The Information Technology sector

As of 31 January 2004, the Information Technology sector comprised 18.54 percent of the S&P 500. The sector in our portfolio is comparatively underweighted, then, accounting for only 17.1 percent.

This particular sector is divided into 3 sectors: Software and Services, Technology and Hardware Equipment, and Semiconductors and Semiconductor Equipment. The three largest companies in the Software and Services Industry are Microsoft ($298.3 billion market cap), Oracle ($72.5 billion), and SAP AG ($51.7 billion). These are by far the largest companies within this industry, since the next largest by market cap is only $15.2 billion. The Technology and Hardware Equipment sector is similarly top heavy with International Business Machines ($167.4 billion) being the largest.

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In addition, Cisco Systems, Inc. ($159.4 billion), Nokia Corporation ($104.5 billion), and Dell Corp. ($87.1 billion) are major companies in this industry. The Semiconductors and Semiconductor Equipment industry is led by Intel ($196 billion) and followed by several companies bunched together in a range from approximately $20 billion to $50 billion in market cap. Among these leaders are Texas Instruments ($53 billion) and Taiwan Semiconductor Manufacturing (42.1 billion). Because of the great potential in each of these industries, we will further examine each of them in our proceeding analyses.

The sector as a whole moves in a cyclical pattern, with some inelastic industries being the exception. Generally, when the economy is doing well households and businesses are more likely to invest in new technology. However, some components of this sector represent industries that are essential to society, such as communication.

The Software and Services industry is currently somewhere between middle growth and nearing maturity stages of the life cycle. It would not be fair to place the industry into either one of these classifications, since the sub-industries (Software & Internet Services) are for the most part not in the same phase of the life cycle.

The industry would currently be classified in the High Growth phase of the business cycle. The industry has already seen rapid expansion through the late 1990’s and now there are becoming fewer players within the industry. This is happening mostly through consolidation. The Information Technology sector as a whole does moderately well in bad economic periods, simply because companies still increase efficiency with upgrades, and attempt to make up for the lack of manpower.

Software has been around for years, and over the last 5 years we have not seen any vast improvements in general software. The one area that could explode in the near future is the development of web based application software. This would possibly move the computing power from the desktop to the server. Another area of growth will be software designed to support the wireless communication between a variety of wireless devices.

With the current industry consolidation we are seeing several anti-trust cases against software companies. Currently the European Union (EU) has filed against the Oracle (ORCL)- PeopleSoft (PSFT) merger, as well as RealNetworks (RNWK) case against Microsoft Corp. (MSFT) claiming that Microsoft has made competition too difficult for their media player software to compete. (Microsoft Responds to Real Networks Suit)

Today’s society regularly uses the Internet and email for simple communications across town and throughout the world. The computer is a household appliance that is growing in popularity everyday. Another social factor is that both business and retail software upgrade sales have been lagging, since many of the recent upgrades are not extremely superior to their predecessors.

As the average age of the world increases, there is a greater demand for healthcare services. Within the IT sector there is increasing demand to create information systems (IS) that can handle patient data at either your practitioners office and the hospital. These firms are in need of firm specific software (e.g. patient databases) to facilitate their needs. There is a new technology that will allow patients to carry a credit card sized card that contains all of their medical vitals. From this a doctor will be able to swipe the card and view a patient’s accurate medical history in seconds.

Currently there is large open source software growth in Asia. IDC Enterprise Server Tracker is predicting that Linux based servers will grow 31 – 40% every year through 2007. E*Trade Japan is the first financial services company to use Linux Operating System (OS) to support their online securities trading system. (Open Source Gaining Traction in Asia) Also, the French government has announced a plan to move a significant number of the desktop PC’s to a Linux OS by 2007 (French Officials Eye Open-Source Apps). In May of 2003 the local government of Munich, Germany announced that they are going to convert all of their 14,000 Windows based desktops and notebooks to a Linux OS. Outsourcing programming jobs to countries with cheaper labor costs is a threat to the US economy, but this should allow companies within the industry increase their margins.

There is a very large potential for growth in the software industry considering that this is a global industry and a majority of the world’s population currently do not have access to PC’s. The first area for growth is within the Internet services sub-industry. Here there is the potential that we will move from smart terminals back to dumb terminals, where all of our applications and data will be saved on an off-site server. This would create a large demand for a different style of software that would be needed to support this change. The second area for growth is with the wireless technologies. As the technology becomes available to transmit data at high speeds across wireless networks, we will need new software that will support this new application of transferring information. The third growth prospect is that we are beginning to see a move from proprietary software to open source software, particularly with operating systems. The growth of open source software has the potential to increase the quality of software across the board, and decrease market prices.

The industry as a whole is seeing signs of maturity, since there are many consolidations that are taking place. The maturity of this industry is still about a decade off, thus there are a lot of profits to gain from the future positive net present value (NPV) projects. Industry supply has greatly increased over the last 5 years, which has been the major factor of the falling prices.

