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Credit FAQ: Latest Views On Hot Tech Topics--Semiconductor Supply Shortage, Inflation, And Big Tech Regulation

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Credit FAQ: Latest Views On Hot Tech Topics--Semiconductor Supply Shortage, Inflation, And Big Tech Regulation

The semiconductor supply shortage is here to stay, at least through the end of this year and into 2022. That has customers scrambling to procure available supplies. In this scenario, we find semiconductor companies and semiconductor equipment manufacturers benefiting until demand-supply imbalance normalizes, while customers in end markets such as auto are losing billions of dollar and having to shut down plants and idle factories.

U.S. tech companies are also facing the prospect of inflation, with cost inflation pervasive and noticeable in the second quarter. Another risk U.S. tech companies are dealing with is the potential for further antitrust action. Although S&P Global Ratings considers the possibility of significant break ups that would cause rating downgrades unlikely, the probability of these scenarios has increased. Here we examine how these developments could affect U.S. tech company ratings and outlooks and answer investors' frequently asked questions.

Frequently Asked Questions

How long will the semiconductor supply shortage last? Who are winners and losers?

While we believe we are near the worst of this chip supply shortage, the demand-supply imbalance, broadly speaking, will likely last until at least the end of this year and through a good part of 2022 for certain products.

Normal lead times, defined as the length of time between when customers place and receive their orders, has lengthened to about 18 weeks currently from a typical level of about 13 weeks in the beginning of 2021, indicating worsening demand-supply imbalance.

The chip supply shortage is broad-based, affecting supply for display drivers, power management chips, and microcontrollers that are typically fabricated in mature nodes, i.e., 40 nanometer (nm) or higher, on eight-inch wafers at foundries. Other components, such as discretes, optoelectronics, and passives, and materials such as substrates, are also in short supply. Back-end capacity constraints in wire bonding and materials and testing further exacerbate the crisis.

The chip supply shortage is also showing signs of spreading to larger wafer (i.e., 12-inch, and lower nodes, 28nm or lower), a result of strengthening demand following a macroeconomic recovery and pent-up demand from delayed purchases not made last year because of the COVID-19 pandemic.

While chip production could be increased to the extent existing fabs capacity is available, it typically takes up to six months from capacity addition to customers receiving the final products. The industry has been increasing its fab utilization but given the expectation for even strong demand for the rest of 2021, following typical seasonality pattern in the semiconductor industry, the current supply-demand imbalance is unlikely to fade until 2022. Semiconductor manufacturers have plans to build new fabs as they anticipate strong secular growth trends in digitalization, electrification, and connectivity, and increasing electric content in auto, factory automation, 5G, cloud computing, and the internet-of-things (IoT); however, higher demand for semiconductors cannot be met through increased utilization alone and production from new fabs is unlikely to provide any relief to the current chip supply shortage as it won't be available until years away.

We believe growth in semiconductor production should outlast overall growth in demand, as there will be a period of tech supply chain replenishing inventory levels to seasonal averages following declines over the past few quarters. This bodes well for semiconductor industry growth through at least early 2022.

Chart 1

image

Not surprisingly, the winners of the chip supply shortage are the semiconductor companies. These companies saw robust demand across a broad range of end markets, an improved pricing environment, and higher factory utilization rates that should benefit margins over the next several quarters. Double-ordering, a term used to describe customers ordering more than they need when there is a shortage to ensure they receive higher allocation of products, likely exists within the supply chain but semiconductor companies are instituting new procurement programs with customers asking them to place firm orders for an extended period, which should minimize double ordering and lead to better visibility of true demand. While revenue growth could be stronger if not for the supply shortage, it could translate to a smoothing effect of the industry cyclicality over the next two years, which we view favorably for the industry. Over the longer term, we believe semiconductor manufacturers will have better bargaining power over their customers given the growing chip content in virtually all electronics, and relatively high barriers to entry which should limit competition within the semiconductor industry.

Another group of winners are semiconductor equipment manufacturers such as Applied Materials Inc., Lam Research Corp., and KLA Corp. They provide the equipment necessary to manufacture these complex chips and have significant competitive moats which result in strong pricing power and limited competition. We expect growth of these companies will outpace the overall semiconductor industry over the longer term given robust demand from various countries and regions that are investing heavily in domestic manufacturing to attain self-sufficiency.

