Enterprise IT Spending: Worry About the Government
December 7, 2010
Enterprise IT Spending: Worry About the Government
- 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
The Voyages of the Starship Enterprise
Every quarter technology investors engage in an arcane dance of triangulation, parsing off-hand earnings call comments, 10K footnotes and the rumor du jour to assess the state of enterprise spending. In previous decades, this agitation would have been largely unnecessary, as IT spending consistently outpaced GDP over nearly any interval, with only slight blips around the recessions of 1982 and 1991. However, the bursting of the Internet bubble in 2000 precipitated nearly three years of declining IT investment, with another sharp downward move in 2008. From the beginning of 2000 to the end of 2009, IT lagged GDP growth by more than 250bp after having beat the overall economy by at least 260bp in each of the three preceding decades (Exhibit 1).
Of course, once the Internet bubble correction reached its end in 2003, technology spending accelerated rapidly, outpacing GDP strongly until the 2008 drop gave back much of the lead. The acceleration was even stronger coming out of 2009. With corporate earnings showing dramatic recovery out of the recent recession, the environment would appear conducive to IT spending growth remaining above the overall economy.
Cloudy, With a Chance of Meatballs
While IT spending shifts have had a historical correlation to changes in corporate earnings, they have had a similarly close correlation in the other direction to changes in unemployment, and an even stronger relationship to changes in GDP (Exhibits 2, 3 and 4). With economic recovery sluggish and unemployment stubbornly high, investors are likely correct to be cautious, yet recent strong earnings results have pushed tech bellwethers to unusually high multiples. The question is whether this is a buying opportunity or a value trap. While we do see significant value in companies that will benefit from a comprehensive transformation of the paradigms that have shaped the last thirty years of the technology, media and telecoms landscape, we believe that enterprise spending, specifically, could be seriously disappointing in the next several quarters.
Ain’t Nuthin’ But a G Thing
From 2000 to 2009, global spending by governments on IT rose from just under 12% of total IT spending to more than 17% of the total, rising at a nearly 9.6% CAGR, while all other enterprise IT spending grew just 3.6%. Importantly, government spending remained strong during the economic downturns at the beginning and end of the decades, helping to blunt the impact of weak technology investment in the private sector. However, increased dependence on government customers can be viewed as more of a liability under current circumstances.
Cisco’s earning call – closely watched both because it is widely held and because it adds a month to the industry reports that come in the weeks before it – specifically called out weakness in government spending that emerged late in the company’s quarter. In retrospect, perhaps the biggest surprise is that it took so long for the technology industry to see the impending gloom.
Rain, Rain, Go Away
In most corners of the world, the tide has turned strongly against government spending of all types. The costly European bailouts of Greece and Ireland, the questionable solvency of other EU members, such as Spain and Portugal, and the austerity budgets that have driven protestors to the streets of Paris and other European capitals certainly cannot be harbingers of robust technology investment. Every one of the G20 nations is running a deficit in 2010, including not the veteran deficit spenders of Europe and North America, but also all four BRIC nations, led by India with its deficit running at more than 8% of its GDP (Exhibit 6). The net debt of Germany, the UK, France, the US, Italy and Japan are all more than 45% of GDP, with Japan topping 100%.
The indebtedness of the US has become a cause célèbre in the wake of the Tea Party assault on the elections of 2010. The Federal deficit has reached more than $1 trillion with the national debt now pushing $14 trillion (Exhibits 7 and 8).
State and local governments in the US have collectively run at deficit in every year since 1986 and hold debt of more than $1.8 trillion (Exhibit 9 and 10). The picture at the state level would be worse were it not for more than $100B in Federal stimulus spending granted to support state budgets.
This does not include off-balance sheet liabilities for public employee pensions and post-retirement benefits. Kellogg School of Management professor Joshua Rauh has estimated unfunded liabilities of roughly $3 trillion at the state government level and another $574 billion from city and county governments. This is a triple whammy for taxpayers in cities like Chicago and New York, who will be asked to bear the costs of local liabilities of about $40K per household, on top of their responsibilities for state and Federal retirees and their share of government debt (Exhibit 11). These numbers are higher than those endorsed by the governments themselves, as the official numbers typically make unrealistic assumptions about the performance of funds invested to fund future payments. This has also been the impetus behind increase risk taking in the management of public pensions – equity has increased from 65% of assets in 2000 to 66.8% in 2009 (Exhibit 12). Given the defined benefit aspect of public pensions, this risk is entirely borne by the taxpayer.
Adding local, state and Federal liabilities, both on and off balance sheet, yields nearly $20 trillion, or more than $170,000 per household on average. Given the median household income of $49,777, the average American taxpayer would work nearly 3 and a half years to earn an even share of these liabilities. Given this, and the attention now being paid to the issue in the political spotlight, it would seem obvious that technology firms cannot count on a continued stream of government spending from any direction.
The Corporate Pocketbook
In 2010, enterprises, including government entities, did step cautiously back into IT spending. According to Gartner, IT spending is forecast to be up about 3% in 2010 after falling 6% from 2008 to 2009. Looking forward, we are not convinced that corporate spending growth will be sufficient to offset weak government outlays, at least for the next year or two. With the unusual economic uncertainty associated with the prolonged unemployment crisis and the reckoning of government budgets, we expect corporate decision makers to remain cautious on projections of recovery and thus, cautious on their discretionary technology spending.
Moreover, the tectonic plate shift of technology architectures away from the now classic PC-driven client server approach to portable devices, fast network and cloud-hosted applications may yield short term indecision on the part of CIOs. Enterprises are taking baby steps toward the cloud, focusing on specific applications particularly well suited to the cloud, such as sales force management systems, and moving incrementally to virtualized implementations on internal data center servers. At the same time, investment in desktop upgrades may be muted. Together, the cautious transition to the new architecture and reduced investment in old platforms is unlikely to add up to a robust near term enterprise spending recovery.
Does Anybody Win?
Gartner is projecting global enterprise IT spending growth of 3.7% for 2011, a modest acceleration from 2010. Given the factors mentioned above, we believe this forecast could prove to be somewhat optimistic. Consensus expectations for revenue growth for the 160 largest US tech companies at 12.8% may be even more optimistic. We are particularly concerned for companies with disproportionate exposure to government spending, reliance on PC client/server architecture and expectations of above average growth. In this, services-oriented companies, such as IBM or Accenture, may be less at risk, given long annuity-like contracts and the focus on reducing overall government expense, while equipment and software outlays for new systems and incremental upgrades may be under particular pressure. In contrast, we prefer companies that focus on the global consumer, where technology spending continues to take share from other discretionary categories, and on the portable/cloud architecture (Exhibit 13).