Companies that provide information technology services to online businesses should continue to enjoy strong growth, but that doesn't mean the sector is risk-free.
For starters, there could be a post-hype slowdown. Market cycles tend to have a hype phase, during which speculation runs wild about the market potential. Risk is perceived to be very low, resulting in high valuations and approval of marginal business plans. Then some marginal businesses fail and reality sets in. The market size and growth is more realistically assessed, and this creates a temporary slowdown in spending and investments.
Following the slowdown--sometimes referred to as a "trough of disillusionment"--the cycle picks up in a longer-term trend, with a more moderate, yet sustained, growth period before reaching maturity. Given the failure of many dot-coms in the past quarter and the pullback in Internet stocks in general, we could be in such a phase of "disillusionment." Investors can mitigate this potential risk, I believe, by focusing on the leaders in e-business solutions and holding those shares through the short-term slowdown.
Large companies, I hear, are being more thoughtful in their e-business decisions. The reduced competitive pressure following the disappointing performance of many of their dot-com competitors this spring seems to be leading to a lower sense of urgency. This of course can lead to less spending.
Other factors such as higher interest rates, slower consumer spending, and higher fuel costs (i.e., higher shipping costs) probably also are contributing to the slowdown in spending. But I believe the increasing number of dot-com failures may be causing brick-and-mortar retailers to feel less urgency to develop their Web presence. I don't necessarily agree that this is the best reaction on the part of brick-and-mortar companies; many would argue that this slowdown period is an opportunity to jump ahead of the competition.
Also, the increases in bad debts from dot-coms could be a risk. E-business solutions firms have begun to address this issue by reducing revenue concentration in dot-coms, pursuing only projects with strong venture capital and/or corporate backers, and implementing advance payment policies and faster collections cycles. Failing dot-coms mean fewer future clients, and even one instance of bad debt at a single e-business solutions firm could have a negative impact on the entire industry. Scient's write-off of Inacom's bad debt following Inacom's bankruptcy filing resulted in weakness in most of the e-business solutions stocks for several days.
Furthermore, a slowing economy could impact e-business growth. While some would argue that forward-thinking firms would continue to spend on technology in economic downturns in order to improve their competitive positions for the inevitable recovery, historical evidence is mixed on this response. For example, in the 1990 recession, revenue growth at the leading IT services firms slowed from double-digit growth to single-digit growth.
I believe the e-business solutions market only has about a 20 percent chance of experiencing the slowdown outlined above. Given that, I think investing in this sector is a reasonable risk to take given the strong earnings growth and long-term growing importance of IT and the Internet in global business. As technology changes and improves, businesses will incorporate new technological advances in an effort to improve their efficiency and gain a competitive advantage.
While the failure of many dot-coms has caused concerns about the viability of Internet companies, the business potential of the Internet has only begun to be tapped. In my opinion, e-business solutions providers, as the architects and builders of online business, will be among the firms that benefit from the growing use of the Internet and other emerging technologies.
Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker, Inc., Baltimore. He can be reached at wrloomis@leggmason.com. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security. Opinions expressed are subject to change. Additional information available on request.