Computer says no

Business, Technology | Thu 2 Jun | Author – Business & Finance computer says no

There is a glitch in the system, writes Aidan Donnelly, as he examines the future prospects for global tech giants.

For anyone who routinely spends much of their working day using some form of technology, be it a simple PC or something more complex, you will know how frustrating it is when it stops working. Normally the only course of action is to call the IT department helpdesk where, if you are lucky, the problem can be solved by the seemingly simple but obviously very technologically advanced words: “Turn it off and then turn it back on again.” A Nobel prize in computer science is on the way to the person who came up with that gem.

Now you might be wondering: what this has got to do with the stock market? Well if you indulge me a moment, I will tell you. Just as in our working lives, technology is a key global sector for investors, not just in size, but more importantly profitability.

Although it definitely operates on a global basis, you will not be surprised to learn that the lion’s share of the industry players is based in the US. Household names like Apple, Intel, Facebook, Alphabet, IBM, Oracle, Microsoft and Cisco generate multi-billion dollar sales and profits every year.

While many may grab the headlines for the low level of taxes they pay, of more importance to equity investors is whether these profits are growing. And recently the picture has been a little less rosy, particularly for some of the long-established companies.

STORM CLOUDS GATHERING

The last few years have seen the beginning of two large secular changes in the world of technology – cloud computing and big data. The disruptive forces associated with both of these are meaningfully shifting budget priorities within IT departments and companies overall. The implications are far-reaching and for some companies these technologies are sounding the deathknell for their traditional business models.

Many are faced with the difficult choice of sacrificing their existing business in order to embrace these new forces – ‘eating their own lunch’ before someone else does may be the only course of action for long-term survival.

Obviously, the percentage of revenues derived from traditional versus newer revenue streams is going to be the major determinant of the initial impact, but provided the quantum of investments in newer areas is large enough, over time these should more than offset some, if not all, of the decline in revenues seen in the traditional businesses. On the other hand, companies heavily exposed to multiple ‘old-school’ revenue streams, such as IBM, are likely to continue to struggle for growth for many years.

TRANSFORMERS

The US first-quarter earnings season is drawing to a close and over the last few weeks we have seen many examples of companies trying to manage through this transformation process – with varying degrees of success.

For some companies like Amazon and Alphabet, the growth in their cloud business is not coming at the expense of their legacy revenue streams. By deciding to open up its internal IT infrastructure and offer it as a public web service, Amazon has made its mark in cloud computing, bringing global scale to emerging start-ups and corporate enterprises, and creating a brand new business in the process.

This strategy was also followed by Alphabet in 2012 when it launched Google Compute Engine, enabling customers to use the same infrastructure that runs Google Search.

The picture has been a little less rosy, particularly for some of the established companies

MARGIN-SOFT MICROSOFT

One company that has seen some positive momentum in its transition from a traditional licence model to a cloud-based service is software giant Microsoft. Cloud performed well in the most recent quarter, with sales from offerings like Azure and Office 365 Commercial growing strongly. Microsoft’s Commercial Cloud is now at a $10bn run rate – but including Office 365 Consumer, Microsoft is the largest public cloud company in the world.

This is impressive since Commercial Cloud revenue was close to $700m back in 2012. But there is always ‘the rub’ in the big picture; profit margins are contracting in the short-term from this shift to cloud, and this trade-off in margins will hinder profitability for the time being.

Another software company in a similar predicament is Oracle. Although it has many advantages as the company evolves its technology portfolio and business model into the cloud, beginning with a massive, entrenched on-premise installed base, a point of concern from investors is whether or not successful customer adoption comes with a negative impact on Oracle’s traditional high-margin software business model. The answer lies in Oracle’s ability to increase its share of the IT budget while also reducing customers’ overall spend – not an easy task.

If this secular change in the landscape wasn’t enough of a drag on the industry’s current overall profitability, it also has to deal with a tepid macro environment, particularly in emerging markets, that is seeing IT spending delayed or deferred in response to mixed economic signals. And then there is the ‘Apple’ factor!

Aidan Donnelly

Aidan Donnelly

You may not be surprised to hear that when it comes to profits, Apple is the ‘Big Kahuna’ in the S&P 500 Technology sector, accounting for over 25% of total profits. But since the start of this year all has not been going to plan in Cupertino, California. As a result, Apple was the largest contributor to the profit decline for the IT sector for Q1 2016. So what’s the worm in the apple?

Apple is the ‘Big Kahuna’ in the S&P 500 Technology sector

Over the past three years, the iPhone product segment has accounted for nearly 60% of the total revenues generated by Apple. Since the launch of the iPhone 6, the product segment has reported year-over-year revenue growth in excess of 35%.

However, in the last quarter of 2015, this growth rate dropped to only 7%, before showing the first year-on-year decline in revenue in 51 quarters, when it reported its March quarter. And the bad news didn’t end there as they reduced their guidance for the June quarter as well. The hope would be that this trend reverses later this year or early next year with the launch of the iPhone 7 – only time will tell.

Even the most cursory examination of the long term will show the impressive growth in profits for the technology sector – albeit subject to the odd period of swoon. As we look out into the future, the glass is certainly not broken – but for now it might just be half full!

About the author: Aidan Donnelly is head of Equities at Davy Private Clients. Views expressed in this article reflect the personal views of the author and not necessarily those of Davy. Follow him on Twitter @aidandonnelly1. J&E Davy, trading as Davy, is regulated by the Central Bank of Ireland.