The Tech Slump

The Tech Slump

Slowing growth, not negative growth, is what's in store. But that's bad enough

By Robert D. Hof in San Mateo. With Peter Elstrom, Steve Hamm, and Marcia Stepanek in New York, William Echikson in Brussels, Peter Burrows in San Mateo, and bureau reports.
Business Week

December 18, 2000

Not long ago, it was easy to dismiss worries about an impending technology slump. Sure, PC sales growth was slowing--but industry bellwethers such as Gateway Inc. (GTW) and Hewlett-Packard Co. (HWP) were still expanding smartly. Yes, chip giant Intel Corp. (INTC) reported that growth would ease, but only because of the weak euro. Granted, telecommunications companies were slowing purchases of new equipment, but hey, look at networking-gear supplier Cisco Systems Inc.'s (CSCO) 66% growth rate. Technology is way too strategic an investment to cut, right?

Wrong. Suddenly, not even an imminent end to the Presidential fight, a strong hint from Federal Reserve Chairman Alan Greenspan that he may be close to lowering interest rates, and the consequent 10% rise in the Nasdaq on Dec. 5 can banish the awful truth about tech spending: Instead of big across-the-board hikes--a trend that has been going on for years now--countless corporate info-tech officers are scrutinizing every penny. Some are even talking about cutting back the budgets they pour into tech. Clearly, tech spending is no longer the magical elixir that helped supercharge the economy for a record 37 straight quarters.

For now, no one is talking about an actual downturn in overall tech spending. Slowing growth, not negative growth, are in store. But after the phenomenal performance the sector has boasted in recent years, that will be plenty painful. And every week, new evidence that growth is slowing mounts. In recent days, networking-gear maker 3Com, PC maker Gateway, and chipmakers LSI Logic (LSI) and Xilinx (XLNX), and electronics retailer Circuit City (CC) all warned that earnings will fall short of expectations, knocking their stocks down as much as 36%. Then, on Dec. 5, Apple Computer Inc. (AAPL) dropped a bomb, saying that slower-than-expected PC sales will vaporize $600 million in fourth-quarter revenues from its original estimate of $1.6 billion. As a result, Apple will post its first loss in three years, sending its stock down 16% on Dec. 6, to 14, the lowest level since March, 1999. Says Apple CEO Steve Jobs: "It looks like we're facing a broad economic slowdown that will affect many segments."

Moreover, the unexpected turn for the worse seems certain to reverberate throughout techdom--forcing consolidation that will extend far beyond the tiny dot-coms that have been the victims so far this year. Unable to survive past the easy-money days, a lot of companies, from niche e-tailers to the umpteenth optical-networking upstart, will simply vanish. "A gigantic scrubbing is going to happen," says Joel Ronning, CEO of Digital River, which runs Web sites for 3M (MMM), Novell (NOVL), and others.

All this has Wall Street analysts backpedaling faster than they can say "Oops." On Oct. 1, according to earnings-estimate tracker First Call Corp., analysts predicted that tech-sector earnings would rise 29% in the fourth quarter. Now, they've slashed that estimate to 15%. Expectations for communications-gear companies are sliding even faster. From a 4% earnings decline expected on Oct. 1, analysts now foresee a 45% plunge. And for 2001, they've cut overall tech earnings projections from 24% to 17%.

That's bad news--and not just for the tech sector. A tech slump would have an outsized impact on the overall economy. Tech spending and the huge productivity gains it has made possible have been the main engines of the record-breaking economic boom (page 62). But now, that tech engine appears to be sputtering. According to recent Commerce Dept. figures, the annualized growth in new orders for information-technology equipment fell to a measly 1.2% in the third quarter from 34% just a quarter before. And scaled-back spending by both consumers and businesses is putting an ever-tightening squeeze on tech players. The growth in consumer spending on telephone services, for instance, fell to 3.1%, a third of the rate a year ago. Meanwhile, business purchases of communications gear actually fell 2%, down from a growth rate of 65% in the first quarter. All of this has contributed to a sharp slowdown in gross domestic product. On Nov. 29, the Commerce Dept. reduced its GDP growth estimate for the third quarter from 2.7% to 2.4%, the slowest rate in four years.

