Winnie Cheng, CFA, Principal Credit Analyst 

It is a story of the haves and have nots, depending on the segment within the technology sector. Hardware, semiconductors, and smartphones all compete in an environment marked by intense competitiveness, business cyclicality, rapid innovation, short product life cycles and high capital intensity. Unsurprisingly, all three segments had larger sales declines in 2022 than other parts of the industry.

After a surge in demand for personal computers and devices during the pandemic, demand decreased precipitously in 2022 and we expect further, but less severe, sales declines in 2023 as inflation, macroeconomic concerns and return to office trends further reduce demand.

Depending on the type of semiconductor chip, demand is either weak or robust. Memory and low-end computing chips suffered significant declines as excess inventory built up when demand for personal computers and devices dropped. Memory chips are generally interchangeable and have sparked price wars for market share gains in the past. More recently, the largest memory chip manufacturers have cut back on production and as device manufacturers work through their inventories, supply and demand dynamics could regain better balance in the latter part of 2023.

In contrast, the high-performance analog chip makers are having difficulty meeting demand and have order backlogs with long wait times from lingering supply chain constraints, production capacity issues, and high secular demand growth. This is due largely to the rising usage of embedded processors in biomedical products, automobiles and the rising trend toward electric vehicles, industrial automation, and demand for smart consumer products. Specialized analog chips with proprietary designs made for specific customers curtail substitution from competitors. Additionally, market share movements are gradual given the long design and life cycles of products that can last two decades. We expect backlogs to slowly abate through the rest of the year as supply chain and production capacity issues subside while demand remains strong.

Large industrial modernization, operational efficiency tech projects helped to drive sales for software, IT consulting and services, and cloud providers, but we are seeing more cautious corporate IT spending outlooks as macroeconomic uncertainty weighs on budgets. We expect some long-term initiatives are being delayed or projects are slowing implementation to lower capital expenditures.

Software and IT service providers are better positioned in an economic slowdown than semiconductor and hardware companies. Software is the most resilient subsector as software is typically offered on a subscription model or as-a-service (SaaS); the recurring nature minimizes earnings volatility and provides greater future earnings visibility. As many software packages are mission critical to the customer base, contracts and revenues are sticky. Software product suites that help customers manage more users and devices to securely connect to their networks for ecommerce, streaming, workflow, financial services, and media/communications have good long-term growth prospects.

Growth opportunities for IT consulting and services come from helping companies understand their options in architectural choices, accessing and analyzing data that may be trapped in siloed or legacy multi-generational software and hardware, moving workloads to private, public or hybrid clouds, data security, and ultimately building new applications and managing them.

Traditional hardware companies like IBM and Hewlett Packard Enterprises are transforming themselves to provide software and services, in addition to traditional products, to grow sustainable and higher margin revenues. IBM has also expanded into cloud services. Cloud providers often offer their platform (PaaS), infrastructure (IaaS) and software (SaaS) as a service, which provides recurring revenues. As more companies move their computing, analytics, and storage off on-premises mainframes to private, public or a hybrid cloud environment, it fuels not only the cloud provider, but also providers of software, security, database management, computing, storage, content delivery, networking and consulting. Estimates that every $1 of platform spend on average drives $3 to $5 of software revenue, $6 to $8 of services, and $1 to $2 of enterprise infrastructure illustrate the revenue multiplier effect for the entire tech ecosystem. As cloud providers raced to build datacenters to support growth, companies providing the hardware, servers and chips for those centers also benefitted. However, not even this fast-growing sector is immune to the uproar in the financial industry, high inflation, rising interest rates, and market concerns. Migration to the cloud will continue, but perhaps at a slower rate as companies reassess their expenditures.

We expect well-rated tech companies with solid cash flows, significant cash hoards, and leverage headroom to be ready to buildout a full stack of products and services with acquisitions of smaller players at currently more reasonable prices. The current equity market environment has deflated valuations and smaller tech companies are reassessing sales to bigger competitors as the probability of tapping the IPO market becomes more remote.

We are not expecting large debt issuances from most tech companies unless they have established capital expenditures for fabrication buildouts or acquisition funding needs. Most companies in our coverage universe have no need to refinance maturing debt. Given investor belief that the technology sector is a safe haven compared to more cyclical industries and concerns involving the financial sector, we would not be surprised by significant over subscription on better rated tech bond deals. 

Sources

Moody’s Investors Service

S&P Capital IQ

USBAM Research