Finding the bottom

E-biz service stocks have been slammed--and for good reason--but Bill Loomis has a game plan for patient investors.

4 min read
A year ago, e-business IT service companies were riding high. Now many of them are trying to figure out how to survive.

Each day offers new evidence that the slowdown is affecting broader IT (information technology) spending patterns. Last week, Corning acknowledged that a "meaningful recovery" in telecommunications spending would probably occur more slowly than previously anticipated. E-business services firm Proxicom also warned that revenues and earnings in the March quarter would fall below expectations. And a week earlier, both Compaq Computer and Computer Sciences told the Street to expect lower-than-expected results.

That followed on the heels of warnings from Cisco Systems, Intel, Motorola, and Oracle. Several e-business services companies, including Sapient and DiamondCluster, lowered their guidance earlier in the month.

Even the good news is being tainted by questions surrounding the uncertain economic climate. Although recent results announced by Jabil Circuit and Solectron were in line with--or even ahead of--expectations, both firms nonetheless reduced their near-term expectations, citing a deterioration in demand and reduced business visibility. So the No. 1 question on investors' minds: When will the pain stop?

Although the reports of weakening IT demand are not new, the drumbeat of preannouncements suggests that the length of the current downturn is becoming less clear and perhaps more prolonged. In fact, the spending slowdown seems increasingly likely to extend beyond the current quarter and even into the third quarter.

Reading tea leaves
Sifting through the preannouncements, a similar theme emerges with companies reporting that demand and pricing power remain weak. What's more, they say their clients remain troubled about the economy as well as their own business performance. This is consistent with what I have been hearing in the e-business services sector.

It seems many clients are unwilling to make major investments in new technology, regardless of whether it might later save them money. Even good projects may not find funding because these same companies are more concerned about their own earnings and cash flow.

I believe the underlying weakness in the economy and the overall lack of corporate profits are going to continue to weigh on IT spending through the second quarter--and now likely extend into the second half of the year. Several companies, both public and private, have recently told me they are managing their businesses with this scenario in mind.

The near-term risk to e-business services companies is increased by the growing likelihood that demand abroad could weaken. E-business revenues from Europe and other international markets are generally expected to continue to show strong growth in the current quarter. In their preannouncements, Sapient and DiamondCluster indicated that international revenues derived largely from Europe would sequentially grow at about 20 percent and 10 percent, respectively, in the first quarter.

Even if this is the case--and I view the 20 percent figure as aggressive--I am increasingly hearing very cautious language about potential weakening of IT demand in Europe. I've also come across initial evidence to corroborate the more tempered outlook.

What's more, I do not believe any of this has been fully reflected in consensus estimates or investor expectations for e-business services companies. Although no slowdown is yet evident, some of the comments from Compaq and Sapient suggest a very real risk of weak demand spreading to Europe.

Same story around the globe
Companies such as Intel and Cisco have been more cautious. They contend that if the U.S. does not undergo a sharp recovery--something which I view as increasingly unlikely--then demand issues are likely to affect Europe and other regions (Intel), and that there are already initial signs of a slowdown in other parts of the world (Cisco).

Demand in Scandinavia has been weak for a little while, a trend which is expected to continue, particularly with warnings from companies such as Ericsson, a client of DiamondCluster.

Netherlands-based Philips warned that results would fall below expectations, explaining that its semiconductor division was being hit by a slowdown in the U.S. economy. Similar situations could cause other European companies to restrain IT spending, much as their U.S. counterparts have done.

Germany's Ifo index, an index of business sentiment in Germany, fell more than expected in February, hitting an 18-month low. This suggests a further worsening of the growth outlook for Europe's biggest economy (the deteriorating U.S. economy was suggested as a contributing factor).

While in Germany for the CeBit show, Hewlett-Packard CEO Carly Fiorina said she was not optimistic about a quick recovery in the second half of the year. Also, Fiorina added, signs indicated the U.S. economic slowdown was reaching across the Atlantic to Europe.

Most ominous were the preannouncements from CSC and Proxicom. Both companies cited the weaker European IT demand environment as a contributing factor. CSC maintains that 40 percent of its earnings miss could be traced to the worldwide slowdown in the consulting and systems integration market, particularly in the Internet sector. What's more, CSC noted that weak demand has recently spread to Europe.

Bottom line, this is how things are shaping up: Sequential revenue growth for most of the e-business IT service companies will be negative for the first two quarters of this year, and possibly into the third quarter as well. I'm assuming that the fundamental "bottoming" period will hit late in the third quarter or early in the fourth (though I recognize stocks may move ahead of this).

A stable-to-improved economic outlook in early 2002 will help convince clients to open the purse strings on technology services spending. Hopefully, the initial project ramp-up will begin late in the third quarter or early in the fourth quarter of 2001. But only when the CEOs of large companies begin feeling more sanguine about their own businesses' outlooks, will budgets loosen up.

And that looks to be a few quarters away.