About This Case

Closed

19 Dec 2007, 11:59PM PT

Bonus Detail

  • Top 3 Qualifying Insights Earn $300 Bonus

Posted

30 Nov 2007, 4:04PM PT

Industries

  • Enterprise Software & Services
  • Finance
  • IT / IT Security
  • Internet / Online Services / Consumer Software
  • Media / Entertainment
  • Telecom / Broadband / Wireless

How Will The Subprime Fallout Impact Tech Companies?

 

Closed: 19 Dec 2007, 11:59PM PT

Earn up to $300 for Insights on this case.

When the subprime crunch hit the mortgage industry, there were some who felt that it would be a good thing for tech stocks, as investors would start to park their money in the tech world again. Everyone knew it could still directly impact some firms that had financial exposure, such as the troubles E*Trade is now experiencing. However, it certainly comes as a surprise to many to hear that EchoStar, provider of the DISH Network satellite TV service, is facing increasing churn due to the subprime mess. Since EchoStar often targeted the low end of the market, the feeling is that its customers may be disproportionately hit by foreclosures and subprime-related issues.

This could serve as a proxy for other "hidden" subprime problem tech companies. Are there other publicly traded companies who most people wouldn't normally associate with mortgages who may be impacted by the trouble in the mortgage industry? For each company you name, please describe why you think they're likely to be impacted by the troubles in the mortgage industry.

14 Insights

 



Anyone whose business operates from a property that has a mortgage on it could be at risk.  Suppose the property owner got a bad deal and has to jettison the property.  Suppose said property also has the data center of the large business.  How many businesses could uproot their datacenter in a month?  What if they only had a day?  (example:http://www.cnn.com/2007/US/11/30/willis.rentervictims/index.html)  

Tech businesses that perform services to properties typically under mortgage will of course be impacted, as their available customer pool is shrinking rapidly.  As small business owners become unable to take out that second mortgage to finance some new operation, the small business service providers will take a hit.  I suspect the biggest surprises will come from businesses with large chunks of mortgaged property, where the business itself is unrelated to the fact that they now have some huge debt to contend with, and various banks or lenders end up foreclosing on seemingly random large business properties.

The problem is not just in the subprime mortgage sector but for mortgages in general in the U.S.  The problem is exerbated in the subprime sector because that is where some of the shakiest loans were made.  During the hay-days of the tech boom, housing prices rose too fast and morgages were made that were beyond most people's ability to pay in a normal market.  Now that the market is correcting, many homeowners are struggling to pay their mortgages.  Salaries are not increasing as expected, fortunes were not made that were expected, people are experiencing extended periods of unemployment, one spouse may not be working, etc.  People will do what they have to do to keep their homes.  It is the one durable asset that they own.

The immediate impact is a cutback of non-essentials such as consumer electronic items, cell phone extras, and entertainment services.  I would expect that EchoStar, DirectTV, and cable companies will see increased churn.  The first effect will be some disconnects and decreasing ARPU as people cut back on premium movie and sports channels.  Look for HBO, Starz, and others to be impacted as well.  Comcast, Time Warner Cable, Cox, Charter, and other cable companies will also experience decreasing ARPU that will increase as they raise prices for basic service.  Cell phone companies like Verizon, AT&T, Sprint, and T-Mobile will see decreased ARPU as parents cut back on their children's cell phone service and downloading capabilities.  They will tend to keep their plans for voice and SMS but cut back on the extras and possibly some extra lines.  The MVNO will be hit the hardest and first because of the correlation between customers.  Although they may pick up some month-to-month customers, the pay-as-you go customers will slow down their buying and stop altogether.  T-Mobile and Sprint may be a beneficiary as customers replace their home phone service with their in-home calling services. 

Big box retailers will see a hit in sales starting with Home Depot and Lowes as customers slow down their home improvements and major appliance purchases.  Circuit City, BestBuy, and other electronics retailers will see a slow down of expensive HDTV and other mid-market electronics purchases.  See customers cutting back to smaller sets and going on-line for purchases.  The real high-end equipment will still continue to sell well as this "crisis" has not hit the high-end of the market (i.e. buy Neimann Marcus).   

Financial services companies like E*Trade, TD Waterhouse, Fidelity, Oppenheimer, and others will see a slowing of trades and purchases because people will allocate more of their disposable income to maintaining their current lifestyle; thereby, shortchanging their future.  Discount brokers will see less income from trades and mutual fund purchases as this money will now go to paying mortgages and other necessities.  Customers have already been draining their investment accounts to keep up with mortgage payments.  These companies will feel this effect for years.  Look for greater consolidation in this industry.

There will be a trickle-down effect to companies that sell to these three segments.  IT spending will be impacted as retailers cut back on IT projects due to decreased growth.  The overall impact when analyzed will be a decrease in growth rate not a decrease in growth causing a slow-down in the economy.  The Fed needs to respond by sopping up excess dollars, and Congress needs to think about tax cuts to stimulate the economy instead of giant bail-out programs. 

icon
Devin Moore
Wed Dec 19 5:20am
I don't really see HDTV sales slowing down at all, in fact I think the vast majority of TV sales will be HDTV's. Not because people want to buy them, but because they don't have a choice -- been to wal-mart lately? They are 90% hdtv now there. I think that a lot of Circuit City / higher markup stores will suffer overall though, especially when you can go to a place like wal-mart or amazon.com and get the same thing for less. People will bargain hunt for the same purchases they would make out of convenience for more money today.