Software is divided into system software (e.g. Microsoft Windows), and application software (e.g. Microsoft Word). The Internet sub-industry is made up of online databases, interactive services, and Internet design services. Both of these sub-industries target businesses and consumers alike.

Concentration is within the software sub-industry with Microsoft dominating the industry. They have also engaged themselves in the Internet Services sub-industry as well with their MSN network.

The Software and Internet sub-industries are easy to enter, since they are not a largely capital intensive area, compared with hardware manufacturing. A virtually infinite amount of opportunities with positive returns exist within this industry. It will take many years for all of the firms in the industry to deplete all of the opportunities that exist.

There are by far more customers than there are suppliers, thus the supplier has control over the market. The power of just one firm, Microsoft, which has a 90% of the OS market share. In the near future, 3-5 years, we will begin to see a change in this power of the suppliers, as competition increases.

Currently we are seeing very high competition as the industry is trying to outdo one another. The prices on many software products have been decreasing slightly, but not nearly as fast as the hardware and semiconductor industries. The competition for OS software is not real great as of yet, but there are many signs of it heating up (French Officials Eye Open-Source Apps).

Within the Software and Services industry the potential exists for substitution in the near future, with the expansion of open source programming. Linux is an open source option that will someday change the industry with their free OS. As the consumer market becomes more open to other program options they will find that the Linux OS is a cheap alternative to the Windows OS. Also available for free download is OpenOffice, which is an office suite similar to Microsoft Office. This free software bundle is almost as powerful as Microsoft Office, but it is improving rapidly.

This sector maintains a broad range of interest from both businesses and households. Providing instruments such as personal computers, wireless phones, mainframes, and other various computer equipment, the need for these products has become an integral part of many societies. This creates a constant demand for such products.

The Technology and Hardware Equipment industry is a broad industry composed of sub-industries such as Communications, and Computers and Peripherals. Communications is a rapidly growing sub-industry because of heightened demand for high quality communications, whether it is through high-speed Internet connections or wireless phones. Telecommunications hardware especially is growing rapidly. As the demand for cellular phones grows both here and abroad, this industry will see continued expansion.

Computers and Peripherals is a sub-industry that is in the maturity stage of its life cycle. While there is always room for growth and improvement in the industry, any radical growth in this sub-industry would probably be an inception of a new sub-industry rather than an expansion of the current.

With the industry being mature, several manufacturers need to look to expand market share in order to increase revenues. This heightens the level of competition between firms. In such a global market, there are several smaller foreign firms that could attempt to gain more market share by producing at a lower cost. This is true for producers such as Legends, Inc. China which is rapidly gaining market share within China.

Semiconductors and Semiconductors Equipment relies heavily on the sale of computer chips and some memory devices. While it may seem like a homogenous industry, there are several different technologies that fall into this category making it more diverse than it seems. In some ways this is the sub-industry that has the most potential for growth, placing it squarely in the growth stage of the industry life cycle. This industry shows some characteristics of cyclical industries, barring vast departures from the norm. For instance the late 90s showed greater than average results.

This is an industry fueled by the need for technology. Demand for faster computers, easier communication, and portable devices create a steady demand in the industry. With demand so constant, other external factors are likely to have more of an influence on the industry.

Recently, there has been much reported about U.S. based companies relocating to other parts of the world, namely India and China. China in particular is aggressively encouraging these moves, hoping to become a worldwide leader in this industry. India too, welcomes the new business, hoping to create a new industry home. While much has been publicized that criticizes these moves from a labor standpoint, looking at them with an investment focus shows great promise. Less costly labor can increase demand (because of lower prices) and widen profit margin. This is important to remember when analyzing these industries. Because the customer base is so well spread, profits will increase, mainly by producing new products more efficiently, not by gaining more customers. Every business has some type of tie to the information technology sector, as do most households in developed and developing countries. Therefore, by transplanting themselves in the Far East, chipmakers give new hope to the industry.

To reiterate, this is an industry that consists of one industry leader, Intel, and several followers. Therefore, it is possible to compete with several of the lower tiered firms, but much more difficult to compete with the industry leader. The major barrier to entry is the capital-intensive nature of the industry. Even though some chipmakers offer rather similar products to Intel, these products have not gained the market share that Intel has. So in this sense, it is not difficult to enter this industry, but very challenging to gain prominence.

As the following numbers show, there was a dramatic rise in sales and sales figures in the late 90s. However, as the economy fell into recession, information technology stocks also drastically fell. However, it is important to realize that the “bubble burst” was simply a correction in prices, not a downturn in the sector. Of course, during the recession several firms and households put off improving IT, but with recovery underway, sales figures were improved in 2003 (not yet available) and expected to rise again in 2004.