Quick Thoughts: The Rain in Spain (and Greece, and Italy, and …)

sagawa

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–          European economic turmoil will undoubtedly affect tech, an inherently global sector with 30% of industry revenue coming from the region

–          The impact on individual companies is a product of their individual geographic exposure, but also their participation in relatively robust new paradigm businesses.

–          Short term Europe-driven shortfalls are likely buying opportunities for well positioned companies, like the major platform owners, Apple, Google and Microsoft.

 

Given recent economic turmoil in Europe, companies across all sectors of the economy have raised flags about macroeconomic uncertainty in earnings releases and forward guidance. Under these fair warnings of instability within the Euro zone, I expect the severity of impact to vary for companies depending not only on their sales exposure to Europe, but also their positioning within the new TMT paradigm shift.  Amongst US companies, 15% of S&P500 constituent revenues and 23% of industrials revenues derive from Europe, but tech companies have a greater exposure to Europe at roughly 30% with some subsectors likely even higher – for example, PWC estimates that 36% of global software sales are in Europe.  This disproportionate exposure puts technology stocks squarely in the spotlight as the Euro currency stands at risk and austerity measures are being adopted even by the most stable European economies.

Assessing the European exposure of the 69 tech constituents of the S&P 500, companies with no direct end markets in reporting revenue – semiconductors, contract manufacturers, and other component makers – were removed. These companies typically sell through channels that ultimately reflect a step in the manufacturing process, not end users and those most likely to be affected by a financial crisis in a geographical region. Financial companies like Visa, Mastercard, Western Union, etc, that are considered to be tech companies by S&P, were also removed. SAP, Amazon, Disney, News Corp, and Time Warner were added in. The result was 38 companies representing just over $2.2T in market cap and $928B in aggregate revenues, $274B of which – around 30% – is sourced from Europe. Tech companies have highly portable brands that can be exported with the click of a button. Software can be sent through the web across a border in an instant, while hardware is the result of design and manufacturing efforts across several countries before reaching a consumer. A device can be designed in the US, components sourced from various foundries across the globe, assembled in China, and shipped directly to an end user in Europe as is the case with just about all Apple products.

 

Within our screen, European exposure wildly varies with SAP, Electronic Arts and Accenture at the upper extreme, sourcing more than 45% of revenue from the region and companies like ADP, Time Warner, Yahoo and Motorola Solutions generating less than 15%. However, most companies fell into one of two clusters – a group with roughly a third of revenue from Europe, give or take a couple of percentage points and another with more like a quarter of sales exposed, again give or take a few percentage points.  The 30%+ crowd includes SAP, HP, Google, eBay, Oracle, IBM, Adobe, and Microsoft. The companies clustered between 22-28% European exposure include Citrix, EMC, CSC, Apple, Dell, Red Hat and F5 Networks (Exhibit 1).

While it is obvious that, all things being equal, less exposure is better than more, all things are not equal.  First, the exposure numbers do not give any hint as to the split between the toxic economies of Southern Europe and the relatively robust North.  Second, spending by enterprise IT, consumers and advertisers may not be effected simultaneously or equally.  Finally, new paradigm businesses, which are taking market share from older platforms, may not be as badly affected by the economic crisis.  For example, Google with its new paradigm focus on digital advertising may not be as vulnerable as its ~36% European exposure might suggest.  According to the Interactive Advertising Bureau Europe, digital ad spending reached 20.9B Euros in 2011 with search seeing the largest growth at 17.9%. eMarketer expects ad spending in Europe to grow by 2.8% in 2012 driven by the London Olympics and the UEFA soccer tournament.  It may also be true that weakness in Europe may be offset by gains in other regions.  Apple’s exposure to Europe fell by 300bp between 2010 and 2011 to 25.7%, largely because of faster growth in other regions. During the same period, Apple’s European revenue still grew at 48.6% driven by iPhone and iPad sales in the region.  EBay may actually benefit from European economic woes as consumers turn to second hand merchandise in times of austerity.

 

For companies already struggling with the weight of the shift from PCs and other moldering platforms, the European crisis is kicking them while they are already down.  38% of Hewlett Packard’s recent PC sales have been to Europe – at last Dell will get benefit from its historic lack of success on the Continent with its relatively modest 25% exposure.  Enterprise IT stalwarts like Oracle, BMC, and IBM, all with better than 31% sales from Europe face downside risk as austerity crimps IT budgets.  Even if the economy were healthy, I would not be enthused with the prospects for traditional PCs and data center IT.  The European crisis makes it that much worse.  Interestingly, Accenture, with its gaudy 45% exposure may at least have the benefit of long-standing contracts and a business that is focused on helping its customers reduce costs.  This may also be a saving grace for IBM, which manages to straddle the line between old paradigm and new.

Despite the growing shadow of Europe on the tech sector, I remain nonetheless encouraged by the relative cheapness of the sector, particularly, the cheapness of stocks at the forefront of the paradigm shift.  Europe fever may well yield a few quarterly misses or disappointing forward guidance on the next round of conference calls, but for well positioned new paradigm stocks, I would view any strong market reaction as a buying opportunity.

For our full research notes, please visit our published research site.

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