Research in Motion has undue exposure to Wall Street customers. When the traders of mortgage backed securities get laid off, the employer will be deactivating the account.

Letting the 40-F speak for itself:

Reduced spending by customers due to the uncertainty of economic and geopolitical conditions may negatively affect the Company.
Many of the Company’s end-users of the BlackBerry solution are directly affected by economic and geopolitical conditions affecting the broader market. Current and future conditions in the domestic and global economies remain uncertain. A slowdown in capital spending by end-users of the Company’s products, coupled with existing economic and geopolitical uncertainties globally and in the financial services or legal markets, may create uncertainty for market demand and may affect RIM’s revenues.

 

It is difficult to estimate the level of growth for the economy as a whole. It is even more difficult to estimate growth in various parts of the economy, including the markets in which the Company participates. Because all components of the Company’s budgeting and forecasting are dependent upon estimates of growth in the markets that the Company serves and demand for its products and services, economic uncertainties make it difficult to estimate future income and expenditures. Downturns in the economy or geopolitical uncertainties may cause end-users to reduce their IT budgets or reduce or cancel orders for the Company’s products which could have a material adverse impact on the Company’s business, operating results and financial condition. In addition, acts of terrorism and the outbreak of hostilities and armed conflicts between countries have created uncertainties that may affect the global economy and could have a material adverse effect on the Company’s business, operating results and financial condition.

In the September quarter, RIMM shipped more than 3 million devices but added only 1.45 million net subscribers. It would be tempting to think that the extra units were an inventory build in advance of the holiday season, but the inventory has been building now for several quarters.

I'm guessing they probably still have a quarter or two ahead of them before the cracks spread too much to continue covering them. 

Google

Not the first person to notice this, but Google gets 34% of revenue from financial services and a large percentage of that from the mortgage folks. Google themselves have noted a cutback in ad spending among their customers, but so far the cuts have been to traditional media outlets.

"We have heard anecdotally from several advertisers that they are cutting their spending," Jon Kaplan, director of financial services advertising at Google (GOOG) told Reuters. "People are cutting their budgets but (Web) search is not the first thing, it's the last thing."

The benefits of online ads in terms of targeting and measurability will indeed accelerate adoption of online ads at the expense of traditional media. But the same thing was true in 2001 and it didn't help Yahoo or AOL any. It won't help Google this time, either.

The good news is, when it does happen it should provide a great buying opportunity for a great cash flow machine. 

Derivatives are not only mortgages. Anyone who has a positive cashflow from a steady source has tried to monetize it by selling derivatives. Telecom operators, for instance; and companies who sell tech support (probably, have not done any deeper analysis). But if so, there are two types of impact: The first is the impact on the derivatives themselves. Take what has happened to Echostar. When the subscribers stop paying, the same thing that happened to the mortgage companies happens: The risk you took over when you bought the derivative increases. The second is the compound risk of having the papers in the portfolio. Even if all tech papers performed as they were supposed to, the bank papers would increase the total risk - and since these portfolios are percentages of different papers (essentially IoU:s), the total risk increas es. Which means the price falls, and the  ;valuation falls. And you have to write down& nbsp;the total assets of the companies. 

The companies who sold their cash flow as derivatives will not feel it to any great degree. Until the next time they try to do so. The ones with the worst performing derivatives will find it difficult to sell them. Which means they can not move the risk off the balance sheet and monetize their cash flow, and some of them will go broke.

The companies who bought derivatives (for instance, to invest their extra cash) will be hit beause they will not get back all of their cash - worst case, their pension funds, or other long-term committments. This can hit any company who has money invested.

So paradoxically, the ones who will be hit are the ones with a steady cash flow which has started to perform unexpectedly badly - and those who are doing well. Those are the ones who will feel the most long-term effect.

Contrary to the question, this will not make it easier for tech companies. They will find the derivatives market more costly (as risk ncreases, fees increase), both to sell and buy. So that will hit all tech companies.

All companies being hit, sounds like a recession....

Hope this helps

//Johan


Cognizant Tech (CTSH)

Financial services unit accounted for approximately half the company's 2006 revenue and revenue growth, and for an even higher share of profit growth, according to annual report.

In the latest 10Q they attributed results to "continued strength" in the financial services unit.

BearingPoint already has seen an impact, let's see how long the strength can continue for Cognizant.

Tech companies get capital from stock not debt.  It will actually help them if the debt market gets soggy.

Here's the key...employees need to be mobile...they are afraid of housing risk.  A top benefit for tech companies should be the use for 1 year of a few condos...held by the firm.  1 year free rent as comp for top engineers.  Things work out...the risk is minimal to a young engineer...things don't work out...housing opens up for a new employee.  Easy to add capacity.  Easy to cut capacity.  

icon
William Trent
Thu Dec 6 8:04am
Anything that affects the debt market will typically flow through to the equity markets as well. And regardless of the way tech companies finance themselves, it is whether the customers have access to capital to fund their tech infrastructure that is going to affect the tech companies.
icon
Ryan Lanham
Thu Dec 6 12:33pm
I disagree that debt and equity markets are linked. That's just not accurate.

