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Tech Industry

The Starting Line: A recession of profits, popularity

After disappointing earnings, big write-offs and gloomy outlooks from technology companies in the second quarter, strategists are scampering to put the tech sector in its place.

After disappointing earnings, big write-offs and gloomy outlooks from technology companies in the second quarter, Wall Street strategists are scampering to put the technology sector in its place.

On Monday, a host of brokerage firms--UBS Warburg, Credit Suisse First Boston and Deutsche Banc Alex Brown--cut their earnings outlook for the Standard & Poor's 500 index. In addition, Wall Street firms are cutting their technology holdings in model portfolios. And even previously optimistic-to-a-fault analysts are handing out downgrades with abandon. Dresdner Kleinwort Wasserstein downgraded former Wall Street darling Cisco Systems to "reduce" from "hold."

When talk of a tech recovery focused on a second-half rebound, Wall Street's best was willing to pay attention. Now that a recovery is being increasingly pushed out, strategists are writing off the tech sector just like companies such as Microsoft, VeriSign and JDS Uniphase wrote off bad investments and pricey acquisitions.

"The much-anticipated recovery in technology earnings is very unlikely to occur during the second half of this year," said Edward Yardeni, chief investment strategist for Deutsche Banc Alex Brown. Yardeni said he recommends investors "underweight," or largely avoid, tech stocks while focusing on other areas.

The message is clear: Technology is an important sector, but it's not the only one out there. The tech sector's inventory problems, weak sales and lack of guidance beyond the current quarter have put the kibosh on once-heady talk about the tech sector.

"Partly because a year ago technology accounted for roughly one-third of the S&P 500 market cap, the sector receives attention from investors and the media that far exceeds its actual importance to S&P earnings," said UBS Warburg strategist Edward Kerschner, who is known to be one of Wall Street's more optimistic market watchers. "It is worth remembering that it (the tech sector) has unique problems that are not shared by the rest of corporate America."

Other strategists, who were busy lowering their earnings estimates for S&P 500 companies, sounded the same theme. In a what-have-you-done-for-me-lately world, the tech sector hasn't done much.

Because of an earnings slump, Kerschner notes that the tech sector will account for about 9 percent of the S&P 500's earnings this year, down from 15.4 percent a year ago.

Coming clean
According to Kerschner, the biggest problem facing the technology sector is that it is just beginning to "come clean" with big write-offs, inventory adjustments and layoffs. For the last decade, technology companies didn't worry about costs because they had to race to beat the competition. The game was revenue growth and market share, not cost cutting, he said.

Contrast tech with old economy companies, which posted much slower growth and hit many "rolling recessions" in the 1990s. For older industrial companies, controlling costs has been the primary focus, a characteristic that enabled them to weather a downturn.

Kerschner said most industries have been "managed for adversity" and didn't suffer from "structural overcapacity and speculative excesses."

"Most non-tech firms were relatively lean and mean," said Kerschner. "They were cautious and disciplined in adding capacity and reacted quickly and effectively to the economic slowdown."

Tech companies had trouble predicting the slowdown and are still having problems. Indeed, Federal Reserve Chairman Alan Greenspan said last week that high-tech inventories are still too high.

Where's the rally?
The good news? Tech companies are likely to show earnings growth next year even if it's only because the comparisons to this year's dismal results will be an easy hurdle.

Meanwhile, investors and analysts aren't expecting much from technology companies anymore. Wall Street is likely to cheer as soon as companies are able to provide any reliable outlook into future quarters, analysts said.

"We are encouraged that investor expectations have come down following poor second-quarter earnings and outlooks," said Steven Milunovich, tech strategist for Merrill Lynch. "A tech rally may be in the offing. We continue to look for a long, frustrating workout though."

That tech rally, however, remains out of sight. In fact, even Merrill's primary tech guru isn't that high on tech stocks right now. Milunovich is currently recommending a "modest underweight in tech."