FITE - IG Technology: Working Through The Cycle
2023-03-30 00:14:00 ET
Summary
- The technology business cycle could have a slower-than-expected recovery, though we remain constructive over the long term.
- Certain parts of the IT sector, such as PCs, are showing early signs of bottoming, although the pace of recovery is uncertain, while other segments are not there yet.
- We intend to manage our exposure to the sector more defensively in the near term, but will look to add risk as opportunities present themselves.
By Ronnie Kihonge
The technology business cycle could have a slower-than-expected recovery, though we remain constructive over the long term.
The technology sector has benefited from long-term secular growth drivers—shifts to the cloud, increased electronic content in industrial applications, digitalization and artificial intelligence—generating revenue growth above GDP and supporting our constructive view. However, the sector has experienced softening demand over the past 6 – 12 months, and its recovery could be slower than normal.
Demand weakness is due to a deteriorating macroenvironment, which is slowing IT spending, exacerbated by a pull-forward in demand that happened during COVID, as work-from-home trends accelerated enterprise and consumer IT spending. Consumer spending on PCs jumped by 45% (to $953 billion) in 2021 compared to 2019. 1 Higher demand across end markets was eventually confronted with constrained supply chains due to lockdowns, leading to longer lead times (order-to-shipment period) for chip components. Lead times peaked at 27 weeks in April 2022 versus the normal 13-week timeframe. 2 As supply constraints eased and demand weakened, excess inventories piled up on company balance sheets, at distributors, and at customers. Company earnings were pressured, and management teams turned to layoffs and other cost cutting to mitigate declining margins.
Certain parts of the IT sector, such as PCs, are showing early signs of bottoming, although the pace of recovery is uncertain, while other segments are not there yet. For example, semiconductor lead times remain elevated at 23 weeks, which signals that supply chains are still constrained. As this unwinds, inventory could build up in markets such as autos, which have held up well so far. This could lead to a pullback in performance, albeit to a lesser extent than other segments because of secular growth drivers including the EV transition.
Credit metrics have normalized in the last year, starting from a position of strength due to the pull-forward in spending. Though the sector is not immune, rating downgrades and fallen angels could be fairly muted. Management teams have pursued conservative financial policies, with slowing mergers and acquisitions and reduced share repurchases.
Given the bifurcation of the investment grade technology sector—made up of large high-quality issuers and higher-beta BBB companies—we prefer high quality issuers and defensive BBBs. More cyclical BBBs have outperformed their lower-beta peers since the middle of 2022, and no longer properly compensate investors for potential macro or idiosyncratic risks, in our view. We intend to manage our exposure to the sector more defensively in the near term, but will look to add risk as opportunities present themselves.
Source: (1) Bureau of Economic Analysis; (2) Susquehanna
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IG Technology: Working Through The Cycle