Further, the capacity of firms to purchase tech is not driven by their ability to access debt capital from homeowners. Relatively few firms are directly impacted by the mortgage crunch directly...the follow on recession from consumer debt is another story.
icon
William Trent
Sat Dec 8 9:20am
If the debt and equity markets are not linked, why does the stock market rally on news of a Fed rate cut?

The risk in the subprime meltdown is raising the overall cost of capital, and particularly the risk premium paid for anything other than treasuries. If investors are willing to continue holding risky assets other than subprime mortgages then there would be no spillover.

But if investors, for example, don't want to own the bonds of finance companies because they fear the companies face greater risks, those companies won't have money to lend to businesses, who then won't have money for expansion (and therefore a need to buy more technology.)

Whether the debt is used directly for buying technology is irrelevant. Debt capital is a source of funds, and with fewer (or more expensive) financing options there is less money to spend on everything, and tech is a big portion of the overall corporate spend.

Even the most basic finance books will explain that debt (as high interest rather than bond price) and equity are, at best, inversely related...that's why stocks rise when interest rates fall--demand goes up for stocks when demand for debt falls.  Most will point out that money moves between these markets based on risk tolerance...not based on correlation.

You implied they were linked by correlation of interest rate to low equity price...that is simply false...there can be monetary expansion, other inflation, currency devaluation, etc. applying much bigger impacts.  Look at any bond and correlate it with stock moves...there is often (usually) little or no relationship--it is often even inverse.  Again, finance 101.  Bonds are typically offered by low risk firms--even junk bonds.  Stocks are offered by all types of firms--particularly smaller and more inchoate technology firms. 

Bonds are much more sensitive to economic shocks than stocks which tend to measure company performance (again, there are exceptions like cyclicals, etc.) 

Stocks are equity and bonds are debt.  Debt is senior--virtually always.  That seniority changes it's performance notably from stocks again with other factors in play--how many assets exist, etc.  Again...interest rates for a given stock tend to fall when the demand for the equity is high.  But not always.  The bonddad blog gives you lots of insights...I'd recommend reading it.

Costs of capital are indeed falling now (in most but not all markets)--interest rates are being cut...not rising.  When debtors default, costs of capital fall...think about it.  But the whole thing is about scale and focus...not any simplistic rule.    

Fewer sources of funding occur during high defaults only for high risk investments or markets that are saturated by junk debt (e.g. cable TV of a few years ago...or cell phone companies.)  Technology purchases for large firms are rarely "high risk." 

What's more, I guarantee that Countrywide would sell all the good mortgages it could right now at very attractive interest rates--30 year mortgages are at multi-year lows...under 6%.    

There is nothing wrong with your insight, but in my opinion, the logic of your comments, while probably intended to advance your own answer by detracting from another, has simply cast doubt on your ability to reason through financial issues.

My position continues to be that there is little direct impact on technology firms from the mortgage fallout absent a broader recession.  Certainly none with regard to "cost of capital."   Disagree if you wish, but the thread is through as far as I am concerned.

 

 

icon
William Trent
Sun Dec 9 6:41am
I'll agree to disagree and let the thread die.

However, I'll ask that you not speculate on my motivations for commenting. My understanding was that this was supposed to be a forum.
icon
Ryan Lanham
Mon Dec 10 9:00am
Fair enough...I apologize for the speculation.

There are two major economic effects that are happening because of the subprime mortgage collapse. The first is an increase in the cost of capital. Not only are the rates for home mortgages going up, but rates for all types of loans are increasing. This is because lenders (namely banks) have lost billions on bad subprime debt and need to make up the profit elsewhere. The banks are also becoming much more risk adverse, meaning they are less willing to lend money, even to people or companies with good credit.

This means that there will be less captial available for loans should companies be looking for money for either a startup or a cash infusion to help a struggling company. Look for those companies that have had bad a bad year or two and hemorrhaging cash - it is likely that they will not be able to refinance their debt easily and the problems could get worse.

The second major effect is a decrease in the amount of consumer spending. We already know that Americans have a negative saving rate, meaning they spend more money than they earn. This is financed by buying with debt, usually in the form of a credit card. During the housing market boom, consumers were using the rapidly increasing value of their home to either sell or re-finance the mortgage to pull out home equity. This was treated as a new source of cash and in a lot of cases used to pay off credit cards or in others, unfortunately, to just buy more things. Now that home prices are crashing, consumers are unable to take out large amount of home equity.

This means that consumer spending is going to tighten and the companies effected are going to be the ones that offer non-stable products. So people will still spend money on food and gas because they have to, but you will see less discretionary spending on things like new cars, expensive electronics, and other high ticket luxury items. The retailers and companies that rely solely on these products will see a drop in sales and thus revenue and profit.

I think you can slice this in a variety of ways:

Companies dependent on ad revenue from housing/mortgage lenders and further downstream secondary effects

Bankrate (Nasdaq: RATE) should be the bad-boy of the subprime mess, but this thing holds up like a champ.  There is a large short interest against the stock but the firm recently  received some big upgrades after trading softly, as the market was expecting some shortness.  RATE operates in two segments: one online and the other offline.  Bankrate acts as a data aggregator of all kinds of rates (mortgages, interest, etc.).  Acting as a middle man, Bankrate gives syndicates its data out to its network of traditional web publishers (frequently for free) who publish these rates.  Users who click through on rates are then taken through a 6-step process intended to generate a mortgage or savings account lead.  Bankrate gets paid by its advertisers and shares out these revs in a split with its publisher partners.  The short argument is pretty straightforward -- as more and more talk of an interest rate reset freeze, this could trigger a decrease in traffic linked to refi's.  Bankrate's customer base has traditionally not been subprime, so you have to do your homework in terms of its exposure to this market. 

