Information Technology Industry Overview
The high technology sector is composed of a number of subsectors. However, the sector can be broadly divided between hardware manufacturers and software and service companies. The business dynamics and risk characteristics of both segments are quite distinct. The levels of cyclicality, capital intensity, operating leverage, and R&D cost and risk are usually much more elevated for hardware than for software companies. This results in hardware subsectors having a materially riskier business and credit profile than software and service companies
The following major factors affect the high technology industry globally and are important in understanding the industry’s competitive environment and prospects for growth and cash flow generation, as well as the industry’s challenges and risks. We include all the subsectors listed above, excluding software and services, in the hardware space
|Industry Challenges And Risks|
|High Tech Hardware||Software And Services|
|Product obsolescence and technology changes||High||Medium/High|
|Research and devlopment costs and risks||High||Medium|
|Competitive pressures on price, costs, and innovation||High||Medium|
|Pressure to move production offshore||High||Medium|
|Revenue, income, and cash flow volatility||High||Low/Medium|
|Cash reserve needs||High||Low/Medium|
Many of the high technology subsectors are very cyclical, which can lead to cash-flow volatility. Many participants therefore tend to limit leverage and financial risk, especially compared with other, less volatile industries
Hardware manufacturers face substantial business risk because of sizable capital and R&D expenditure requirements, the rapid rate of technological change, intense competition, and the cyclical nature of the business. Many areas of high technology are highly competitive and are subject to rapid, unanticipated changes. The dynamic business climate poses significant challenges for company management, requiring companies to adapt rapidly to evolving conditions. Because of the high level of business risk, many of these companies’ financial risk and leverage profiles tend to be more conservative, characterized by relatively high levels of equity capital, modest debt, and often substantial cash reserves accumulated because they need cash available to protect against cyclicality and unexpected downturns in earnings. While many companies have substantial total cash and marketable securities balances, we are concerned that the cash may not be domiciled to meet global financial and operating requirements, or may have high costs to repatriate it. In addition, during sharp industry declines such as 2000-2001 or 2008-2009, cash balances can be depleted very rapidly. As a result, we typically do not view high technology companies on a net debt basis. Although individual companies may have asset-light business models, the overall industry is capital intensive.
For software and services, the subsectors involved tend to be much less capital intensive than high technology hardware, and revenues, profit margins, and cash flows demonstrate markedly higher stability, because of significantly recurring revenue streams from maintenance, long-term contracts, and other sources. These are human capital-intensive businesses, often have high switching costs, and are not subject to as high a degree of cyclicality and obsolescence as hardware companies.
While the timing of technological change and obsolescence is difficult to predict, rapidly changing technologies with marked potential for materially eroding companies’ business and financial profiles are one of the few constants in the high technology sector. Cyclicality and technological change can create sharp declines and significant shifts in competitive dynamics, customer requirements, and buying patterns, which can rapidly reshape industry subsectors. The ongoing transformation of the data storage and semiconductor industry segments is an example of these market dynamics at work.
High technology companies’ earnings and cash flows are subject to cyclicality created by the business and/or consumer cycles. In many developed countries in recent years, volatility in business/corporate sector demand has tended to be markedly greater than cyclicality in the consumer economy. Historical recessions have largely been business-driven, rather than consumer-led, but in the current recession, demand is down sharply across both consumer and business markets.
Consolidation remains a long-term trend in many high technology subsectors as growth rates have slowed. Managements of larger companies view their subsidiaries as components of a portfolio that should be actively managed, a strategy generating ongoing acquisition and divestment activity. Customers want integrated solutions; in response, high technology companies are broadening their offerings through acquisitions
We consider the following factors to be the primary contributors of business success in the high technology industry.
- Defensible market position/barriers to entry;
- Technological and product innovation and leadership;
- Custom-engineered features;
- Effective distribution capabilities;
- Diversification of product lines, customer base and geography;
- Cost efficiency and flexible manufacturing operations;
- Recurring revenue base;
- Management with rounded skill set in business growth and marketing; and
- Sound financial management.
In analyzing a company’s competitive position, we consider the following factors:
- Barriers to entry;
- Market share, size, and leadership position;
- Operating efficiency and scale;
- Technological innovation, cost, and risk;
- Profitability and peer comparisons.
Barriers to entry. Barriers that limit new market entrants result in an entrenched base that can help expand existing customer relationships. Barriers include breadth of adoption of proprietary technology and platforms, the number of applications written for the platform, and high customer switching costs. Barriers are created when hardware and software applications become embedded in the client’s management of sensitive business data or critical operations, whereby it is said to have hooks.
