Technology companies have bucked the trend in recent quarters, as their CEOs and financial managers have remained relatively bullish about earnings growth. But within weeks of the end of the third quarter, all that is changing, as economic uncertainty and the headwinds from sluggish growth in Europe, China and the United States take a toll on earnings projections.
The reporting season for the second quarter of 2012 is largely over, and with only a few weeks left in the third quarter, investors and analysts are already beginning to fret about what it and the rest of the year may have in store. Certainly, companies themselves have been strikingly conservative when it comes to the guidance they have offered; of S&P 500 companies that have provided the market with some thoughts about what they expect for the third quarter, 81 have posted negative comments while only 19 have been upbeat. That is the most bearish guidance ratio (4.3) on record since the third quarter of 2001.
Most strikingly, however, is what has happened to the outlook for the Information Technology sector. Until very recently, management teams in this industry were significantly more positive when it came to their earnings prospects than those of their peers in other sectors, as reflected in its generally lower negative:positive guidance ratio. (The second quarter ratio did end up being slightly higher than that of the S&P, but not by a significant amount.) In contrast, management fears for third quarter earnings appear to have risen dramatically of late, and today, as seen in the chart below, the guidance ratio paints a far more bearish picture of the universe of technology companies in the S&P 500 than it does of the earnings outlook for the S&P 500 as a whole.
Their anxiety appears to be well founded; a drop in the rate of earnings growth has accompanied the increased pessimism seen in this guidance ratio. Throughout the last 12 months technology industry earnings have held up remarkably well, and companies in this group have posted some of the most impressive rates of growth in profitability. Now, however, that earnings growth rate – which moved into the single digits during the second quarter, hitting 8.7% — is expected to slide still further, to 3.6%, for the third quarter of 2012. To be sure, that is better than the 2% decline in profits that analysts forecast for the S&P 500 as a whole, it’s a big change from the last several quarters, and can only be seen as bearish.
One reason that companies in the information technology sector have fared better than their peers when it comes to posting higher growth rates is the fact that they are the primary beneficiaries from a drive for increased efficiency across the corporate landscape. Cost-cutting initiatives mean a need for greater productivity as companies try to maintain or increase profit margins, and that is done primarily with the help of investments in technology. Meanwhile, consumers have been spending on technology, notably on smartphones and other mobile computing devices. But both trends appear to be slowing, at least for the time being, as customers delay purchases due to economic uncertainty or wait for a new generation of products to reach the market.
It is in this context that Applied Materials, Inc. (AMAT.O) estimated that its third quarter earnings will be only 3 cents per share, a sharp decline from the 12 cents that analysts had projected. The company, a major producer of semiconductor fabrication equipment, cited everything from European austerity and slow growth in China and the US, to seasonal factors. “We are feeling the effects of more pronounced seasonal buying as consumers wait for new smartphone and tablet models to be released”, said CEO Mike Splinter during the company’s earnings conference call. “With foundries representing about 45% of wafer fab equipment spending in 2012, the investment patterns of these customers are the single most important factor impacting our business today.” This shift in consumer demand also has had a large impact on the display manufacturing equipment division of Applied Materials; 100% of the orders in previous quarters were for equipment used to make mobile device displays. As the flat panel TV market matures, companies that supply electronic components will be more reliant on sales of mobile devices for growth.
Unlike Applied Materials, Cisco Systems Inc. (CSCO.O) didn’t rattle the market by providing drastically lower guidance; its forecast fell within the range analysts had anticipated. Cisco, too, however, has seen an impact on its business from this kind of cyclical pattern, and CEO John Chambers discussed various other difficulties that he expects to affect the company in the coming quarter. Europe, he says will “continue to be very challenging over the next several quarters”, as well public spending by governments worldwide, particularly in the United States and Europe. Moreover, he added, “many of our customers continue to anticipate a challenging next 12 months on a global basis, and therefore these CEOs will remain conservative both in their IT expenditures but also in their hiring.”
Analog Devices, Inc. (ADI.O), which makes signal processing circuits, guided analysts lower last week, trimming two cents from the consensus forecast by analysts that it would earning 59 cents a share; this would mark a 4% reduction in earnings from year-earlier levels. Analog Devices supplies a wide variety of components to automobile manufacturers; the slow new car market in Europe is hurting sales. The weak economies in major markets, especially in Europe, makes planning difficult, the company said. Jerry Fishman, the company’s CEO told listeners to the earnings conference call that the company’s distributors have warned it that they see “a wide range of possible outcomes” for the quarter ending September 30.
This increasingly downbeat guidance from companies in the Information Technology sector reflects the uncertainty governing the economic outlook as a whole for the third quarter and beyond. Across the board, companies have cited the European sovereign debt crisis, the fiscal cliff in the US, and unknown future growth in China as reasons for delaying investment and hiring decisions. Now that the technology sector also seems to have succumbed to the same pressures, it is hard to tell whether more robust earnings growth forecasts for the fourth quarter of 2012 and into 2013 are reasonable. Certainly, the prospect exists that these economic headwinds will continue to create an environment of uncertainty, postponing spending on the part of companies and consumers and curbing earnings growth prospects for the rest of the year.
For more insight into third-quarter earnings trends, please see this commentary by analyst Jharonne Martis-Olivo.