The losers appear to be the auto original equipment manfacturers (OEMs), and to a lesser extent tech OEMs that cannot procure sufficient parts to meet demand. Apple Inc. mentioned about $3 billion to $4 billion of lost revenue in fiscal third-quarter 2021 due to component shortages that prevented the company from meeting demand for their iPad and Macs. Samsung Electronics has also mentioned that sales of display panels to smartphone OEMs have suffered as these customers have been unable to access various semiconductor chips needed to manufacture smartphones, although, in our view, the impact from chip supply shortage on overall tech sectors have been relatively modest thus far. On the other hand, GM, Ford, Volkswagen, Daimler, and other automakers have announced plant shutdowns and estimated losses in the billions of dollars as they've had to idle factories due to chip shortages. Foundries and semiconductor manufacturers have announced capacity additions. Prioritization to end markets with worst supply shortages, such as auto, which typically use chips that carry lower profit margins for semiconductor companies, will be key for the auto industry. One silver lining is that auto OEMs have been able to pass along higher input costs to customers through higher vehicle prices.

We believe the chip supply shortage serves as a rude awakening for the auto OEMs, tier 1 suppliers, and semiconductor companies, prompting them to better align their short- and longer-term forecasts. There could be more direct collaboration between the auto OEMs and semiconductor companies as a result. We already saw trade associations and industry participants in both the auto and semiconductor industries jump to action with SEMI, formerly Semiconductor Equipment and Materials International, and the Center for Automotive Research (CAR) recently signing a memorandum of understanding to advance collaboration between the semiconductor and automotive industries.

Other behavior changes could include higher inventory levels along the supply chain for certain semiconductor products that are at higher risk of bottleneck, such as those manufactured at legacy nodes utilizing smaller wafers and are less flexible in adding capacity in short notices. We could also see auto OEMs and tier 1 suppliers incentivize semiconductor manufacturers to allocate and guarantee higher capacity to them through committed long-term contracts.

How has inflation affected the tech sector?

The tech sector is seeing higher cost pressure on account of COVID-19-related factory shutdowns in Malaysia, Taiwan, and China, increasing logistics costs, and rising component pricing due to demand significantly outstripping supply. This is after having to contend with the power outages across Texas and the earthquake in Fukushima, Japan, in February that caused about a month of lost production at certain semiconductor manufacturers. Cost inflation is pervasive and noticeable in the second quarter, affecting chips and components that go into auto, consumer, enterprise, industrial, and other end markets.

That said, the impact to tech companies has been benign thus far. In some cases, longer-term customer arrangements prevent tech companies from raising prices immediately. However, for the most part, end-customer demand is strong and appears likely to remain so over the near term, allowing tech companies to pass along higher costs to customers, preserving their profitability. We've observed that tech companies have been able to pass along higher costs to customers because their products and offerings either lack substitutes, help customers improve productivity that can be justified at even higher prices, have tremendous brand loyalty, or are viewed as mission critical to business operations.

Not all tech companies are passing along the higher costs though. Cisco Systems Inc., for example, stated that because that the rising cost pressure from supply chain shortages will likely remain through the end of 2021 but be temporary, it is opting to absorb some of the incremental costs to ensure the business momentum seen over the past two quarters continues. However, if management concludes that the cost increases will be sustained, it will then consider strategic price increases.

Table 1

Select Hardware OEMs, Electronics Manufacturing Services Providers, And Distributors' Comments On Impact From Cost Inflation
Company Rating/outlook Comments from latest public disclosure
Hardware

Cisco Systems Inc.

AA-/Stable/A-1+ From 05/19/21 Q3 earnings call: “On the supply chain front, we continue to manage through the constraints seeing industry-wide and continue to incur additional costs. We are partnering with our key suppliers, leveraging our volume purchasing and extending supply commitments as we address the supply chain challenges… to protect shipment to our customers, there are unit price increases, unit cost increases on certain components that's built into it. There's also increased expedite fees, again, to ensure that we get the components in and we can get the product back out the door and a slight increase in freight.”

NetApp Inc.

BBB+/Stable/A-2 From 06/03/21 Cowen Annual TMT Conference: “We’re not seeing real inflationary pressures along the component pricing, but we are seeing longer lead times... we will increase our inventory levels. You should expect to see our inventory turns come down.”

HP Inc.

BBB/Stable/A-2 From 06/03/21 Bernstein’s Strategic Decisions Conference: “the industry overall is in a component shortage situation. We are seeing cost of components increasing. We are also seeing logistics cost increasing, and we were reflecting some of this in the guide. Of course, we will be repricing... as we have done in the past. What is very hard to predict is exactly what will be the timing of cost increases and price increases.”

Hewlett Packard Enterprise Co.

