December 7, 2010 – Enterprise IT Spending: Worry About the Government

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If enterprise IT spending were to follow closely to historical precedent, we might expect the rebound from the exceptionally weak 2009 to accelerate going forward.  Strong corporate earnings and modest economic growth ought to be enough to signal a pick-up for tech.  However, we believe that several unusual conditions may yield unexpectedly slow spending.  First, government spending in most geographies and levels appears to be under unprecedented pressure that may take years to abate.  Second, political uncertainty and weak employment may dampen corporate spending despite strong earnings.  Third, a sea change underway in the technology landscape raises stakes for IT investment decisions, prompting caution.  As such, we are pessimistic for a near term rebound in enterprise technology growth, particularly for companies with disproportionate exposure to the PC value chain or to government spending.   Near term growth is more likely from consumer-driven tech, particularly related to portable platforms, wireless broadband, and high performance delivery of cloud-based applications

Over time, changes in enterprise IT spending have shown close correlation to changes in the overall economy and to corporate earnings.  To that end, projected 2010 U.S. GDP growth of 2.6% and global economic growth forecasted at 4.8%, coming after economic contraction during the official recession of 2008-2009, should be a bullish sign.  Similarly, year over year S&P500 EPS growth of 55.6% during the first 3 quarters of 2010 reverses a decline of 19.9% over the same period in 2009, establishing a historic peak in large cap profits.  Ordinarily, this would presage accelerating tech spending

However, government spending, roughly 18% of the enterprise IT market, presents a major problem.  Years of deficit spending, at every level and in nearly every corner of the developed world, has raised the stakes to crisis level in municipalities (e.g. Detroit, MI and Harrisburg, PA), states (e.g. California, Illinois, New York and New Jersey), and countries (e.g. Greece, Ireland, Portugal and Spain).  Even governments without risk of insolvency strain under the burden of unprecedented indebtedness, and potentially, assumed responsibility for the troubles of constituent states and municipalities, or of other countries affiliated through economic union.  With battle lines drawn by labor, looking to protect jobs, pensions and benefits, discretionary government IT spending would appear at serious risk.  As governments have historically accelerated their IT investment at moments of economic weakness, a strong downturn would weigh heavily on the technology industry

We fear that an environment of government austerity, political instability and stubborn unemployment will also have a detrimental effect on corporate IT investment.  We note that government tax policy, such as allowing technology investments to be expensed rather than depreciated, could work to counteract spending caution

At the same time, the IT industry is at its own crossroads, as thin devices, wireless networks and network hosted applications are just beginning to displace the PC-centered client server architecture that has dominated enterprise IT for more than 20 years.  This tectonic plate shift is reminiscent of the late ‘80’s, when the denouement of the dumb terminal, departmental mini-computer, corporate mainframe gave way to the PC era.  Then, as now, the large cap champions of the older architecture struggled, while spending on the new generation fueled fast growing upstarts, but was yet insufficient to prop up the whole sector.  We expect IT managers to be cautious during the transition, stanching spending on desktop upgrades while taking only measured steps toward clouds, netbooks and tablets

We expect market conditions to be particularly vexing for companies with disproportionate exposure to government spending and to the now traditional PC-centered client server architecture.  Amongst large cap companies, PC oriented firms like Hewlett Packard, Dell, Intel, and Microsoft are positioned in this way

In contrast, we prefer companies with less than average exposure to these markets, particularly if they have focus on key elements of the emerging portable/cloud computing paradigm and critical mass in addressing the more vibrant consumer market.  We see smartphone/tablet device architecture, wireless broadband, content delivery networks, distributed public data centers, and cloud applications and infrastructure as the most important building blocks.  Against this, Apple, Google, Qualcomm, Amazon, Salesforce.com, and other similar companies all appear well positioned

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