If Bankrate truly does tank because there is less refi traffic, than any publisher that receives significant revenue from Bankrate would suffer as well as they'd get less of a payout.  Move.com (Nasdaq: MOVE) is a recent addition to the network and Bankrate also has Yahoo! (Nasdaq: YHOO), America Online (NYSE: TWX), The Wall Street Journal (NYSE: DJ) and The New York Times (NYSE: NYT) in its network.

Google (Nasdaq: GOOG) has traditionally seen a lot of mortgage related keyword bidding with some refi/subprime keyword being very lucrative for the firm.  Google says its not affected by what's happening but you have to think that demand for certain keywords has softened.  That said, when advertiser scale back, they're frequently reallocating offline funds to online -- and search generally has the best ROI.

IAC (Nasdaq: IACI): Owns Lendingtree, which is one of the largest players in the lead generation game, along with Lowermybills.com, now owned by Experian.  Lendingtree allows users to submit a mortgage request and then mortgage firms bid on the business.  Lendingtree gets paid by the lead.  By keeping a limited number of bids per every RFP for a loan, Lendingtree can juice the fees it gets paid for leads.

Yahoo (Nasdaq: YHOO): A lot of estimates point to Yahoo having the� largest �share �o f�mortgage-related� display� advertising� - totaling� approximately� $225� million �for �the� 12� months �ended� July �2007, according to a research piece by Bernstein.  This �means� that �approximately� 18%� of �Yahoo!'s �online� display �advertising �revenues� in� the �last �12� months� came� from� mortgage-related advertisers.

Companies affected by less spending money at the household level


Earthlink (Nasdaq: ELNK):  While Earthlink has transitioned many older customers to DSL, they still have a sizeable business in the dial-up, lower end of the market.  They're hurting here anyway and what's going on in subprime land can't help.

Callwave (Nasdaq: CALL):  Dialup customers use this to divert incoming calls to voice mail while they are online surfing.  This targets the lower end of the market.

DealerTrack (NAsdaq: TRAK): provider of on-demand software, network and data solutions for the automotive retail industry, also facilitates credit applications.  People stop buying/financing cars, dealers use less on-demand software.

IDT (NYSE: IDT) IDT does a lot of business in the affinity calling card industry.  These specifically target lower means minorities, already suffering from the mortgage squeeze.

Companies like Harris Interactive (Nasdaq; HPOL), and Greenfield Online (Nasdaq:SRVY) internet-enabled polling and survey firms may see reduced business as their clients, primarily B2C, mass market firms ease up on spending as the US consumer weakens.

Construction/general real estate effects on certain tech companies

Tyco (NYSE: TYC):  Tyco is a pretty diversified company, although somewhat less so after breaking itself apart earlier this year.  TYC still owns ADT, an alarm services firm.  Less turnover in housing, less new real estate being built, means less business for ADT.  They also have a valve, safety and fire business -- though these are more exposed to the commercial real estate market.
icon
Joseph Hunkins
Wed Dec 19 11:53pm
when advertiser scale back, they're frequently reallocating offline funds to online -- and search generally has the best ROI.

I think this is an excellent point. Unfortunately this makes it even harder to know if having a lot of distressed companies is going to hurt Google revenues very much. I agree with you it won't be a major factor, though probably a negative and minor one.
icon
Zack Miller
Thu Dec 20 1:53am
Thanks for your comments, joeduck. I agree with you. I sat with another publicly traded internet CEO this morning and pushed him on what he thinks would happen in a recession on CPC rates. I think search, although it would take a hit, is almost at the point of being recession-proof. It's that important for advertisers --- I see it almost as the just the cost of doing business nowadays.
icon
Zack Miller
Fri Feb 22 2:05am
by the way (and oh, i feel like a blog post coming on), there is tremendous exposure in tech now for many tech firms on their own balance sheets given their cash and near cash holdings. I've spoken with a few firms (software firms in particular because they generate a lot of cash) that for an extra 100 basis points, have been investing in SIV type vehicles and are now impairing their cash. Value investors, be prepared to see some cash disappear as CFOs understand that not all money market-type investments are safe.

The first victims may be homeowners pinched by a tightening housing market, but then the ripples will spread. Homeowners do more than subscribe to satellite television services. They shop on Amazon and they subscribe to AOL.

As an example, let's take eBay, which could gain and lose money from the subprime mortgage crisis. If homeowners are dropping services like EchoStar (and DirecTV), it implies that consumers would also cut back on unnecessary online purchases, while some will also decide to raise money with their own online auctions. Meanwhile, mostly-seller sites like Amazon and Barnes and Noble would face an unmitigated drop in their incoming revenue.

Sales of expensive handheld devices are sure to taper off in a cash-strapped economy. This could also end up hurting Apple, which enjoyed a surge in revenue from iPhone (and iPod) sales. But ultimately, all web sites should feel the pinch. Most online advertisements are for consumer items like automobiles and clothing. When home-owning consumers trim their spending, advertisers feel pressure to trim unnecessary expenses — and the first expense to go is always advertising. I experienced this in early 2001 when working for a web site about PDAs. Palm laid off 20% of their work force. Then they stopped buying advertisements on our web site. And then we laid off 20% of our workforce.

