Results were largely in-line with expectations; however, expectations were low and many companies provided soft guidance and cautious outlooks. We believe the semiconductor and IT hardware subsectors are experiencing weakness as customers delay purchases and reduce spending in light of macroeconomic and tariff concerns. The semiconductor and hardware companies are particularly exposed to the tariff concerns given their global supply chains and significant manufacturing presence in China. Weakness was most pronounced among large enterprise customers and Chinese customers. Outlooks call for weakness persisting through 2019 and into 2020. In contrast, the software companies remain healthy and provided much more robust outlooks, reflecting software’s limited exposure to the trade war and increasing demand for cloud/data services.
Our Industry Assessment is supported by:
Level of Competition
Competition varies across subsectors. The largest tech names, including MSFT and GOOG, face modest competition and enjoy minimal risk of market share losses. Hardware companies face increasing competition from cloud services and increasing product commoditization.
Antitrust scrutiny remains high and the significant amount of mergers and acquisitions (M&A) in the technology sector means regulators play an important role in determining which transactions are allowed or disallowed.
Gross leverage has increased for many constituents in the sector due to debt funded share buybacks, driving balance sheet deterioration. The strong free cash flow generation and large cash balances many tech companies maintain reduces the impact these share buybacks will have on credit profiles.
M&A activity remains elevated in the sector. Some of these transactions are reasonable and are good strategic fits (FISV/FDC and FIS/WP) but other transactions occur at stretched valuations (Red Hat acquisition price = 52x earnings before interest, taxes, depreciation and amortization).1
Environmental, Social and Governance (ESG)/Transformational Risk
Technology is a rapidly evolving sector, which limits long-term visibility for even the most established firms. The sector requires continuous innovation to remain relevant. This is balanced by the often-sticky nature of customer relationships allowing market leaders to better defend their position. Growing areas of the technology sector (cloud services, security) create opportunities for businesses to adjust to transformational risks. Key ESG Factors: Litigation regarding anticompetitive behavior, customer privacy policies, and material sourcing risks are relevant for the sector; however, the magnitude of ESG risks in technology remains modest compared to other sectors.
Position in Credit Cycle
IT spending is forecast to grow in the low to mid-single digits for 2019.2 Cloud services revenue is expected to grow faster and represent a major growth driver for the sector. Spending will be weaker for on-premise IT infrastructure, and tariffs are expected to reduce growth across the technology supply chain for companies exposed to China. Recent sector growth trends have been negatively affected by a downswing in the semiconductor space, which will correct as inventory stockpiles decline.