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The IT Spending Slump

Posted on: November 20, 2008 - Email Article - Printable Version

Brian Clionsky

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Due to the current state of the U.S. economy, along with the current economic state of countries around the globe, a global credit crisis, and the need for businesses to cut costs and focus on revenue generating operations, we will experience IT spending cuts. While IT spending cuts may not reach negative growth levels like those experienced during the dot-com bubble burst, we will experience slowed IT spending growth both in the US and worldwide. First let’s take a quick look at the Dot-Com Bubble and how it “burst.” Then we will take a look at our current situation and what to look for going forward.

The Dot-Com Bubble

The Dot-Com Bubble was a speculative bubble caused by the emerging internet sector and its related fields. The Dot-Com Bubble got its name from the formation of many new Internet-based companies frequently referred to as “dot-coms.” The Dot-Com bubble experienced a combination of large and rapid increases in stock price and trade volume, speculation and available venture capital, creating an environment in which many of these dot-coms dismissed standard business models to focus on increasing market share at the expense of the bottom line. The Dot-com Bubble lasted roughly 6 years, spanning from 1995-2001. The Dot-Com Bubble reached its peak on March 10, 2000, when the Nasdaq ended the day at 5,048.62 and reached an all time high of 5132.52 during intraday trading. The bubble “burst” following this peak.

The Dot-Com Bubble Burst

The Fed increased interest rates from 1999-2000 which helped slow down the runaway economy at the time. The slowing of the economy along with market corrections, massive sell orders of IT bellwethers, and large position acquisitions caused the Nasdaq to fall 9% in six days following its peak. Also fueling the Dot-com Bubble burst were the huge declines in IT business spending as businesses made huge spending increases in 1999 in preparation of Y2K. In addition to Y2K preparation, companies had to ensure that they had all of the IT infrastructure and hardware they needed for the near future.

This decline in business spending, combined with market corrections, caused many dot-com companies to fold, freeze hiring andlayoff employees. Mass business consolidations were experienced worldwide, but especially within IT. During the resulting burst from the dot com bubble, many investors lost substantial sums of money on the dot-com bubble, helping to trigger a mild economic recession in the early 2000s and IT companies were plagued with U.S. IT spending decreases around 12%. This was not simply slowed IT spending growth as we are projected to experience today, but an actual 12% decline in business IT spending.

Current Situation- What’s The Deal?

Luckily for current IT companies this next series of business IT spending cuts is going to be much smaller in magnitude compared to the dot-com bubble burst. Worldwide IT spending is projected to grow by only 3-4% from 2008-2009, down from IT spending growth well over 5% from 2007-2008. Analysts project that the worst case scenario at this point would be an IT spending growth slowdown to 2% worldwide. U.S. IT spending is projected to grow by 2-3% from 2008-2009, but some analysts project this figure could drop as low as 0.9% growth. The U.S. experienced IT spending growth of a little over 5% from 2007-2008. Analysts expect IT spending to decline to a growth rate of 0.8% for 2009. In the Asia/Pacific regions IT spending is expected to increase by 8.3% fueled by increased needs for IT infrastructure. Over 75% of U.S. businesses are projected to decrease their IT spending budgets or keep them at current levels.

Undoubtedly the uncertainty of our current economic condition and looming concerns of a U.S. and worldwide recession will dramatically change and in many cases decrease IT budgets across the globe. However, Information Technology has shifted its position from a back-office cost efficiency, or behind the scenes, to a front-office business partner which makes IT spending harder to cut in the short term. This is a major difference between the dot com bubble-inspired IT spending cuts and today’s IT spending cuts.

IT spending decreases usually lag the economy by at least two quarters so we will not initially see the full effect, if any effect, of IT spending cuts until early to mid-2009 at the earliest, but many IT companies are already beginning to tighten or decrease their revenue guidance and projections for the upcoming quarter and for 2009.

