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Tech Industry

Tech picture not improving yet

Corporate profit warnings aren't slowing down, inventories may still be heavy and no sector can say demand is improving.

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      End in sight for server slump?
    Mark Melenovsky, research manager, IDC
    Warning: More warnings ahead.

    Investors drove stock markets lower Tuesday morning after cell phone stalwart Nokia warned of lower-than-expected quarterly results, but broad indexes recouped most of their losses by the time markets closed, as investors regained faith in an economic revival. After all, some leading technology companies such as Intel and Applied Materials have called for a rebound in the second half.

    But based on the data so far, things won't get better in the near future. This quarter has seen about the same rate of tech profit warnings as the first three months of the year, according to the latest data from First Call, which tracks corporate earnings and analyst estimates.

    On the surface things look better: The first 72 days of the second quarter have seen 171 "negative preannouncements" from organizations followed by First Call, compared with 190 cautions through the same period in the first quarter. And according to First Call, 36 percent of all second-quarter cautions so far have come from tech companies, compared with 41 percent for the same period in the first quarter.

    But these numbers are deceptive; some companies issued bad news, but these days analysts have been cutting estimates so much that companies' lowered estimates don't show up as warnings. In reality, the differences between this quarter and the first are too small to be significant, said Chuck Hill, First Call's director of research. As far as he's concerned, bad news continues unabated.

    "The worrisome thing is that we're not seeing a slowdown in the number of warnings," Hill said.

    Nokia's Tuesday report is only the latest reason to doubt an imminent tech revival.

    Rising demand for communications hardware looks to be as distant as the end of a live performance of "In-A-Gadda-Da-Vida." High-end router maker Juniper Networks last week said it could earn just one-third of what analysts predicted. 3Com and Broadcom see lower-than-expected revenue. Intel during its recent midquarter report refused to call a bottom for the communications sector.

    And though Intel said its core business of processors will grow in the third quarter, some analysts and industry observers believe improvement is further away. Don Young of UBS Warburg and Joseph Osha of Merrill Lynch said PC inventories have actually increased as a percentage of revenue from earlier this year.

    The server market appears no better. Sun Microsystems recently projected earnings at least 33 percent below analyst estimates.

    Don't look for better days from other enterprise hardware makers. Network storage king EMC hasn't warned of lower sales, but it may have to lower prices--and take a hit on margins, and thus profits--to stimulate demand, according to Morgan Stanley analyst Gillian Munson.

    "It feels to us as if a multiyear period of explosive data growth, and therefore customers willing to pay anything to get their storage in place, has now tapered off and enabled customers to sit back and hesitate a bit," Munson wrote in a Tuesday research note.

    "We think at this juncture the evidence warrants being conservative about EMC's gross margin capability," she continued. "Therefore, we are lowering our gross margin assumptions and our earnings-per-share estimates for EMC, given what appears to be a continued slow-moving sales-close cycle and heavy price discounting."

    History repeats itself--but how?
    So, no part of the technology world can truly say demand is improving.

    Of course, tech sales will increase eventually, but a rebound was never in question; the important thing for investors is the timing of a recovery. It appears to be further away than it seemed only a few months ago.

    Belief in a second-half rebound largely rests on the past record. Historically, companies such as Intel have seen improved sales in the last six months of the year, and they're content to believe history will repeat itself, economic slowdown or not.

    But Ed Keon, a director of quantitative research at Prudential Securities, recently pointed out that history indicates the tech slump could extend beyond this year. The last major technology slowdown lasted three years, in the early 1990s. Then, as now, technology prices fell as companies cleared inventories despite lower demand.

    "Based on the experience of the early 1990s, it may take a while for tech companies to regain the profitability to expand (research and development) that generates the progress that leads to higher profitability and increased economic share," Keon wrote in a research report released earlier this week. "We do not pretend that the above argument is conclusive, but it does suggest that the tech earnings slowdown may not reverse as quickly or as decisively as we might hope."

    Profit warnings came in record numbers in the fourth and first quarters, First Call's Hill noted. Until that pace settles down, there's no reason to look for improved earnings.

    "You don't suddenly throw the switch from record levels to normal," Hill said. "I'm not seeing a deceleration in warnings yet."