That signaled the start of the "dotcom bust," which lends new significance to today's rumors that this Christmas, Palm will again be laying off hundreds of workers. Some would even argue this represents a best-case scenario, with the damage limited to homeowners, the companies that cater to them, and the publishers who run those companies' ads. If a genuine "liquidity crisis" comes, it could threaten all stock portfolios (including retirement funds), hurt profitability across all industries, and lead to widespread layoffs in all industries. The hardship would continue in ways that are small and unexpected. (For example, corporations would curtail unnecessary air travel, leading to unexpected hardships in the airline industry...)

Paul Krugman wrote that a major concern is that "hundreds of thousands, and probably millions, of American families will lose their homes," then added that "the financial system as a whole is getting wobbly." In a later column he added that the market isn't panicking irrationally. "It's a wholly rational panic, because there's a lot of bad debt out there..." And elsewhere he admitted that "I’ve never seen financial insiders this spooked."

Companies like EchoStar may be sending us an early warning — that the mortgage crisis will impact more companies than just those in the financial sector. Ultimately, it will impact them all.

Obviously, those tech companies which have a direct link to the low-end cash fluidity market will suffer, if they haven't seen problems already, like E*trade and EchoStar. But there's absolutely no reason at all that tech stocks in general should be hit by the subprime mortgage problems facing the US economy at the moment.

However, it would be blinkered to ignore the fact that the economy has been hit and could be hit further by the amount of low-end borrowing that sub-prime mortgages have encouraged. With high interest rates and a lack of easily available capital, many investments, not just in tech stocks, have seen little, no, or negative return in the last few months. This started with the sub-prime market and has spilled over into other areas to the point where it can it inevitable that a few tech stocks are affected. 

The effect that this should have is to make the market less crowded however. Only the strong offerings should be able to survive in such a climate as all available capital gets sunk into less risky opportunities. Tech stocks will still be seen as high risk, but some will be obviously less high risk than others, at a similar rate of return. In reality this trend will take time to appear. Some tech companies will already have pre-crisis funding to last them the year, some will already have burnt all their funding and be on the way out, some will be using it wisely or not require funding yet.

Expect the really strong players to come through the crisis and emerge still strong at the beginning of the financial year after next, after the subprime crisis has played out and re-investment is being sought. 

Recent turmoil in credit markets, significant slowdown of the previously booming residential construction segment and a national decline in average housing prices, all related to the breakdown of the U.S. subprime mortgage industry in August 2007, have caused some economists to ponder the possibility of a pronounced recession. This is particularly relevant to companies in the technology sector since the last two U.S. recessions, in 1991 and 2001, proved to hit its members hard. The prospect and according effect of a near-term slowdown in IT spending over the next 10-12 months is likely to be reflected first in consumer IT spending with the tendency to become IT segment-specific in nature.


Segment Expectations
Pending a slowdown of GDP worldwide related to the fallout from the subprime mortgage crisis, there following is a breakdown of what to expect from individual IT industry segments.


End-user focused
Since the downturn is consumer-led, its main impact will be on consumer buying. Initially, mature markets, where technology penetration is elevated, will feel the effects of a downturn first. Therefore growth in consumer technology markets which sport high penetration will slow. Small business investment will follow suite by cutting investments due to uncertainty and reduced demand for products and services. Finally, larger businesses will re-prioritize initiatives and postpone major projects/investments that present high levels of risk.

Impact on Microsoft
The Redmond-based company’s desktop operating system monopoly suffered a major blow as its Vista operating system, released in January of this year, struggled to gain traction in the marketplace during 2007. The company predicted that Vista would quickly overtake XP as the preferred desktop environment for customers but when this did not occur it was forced to extend the shelf life of the latter by five months [see: http://news.bbc.co.uk/1/hi/technology/7017624.stm]. Users consistently complained that the negatives of upgrading to Vista outweighed the positives. Microsoft responded, in effect, by stating that it expected 2008 to be the year where Vista picks up some seriously needed momentum. However, the subprime mortgage debacle and its effect on IT spending levels bode unpleasantly for this expectation. And as the effects economic slowdown deepens, Microsoft’s bet that Vista will rebound in 2008 and into 2009 looks increasingly tenuous.

On the other side of the coin, this year marked the emergence of a worthy competitor on the consumer desktop operating system front in the form of Ubuntu [http://www.ubuntu.org/]. Backed by Canonical, Ltd. the open source operating system garnered a partnership with Dell [see: http://www.dell.com/content/topics/segtopic.aspx/ubuntu?c=us&cs=19&l=en& amp;s=dhs&dgc=EM&cid=21690&lid=511380]. While Ubuntu is still a bit rough around the edges for the average Windows user, exposure to that same crowd is set to shed light on its weakness while concomitantly accelerating the shoring up of those areas. It is very possible that by the time an economic downturn concludes and consumer spending returns to previous levels Ubuntu might be a considerably closer alternative to Vista for the mainstream user. Considering the rapid rate of improvement and innovation demonstrated by the Ubuntu community, this is far from impossible. In addition, the continued strong demand for Internet-based office productivity tools that should also increase during a decline looms somewhat ominous for Microsoft.

