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Mathew Ingram

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Feast or famine?

Mathew Ingram

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TORONTO (GlobeinvestorGOLD) ó No one would argue that technology stocks have had a great year so far. The Nasdaq composite index has fallen by about 4 per cent in the year to date, and until a couple of months ago, the index was down more than 12 per cent from the start of the year. But does that mean techs are poised for recovery, or is the weakness likely to continue? Judging from what some of the leading players have been saying (with a few exceptions), things donít look that rosy for the sector, regardless of what happens in the White House.

One of the biggest bellwethers for the technology group is chip-maker Intel Corp. The companyís microprocessors are used in about 85 per cent of the worldís personal computers, which explains why Intel is half of what some like to call the "Wintel" monopoly, along with software giant Microsoft. What Intel says about its market sends ripples through the entire technology sector, and what it has been saying lately is far from bullish. While the companyís latest quarter was better than some of the gloomier forecasts, there are still some significant question marks.

Intelís sales have been rising over the past several quarters, but not at a terribly rapid pace. In the latest quarter they climbed just 8 per cent over last year, which wasnít a very good year (and therefore made an easy comparison). In large part, thatís because the chip-maker has been suffering ó along with the rest of the semiconductor sector ó from a rise in inventories. That in turn is a sign of lagging demand, and it not only eats into future revenue but cuts profit margins as well, since companies like Intel have to spend money to store their products, then cut prices to get rid of them.

There are those who believe this is a short-term problem, and that semiconductor stocks such as Intel (which is down 35 per cent this year) have fallen to the point where they are once again good value. Others, however, argue that this is wishful thinking. Goldman Sachs, for example, says that in every previous technology cycle, the Philadelphia Semiconductor index, or SOX, has reached about 200 before rallying, and the SOX is around the 400 level. Merrill Lynch says Intelís margins could be under pressure for some time.

Microsoft doesnít have the same kind of inventory problem, but it said a few things in its latest quarter that might give an investor pause. Although the software makerís revenue climbed 12 per cent, its forecast for the current quarter was lower than expected, and so was "unearned revenue." Thatís a category Microsoft came up with when it moved to a multi-year licensing program, and itís a figure that represents future sales. It fell by a larger than expected amount, to $7.8-billion (U.S.), although the company told analysts it didnít see any cause for concern.

Another technology leader, Cisco Systems, has also given tech investors little reason to cheer. In its most recent quarter, the worldís largest networking-equipment maker said that business leaders still seemed cautious about spending, and to some extent Cisco is suffering the same problem as Intel: too much inventory. The companyís inventory level rose 22 per cent in the second quarter, 49 per cent in the third and 40 per cent in the fourth. Thatís likely to keep a lid on Ciscoís profit margins for the near future.

There are some technology companies that continue to do well, of course, despite signs that growth in the U.S. economy has slowed somewhat. Dell is one, with revenue that climbs by double digits every quarter, almost without fail. Its success, however, comes at the expense of more traditional tech players such as Hewlett-Packard, which have difficulty competing with Dellís ultra-low-price business model. In that sense, Dell isnít really a technology company at all, so much as it is a manufacturing company ó one specializing in just-in-time delivery.

Then thereís the Internet sector. For investors, the problem with stocks such as Yahoo, eBay, Amazon and Google is that they are already so highly-valued ó by most traditional measures at least ó that itís difficult to know how much higher they can go. That hasnít stopped analysts from putting a $200 price target on Google, or a "strong buy" on eBay, but it means they have to go to increasing lengths to justify those targets. Googleís stock is selling for more than 225 times its profit in the past 12 months, and about 60 times its forecast profit; Yahoo is selling for almost 100 times its profit in the past year and 71 times next yearís.

Thatís not to say shares of eBay or Yahoo or Google wonít go even higher in the next year. Buying momentum can push a stock up for quite a long time, especially when thereís a dearth of other investments out there to get excited about. But itís difficult to know when to get off that particular train, and if youíre a value investor you probably like to think your stocks are going up for some rational reason. With many Internet stocks, itís difficult to feel that way. Googleís stock has doubled since its initial offering, even though some analysts said it was over-priced before the companyís IPO.

With a few exceptions, in other words, the tech sector is bit of a feast-or-famine story at the moment: stalwarts such as Microsoft, Intel, HP and Cisco are growing too slowly to make them attractive, while Internet stocks are being valued as though they will never stop growing, which makes it difficult for investors to feel comfortable buying them.

And there is little reason to think either of those outlooks will change any time soon.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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