Will the U.S. Tech Industry Continue to Defy the Economic Downturn?

The IT industry has received other good news in recent weeks. Global PC shipments continued to rise during the first quarter. Venture capital investments in Internet-related start-ups were at the same level as they were a year ago. And other measures such as IT labor statistics, CIO spending and even IT trade-show attendance appear to be holding steady for the first quarter.

"Tech seems to be holding up, but it's really hard to generalize with so many of these companies because you're talking about company-specific issues," says Rick Hanna, an equity analyst with Morningstar who covers hardware vendors, including IBM, Apple, Dell and HP. "The longer a recession might continue, the more pressure it will put on tech. Right now, it's very solid."

Of course, all bets are off, experts say, if the economy sinks into a full-fledged recession, the housing crisis broadens or another natural disaster wreaks havoc. It's also possible that companies due to announce their latest financial results next week -- including Verizon, Comcast and Sun -- could put an end to the IT industry's winning streak.

"The IT industry is seeing surprisingly good results, and people are looking around and trying to explain it in terms of international markets and currency fluctuations," says J.P. Allen, associate professor of information technology at the University of San Francisco's School of Business and Management. "But if you look at these numbers, they are based on real revenue growth. It's the result of the great migration of business activity online."

"Tech is showing resilience for a couple of reasons," says Mark McDonald, group vice president and head of research for Gartner Executive Programs. "The nature of IT budgets has changed dramatically since 2001 and 2002. They are much more business based and business rationalized than in the past... IT is not the target-rich environment for cost-cutting that it was before.

Consumers, companies still buying

The U.S. economy has been headed south for six months, and Americanconsumers have been hit hard by the one-two punch of spiraling gasprices and plummeting housing values. But so far it appears thatcash-strapped consumers aren't cutting back on cell phones, textmessages or broadband services.

EvenPC sales continue to grow. IDC announced on April 16 that PCshipments rose 14.6% in the first quarter of 2008. While U.S. PC salesrose only 3.5%, sales in developing countries more than offset thatweakness, and demand remained strong for notebooks.

Analysts say that PC sales -- along with sales of cell phones, iPodsand other devices -- continue to rise in part because prices continueto fall.

"A consumer may not buy a house or a new car, but that doesn't seem[affected] when it comes to getting a new PDA," says Tracy Lefteroff,global managing partner for the venture capital practice atPricewaterhouseCoopers (PWC). "iPod sales have not been hit that hard.iPhones are still flying out of stores. I don't see that much change inconsumer buying habits."

Pradeep Chintagunta, the Robert Law Professor of Marketing at theUniversity of Chicago's Graduate School of Business, says consumerscontinue to buy wirelessdevices because most of them -- except the iPhone -- are subsidizedby service providers.

"The fact that cell phone devices in most cases are heavilysubsidized by service providers actually in some sense shields thisindustry from a big downturn right away because the service providerprovides the phones for almost free," he says.

Chintagunta doubts American consumers will cancel cell phonesubscriptions because of the economic downturn, but they might speed uptheir transition from landlines to wireless. He says consumers maydelay PC upgrades or buy fewer bells and whistles.

"A sustained economic downturn "will delay the replacement cycle ofPCs. There's no doubt about that," Chintagunta says. "People will bemore willing to buy a 1.6GHz machine versus upgrading to the 2.5 GHzmachine. That will certainly happen... But if manufacturers react byfurther lowering prices, it could be that shipments continue to be highbut profit margins for the manufacturers are declining."

Apple had record-breaking results based on strong sales of its Macbusiness, which grew 51% in units and 54% in revenues due to risingconsumer demand for the machine's unique look-and-feel.

"Apple is growing 3.5 times the market rate, which is not anindicator in general but a sign of Apple's strength," Hanna says.

Corporate IT buying isn't plummeting either. In fact, corporate ITbudgets worldwide will rise 3.3% in 2008, according to a surveyof more than 1,000 CIOs that Gartner released in April.

Gartner's survey gauged the potential impact of macroeconomicconcerns on corporate IT budgets. Gartner found some softness in theU.S. market, where IT budgets are growing at a slightly lower rate thanlast year, but this softness is overshadowed by larger increases inAsia and Europe.