Impact on Red Hat
In much the same way that Ubuntu will potentially be afforded the opportunity to make up room on the consumer desktop end, Red Hat will have a similar opening on the enterprise desktop. If organizations, that in the past have considered migrating to Linux and are due to upgrade PC operating systems, face reduced IT budgets through 2009 then Red Hat Enterprise Linux will be the leading candidate. For those companies that have yet to consider Linux on the desktop delayed upgrades might serve as the occasion to start investigating what all the “hype” is about. Expect Red Hat to benefit greatly from any reductions in government and education budgets in 2008 and 2009 as a result of lower levels of tax revenue. These sectors have traditionally been at the forefront of considering Linux on the desktop and the impact of the subprime debacle has a good chance to emerge as a tipping point.


Hardware
A slowdown can be expected in every segment but it will start in the PC and handset market. At the outset it will be consumer-directed but should extend to the professional market as businesses extend hardware life cycles and find ways to better utilize existing hardware assets. Already set to slow over the next five years due, in part, to the rise of rapidly maturing virtualization technologies, server and storage shipments will slow as extra capacity will be put to better use.

Impact on Dell
Depending on both the nature and depth of a downturn, the Round Rock, Texas company will find consumer sales of notebooks, desktops, monitors, printers and other accessories affected negatively. Upon announcing 3Q07 earnings, founder and CEO Michael Dell predicted more restructuring costs for the future, including acquisitions, layoffs. He also summarized a long-term strategy to “grow cash flow considerably over time,” key to this is a focus on hardware for consumers, software and other products for small- and mid-size businesses (SMB), and the increasingly profitable business of managed software services.

A drop in consumer spending would undoubtedly affect Dell’s plans to execute the aforementioned strategy over the remainder of the current fiscal year (over at the end of January) and into the first three quarters of 2008. This would not bode well for the company as it seeks to prove to Wall Street that it is on the path to sustained growth experiencing several setbacks since August 2006, when the computer vendor disclosed an internal accounting investigation and issued a massive notebook battery recall. It would also affect Dell’s pursuit to regain the No. 1 position in the PC market that it lost several months later to rival Hewlett-Packard Co., which it has yet to gain it back.

Impact on Cisco
The network solutions firm has found itself positioned somewhat at the epicenter of the tech fallout since early November after posting stronger-than-expected earnings and then turning around and offering a cautionary outlook. Cisco spoke of a slowdown in Internet technology spend from its corporate customers, particularly those in the banking and retail sectors. Far from playing the role of “wet blanket” Cisco’s statement reflected the realities of the early effects of the subprime driven credit crunch finally putting the clamps on tech firms. In November, the 3% drop year-over-year in the San Jose, Calif.-based company’s core switching business because of weakness in the U.S. market is a definite sign that it will be difficult to make good on its long-term target for revenue growth of 12% to 17%. This is proof that even global hegemonies like Cisco are not immune to unexpected deteriorations in the spending atmosphere.

Cisco has long depended on enterprise customers that compose a large chunk of the companies that have been hit hard by recent market turmoil including: all major Wall Street banks, retailers, and those in the manufacturing sector. The wave of write-downs tied to mortgage-backed securities and a drop in consumer confidence currently plaguing retailers and automakers (Ford and General Motors are customers) means that Cisco’s customer base won’t be spending anytime soon. In fact, most are looking to survive to spend another day further down the line.

Impact on Apple
Riding high on the recent success of the iPhone, Apple is looking to this year’s holiday season to provide an additional boost in the form of a jump in sales of Mac computers and iPhones. However, if consumers pull back during the winter, Apple might take an unexpected hit to sales. Furthermore, the company might not be able to depend on sales of the iPhone in Europe to balance lower numbers at home, since the device is noticeably slower, more expensive and less flexible than others already available across the Atlantic. Plus, the device sports a restricted range of carrier flexibility than what Europeans are accustomed to. These are just some of the numerous barriers to healthy sales in Europe, if numbers don’t hit sales targets (200,000 by January 1, 2008) this would serve as a double whammy for Apple in the face of potential for reduced consumer demand in the U.S.

 

IT leasing and financing
Since 2005 a number of companies have entered the IT equipment leasing marking using collateralized debt obligations (CDOs) as a method of raising sizeable amounts of capital. However since the July – August time frame of the current calendar year the sale of CDOs have dropped precipitously as a result of the subprime mortgage troubles. Before the subprime bubble burst, companies packaging up CDOs generally comprising of 75 to 80 transactions were under pressure to move the portfolio to market. As a result, there was a noticeable trend of surprisingly low price quotes for IT leasing or financing transactions emanating from companies that were trying to finalize and push CDOs to an underwriter. Meaning quotes were being offered at those levels only to complete a pool of deals, as opposed to the result of some type of innovation or market disruption that those involved with the IT leasing industry have come to expect.

However now that the market attractiveness for CDOs has weakened severely, there is a reduced source of capital into the IT leasing/financing market. This could result in stable pricing levels for customers or even higher lease/finance rates across the board. Pockets of competitive pricing might also evaporate as providers find themselves under the added pressure of a new set of industry wide forces created by subprime troubles. Meaning, IT leasing and financing providers that have direct access to financial markets are best suited to ride out this market development and continue to remain competitive in its aftermath. This includes companies such as CIT, GE (through its GE Capital arm) and IBM (through its IBM Global Financing branch). The size and breadth of all three help buoy their status as top options for customers that are increasingly cautious in carefully considering all contract terms and conditions.

