Location: New York
Author: Nick Nilarp
Date: Monday, December 10, 2007
Fitch 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.
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.
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 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.
Fitch believes the majority of rating actions for the U.S. technology sector in 2008 will occur in the IT Services and EMS sectors. The credit outlook for IT Services is generally stable, as Fitch's coverage currently includes companies with positive and negative Outlooks, all of which Fitch believes will be resolved in 2008. Increased share buybacks, potentially debt-financed acquisitions, and event risk of altered capital structures are all credit concerns for 2008. Fitch continues to focus primarily on the quality and sustainability of free cash flow and investment requirements for contract signings. EMS is the one and only sector where Fitch has a negative outlook for 2008 due to continued operational challenges and increasing competitive threats. These companies are the most likely to experience weakened operating and credit profiles, potentially leading to negative rating actions. Opportunities for meaningful debt reduction appear unlikely, although EMS companies have been able to generate free cash flow from working capital in a declining revenue environment.
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.
The 2008 operating and credit outlooks for the IT services industry are stable, despite company-specific issues influencing the credit outlooks for a few companies. Fitch believes acquisition activity by strategic buyers in the IT services industry will accelerate in 2008 due to pent-up demand, potentially replacing share repurchases as the primary use of cash. As the vast majority of companies within Fitch's rating coverage have dramatically scaled their offshore delivery resources, Fitch believes future acquisitions will primarily be designed to diversify service line mix or add capabilities in targeted vertical markets.
The stable operating outlook is driven by expectations of total IT services market growth in the mid-single digits supported by a healthy pipeline of transactions particularly from the government sector. However, Fitch remains cautious about growth, due to increasing economic uncertainty in the U.S. which could dampen demand for consulting services. Also, commercial outsourcing signings will continue to be pressured by the increasing competitiveness and scope of services offered by India-based vendors, escalating commercial demand for lower-priced offshore services, and greater use of multi-sourcing. Although, the long-term nature of outsourcing and infrastructure services contracts result in a recurring revenue base and consistent cash-generation even in a lower growth environment.
The 2008 credit and operating outlooks for the hardware sector are generally stable with a potentially negative bias for less diversified hardware manufacturers, with respect to product portfolio, industry concentration and/or geographic perspective, due to uncertainty associated with the economic environment, particularly in the U.S. Fitch expects hardware revenue growth in the low-single-digit range for 2008. Commercial hardware spending in the U.S. could also be constrained by the financial services vertical, which is the worldwide leader in terms of IT spending. The turmoil in the financial services sector poses downside risk to the server market in 2008, since it accounted for nearly 25% of worldwide server revenue in 2006, according to Gartner. The three server vendors with the greatest exposure to the financial services vertical includes IBM (45% share of financial services total server revenue in 2006), Hewlett-Packard (27%) and Sun Microsystems (9%). Acquisition activity is expected to continue as companies seek to diversify into higher-margin, recurring revenue offerings such as software and IT services.
Fitch believes worldwide personal computer (PC) unit demand will moderate slightly from 2007, but remain solid, growing at approximately 10% in 2008 versus expected growth of approximately 12% in 2007. Fitch expects PC demand in 2008 to be driven by the continued shift to notebooks from desktops and solid demand from consumers (especially internationally) and emerging markets. Fitch believes the PC market is increasingly reliant on emerging markets for growth, as U.S. demand, which accounts for approximately 27% of worldwide unit sales, will likely moderate in 2008. Worldwide server unit growth could slow in 2008 due to enterprises' implementation of virtualization and multi-core processors in the data center. Fitch expects total worldwide revenues from commercial disk storage systems to increase in the mid-single-digit range for 2008 and revenues from consumer-oriented storage products to grow in excess of the commercial growth rate due to expansion of consumers' digital rich media portfolios.
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.
For further analysis of Fitch's 2008 Global semiconductor outlook, see the Fitch press release titled 'Fitch: Consumer Electronics Key to Stable 2008 Semiconductor Outlook,' available on the Fitch web site at 'www.fitchratings.com'.
Fitch expects the credit profiles of the IT distributors to remain fairly stable in 2008 with the potential for modest debt issuance offset by continued growth in EBITDA and free cash flow. Lower growth expectations for semiconductors and IT equipment could test the distributors' ability to manage cyclical downturns particularly in regard to the semiconductor exposure at Arrow and Avnet. Fitch believes that since the last industry downturn in 2002, the distributors' increased diversification, geographically and by end-market, as well as improved inventory management systems, should reduce the variability in results going forward. With no meaningful industry maturities in 2008, Fitch expects debt issuance to be driven by further acquisition activity and potentially some shareholder-friendly actions, which Fitch expects would become increasingly likely if the stocks of the distributors are affected negatively by broader market concerns. Acquisitions will likely continue to be a priority, continuing a trend of consolidating market share and international expansion.
Fitch expects Anixter (rated 'BB+', with a Stable Outlook) to continue to demonstrate strong results although negative macroeconomic trends could limit organic growth rates in 2008. However, slower growth should drive higher free cash flow which would help mitigate any need for additional borrowings due to acquisitions or shareholder-friendly actions. Tech Data (rated 'BB+', with a Stable Outlook) has achieved improved operating results in recent quarters including strong free cash flow trends which, if continued into 2008, could lead to positive rating actions.
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' (rated 'BB+', with a Negative Outlook) 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 (rated 'B+', with a Negative Outlook) and Sanmina (rated 'B+', with a Negative Outlook) 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.
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.
Fitch's outlook on the payment processing industry is stable, balanced by continued modest organic growth with increased debt issuance, primarily related to merger and acquisition activity. Fitch expects modest revenue growth in the mid to high-single digits over the next several years, driven by general economic growth and a continued transition toward a higher mix of electronic payment transactions. Given the fragmented market share across much of the payment processing sector, Fitch expects continued acquisition activity. In addition, share repurchase programs financed primarily through the use of free cash flow remain a significant part of most companies' capital allocation strategy reflecting the high free cash flow nature of the financial model for most of the companies in this sector.
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