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Fitch Ratings: 2009 Concerns for U.S. Technology
December 4, 2008 |Estimated reading time: 7 minutes
NEW YORK Fitch Ratings put out its outlook for a majority of U.S. information technology (IT) sectors as negative for 2009. Sectors such as EMS and IT distributors will be affected by an economic downturn from a profitability standpoint, but this decline has historically been offset by working capital improvements, Fitch asserts.
Weak market demand drives Fitch's "Outlook for 2009" as capital investments decline and consumer spending will be pressured significantly. The financial services vertical, which is the worldwide leader in terms of IT spending, is expected to experience the most severe reduction in spending with the hardware sector being most affected. IT services/software is the only segment that currently has a stable outlook. Fitch expects the semiconductor industry will experience a decline of high-single digits with personal computer (PC) and mobile handset units flat to down in the low-single digits for 2009. As a result, the worldwide technology industry overall could experience a decline of approximately 23% with many companies achieving substantially worse revenue declines for 2009. Geographically, Fitch expects the U.S. and Western Europe to decline greater than average, offset by relative strength in emerging markets.
Concerns for the industry center on profitability challenges, demand uncertainties, and potentially higher debt levels, all of which could deteriorate credit protection measures. Although balance sheets remain solid and industry financial flexibility is adequate, industry cash levels in excess of $250 billion will be pressured in 2009 driven by top-line and resultant profitability declines. Total industry debt is also expected to increase in 2009, surpassing the record 2008 level of more than $220 billion. In 2009 Fitch believes the maturing technology industry will continue to experience solid acquisition activity from strategic buyers, particularly for the software and IT services sectors, and potentially, though less likely, the EMS and distributor sectors.
Fitch believes the backlog of debt issuance continues to increase, indicating debt levels may rise in 2009 as companies examine issuing debt mostly due to difficulties accessing offshore cash in a tax-efficient manner. Refinancing deals will also drive debt issuance as the industry has approximately $25 billion of debt maturing in 2009. Longer term, Fitch believes a technology company's cash balance components and location will become increasingly important for liquidity and leverage analysis, whereby a partial net debt analysis may have to be weighed for companies issuing debt in the U.S. for tax efficiency reasons while cash overseas grows.
While there are longer-term concerns for companies with significant amounts of debt and those who are experiencing operating challenges, Fitch does not expect a significant increase in the number of defaults over the near term.
With a few notable exceptions, liquidity for the technology sector is generally solid, and supported by strong cash balances and pressured free cash flow (FCF), providing a cushion to address potential liquidity issues. Fitch estimates that more than $100 billion of the industry's $250 billion in cash is located overseas. In the near term, Fitch expects industry cash to remain at current levels as the state of the credit markets requires a prudent approach to utilization of excess liquidity. Fitch continues to consider the various geographic locations of a company's cash position as well as the portfolio breakdown of the cash and marketable securities for liquidity analysis.
Since approximately half of technology issuers are on negative outlook, Fitch believes negative rating actions for the U.S. technology sector could occur throughout 2009, with a limited number of higher-rated companies remaining unaffected by market demand uncertainty.
The technology industry's revenue base is correlated to general economic conditions, although some sectors will suffer more than others. For example, hardware is most susceptible to a downturn and exposure to the financial services sector while most IT services and software companies receive a significant amount of predictable recurring revenue and free cash flow from long-term contracts or maintenance streams, resulting in a stronger capability to withstand an economic downturn. Sectors such as EMS and IT distributors will clearly be affected by an economic downturn from a profitability standpoint, but this decline has historically been offset by working capital improvements.
According to Fitch, the worldwide IT spending environment will decline 23% in 2009, led by hardware and semiconductors with the $1 trillion IT services and software sectors remaining fairly stable. While there is limited visibility for worldwide demand, Fitch believes declining macroeconomic trends (Fitch 2009 GDP forecasts: -1.2% U.S., -0.6% Euro Area, 5.7% BRIC) could pressure companies that lack product depth and geographic revenue diversity. While the small and medium business (SMB) market has been a source of growth and strong focus of the IT industry the last few years, Fitch expects this market to contract in 2009 and possibly result in additional receivables write-offs.
