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If this is a tech rebound, pinch me

Knowledge@Wharton goes inside the IT conundrum to examine why capital spending--and corporate confidence--remains low.

If this is a tech rebound, pinch me
From Knowledge@Wharton
Special to CNET News.com
August 14, 2004, 6:00 AM PDT

Technology buyers hit the brakes toward the end of the second quarter 2004, and it's worth asking whether spending on software and hardware--not to mention capital spending overall--is being hampered by gun-shy corporate executives.

Experts at Wharton say the June lull that resulted in a slew of technology profit warnings is probably a soft patch, but they are reserving judgment for now. Yet given that capital spending from corporations has largely been absent during a consumer-fueled economic rebound, one wonders whether executives are becoming unnecessarily risk-averse.

"You have to be careful with only a couple months of data," Wharton finance professor Jeremy Siegel says. "There are always random blips and fluctuations during a recovery." Siegel's hunch is that consumers, spooked by rising prices, have curbed spending but that for now, the spending dip looks temporary.

If consumer demand is shaky, corporate spending may be as well. But it's too early to tell what the thinking is inside corporate boardrooms, according to Wharton experts. At the same time, the psyche of corporate America is worth watching, since it could thwart an economic rebound.

Technology buyers in particular are clearly scared of being burned by previous software purchases that didn't operate as advertised and are finding other uses for their cash. They aren't the only ones. According to an analysis by BusinessWeek, the 374 industrialized companies in Standard & Poor's 500 Index are collectively holding $555.6 billion in cash and short-term investments--more than double the amount in 1999.

Federal Reserve Chairman Alan Greenspan addressed the issue of corporate confidence in testimony before Congress June 20. Greenspan was quizzed about the June lull and said he believed that it was just a soft patch. He did, however, note that the economy would be better off next year, if businesses become less reluctant to spend and hire.

In his semiannual testimony, Greenspan said corporate America is holding back on new capital investment, even though it's clear that the economic recovery is gaining steam. "We are far from behaving the way we typically did," Greenspan said, adding that corporate executives are timid because of the stock market swoon in 2000, scandals and other fears, such as terrorist attacks and uncertainty in Iraq.

"Businesses' ability to boost output without adding appreciably to their work forces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment, which was an apparent outgrowth of the capital goods boom of the 1990s," Greenspan said.

"Indeed, over much of the previous three years, managers had seemed to pursue every avenue to avoid new hiring, despite rising business sales. Their hesitancy to assume risks and expand employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the decline in stock prices--and also, of course, by the environment of heightened geopolitical tensions," he added.

"Even now, following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cash flow," Greenspan said. "The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape."

Wharton's Siegel says you can add political uncertainty over who will be president to the list as well. "The drop of President Bush in the polls has been somewhat of a damper."

Confidence issues
Worrying about the lack of corporate America's confidence is a relatively new concern. Until recently, CEO overconfidence was much more of an issue and has led to questionable mergers, such as that of America Online and Time Warner.

In a working paper, Wharton finance professor Geoffrey Tate argues that overconfidence of chief executives has a big impact on corporate investment. An overconfident CEO will overestimate returns on investment projects and fund them with the company's cash flow. When the company has to get outside investment, overconfident CEOs cut back on corporate investment instead of raising cash on the equity markets, where shares are believed to be undervalued.

Tate says neither outcome is optimal. "We argue that personal characteristics of CEOs in large corporations lead to distortions in corporate investment policies," writes Tate, who co-authored the paper with Ulrike Malmendier of Stanford University.

To identify overconfident behavior, Tate looked at CEO behavior with stock holdings. An executive who held company stock options for a 10-year term was classified as overconfident--so confident in his company that he didn't diversify. Executives who also increased company holdings were deemed overconfident. Today, however, the pendulum may have swung the other way. Lack of confidence may be the bigger issue. How long that lasts remains to be seen.

The effects of corporate spending restraint showed up in the latest round of technology earnings. Earnings compared to a year ago were strong but fell below expectations of many analysts. In the software sector, it became clear that CEOs pulled the plug on making big spending plans at the end of June.

In fact, it almost sounded as if the same person wrote all the preannouncements coming from the technology sector, especially for software companies. Consider this sampling from among nearly two dozen technology profit warnings:

Siebel Systems announced that its second-quarter revenue would miss Wall Street targets. "These disappointing results were primarily due to unexpected delays in purchasing decisions by certain prospects and customers near the end of the quarter," the company said.

BMC Software sang the same tune. "At the end of the quarter, the company experienced delays in customer purchasing decisions among larger accounts, primarily in the United States."

Veritas Software warned that its earnings would fall short of expectations but offered no reason. It didn't take long for analysts to come up with a few. William Blair & Co. analyst Laura Lederman noted that Veritas' sales looked fine right up to the last three days of June.

"The market for tech is still relatively weak...The economy appears to have weakened recently, and as we know, technology spending and the economy are intricately linked," Lederman said. "CFOs and technology chiefs alike appear to be worried about job growth, the situation in Iraq, oil prices and the potential of a Democratic president."

According to Wharton marketing professor Peter Fader, recent history may also make it easy for executives to put technology projects on the back burner. Fader says so many companies were burned by overhyped software that they don't hesitate to pull the plug on projects now. "Many CRM (customer relationship management) and ERP (enterprise resource planning) companies are looking just to make a sale," Fader says. "And every one of them has made outrageous claims."

Fader says it is possible that the boom time actions of software vendors are still coming back to haunt them but that there also appears to be a demand slowdown. The only blip in an otherwise strong quarter for IBM was its flat software sales. Big Blue, like its rivals, noted that customers deferred decisions and cut back on big deals.

Research firm Gartner says software spending growth won't return to normal until 2006. Why? Technology spending is increasingly becoming discretionary. Gartner says companies' preoccupation with Sarbanes-Oxley compliance and terrorism also hurt sales.

What's next? If Greenspan is testifying this time next year that corporations need to spend more, the economy is likely to be on a downswing. For now, however, the jury is out.

Siegel is siding with Greenspan's "just a blip" argument but notes that economy watchers should find out soon whether June was a lull or something more serious. "We'll be getting a lot of data well before the third quarter ends," he notes. "We'll know if the economy is picking up by the next round of earnings."

 
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