As the tech industry faces turmoil unlike any period in the past decade or more, it is time for the companies to tell the truth about where they are headed.
The tech industry has been rife with issues in 2019. The semiconductor business has experienced a painful downturn, a tariff fight with China has hurt the profits of a range of hardware makers, and internet and social media companies are under regulatory scrutiny after a year of privacy and security scandals and issues. The results: a potential earnings recession in the S&P 500 SPX, +0.22% which would be the first such decline in three years, led by a fall in the technology and materials sectors.
FactSet estimates earnings overall at information-technology companies will be down 12% in the second quarter, excluding interactive media and services companies like Alphabet Inc. GOOGL, +0.01% GOOG, -0.06% and Facebook Inc. FB, +0.18% which have moved to a different sector that is expected to decline less than half a percent overall. The real anchor for earnings right now are semiconductors, which are expected to report a 32% nosedive amid a shocking decline that has been faster and deeper than even the 2008-2009 downturn, according to Dan Hutcheson, president of VLSI Research.
Chip companies have repeatedly promised a better second half, after a sudden slowdown in sales at the end of 2018 caught them off guard. As this column warned earlier this year, though, those promises didn’t have a lot of support, and now their forecasts will have to be much more specific.
As we approach earnings season, those promises need much more context. Yes, the second half is likely to be better, but only when compared with the first half, not last year’s results.
“We don’t think the second half will pass 2018 levels,” Hutcheson said. “Saying the second half is going to be stronger is not saying much.”
Investors received a dose of optimism about chip stocks after a trade truce between the U.S. and China was announced on Twitter by President Donald Trump. Chip stocks and their related indexes jumped, even though China may be the potential winner.
But the trade truce does not change much of anything yet, as tariffs that were already installed are still in place and chip companies have already implemented costly workarounds to deal with them. Many U.S. chip companies have had to pay tariffs on certain products that they manufacture in China, even if made by a U.S. company. And while there have been signals that the downturn may have bottomed, such as the early results from memory-chip company Micron Technology Inc. MU, +1.82% there still hasn’t been much data to support the thought that the second half will include a rebound.
May was a horrible month for chip sales. Worldwide semiconductor sales tumbled 14.6% to $33.1 billion versus a year ago, as hardware makers held off on buying more chips to use up their current inventories. Micron executives told analysts that in the cloud computing area, they felt “like the challenges, in terms of inventory levels, were behind that part of the market,” but on the enterprise front, companies that make hardware to be used on-premises “needs some recovery.”
The larger tech industry desperately needs for the problem with chips to be an isolated and temporary issue, because otherwise, it would likely be a precursor of further woes to come in tech. Chips can be the canary in a coal mine of the tech sector because of their position early in the supply chain, and the warning light of more problems to come is already blinking.
“This much is clear: tech spending growth is decelerating,” Bernstein Research analyst Toni Sacconaghi wrote in a note at the end of June summarizing a May/June survey of CIOs by Bernstein. “The year 2018 was truly an annus mirabilis for global IT spending, which grew 7-8% — the highest rate in over a decade — amid broad-based macro improvement and U.S. tax reform. In contrast, the Q1 19 reporting season has been more sobering, with companies such as Dell DELL, +0.71% HP Enterprise HPE, +1.82% Intel INTC, +1.87% and NetApp NTAP, +0.39% all missing top line expectations and identifying incremental end market weakness.”
In another note about tech stocks, which are trading at their highest valuations in 15 years, he highlighted seven of the 17 largest cap tech companies that have flat to negative earnings growth.
Sacconaghi said he expects actual IT spending growth to decelerate to somewhere around 4% to 6% in 2019, with a key concern among investors being whether or not the issues in China and the cloud companies will spread more widely through enterprise tech.
There are signs that it has. Broadcom Inc. AVGO, +2.18% now seen as a sort of tech conglomerate with its recent software acquisition, lowered its guidance for the second half of the year in its early second-quarter report. The company cited a “broad-based slowdown,” due in part to geopolitical issues, trade, and the effects of export restrictions on Huawei, one of its big customers.
“We don’t know if Broadcom cut enough, but they cut pretty big,” said Stacy Rasgon, a Bernstein Research analyst. “It sounded like they are baking in stuff they haven’t seen.”
In addition, second-quarter PC sales grew slightly in a surprisingly better-than-expected quarter, leading some to think that the second half might disappoint. Many companies have completed their transition to Microsoft Corp.’s MSFT, +0.23% Windows 10 operating system, warned IDC. “The closing sprint is unlikely to generate the spike seen when Windows XP met its [end of service] because we are further ahead of the migration with two quarters to go,” IDC analyst Lynn Huang said.
Others believe, though, that earnings hit bottom in the first quarter, and that slight improvement in the second half would be a sign that the worst is behind us.
“Instead of everyone being so worried about earnings, we have troughed,” said Brendan Connaughton, founder and managing director of Catalyst Private Wealth. “Yes, it’s still a year-over- year contraction, but you have to go back up after the trough.”
Connaughton’s research showed that combined earnings for S&P 500 companies are estimated at $40.35 a share in the second quarter, down from the year-ago number of $41.13; third-quarter earnings are estimated at $42.89, nearly flat with $42.87 in the third quarter of 2018; and the fourth quarter is estimated at $44.19, a jump from $41.32 a year ago.
“Q1 of 2019, that was the trough, that is the way it is playing out,” he said. “There are still a lot of fish to fry — you don’t know what will happen with the tariffs [or] the political situation in 2020. … But from an earnings standpoint, I am not scared of this market.”
There are many conflicting factors at play right now, but more seem bearish than bullish. Hutcheson of VLSI Research, though, said that he believed the semiconductor downturn has bottomed. “You can see there is a bottom and it looks like we hit it in May,” he said. “We are pulling out of this thing, but if you expect the second half to be above 2018 the answer is no. Now we are pulling away from 2017 levels.”
The U.S. reversal on its ban on selling some products to Huawei is helpful to hardware companies, but that is only one incremental factor — Broadcom suggested that only about a quarter of the $2 billion it cleaved from its second-half outlook was due to Huawei.
As tech companies step to the plate in the next couple of months, expect those that admit weakness ahead to be pummeled, much as Google was amid slowing growth and cloud-software companies that issued disappointing forecasts were last quarter. But companies that acknowledge reality may ultimately be rewarded, since investors prefer facts to false hopes.
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