"Globally, IT budgets for 2008 remain stable. The growth rates areslowing in the U.S., while there is accelerating growth in Europe andAsia Pacific," McDonald explains.

In the United States, corporate IT budgets will grow 2.3% this year,instead of the 3.1% rise predicted by Gartner in the fall of 2007.

McDonald points out that the average annual increase for U.S. ITbudgets from 2004 to 2008 was 2.8%, so that the projected U.S. increaseof 2.3% isn't that big of a drop.

"IT budgets have become more like other business budgets, which isanother factor why IT won't go through the significant boom and bustcycle like it did in the last economic downturn," McDonald predicts.

McDonald says that 65% of U.S. CIOs said their IT budgets hadn'tchanged from their original commitments, and 10% said their IT budgetshad increased in the first quarter.

"One in four companies in the U.S. said they had cut their ITbudgets for 2008. The average reduction was 9.6%," McDonald says. "CIOs are taking a conservative approach going into the start of theyear... This is caution, versus cost-cutting."

One reason enterprise IT sales remain solid is that vendors arehawking wares such as virtualization and utility computing that help corporations save money and increase productivity.

"Companies still seem to be willing to invest in technology when it relates to cutting costs," Morningstarâ¬"s Hanna says, pointing to IBMâ¬"s strong sales of mainframes and services designed to help their customers consolidate data centers and servers.

For example, Mark Tirschwell, CTO of Wall Street Systems, expects to expand his firm's use of Savvis' utility computing and data center services in 2008.

"We havenâ¬"t seen anything yet" in terms of a macroeconomic impact on the company's sales of software to the financial services industry, Tirschwell says. "But based on the fact that everybody is going to be scrutinizing costs if the economy slips into a recession, I expect our value proposition -- especially for our software-as-a-service offering -- to carry more weight."

Meanwhile, new technologies such as mobility and Web 2.0 socialnetworking features are engaging more consumers online. Companies can't afford to skip investments in these kinds of technologies withoutputting their businesses at risk, experts say.

"The big trend I'm really interested in is Web 2.0 tools in theenterprise," USF's Allen says. "It's not big money yet, but that's ahuge trend in terms of changing the way the business operates not justin terms of communication but also in collaboration."

Allen also is upbeat about corporate investments in data miningsoftware.

"It's not just a story of retrenchment and doing transactionscheaper than before and consolidating systems," Allen says. "Companiesare sitting on mounds of data. With business intelligence andanalytics, you invest a little and get a whole lot back. I don't seethat trend stopping anytime soon."

No deja  vu of 2002

Experts see many differences between how the tech industry isresponding to this economic slowdown compared with the last one in 2001and 2002. For example, this downturn is being led by the housingindustry, while the last recession was driven by the dot-com bust andaffected the tech industry first.

"Back then, company value was based on the stock price and now it'sbased on revenues," Allen says. "We used to talk about the NewEconomy. Now it's the Real Economy... You see over and over again thatthe financial results in the tech industry are based in reality. They're not based on speculation about share prices or hopes that youcan monetize visitors to your Web site."

Experts say one reason the tech industry should fare better thistime around is that it isn't as overbuilt. There's not as much excessin stock prices, venture capital investing or corporate IT spending asthere was in 1999 and 2000.

"I think this downturn will have less of an impact on the techindustry because we're starting at much lower levels," PWC's Lefteroffsays. "You don't have the excesses that have to be cleaned out first.The start-ups funded now are companies that have reasonable prospectsfor developing a good business."

Hanna says that during the 2001/2002 recession, demand fortechnology in emerging markets wasn't as strong as it is today.

"Now the developing world is an incredible engine, and it'sproviding a tremendous amount of growth," Hanna says, adding thatglobal demand is benefiting IBM and HP, which is expected to announceits latest financial results in May.

So far, it appears that CIOs aren't cutting staff dramatically.Despite some layoffs, including AT&T's recently announced plans toeliminate 4,600 white-collar jobs, overall IT employment is up. Allensays the Bureau of Labor Statistics data show that the U.S. IT laborforce is at its highest levels ever.