 

Software
Most likely, this market will experience a categorical slowdown. After the last major infrastructure overhaul in preparation of Y2K (1998 through 1999) the next cycle began in 2006 for most organizations. Over the past five years companies have been particularly active in adding applications that augment underlying architectures. Meaning wide-accepted areas of perceived strategic value like data warehousing and business intelligence (BI) attracted a lion’s share of investment. In the case that a protracted downturn becomes imminent, planned upgrades will be pushed to the back burner as expenditures are bridled until the economic outlook recovers.

Generally, the applications market would experience the biggest impact. Enterprise collaboration and productivity would continue as a priority as will cost-effective, customer-centric efforts and projects. On the other hand, the CRM suite and ERP suite markets are typically affected by swings in the GDP so they are more likely to weaken through the end of 2008 and into 2009. It is also worth noting that as the larger, publicly-traded CRM vendors move to offer consolidated platforms the price points of offerings and services has risen. Customers are being encouraged to upgrade to these new platform-centric products that encapsulate more and more of the categorical functionality.

Impact on...
The Oracle CRM business – Centered on a portfolio of: E-Business Suite CRM, PeopleSoft CRM and Oracle Siebel CRM On Demand, offers a range of choices to a variety of customers. However, the desire to simultaneously grow revenue-generating opportunities and contain costs that tends to characterize the business environment during an economic downturn should help generate more demand for Siebel CRM On Demand. This is a solution that has developed into a leader in the enterprise CRM Suite market by duplicating the benefits offered by other CRM software-as-a-service (SaaS) solutions: faster implementation times, usability, and affordable upfront costs. Values that customers in the SMB sector will prize even during a d However, the demand for implementations involving the other two heavyweights in Oracle’s CRM portfolio will level off, at best, if they don’t drop sharply.

Salesforce.com – The company’s Salesforce continues to provide easy-to-use, strong SFA functionality coupled with an expanding array of capabilities in areas like customer service, partner relationship management, and marketing features. Key to its successes is top-notch mobile device support introduced by its acquisition of Sendia in the first half of 2006. Salesforce is billed as CRM for everyone, so the vendor doesn't offer deep industry-specific editions. As a leader in midmarket CRM suites, Salesforce.com enables short deployment time frames (normally within 30 days) as well as other features particularly attractive the SMBs. And despite the fact that a fluctuation in GDP output would have a sizable affect on a pure-play CRM vendor like Salesforce.com, the company will actually benefit from an impressive customer base (over 27,000) with less money to spend on new initiatives since most, if not all, will turn their attention to maintenance spending that improves their customer facing efficiency. Considering the size of its customer base, this will produce anything but a small effect on the company’s bottom line.

 

Services
The entire IT services industry has been moving towards consolidation en masse marked by an increase in leveraged buyouts and acquisitions. The credit squeeze has brought this trend to a halt as well as calm to the industry landscape for the time being. The downturn has sustained the U.S. market by safeguarding the revenue of U.S. vendors while slowing down the rate of acquisitions amongst Latin American IT services vendors. Still an economic downturn affects business confidence which, in turn, determines the willingness to invest in IT-related projects. Ultimately, this is a net decrease in the number of opportunities for companies in the professional services sphere.

Impact on CSC
Long regarded as an old-fashioned IT outsourcer with strong technical skills but a lacking in deeper business expertise, CSC is a company with a strong orientation toward business technology (BT) and a solid business orientation in its services positioning. Almost 50 years of experience as an outsourcer has strengthened its ability to deliver business results to clients. However, during a downturn there are opportunities to offer alternative models to custom IT projects in the form of expensed IT management and process management. To do so requires strong, flexible services capable of positioning a services company well enough to capitalize on the chance to buffer the effects of a shifting economy.

When compared to competitors like Accenture, IBM Global Business Services (GBS) and Infosys, CSC is not a good pick to best adapt to the realities of a downturn. While it is big (79,000 employees) with $14.6 billion in revenues the company’s overall financial performance is noticeably weaker than that of the other companies of a similar complexion. CSC revenues grew only by 4% while net earnings declined by 22%. Coming off a year where net earnings dropped by over 1/5 an economic downturn (even a slight one) is the last thing that a company like CSC needs. Add to that, Americas remain the main driver of its business and countries with the strongest connections to U.S. economy will experience the consequences of a slowdown first and foremost.