Market share, size, and leadership position. High market shares let companies spread out costs and enjoy greater economies of scale than the competition. Strong market positions also let manufacturers reinvest in fixed assets and R&D to maintain product leadership. Market-share leadership creates clout with distributors, reducing the potential for price deflation. These traits can be shared by large companies such as Microsoft and IBM or by smaller companies focused on small, niche markets. Size allows cost efficiencies and greater resources to fund R&D, productivity, and service enhancements. Because size often closely correlates with–or may be an outgrowth of–diversification, companies need to have multiple products and revenue streams across broad geographies to grow. Smaller and midsize companies usually are precluded from reaching the highest ratings levels, despite having potentially strong profitability and financial ratios, because they lack product, market, and/or geographic diversification.
Brand tends not to be a major consideration for ratings in many high technology sectors, because most companies sell to other companies, not directly to consumers, so products and services tend to be bought on quality, price, content, and utility, rather than name. However, there are exceptions, such as Apple in the consumer electronics sector, where brand name does provide a degree of competitive advantage and differentiation.
Operating efficiency and scale. We typically view more flexible cost structures as important, because even though heavy fixed asset requirements can create a barrier to entry, they can also generate significant operating leverage. This can lead to dramatic declines in operating profit if unit volumes fall off. Cost position is important in most high technology company sectors because of pricing pressures. When the inability to raise prices causes margin pressures, constant initiatives to lower costs must offset those pressures. Varying the cost structure by limiting fixed capital investment–often by outsourcing noncritical activities–helps companies in highly cyclical industries maintain credit protection measures. Proven efficiency improvement techniques, such as Six Sigma and lean manufacturing, typically improve cost position. And, for those companies where labor costs are a meaningful percentage of product costs, geographic footprint can be a cost driver.
Diversification. We analyze diversification in terms of product lines, customer base, and geography.
- Product lines: A broad product portfolio lessens business risk and can mitigate cyclical pressures. New products offering increased value to customers enable the company to reset the price base, also easing pricing pressures.
- Customer base: Customer diversity can ease price pressures and protect against a sudden loss of demand.
- Geography: Regions may be in different stages of the business cycle and experience different degrees of severity of cyclicality, with downdrafts in some areas offset by upswings in others. Regions may have different underlying growth rates. A company’s ability to tailor strategies to the needs of local markets and manage foreign exchange risks is also important.
Technological innovation, cost, and risk. High technology companies must continually develop new features and capabilities for products, requiring them to attract and retain development talent and to efficiently allocate resources. Consequently, software R&D expenditures are a competitive necessity and are often largely fixed, given rapidly evolving technology. Measures of success include:
- R&D as a percentage of sales;
- Number of patents; and
- Royalty revenue as percentage of total sales.
A recurring base of maintenance, financing, supplies, consulting, and training revenue is a cushion against sales declines when the spending environment deteriorates, which leads to lower sales of new licenses and equipment. Long-term outsourcing contracts provide revenue continuity: Contracts are often five to 10 years long, and are rarely broken. While not strictly a recurring revenue stream, the opportunity for entrenched vendors to sell the next generation of technology or software to a relatively captive customer base promotes stable sales levels. Some of the more successful high technology companies benefit from customers vested in successive generations of their platforms.
Management. We look at management’s ability to run and expand the business efficiently, while mitigating inherent business and financial risks. We focus on the credibility and realism of management’s strategy and plans or projections, its operating and financial track record, and appetite for assuming business and financial risk. The high technology industry is very competitive, requiring experienced and successful management teams with a strong mix of the following disciplines:
- Revenue diversification and earnings quality;
- Product development, innovation, and engineering excellence;
- Operating efficiency and cost control;
- M&A integration and divestment;
- In some cases, brand development and management; and
- Sales force and distributor network.
The operating track record, management depth, and effectiveness of the organizational structure are also important factors.
Profitability and peer comparisons. Profit potential is a critical determinant of credit protection for high technology companies. A company that generates higher operating margins and return on capital also has a greater ability to generate equity capital internally, attract capital externally, and withstand business adversity. Earnings power ultimately attests to the value of the company’s assets as well. In fact, a company’s profit performance offers a litmus test of its fundamental health and competitive position. Accordingly, the conclusions about profitability should confirm the assessment of business risk. Profitability measures include the following ratios, which need to be compared with both those of other participants and of rated entities in other industries:
- Pretax, pre-interest return on capital;
- Earnings before depreciation, amortization, interest, and taxes as a percentage of sales; and
- Earnings and cash flow assessments of business segments.
Return on capital measures the underlying efficiency of a company’s invested assets and can be a leading indicator of long-term survival. This profitability ratio is indifferent to the mix of debt and equity in a company’s capital structure, facilitating the comparison of one company to another.
Source Standard and Poor’s