Fitch sees IT budgets flat for 2002, weak outlook for telecom markets

Nashville, Tenn., Dec. 13 - The unprecedented technology downturn in 2001 along with a deteriorating worldwide economy resulted in weaker credit protection measures for technology issues and caused a significant number of negative rating actions, noted Fitch in a report Thursday in which the rating agency said it expects IT budgets to be flat in 2002 and the outlook for the telecom markets to remain weak.

With extraordinary speed, end-product demand dramatically slowed in 2001, and the decline in the telecom market caused a domino effect throughout the technology sector with almost all segments, especially equipment makers, showing significant deterioration in financial results and limited visibility regarding future order patterns. Noted Fitch credit analysts Brendan Buckley, Nick Nilarp and P. Martin Ressinger in the report.

Rapid growth of the internet over the past couple years resulted in service providers aggressively expanding "Companies have reacted with significant cost restructuring programs, which included headcount reductions and closing of facilities as well as aggressive working capital management to offset deterioration in profitability. While Fitch believes these expense and capital savings programs should continue to have a significant impact on operating results in 2002 the bigger question is when will end product demand return for the technology sector," the report said.

"Fitch's expectations for 2002 are for corporate information technology (IT) budgets to be flat to slightly down as most companies will continue to operate below optimum capacity utilization levels, pricing pressures remain severe, the outlook for the telecommunications market is projected to be weak, and the timing of a recovery in demand is uncertain. Therefore, the resultant credit outlook for technology companies remains uncertain. For companies currently on negative outlook, a prolonged recession and an inability to achieve improved profitability and balance sheet improvement could lead to additional rating actions."

However, it is important to analyze specific segments within the technology sector as each exhibits specific credit attributes, the analysts said.

With uncertainty ahead for at least the next few quarters, the computer hardware industry continues to experience severe price competition as well as negative unit growth in most sectors. This is resulting in headcount reductions, closing of facilities, and restructuring charges. Participants must cut costs dramatically to be able to offset margin erosion to weather this pricing and lower demand environment, the analysts said The risk for hardware manufacturers is that commoditization will extend beyond the PC segment to low-end servers such as 2-way, 4-way and possibly, the 8-way server products. There is less risk of commoditization in the high-end server segment, where companies compete on capability and value-added services rather than price.

The severity of demand decline that the telecommunications equipment industry suffered in 2001 is not expected to stabilize in the first half of 2002. Most estimates indicate that this segment will shrink by 15-20% in 2002 as demand remains pressured resulting from service provider overcapacity, especially in North America. Additional concerns include a lack of capital availability for start-up telecom providers and a continued weak economy. More so than the other segments, communications equipment companies have been forced take significant write-downs to goodwill as a result of overly aggressive acquisitions in recent years, which have negatively impacted their capital structures. Fitch expects more pricing pressure in 2002, which may further depress margins, continued product line consolidation, limited financial flexibility, and event risk associated with significant internal restructurings.

Despite the technology downturn of 2001 and the weaker overall economy, companies in the IT services industry continue to perform better than other technology segments due to the industry's long-term contracts, which support a recurring revenue base, Fitch said. Currently, IT services companies are considered to be a safe haven in the technology industry as volatility remains low, the strong cash-generating capabilities are increasing overall financial stability in the face of an economic and industry recession, and there is a robust pipeline for contracts, especially from the government sector. Fitch expects the credit trends for the industry to remain relatively stable in 2002 and possibly improve as contracts get booked and as the economy recovers.

The prolonged, significant reduction in demand from the electronic manufacturer services industry's existing customers weakened the financial profile of the sector in 2001 and will likely continue in 2002, as limited visibility in the marketplace persists, the Fitch analysts said. Adverse market conditions are expected to continue, especially if outsourcing contracts do not materialize from new customers or industries. If companies in the EMS industry are unsuccessful in the execution of planned cost reductions, facilities rationalizations, and restructuring actions, credit ratings may be further negatively impacted, the analysts noted.

It is not clear that the semiconductor industry has yet bottomed. Regardless of the timing of the recovery, Fitch believes that it is important for semiconductor vendors not to focus solely on near-term operations through the downturn, but also to plan strategically for the inevitable turnaround. The first priority for these vendors is to deplete remaining excess inventories, and the second is to recalibrate production to a more rational expectation of demand, the Fitch analysts said. Key considerations as to how well companies will emerge from the downturn center on the strength and proactiveness of the management teams, the strength of their capital structure, financial flexibility, security of product positioning, intellectual property position and ability to reduce commoditization.

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