The Nasdaq has fallen nearly 43% and the S&P 500 Information Technology Composite has fallen over 45% due to the current credit crisis and economic uncertainties. However, I think we have yet to see the bottom of the IT sector and these upcoming IT spending cuts will propel the IT sector down even further. I think the IT sector will be the next sector to experience the same “bottoming out” that the Financials and Energy sectors are currently experiencing.

Who will be affected?

Going forward I expect small and mid-cap IT companies to take the biggest hit as a result of IT spending cuts; however, DO NOT think that a company is too big or too “strong” to be affected by potential IT spending cuts and the current economic conditions and possible recession. No company is immune to the effects of IT spending cuts and this is definitely made apparent in many recent public statements made by the CEO’s of four companies I consider to be large cap leaders within the IT sector, Microsoft [MSFT: 20.52, 0.00 (0.00%)], Intel [INTC: 14.91, 0.00 (0.00%)], IBM [IBM: 86.82, 0.00 (0.00%)] and Google [GOOG: 328.05, 0.00 (0.00%)].

Microsoft CEO Steve Ballmer stated, “Financial issues are going to affect both business spending and consumer spending, and particularly…spending by the financial services industry…We have a lot of business with the corporate sector as well as with the consumer sector and whatever happens economically will certainly effect itself on Microsoft…I think one has to anticipate that no company is immune to these issues.”

Intel just recently cut its fourth quarter 2008 revenue guidance by almost $1Billion due to current and forward looking economic problems and a weak global demand. Intel stated, “Current uncertainty in global economic conditions poses a risk to the overall economy as consumers and businesses may defer purchases in response to tighter credit and negative financial news, which could negatively affect product demand and other related matters…There could be a number of follow-on effects from the credit crisis on Intel’s business, including insolvency of key suppliers resulting in product delays.”

Google CEO Eric Schmidt said that the Web search giant “is not completely immune” to the U.S. economic downturn, but he said the shift in advertising towards cheaper, online methods like Google’s search business should intensify during hard times. This goes along with an increased focus for efficiencies as a way for companies to survive these cuts going forward, as noted below. However, it was also noted that Google could see lost business as their advertisers get hit from the current credit and economic crisis.

These CEOs are not the only ones issuing warnings and re-issuing guidance with lower revenue targets to take these potential negatives of the sector into account, but the fact that these IT bellwethers and large-cap IT companies realize they are not immune to IT spending cuts and the weakening economy definitely raises concerns about the IT sector as a whole going forward.

How will a company survive?

Although no company may be completely immune to the effects of IT spending cuts, some companies will fare better and perform better than most during the upcoming IT spending cuts and the weakening economy. These companies will need to possess a few key factors. Companies that have a diverse business mix, revenue breakdown and customer base will feel less of an impact from IT spending cuts. A diverse customer base by industry and not being too highly exposed to any one customer will make it so that industry specific IT budget cuts or IT budget cuts of one particular customer will not have as big of an impact. With that said in this environment I would prefer a company to receive no more than 10% of its revenue from any one customer. A wide array of product and service offerings along with innovative technologies will help minimize the impact of a revenue decrease of any one product or service due to IT spending cuts. I feel that a strong geographic revenue breakdown is also important. I do not feel that a strong geographic mix is as important as these other diversification factors, but it is definitely something important to watch going forward especially with the strengthening of the Dollar compared to other major currencies and the fact that IT cuts will be experienced worldwide.

Next, long term contracts are very important to the health of IT companies during spending cuts. Long term contracts make IT spending cuts very difficult to initiate in the short term and will at least provide some guaranteed revenue. This goes along with the shift of IT to a more active business partner within businesses. IT is now entrenched and running in almost every aspect of business which creates limitations on spending cuts in the short term. Also, increased need for technology related efficiencies could combat slowed spending growth. Businesses will continue to invest in improvements to internal processes to reduce costs, and will also look for new innovations to increase efficiencies. Businesses are also cutting jobs and could possibly look for ways to replace human labor with efficient technological solutions and services.

-Brian Clionsky

Disclosure: The mutual fund this author is associated with is long GOOG, INTC, and MSFT.

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