After some recent years of stagnation, spending in the information technology sector is on a modest upswing. But is it a full-blown spending recovery? Well, not exactly. Corporate IT spending is inching upward, but not at a high growth rate. Going into 2006, I expect we'll see more, albeit modest, budget increases over 2005 and 2004. But the current mini-boom is certainly not enough to justify owning stocks in computer hardware companies, unless you have a five-year or, even better, a 10-year investment horizon. This "recovery" will happen on a long, gradual trajectory. Let's examine why, what you can expect down the road; and where you might want to put your investment dollars.
The U.S. hardware business is growing about 4% to 5% faster than the gross domestic product. Hardware companies such as Motley Fool Stock Advisor recommendation Dell (NASDAQ:DELL), Hewlett-Packard (NYSE:HPQ), and IBM (NYSE:IBM) -- forget Sun Microsystems (NASDAQ:SUNW), which is mired in turnaround troubles, with a revenue base that continues to decompose as I'm typing -- are selling computer units just fine. But they're selling the units at lower prices and lower margins. And instead of lucrative capability upgrades, what we're seeing -- and have been since late 2002 -- is largely a continued maintenance replacement cycle.
The U.S. software business, meanwhile, is probably growing at GDP + 2% to 3%, although split wildly by categories with diverging market shares. For example, Oracle (NASDAQ:ORCL) says it's increasing its share of the market. Sounds fine until you realize that what that has to mean is not just Oracle, but Oracle plus its acquisitions, including PeopleSoft and J.D. Edwards.
Replacement spending, not upgrade spending
Some analysts suggest that when corporate profitability returns, companies will start to spend more on technology. But even in the best of times, there simply has to be a business need for new technology.
The uptick in tech spending since the doldrums of 2002 is in part just a bounceback from untenable IT spending lows. What we're seeing isn't an upgrade cycle as much as a hardware replacement cycle -- particularly for PCs. Components of equal power are being replaced as needed.
The "software spiral"
The PC business is a good example of how this "recovery" differs from past cycles. In the nearly 25 years since the introduction of the PC, we've seen cycle after cycle of upgrades, each one driven by new and compelling capabilities. Companies would replace everything they had, and that included software. In fact, it's usually been the so-called "software spiral" that has primarily driven these PC upgrades -- not to mention their proliferation. As long as software makers continue to write applications with more compelling business uses, companies -- and consumers -- will continue to buy more capable PCs.
Currently, however, the software spiral is not driving an upgrade cycle in hardware. Companies are running their applications on older PCs, or on new PCs that are not substantially different from their old ones. And since companies overall are not staffing up, there is little reason to buy more PCs than they've previously purchased. In fact, most major companies are now primarily replacing their oldest machines (four to five years old) with comparable new machines because it costs less to replace than repair them.
An "echo boom"
Even these replacements, though, are different from what we've seen in previous cycles. Since 2002, companies have been replacing old or broken boxes with inexpensive, bottom-of-the-line machines. My sense is that if companies could save money buying even less-capable boxes, they would.
So the current PC boom is really an "echo boom." With the exception of Dell -- which, thanks to superior expense management, has increased share at the expense of competitors such as HP and IBM/Lenovo -- we're not seeing substantially higher business revenues or profitability from PC sales, even though PC processor unit volumes are higher than pre-Y2K levels.
I think this mini-boom will last for a few more quarters. But even though it has to happen eventually, I still don't see a wholesale corporate upgrade cycle -- to next-generation hardware -- anywhere in sight.
Challenging environment for profit margins
The impact is clear: Hardware manufacturers, semiconductor makers, storage and disk drive makers, and all of their suppliers are likely to continue to sell lower-margin products. That's a problem for companies like Intel, Sun, and HP, which make the lion's share of their profits from sales of their high-end product lines.
Some analysts believe that the introduction of new wireless notebooks will stimulate demand for new PCs. And it's true that in the highly mobile worlds of Wall Street analysts, lawyers, and journalists, the utility of such devices is indisputable. But in many American companies, fewer than 10 percent of the employees are mobile. Most are on the phone, entering data, or in administrative roles -- not engaged in activities that would tend to make wireless PCs a compelling investment for their companies.
Doing more with what they've got
Many organizations that had never troubled to learn the full capabilities of their software are now taking better advantage of what's already there, rather than upgrading. This trend is having a substantial impact on large-systems integrators, who, having historically made their money on big implementation projects, are now bidding for minor "enhancement" projects at reduced rates.
Given this trend, I see no compelling reason to believe that many companies will start throwing large amounts of money at technology upgrades, even if profits do recover substantially in the coming year or two. While there should continue to be replacement spending, I don't see a substantial absolute-dollar increase in IT spending for 2006, absent a broad-based economic recovery.
Sustainable and meaningful growth in corporate profits is the only thing that will be able to support real growth in IT spending. Even if unit sales do continue to increase, they will still be accompanied by ongoing declines in system prices and contraction of manufacturers' profit margins. That makes it tough to own hardware stocks, unless you are prepared to be very, very patient. Even a steep rebound in IT spending doesn't make for an adequate catalyst.
What to look for
Shifts in market share within the consolidating hardware sector, however, have been and should continue to be a driver. Dell, the recipient of more share at the expense of HP, is one example. IBM, compared with Sun, is another. Turnaround initiatives, such as those at HP and Sun, have been another catalyst. HP should enjoy reasonable success, largely thanks to its own internal cost-cutting measures.
But so far, even Dell lacks evidence of the all-important revenue growth required for an A-level turnaround. It also isn't showing substantial improvement in its enterprise business. To Sun, a C-Level turnaround play, I assign a low chance of success.
But for those willing to buy and hold for three to five years, I'd favor Dell -- a low-cost producer with a growing market share, particularly in overseas markets. I like HP as a medium-term buy, but on its turnaround potential rather than its outlook for growth. I'd also consider a couple of the storage companies, such as Network Appliance (an Ethernet storage play) and bellwether EMC. Beyond that, be wary.
Fool contributor Melanie Hollands does not own shares in any company mentioned.