BBB/Stable/A-2 From 06/01/21 Q2 earnings call: “We have also executed well throughout the industry-wide tightening and cost inflationary trends with minimal impact to our first half. We have taken proactive inventory buffering measures to position us well for the second half.”

Dell Technologies Inc.

BB+/Watch Pos/-- From 05/27/21 Q1 earnings call: “it is our intent that we will price the input cost increases as appropriate, keeping a thoughtful eye on the market and making sure we're in a competitive position... component costs in Q2 are going to be inflationary. We will price that inflation -- that input cost to increase as appropriate... we'll watch to see of any impact on demand.”
Distributors

Arrow Electronics Inc.

BBB-/Stable/-- From 06/09/21 BAML Global Technology Conference: “as new and new technologies come to market, the older technologies reduce in price. So, a little bit of inflation shores that up because we are able to pass-through any price increases, and we make a margin on a cost. So, if that cost goes up, then that gives us a little more dollar profit as we pass that through”

Avnet Inc.

BBB-/Stable/-- From 06/08/21 Stifel Cross Sector Insight Conference: “We feel confident we're passing the majority through. I'm not going to say we're passing everything through. There are some contracts that are tighter than others. And I remember there are probably north of 50 suppliers that have had some kind of price adjustments, and they're all a little bit different.”
Electronic manufacturing services

Flex Ltd.

BBB-/Stable/-- From 05/05/21 Q4 earnings call: “there's been enough conversation on this to know that you have to be able to pass on these prices [higher costs]. You have to be disciplined about that... And I'd say we're navigating that really, really well. And I think it's important to think about the Flex core margin. Even with the factory shutdowns due to shortages or due to COVID outbreaks and all that, we expect that the core Flex operating margins for the year, we'll still have [4%+]. And so continued margin improvement, even with these changes.”

Jabil Inc.

BBB-/Stable/-- From 06/17/21 Q3 earnings call: "the trust and long-term relationships we have with suppliers, and that spans across things, whether it's semis, PCBs, interconnects, passives...we've done a very good job in terms of bulk purchases, locking in pricing on raw commodities.”
Semiconductors

Texas Instruments Inc.

A+/Stable/A-1 From 04/27/21 Q1 earning call: “The competitive advantage of manufacturing technology and owning, controlling our manufacturing asset also gives us control of our cost there. So we haven't been in a position where we've had to go in and raise prices as many of our other peers have.”

NXP Semiconductors N.V.

BBB/Stable/-- From 04/27/21 Q1 earnings call: “In terms of pricing, it's having no impact whatsoever... although some suppliers were being very tactical and trying to take advantage of the situation, that was not our strategy. We said we would definitely pass on any cost increases that we have, and we're able to do that. But we have no intention of trying to improve our profitability through gouging our customers.”

Broadcom Inc.

BBB-/Stable/-- From 06/03/21 Q2 earnings call: “in this environment, we are very, very open to talking to our customers who are, in turn, very open to being able to address inflationary cost pressure in a higher purchase price on your side... which is why our margin has been stable.”
Source: S&P Global Ratings and companies' public disclosures.
Could the U.S. be successful in achieving legislators' intended goals in pursuing more onshore manufacturing?

The push by the U.S. government to develop new strategies and provide financial incentives to the domestic semiconductor industry aims at preventing the U.S. from falling further behind Taiwan and Korea in leading semiconductor manufacturing processes because such a lag could have national security implications. While the U.S. currently leads in semiconductor chip designs and IP, it lags Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) and Samsung Electronics Co. Ltd. in process technology with TSMC alone accounting for over 50% of global semiconductor foundry services and over 80% if only counting technologies at the leading-edge nodes. Moreover, China publicly announced its ambition to close its advanced semiconductor technology gap with the U.S. and has been closely aligning its national interests with its domestic semiconductor manufacturing companies.

The U.S. Senate recently passed the U.S. Innovation and Competition Act, a bill that includes a provision that allocates $52 billion to fund semiconductor R&D and manufacturing initiatives. The bill will head to the U.S. House of Representatives for approval over the coming months. Alignment between the U.S. government and the private sector to promote domestic semiconductor design and manufacturing will be beneficial to U.S.-based tech companies. Additional U.S. semiconductor manufacturing capabilities would strengthen the supply chain of U.S.-based companies through diversification away from existing foundry services providers such as TSMC and Samsung that have a semiconductor manufacturing presence concentrated in Taiwan and Korea. It would also diminish any impact from natural disasters, as TSMC is subject to risks of earthquakes, or geopolitical concerns from neighboring countries, such as China and North Korea. Furthermore, the tighter integration between chip designs and the semiconductor manufacturing process is important to continuous improvements, an idea Intel would surely concur as it recently announced plans to spend $20 billion to build a semiconductor fab in Arizona to boost capacity and, separately, plans to provide foundry services at another "mega fab" in the U.S. or Europe to manufacture chips for others.

