, in general tech stocks should move more on company economics than new
technologies. That said, a few names could move on technology-related drivers
(such as some Linux and VOIP plays).

 

Fundamentally, we could see
growth in corporate operating cash flows. I’d also expect a cyclical investment
cycle, such as the rotation out of semiconductor stocks and into software and
non-tech areas like energy during 2004. As companies continue to keep operating
costs tight, and that should lead to ongoing incremental improvements in
operating leverage. Growth cyclicals propelled out-performance in 2003 as
technology stocks began to discount the increased operating leverage in their
business models. So, a similar effect could provide an incremental boost during
2005.

 

To move the tech sector
meaningfully higher, there would need to be a significant and sustainable
improvement in top-line growth rates – particularly in the large cap techs, if
this is to contribute to large cap indexes like the NASDAQ. However, absent a
real increase in end-demand that seems unlikely and cost cutting can only propel
tech stocks so far. That said, modest technology drivers for certain technology
stocks might include increased consumer adoption rates, increased levels of
broadband access, higher adoption rates for wireless technologies, and a
continuing trend towards embedded intelligence (chips; storage, etc).

 

Looking Longer-Term: Some Technology Drivers For the
Next 3 Years

 

For the next three-to-six years I’d be gradually and
increasingly bullish on the fundamentals of technology companies. Some broader
long-term growth themes in technology with appeal include RFID, high definition
TV, tablet PCs, VOIP, TCP Ipv6, Wi-Max, and possibly GPS (global positioning
system).

 

RFID
(radio frequency identification) technology should exhibit growth in 2005. The
following year we should see RFID being adopted more rapidly, and it is closely
linked to fundamental improvements in the warehousing, logistics,
transportation, retail and some other sectors.
It’s too early
to say how far and how fast the proliferation will go. Right now, retail giant
Walmart uses RFID at the pallet level, but this particular company’s needs are
huge Mid-sized and smaller enterprises probably wouldn’t see much of an
advantage from using RFID. But if Walmart and other big retailers start to
enforce it (i.e., “you must use RFID to do business with us”) things could get
more interesting.
 

VOIP, Wi-Max,
and other related communications technologies. VOIP,
which enables
people to use the Internet a low-cost transmission vehicle for telephone calls,
could really take off in 2005 and there should be some good opportunities to
play this trend. There are a number of little stocks in this area, including
ALVR, DDDC, EGHT, IBAS, NRRD, and VOCL. My favorite for a longer-term position
is Wi-Max provider
(
ALVR |
Quote |
Chart |
News |
PowerRating).

 

 

Linux
begins to look more attractive, via stocks like RHAT, in 2005. So long as
consumer resistance continues to build against Microsoft’s relatively
weaker products, then Red Hat should continue to grow. Growth in Linux continues
at a steady pace, and according to some research is outpacing growth Microsoft
growth rates in the Asian regions.

 

 

TCP/IP-6.
The Internet currently operates with TCP/IPv4. Moving to IPv6 will enable and
stimulate the development of new applications. Ipv6 should also lead to IP
telephony on quite a large scale.

 

High
Definition or Digital TV
should experience more growth in 2004 and into 2005. Rather than play this theme
with stocks of the hardware manufacturers (like Sony, Mitsubishi, etc.) I’d look
at suppliers to these types of companies. One name I have liked in this space
since early 2003, and continue to like, is Spatialite, which trades on the
NASDAQ under the ticker HDTV.  The company develops liquid-crystal-on-silicon (LCoS)
micro-displays, which provide high-resolution images and are used in monitors
and TVs.

 

Melanie Hollands