If the credit crunch persists into 2009 the company will be hit especially hard seeing how it doesn’t have the luxury of picking up the slack in other markets across the world, like an IBM Global Business Services does. To address this fact, CSC has already significantly invested in developing new engagement management and service delivery models for its outsourcing offerings, something which was at the root of an increase in the ratio of sales-related expenses to overall revenues. Yet this investment will take time to pay dividends and in the meantime CSC must confront unpleasant realities in the short-term.

icon
Alex Fletcher
Wed Dec 19 9:38pm
Since I neglected to include links in my submission here are the Google Finance links for the companies listed in my insight to aid references made by anyone reading this submission:

- Microsoft [http://finance.google.com/finance?q=MSFT]
- Red Hat [http://finance.google.com/finance?q=RHT]
- Dell [http://finance.google.com/finance?q=NASDAQ%3ADELL]
- Cisco [http://finance.google.com/finance?q=NASDAQ%3ACSCO]
- Apple [http://finance.google.com/finance?q=NASDAQ%3AAAPL]
- IBM [http://finance.google.com/finance?q=NYSE%3AIBM]
- CIT [http://finance.google.com/finance?q=NYSE%3ACIT]
- GE [http://finance.google.com/finance?q=NYSE%3AGE]
- Oracle [http://finance.google.com/finance?q=NASDAQ%3AORCL]
- Salesforce.com [http://finance.google.com/finance?q=NYSE%3ACRM]
- CSC [http://finance.google.com/finance?q=NYSE%3ACSC]
icon
Joseph Hunkins
Wed Dec 19 11:51pm
Nicely detailed points here Alex. Agree that the broader trends are negative though I think it's extremely hard to parse out the effect on individual stocks since broad market info is incorporated so quickly into share prices.
icon
Alex Fletcher
Thu Dec 20 7:02am
Good point, Joe.

In my opinion the subprime fallout is NOT likely to have predictable *additional* effects on any technology stocks for three main reasons:

1) It is reasonable to assume that the market has now incorporated the subprime mortgage meltdown into both financial and other sectors.   Unless new and extremely bad news is on the horizon - and I'd suggest this is unlikely - the markets are unlikely to respond significantly.    I do think there is more "bad news to come" from key lenders like Sallie Mae, but I think the market has already factored in a lot more bad news.      

2) It is now clear that active and expensive government interventions are going to lessen the economic instability from the subprime fiasco as well as distort its effect on markets, making all stock predictions even more speculative than they'd normally be in a case like this.    Given the bailout, I think a rebound in stocks like Sallie Mae and Etrade is as likely as further declines in their share prices.    If the government chooses to massively intervene as they still might do, financial sector stocks could be poised for a significant rebound.

3) Online advertising potential remains strong.   The effectiveness of online advertising, especially pay per click for targeted market niches, is still underestimated.   Some suggest financial company troubles will lead to a decrease in their online advertising spend, but to the extent they need to increase the effectiveness of their advertising it may lead them to change the advertising mix to a higher online percentage.   On balance it appears likely there will be less online advertising in the financial services sector as companies like Countrywide and Etrade - both major online advertisers -  continue to struggle to survive.  However given the uncertainty of government action and overall market stability this probably drop will not impact the bottom line of Google and Yahoo enough to put more than very minor pressure on their stock prices.  I would suggest that Google is more vulnerable than Yahoo because the market appears to have incorporated a lot of advertising growth into the GOOG share price and Google controls about half the online ad market so their exposure is greater.  

After examining the SEC report I'm very skeptical about the suggestion that Echostar had significant 'subprime churn' problems.  The year to year churn rate in 2006 was 1.76%  and increased to  1.94% for 2007.    Elsewhere, the report notes that churn rate is not consistently measured in the industry and also that subscriber concerns about programming changes also led to increased churn.   Teasing out the source of the .18% increase would be very difficult, and I suspect this is simply an after the fact, questionable analysis from those who had an incentive to blame this on the economy rather than corporate mistakes.

Certainly the US Economy and US stocks, many of which are still within 10% of historic highs,  are potentially threatened by the subprime meltdown and related economic fallout.   Therefore in general it would seem this is a time to be bearish on the prospects of stocks in general.    However I think it is too wildly speculative to suggest any specific technology companies that would stand to lose or gain specifically from the subprime factors.   In fact the strategy I'd examine carefully at this time would be to assume that election pressure will keep the government in a very proactive bailout role for the next few years, leading to potential gains by the stocks of companies (like Etrade) that have been severely beaten down but still have a chance to survive.    Citigroup, Wachovia, Merrill Lynch, Bear Stearns remain near annual lows.  Although I don't think I'd recommend a buy on them I think they do not have as far to fall as many other high flying stocks.

Overall Recommendation:  Sit tight or invest in distressed real estate.   In terms of stocks opportunity is not knocking right now. 

Info sources & more:

Barrons - opinion roundup:
http://online.barrons.com/article/SB119041439513335753.html

Henry Blodget - online ad market may suffer:
http://www.alleyinsider.com/2007/09/google-not-immu.html

New York Times - Subprime problems may help Venture Capital tech investments thrive:
http://www.nytimes.com/2007/08/24/business/24venture.html?fta=y

Forbes - Subprime Bailout:
http://www.forbes.com/reuters/feeds/reuters/2007/12/14/2007-12-14T173259 Z_01_N14315981_RTRIDST_0_USA-SUBPRIME-FHA-UPDATE-1.html

Financial Times - Online ad market will be OK:
http://www.ft.com/cms/s/0/3bd95d94-69f7-11dc-a571-0000779fd2ac.html

Re uters - Subprime Bailout:
http://www.reuters.com/article/politicsNews/idUSWBT00805520071213?feedTy pe=RSS&feedName=politicsNews

CNET - Subprime problems and tech stocks:
http://www.news.com/2100-1014_3-6204363.html

Buffett on subprime and economy:
http://www.marketwatch.com/news/story/buffett-says-subprime-crisis-not/s tory.aspx?guid=%7B075F9A09-6B32-484C-8B57-D9811F351B05%7D