Fitch's negative outlook on the EMS sector largely reflects expectations for a weakening global economy to pressure operating results, particularly due to revenue declines in IT hardware and consumer electronics. The sector's ability to sustain profit margins near current levels and produce positive net returns on capital will be challenged in the weakened economic environment. Conversely, solid liquidity and minimal near term maturities for the EMS companies in Fitch's coverage universe should provide significant margin in managing through this downturn. Fitch expects macro-economic weakness to be partially tempered by the secular trend of increased outsourcing of manufacturing by OEMs, particularly in non-traditional end-markets.
Fitch expects EMS companies to conserve cash and liquidity (augmented by reduced working capital requirements in a declining revenue environment) while minimizing leverage through the downturn. The incurrence of significant incremental debt, depletion of existing cash, or use of excess cash and free cash flow generated from reduced working capital requirements to finance acquisitions or shareholder friendly actions could have negative ratings implications as these events are factored in to current ratings. Flextronics International and Jabil Circuit Inc. have significant exposure to the IT hardware and consumer electronics segments (approximately 85% and 71% of total revenue, respectively) but remain the best positioned in the industry with solid liquidity. Celestica Inc. with less than 10% of total revenue sourced from non-traditional end-markets, retains a net cash position of nearly $500 million. Sanmina-SCI Corp. generates approximately 25% of its revenue from non-traditional markets and has $870 million of cash with the nearest maturity in 2010. However, Sanmina-SCI has been losing market share in its remaining EMS business, which has resulted in declining revenue for most of the past two years, a trend which Fitch believes could be exacerbated by the economic downturn in 2009, Fitch asserts.
Fitch's 2009 outlook for the semiconductor industry is negative due to a meaningfully weaker macroeconomic environment which Fitch believes will result in lower revenues for all semiconductor makers, driven particularly by the aforementioned pressures in PC and mobile handset units, which represent nearly 60% of global semiconductor consumption. While the overall market will be lower, Fitch expects developing economies will experience lower albeit still positive unit growth. Analog companies, typically less susceptible to industry cyclicality, will be negatively impacted by reduced global automotive production schedules and ongoing significant weakness expected for industrial products.
Overall, Fitch expects global semiconductor industry revenues, including memory makers, to decrease in the high single digits in 2009 from modestly negative revenue growth in 2008. Excluding memory makers, Fitch believes semiconductor industry revenues will decrease in the mid single digits, given that memory makers are more exposed to consumer electronics. The analysts expect the more volatile semiconductor equipment industry will experience revenue declines in the high teens and beyond. While this will mark the industry's first revenue decline since 2001, the company does not expect revenue declines to be on the same magnitude as those of 2001 (~30%). However, Fitch notes the semiconductor industry remains volatile and believes there is more down- than up-side risk to current expectations. From a business and operating profile standpoint, semiconductor companies continue to be subject to the highest technology risk within the technology industry.
Fitch expects the printer (excluding supplies), PC, and server markets to be most adversely affected hardware segments in the near-term economic turmoil as enterprises lengthen PC and printer refresh cycles and reallocate resources to improve the usage and efficiency of their existing IT infrastructure, including virtualization, systems management and automation, and data de-duplication software, in lieu of purchasing new equipment. Therefore, Fitch projects worldwide PC unit growth of 0% to -3% in 2009. Gross margins are likely to weaken in 2009. Furthermore, shifts in product mix could also undermine issuer profitability, including the potential cannibalization of notebooks from low-cost notebooks and declining sales of high-end servers to the financial services industry.
For more information and full ratings of companies in the sector, see www.fitchratings.com.