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Buying IT stocks at a discount

The year 2000 bug has had a tremendous effect on the technology industry over the past three years, and will continue to do so even after the stroke of midnight on December 31.

The year 2000 bug has had a tremendous effect on the technology industry over the past three years, and will continue to do so even after the stroke of midnight on December 31.

While money spent fixing the millennium bug has diverted funds from other information technology projects, trends in the enterprise resource planning (ERP) software market clearly indicate that there was a borrowing of sales from 1999 into 1997 and 1998 as companies didn't fix systems, but replaced them.

Confusion over how Y2K spending will impact other IT projects over the next year has sent IT services stocks into a free-fall since mid-January. To be sure, most IT services stocks have collapsed some 50 percent from 52-week high levels.

Until investors better understand the impact of the year 2000 bug, the sector will continue to underperform the broader market. Now is the time to buy stocks in this discounted sector, however, as there are several trends that point to very strong industry growth over the next several years.

As addressed in my last column, I believe the Internet will be the next major driver of IT spending due largely to the Net's impact on business models. Clearly, the Internet may be the most powerful agent of change the technology world has ever created. The Internet has affected business models, operations, target markets, spending patterns, as well as customer relationships.

Change has historically been a key driver of IT spending, whether it is deregulation, increased globalization, or other events. While the overall IT services market in the United States is about $139 billion and growing 10 percent per year, the U.S. Internet and e-commerce IT services market was $4.6 billion in 1998 and is growing at a stunning 50 percent compound annual growth rate.

Some clear trends have emerged in the industry over the past two quarters. We have seen Y2K compliance revenue peak in the third quarter, and subsequently drop off much faster than anticipated some six months ago. This trend has appeared in all of the IT services companies that do year 2000 compliance work.

I believe these trends are very positive for the industry, as it means less negative impact on non-Y2K budgets in the second half of the year, as well as a more gradual transition of projects from Y2K to non-Y2K than previously thought.

However, better-than-expected growth in certain areas of IT services are more than making up for the year 2000 slump in some well-positioned companies. For example, demand for Internet-related application development is soaring. This includes e-commerce, the transfer of existing applications to the Web, and other emerging technologies such as data warehousing. Other technologies, such as customer relationship management package applications (sales force automation and supply chain package applications), have also seen strong growth. Application integration, or middleware used to tie together ERP and other package software, looks like another strong growth area over the next few years.

In the second half of the year and into the next, one can also expect some pent-up demand for projects that were delayed due to year 2000 concerns.

After several years of outperforming the broader market, the IT services industry stumbled in 1998, and continues to do so in 1999. The group reached an all-time high in July 1998, and subsequently declined 36 percent to new lows in October. After rallying in mid-January, the IT services stock index has since fallen 29 percent. A more telling figure, however, is that the average IT services stock has sunk 50 percent from its 52-week high.

But to paint that drop in a different light: IT services companies shares over the past five years have climbed 650 percent--compared with the Nasdaq's 197 percent gain.

Are there leading indicators that may show sentiment is turning for the better? One indicator to look for later this year could be an improved outlook toward ERP and other enterprise software stocks, along with a rebound in share price. Late in 1999, ERP software companies should begin to have easier year-over-year comparisons. I think demand for ERP stocks could pick up late in the year, as companies fully complete year 2000 projects and move on to higher return-on-investment projects, while ERP companies focus more on front-office modules and other faster ROI applications.

Sometime in the second half of the year, investor sentiment toward the IT services sector should shift from seeing companies as constrained by year 2000 concerns, to enabling corporations to move to the Web and networked applications. Now is the time to start looking at these companies.