Initially, any new manufacturing capacity in the U.S. will likely be less cost efficient than those operated overseas by industry leaders TSMC and Samsung, given the high construction cost of fabs in the U.S. as well as higher logistics and labor costs. Also, the supply chain would be more complex at first until the full front- and back-end semiconductor manufacturing is built out in the U.S. That's the reason why the $52 billion financial incentives the U.S. government plans to provide would be a critical first step to entice U.S. semiconductor companies to commit to a greater domestic manufacturing presence. We believe that additional incentives such as tax breaks and grants will be necessary to increase the chance of longer-term success of this onshoring of semiconductor manufacturing initiative.

We believe that TSMC and Samsung are committed to their foundry leaderships and will continue to allocate significant investments in this secular growth market. While there are no guarantees that U.S. foundry will ever catch up to TSMC's leadership in process technology or cost competitiveness, a greater U.S. domestic manufacturing presence would, at the very least, reduce reliance on foreign suppliers.

What's S&P Global Ratings' latest view on Big Tech regulation?

The risk of antitrust action in the U.S. is increasing. We continue to believe that significant break ups that would cause rating downgrades are unlikely but the probability of these scenarios is increasing. In addition, the prospect for new antitrust laws with more rigorous enforcement seems likely but we expect that tech companies such as Alphabet, Amazon, and Apple will be able to manage any potentially negative impacts while preserving their credit ratings.

U.S. lawmakers have introduced five bipartisan bills aimed at beefing up antitrust law, which currently has a narrow focus on consumer prices and exclusionary conduct requiring a high burden of proof. If passed, these bills would provide muscular regulators like new FTC chair Lina Khan additional tools to strengthen enforcement. They would prohibit discriminatory conduct, increase scrutiny on acquisitions that could stifle competition, restrain companies from favoring their own products on their platforms, require data portability, and raise merger fees to fund enforcement. For example, the bills could prohibit Google from promoting YouTube videos in search results, Amazon from selling its branded products in its own marketplace with other third-party sellers, and require Apple to allow customers to access apps through alternative app stores. Merger fees seem to have the most support; the other pieces will be hotly contested.

The big tech companies have raised concerns that these laws would harm small businesses, jeopardize privacy and security, and weaken the U.S.'s competitiveness vis-à-vis China. Many Republicans worry about giving too much power to government regulators. We think some of the proposed provisions are likely to pass, but that the most aggressive portions are likely to be moderated to the point that businesses will be able to make changes to their business practices that will bring them into compliance. Such changes would require additional costs and may even include shutting down certain revenue streams, but they are unlikely to be significant enough to materially weaken tech companies' credit profiles. Although adverse outcomes that require significant breakups that would result in downgrades have a low probability of occurring in our view, the risk is rising. Regardless, we think the tech companies will be able to challenge any new laws in the courts, which would lengthen the time to reach final judgements.

In addition, in the U.S., politicians of both parties have proposed modifying rules that limit the liability of platforms for user-generated content. If these safe-harbor protections were revoked, it would open the possibility for significantly increased litigation risks and costs to moderate user content. But the two parties differ in their focus. Democrats worry about disinformation and harassment, and they want platforms to moderate user content more aggressively. Republicans worry about political bias and believe the platforms censor conservative views more harshly; they support encouraging less moderation. We think this difference in focus makes compromise on a bill that significantly undermines liability protections unlikely, although minor carveouts are possible.

In the privacy area, we believe that new restrictions will be manageable. In May 2018, the EU implemented the General Data Protection Regulation (GDPR), creating new compliance obligations aimed at giving EU residents more control over their personal data. Violations could carry fines of up to 4% of global annual turnover for the preceding financial year for the most serious infringements. Tech companies have changed their business practices and added costs to comply with the law, and these actions do not seem to have affected business performance. Nevertheless, we believe new cases from the Irish data regulator are likely on the horizon this year. U.S. federal and state lawmakers could consider adopting similar regulations, as California and Virginia have done. Increasing transnational, national, state, and local privacy regulations would increase operating cost and complexity, but they could also create barriers to competition because the capacity of smaller challengers to deal with these regulations would be much weaker than that of the big tech players.

Tech rating actions have been overwhelmingly positive year-to-date. What is expectation for the rest of the year?