"The IT labor force peaked in 2001, and it has now come out theother side," Allen says. "Companies can turn the capital spending spigot on and off, but committing to the labor force is more of acommitment."

Allen says the mix of the U.S. IT labor force is also positive

"We have fewer programmers and more higher-level analysts andsoftware engineers," Allen adds. "We are successfully moving up thechain and keeping the higher value-add activities, and that bodes wellfor American tech companies."

Another difference is that IT vendors aren't bailing out on tradeshows. Interop, which will beheld in Las Vegas next week, says the number of exhibitors is up 25%,including first-time participant Amazon.com.

"In 2001/2002, it was very evident that companies were dropping outand people weren't showing up. So far, we are not seeing that," saysLenny Heyman, general manager of Interop.

Keeping an eye on innovation

One indicator to keep an eye on is the impact of the U.S. downturnon innovation in the IT industry.

Investments in Internet start-ups hit $1.3 billion in the firstquarter of 2008, the same level of investment as a year ago, accordingto the MoneyTree survey compiled by PricewaterhouseCoopers and the National Venture Capital Association using data from Thomson Financial. Venture firms closed 195 Internet-related deals in the first quarter of this year, compared with 167 deals in the first quarter of 2007.

The first-quarter-2008 numbers are down slightly from the fourth quarter of 2007, when venture firms invested $1.4 billion in 217 Internet-related companies.

Overall, venture capital investments declined 8.5% in the first quarter of 2008 compared with the fourth quarter of 2007. Venture firms invested $7.1 billion in 922 deals in the first three months of this year, compared with $7.8 billion invested in 1,045 deals during the last three months of 2007. Leading areas of investment were biotechnology and software.

Venture capital experts said the first-quarter results were solid.

"We see from an early-stage-investing point of view, the economic slowdown has had an impact and perhaps people are being mindful of the economic slowdown. But, at the same time, the effects of it are milder than you might imagine from listening to the evening news," said Nina Saberi, managing general partner of Castile Ventures at an April 18 press conference when the MoneyTree data was released.

"I haven't seen any slowdown in the pace of investment from the venture community. They've been very steady. Although, they haven't ramped it up either," Lefteroff says. "The areas that continue to attract the most interest are the life sciences and Internet-related, Web 2.0 consumer-oriented Web sites."

Lefteroff points out that the venture capital industry is notbacking enterprise-oriented IT companies or network service providersat the levels they were in 1999 and 2000. But he remains optimisticabout start-ups targeting wireless and broadband Internet services.

"If there's one thing that consumers have demonstrated they have anunquenched thirst for is applications and information that they can getover mobile devices," Lefteroff says. "As long as we're still makingimprovements in our ability to deliver content through mobile devices,that trend will continue to stay quite hot."

One challenge for the venture capital industry is that the IPO market is virtually nonexistent, leaving acquisition by another ITcompany as the only exit strategy for these start-ups.

"If you can't go public you're at the mercy of the big companies todetermine your price," Lefteroff says, pointing out that the number ofpotential buyers is down because the IT industry has consolidated since 2001. "There's been a lot of consolidation in the tech space, which has left very large, very well funded, tough competition that are bigc ompanies. The top IT vendors really do have a swagger now that impacts everybody."

Not out of the woods yet

While they remain optimistic, experts agree that the IT industry is not out of the woods yet. If the economic downturn persists for another six months, corporate IT budgets could be reduced for 2009. If the mortgage crisis worsens, consumer electronics purchases could be cutback for the holidays.

The lag time between when an economic downturn hits the tech industry is "anywhere from six months to a year," McDonald says.

"If the overall economy stays down for a while, it will certainly start to affect" consumer technology purchases, Chintagunta says. "Idon't think any sector is completely bulletproof."

Whether the U.S. tech industry can continue to avoid getting dragged down by macroe conomic forces depends on many things, including the price of oil and the value of the dollar, Chintagunta says.

"There are a lot of moving parts to this picture, but it doesn't seem as if this downturn is going to be as bad as the last one," he adds.

But for now, experts remain upbeat about the U.S. tech industry.

"I think the outlook for the tech industry is certainly better than for other areas of the economy," USF's Allen says. "Given the international situation and the trends I see, I think it could survive anything short of a depression."