INFORMATION TECHNOLOGY SECTOR ANALYSIS

1
INFORMATION TECHNOLOGY SECTOR ANALYSIS

• Anu Shultes
• David Ferguson

2
Recommendations

• Maintain Current Weighting of 9.54, which is
  4.8 under weighted compared to the SP 500
• Why? P/E, P/B, and P/S remain high compared to
  other SP 500 Sectors (as of 12/31/01)
• Projected flat to declining corporate spending in
  2003 on information technology may dampen returns

3
Size CompositionSector Weights
4
Size CompositionIndustries w/in Info Tech
Sector
Sector Profile The top 4 industries have sector
leaders with market caps approx. 2X the nearest
competitor
5
Business AnalysisDemand Factors

• Phase of Life Cycle Growth/Pioneer
• Industry maintains a very high P/E, P/S and P/B
  ratios along with a very low payout. Total PCs
  shipped recently surpassed 1B, expected to double
  in 8 years. There also remains the possibility of
  the next great invention (i.e. nano-technology)
  which could result in another Pioneer phase.
• Classification by business cycle Cyclical
• The sector tends to mimic the general economic
  results of the U.S. economy (and foreign
  economies) in an exaggerated manner.

6
Business AnalysisDemand Factors (continued)

• External Factors
• Corporate spending on hardware and software is a
  key driver for growth.
• RD investment is crucial for creating
  technological leaps that can spur growth
• User Geography
• Three major user groups manufacturing, banking
  and government
• US and European markets saturated growth
  prospects in Asia and Central America

7
Business AnalysisDemand Factors (continued)
8
Business AnalysisDemand Factors (continued)
9
Business AnalysisDemand Factors (continued)
Industry revenue appears to be sensitive to
industrial production and manufacturing
10
Business AnalysisSupply Considerations

• New capacity additions
• Capital expenditures are high for new computer
  chip and memory components. However, the
  marginal cost of producing additional products
  such as software are quite low.

11
Business AnalysisProfitability and Pricing

• Industry/Sector Concentration
• Recent consolidation in the PC industry (Compaq
  HP). Numerous dot.coms have gone out of
  business. Most industries are concentrated
  around a clear market leader and numerous (often
  specialized) smaller competitors.
• Barriers to entry Mixed
• Few legal barriers, however, capital equipment
  and RD expenditures are significant.
  Established firms such as Microsoft and Intel
  maintain significant market shares in respective
  sectors. Switching cost can prohibitive for many
  technologies.

12
Business AnalysisProfitability Pricing

• Pricing Providers of newer technology may enjoy
  initial periods of pricing power. Prices tend to
  fall quickly as next generation technology
  becomes available.
• Strength of Customers Low
• Corporations and governments may have some
  leverage.
• Strength of Suppliers Low
• Input prices have typically fallen over time.
• Competition High
• Market leaders such as Microsoft, Intel and Cisco
  have distanced themselves from competition within
  their respective industries. However, rapid
  technological change forces companies to remain
  vigilant of emerging technologies that could
  render their products obsolete.
• Substitution Low
• There are few viable substitutes for PCs,
  operating systems or servers.

13
Financial AnalysisRevenue, Earnings and Margins
Revenues, Earnings and Adjusted Net Margin appear
to have bottomed.
14
Financial AnalysisRevenue, Earnings and Margins
vs. SP
15
Financial AnalysisROE and ROC
Slight up-tick for both ROE and ROC.
16
Valuation AnalysisRecent Growth and Margin Check
Median estimate of 15.5. High standard
deviation.
17
Financial AnalysisIncome Statement
Gross Profit Margins 38, 42, 41, 40, 41 for
prior 5 years RD 10, 8, 8, 8, 13 for prior
5 years
18
Financial AnalysisBalance Sheet
Current Ratio 1.80 average over the prior 5
years Debt to Equity 0.42 average over the prior
5 Years As of 12/31/01 MSFT, INTL, ORCL, Cisco
had 67.5B in Cash Equiv., 1.3B in LT Debt.
19
Financial AnalysisStatement of Cash Flows

• 2001 Enormous write offs (Accounting Adj.)
  results in a Net Loss for the sector
• Net Income Adjusted reveals sharp drop in overall
  profits
• However, sector consistently generates large
  amounts of Free Cash Flow

20
Financial AnalysisSummary

• Mixed Results
• Revenue, earnings and net margin declines appear
  to have bottomed.
• Gross margins have recently fallen
• The sector continues to generate positive free
  cash flow while market leaders maintain large
  cash reserves
• Massive accounting write-offs in 2001

21
Valuation AnalysisMoving Averages
22
Valuation AnalysisP/CF, P/E, P/B, P/S Charts
23
Valuation AnalysisP/CF, P/E, P/B, P/S vs. SP 500
24
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
25
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
26
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
27
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
28
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
29
Valuation AnalysisP/CF, P/E, P/B, P/S by
Sector/Industry
30
Valuation AnalysisSummary

• P/E, P/S, P/B, P/CF remain high compared to SP
  500. Only slight signs of pending growth.
• Communication Equipment industry shows signs of
  growth in P/S, P/CF and P/BV ratios.
• Changes in relative valuations Contracted
  significantly since 2000 with the dot com bubble
  bursting and slowdowns in capital expenditures by
  corporations
• Will valuations expand or contract? Valuation
  will contract further, but not as steeply.

31
Valuation AnalysisDividend Discount Model
Stock Price Earnings Payout (1g)
required rate of return g Payout
Dividend Yield 0.31 Growth rate 15.6 median
with std dev of 6 r dividend yield growth
rate 15.91 ß 2.03 implies r should be above
16
32
Valuation AnalysisDividend Discount Model
Valuation Payout (1g) r
g Payout will remain steady Rate of return
should increase Growth rate will not increase
significantly gt Valuation will decrease!
33
Information Technology Sector

• Market leaders generate and maintain !
• Market leaders are buying back shares
• Offers lure of the next big thing
• Aging PC base
• Stock prices have been beaten down
• Yet
• Valuations remains expensive
• Continue Underweighting Sector