Bottled Up. No one knows for sure how far tech will fall--or how much it will drag down the rest of the economy. If Federal Reserve Chairman Alan Greenspan moves to lower interest rates, that could free up billions of dollars in capital that had been sidelined, easing the credit squeeze in key tech sectors, such as telecommunications (page 64). But for now, the underlying problem persists: The great pools of money that fueled the tech-buying binge--the market for initial public offerings, the debt market, and corporate earnings--are starting to dry up.

The financial cracks in the tech juggernaut are plain to see. Venture capital is on the wane: Third-quarter venture investments totaled $25.9 billion, down 6.8% from the second quarter, according to fund watcher Venture Economics--the first drop since 1996. Crosspoint Venture Partners, for one, even dumped plans for a new $1 billion fund, partly because they can't get returns from IPOs, which have slowed to a trickle. And debt markets, which drove furious investments in telecommunications equipment, have been bottled up as companies have struggled to make adequate returns on the huge investments already made on high-speed networks. Overall, telecom companies had been raising a total of $8.3 billion a month in debt and equity. Now, that spending has dwindled to a trickle, to just $1.3 billion in November.

Most damaging of all, however, is the extent to which the world's largest purchasers of technology, from General Motors (GM) to Nestle (NSRGY) to First Union (FTU), are casting a cold eye on all of their spending. In dozens of interviews with top technology purchasers, BUSINESS WEEK found that many companies are cutting back or rethinking big spending. Especially hard-hit in these purchasing trims: PCs and older telecommunications gear that don't provide much profit bang for the buck. "We will spend significantly less for the next couple of years," says John Hollenbeck, executive vice-president for technology at title insurer First American Financial Corp. "I'd say tech spending will be flat to down."

Even those companies that are holding the line or raising tech spending are focusing strictly on technologies with a clear payoff. That includes more efficient computer servers, fast networking gear to speed their operations, and Net software that cuts costs or forges stronger links with customers and suppliers.

So far, the cuts are acute in a few big industries. Telecom companies, banks, brokerages, and retailers are reducing tech spending the most, according to Andrew Bartels, a vice-president at tech consultant Giga Information Group. Capital spending at U.S. telecom companies such as AT&T (T) and Sprint Corp. (FON), for instance, has been soaring by 40% annually for the past two years, but that is expected to fall to just 3% next year as they face financial pressures and consolidation. Ditto for banks and brokerages. And retailers are easing up on tech spending as the the fear of being ''Amazoned'' by e-tailers diminishes by the day.

But with GDP slowing, nobody thinks those industries will be the only tech penny-pinchers. For tech suppliers, that means the worst may be yet to come. The tech sector, already taking on water from wave after wave of profit warnings and market volatility, could get further swamped if political wild cards such as an escalation of strife in the Middle East and a new U.S. president with a weak mandate further burden the economy. "When there's a slowing of the economy, it doesn't take long for CEOs to say: 'Hey, wait a minute, what does this spending do for the bottom line?'" says Ralph Szygenda, GM's chief information officer. "We're just going to become more frugal."

The slowing economy isn't the only problem. Making matters worse, for the first time in 20 years, technology may be suffering from far more than its usual periodic bouts of overproduction that follow boom times. Now, it's on the verge of plunging into a bona fide slowdown.

Plunging Returns. It's all a far cry from the boom times of just a few months ago. What went wrong? For starters, flagging consumer demand. Some 60% of American households now own at least one PC, according to market researcher IDC. The PC slump is also putting the brakes on chipmakers. They're being forced to cut prices, leading First Call to reduce its estimate of 96% profit growth this year to just 18% next year.

Businesses are feeling the cold chill of winter, too, and they account for most technology spending. Take telecommunications companies. Hoping to tap into new markets such as wireless and the Internet, they've been jacking up capital expenditures by 30% a year for the past two years. The glut of would-be players, coupled with revenues that have risen only 11% a year, means returns plunged--and now, so is spending. Merrill, Lynch & Co. predicts that telecommunications spending will actually decline 1% next year, to $238 billion, and fall 5% more in 2002. That huge shift seems certain to wreak havoc with telecom-gear suppliers. Especially vulnerable are those focused on older technologies, such as Lucent Technologies (LU). Telecom suppliers had been counting on 15% to 30% hikes for years to come.

The falloff in corporate IT spending has spread worldwide, too, coming home to roost among American suppliers. In Europe, slow adoption of Microsoft Corp.'s new Windows 2000 software has pulled down corporate PC sales by over 20% this year, according to Context Research International Ltd. in London. That slammed the earnings of tech powerhouses Intel and Dell Computer Corp. (DELL), which had counted on the European market for a sales boost. "We used to renew our PCs every three years," says Jean-Claude Dispaux, IT director at Nestle. "Now, we may keep our older Pentium II machines longer."

Moreover, as the dust settles on the dot-com shakeout, it is becoming clear that the frenzied tech spending they unleashed in recent years was like a snowball, gathering up everything in its path. Up to now, even big companies chose to spend huge sums just to keep pace with the dot-com upstarts that seemed poised to eat their lunch. With that threat starting to melt, "there's less pressure on brick-and-mortar companies to spend a lot," says Tom Kucharvy, president of e-business consultant Summit Strategies Inc. "The days of the Gold Rush of the Internet generation are over," agrees GM's Szygenda. "Now, it's 'Show me the real benefits.'"

Compounding that caution is yet another hangover from the '90s high-tech-spending party: slowing investment in some back-office software and hardware upgrades. Even before the Internet and Y2K, corporations through most of the decade were frantically upgrading their back-room systems with new software, such as database programs from Oracle Corp. (ORCL) and enterprise-planning software from SAP (SAP). Now, for most large companies, that's done, so growth is slowing. "The internal stuff, reengineering stuff, has been winding down," says David Drew, chief information officer for 3M. "Our information-technology costs will rise slowly, but less than sales growth."

Absolute Concern. As the tech-spending boom unwinds, the problems could accelerate for a little-known reason: Many technology suppliers essentially have been paying for their own sales with aggressive financing of their customers' purchases. Analysts think that's especially a problem in fast-growing areas such as networking gear, where startup customers such as dot-coms suddenly go under and can't pay their bills. That creates a double whammy, because equipment suppliers are not only looking at reduced sales going forward but also at a loss of sales already booked.

Lucent, for instance, extended more than $7 billion in financing to customers, many of them struggling young telecom-service providers. In November, Lucent said it is lowering estimates partly because it might not collect on some of that revenue. "It's absolutely a concern," even for still-booming companies such as Cisco, says Jim Cottle, a technology analyst at the University of California Endowment & Employee Pension Fund, which owns shares of Lucent, Cisco, and Nortel Networks (NT).

To put all this in perspective, however, even with the relentless doom-and-gloom announcements, no one yet believes that technology-spending growth overall is going to turn negative. Indeed, despite the increasing signs of trouble, market-research consultant GartnerGroup is still sticking with estimates it compiled several weeks ago that overall spending on info-tech hardware, software, services, and telecommunications as a whole could rise 11.6% next year--just a hair under the 12% expected this year. Moreover, not every company is cutting spending. "We're running at full bore," says Jim Yost, vice-president for corporate strategy at Ford Motor Co. (F), which is one of several large corporations with no plans to trim information-technology budgets. "The need to spend IT dollars has never been higher."

Maybe. But it's hard to see what hot new products or services might turn the situation around in the short term. In previous tech downturns, new products and lower prices often provided the spark for a rebound. In 1990, the arrival of Microsoft's Windows 3.0 and the advent of low-cost PCs from Apple and others sparked new demand for PCs.

This time around, Windows 2000 doesn't appear to be a barnburner with corporations or consumers, who find little reason to upgrade. Some devices and services, including high-speed data services such as DSL, handheld computers, interactive TV units, and DVD players are selling well. But together, these newfangled devices and services aren't much more than a rounding error compared with the PC industry. "There's just not many products that cost $1,000 and sell 130 million a year," notes SoundView Financial Group analyst Mark Specker.

That's why investors will be watching tech like hawks from here on out. Michael Kwatinetz, a managing partner at Azure Capital Partners, a San Francisco venture-capital firm, for one, expects the dot-com meltdown to hit even server sales, which have been booming. If so, look out below, says William T. Coleman III, CEO of software maker BEA Systems Inc. (BEAS): "If Cisco and Sun Microsystems start losing sales, then there's real trouble. There's a recession going on." That hasn't happened yet. But until the spending swoon abates, neither the tech industry--nor the U.S. economy--will be out of the woods.