We've seen an overwhelmingly positive rating bias among U.S.-based tech companies, with 50 positives versus 13 negative rating actions in the first half of 2021. Prior to that, many of the positive rating actions were due in part to a reversal of negative rating actions taken stemming from pandemic-related business weaknesses. The positive rating actions taken in 2021, however, were predominately reflecting improving credit profiles but also a result of debt reductions or corporate action such as IPOs.

Chart 2

image

Table 2

U.S. Tech Sector Rating Actions YTD Through June 30, 2021
Upgrade
Date Company To From Subsector
1 01/26/2021

Riverbed Parent Inc.

CCC+/Negative/-- SD/--/-- Network equipment
2 01/26/2021

Rocket Software Inc.

B/Stable/-- B-/Stable/-- IT infrastructure software
3 02/03/2021

Datto Inc.

BB-/Stable/-- B/Watch Pos/-- Application specific software
4 02/16/2021

Uber Technologies Inc.

B/Stable/-- B-/Stable/-- Internet based services
5 02/22/2021

Dynatrace Inc.

BB+/Stable/-- BB-/Stable/-- IT infrastructure software
6 02/23/2021

Advanced Micro Devices Inc.

BBB-/Watch Pos/-- BB+/Watch Pos/-- Semi - microprocessors
7 02/25/2021

Corsair Gaming Inc.

BB-/Stable/-- B+/Stable/-- Specialty hardware
8 03/02/2021

Cornerstone OnDemand Inc.

B+/Stable/-- B/Stable/-- Application specific software
9 03/03/2021

VS Holding I Inc.

B/Stable/-- B-/Stable/-- Enterprise software
10 03/10/2021

ThoughtWorks Inc.

B+/Stable/-- B/Stable/-- IT services
11 03/31/2021

Priority Holdings LLC

B-/Stable/-- CCC+/Watch Pos/-- Payment processor
12 04/16/2021

VeriSign Inc.

BBB/Stable/-- BBB-/Stable/-- Security software
13 04/22/2021

Qorvo Inc.

BBB-/Stable/-- BB+/Stable/-- Semi - analog
14 04/26/2021

Cohu Inc.

B+/Stable/-- B-/Stable/-- Semi cap equipment
15 05/10/2021

Accenture PLC

AA-/Stable/-- A+/Stable/-- IT services
16 05/11/2021

Blackhawk Network Holdings Inc.

B/Stable/-- B-/Stable/-- Payment processor
17 05/26/2021

CDW Corp.

BBB-/Stable/-- BB+/Stable/-- Value added reseller
18 06/02/2021

Avaya Holdings Corp.

B+/Stable/-- B/Stable/-- Specialty hardware
19 06/11/2021

Gigamon Inc.

B/Stable/-- B-/Stable/-- Network equipment
20 06/14/2021

NAB Holdings LLC

B/Stable/-- B-/Stable/-- Payment processor
21 06/28/2021

Unisys Corp.

B+/Stable/-- B/Positive/-- IT services
22 06/29/2021

Salesforce.com Inc.

A+/Stable/-- A/Stable/-- Application specific software
Positive outlook change
Date Company To From Subsector
1 01/27/2021

TE Connectivity Ltd.

A-/Stable/A-2 A-/Negative/A-2 Components
2 02/09/2021

Dell Technologies Inc.

BB+/Stable/-- BB+/Negative/-- Enterprise hardware
3 02/09/2021

VMware Inc.

BBB-/Stable/-- BBB-/Negative/-- IT infrastructure software
4 02/22/2021

Plantronics Inc.

B+/Stable/-- B+/Negative/-- Specialty hardware
5 03/04/2021

Eastman Kodak Co.

CCC+/Stable/-- CCC+/Negative/-- Specialty hardware
6 03/08/2021

McAfee Corp.

BB-/Watch Pos/-- BB-/Stable/-- Security software
7 03/09/2021

Priority Holdings LLC

CCC+/Watch Pos/-- CCC+/Stable/-- Payment processor
8 03/17/2021

Aspen Jersey Topco Ltd.

B-/Stable/-- B-/Negative/-- Application specific software
9 03/17/2021

Solera Parent Holding LLC

B-/Stable/-- B-/Negative/-- Automotive software
10 03/23/2021

MACOM Technology Solutions Holdings Inc.

B/Positive/-- B/Stable/-- Semi - analog
11 03/23/2021

Tech Data Corp.

BB/Watch Pos/-- BB/Stable/-- Distributor
12 03/25/2021

Intermedia Holdings Inc.

B/Watch Pos/-- B/Stable/-- IT services
13 04/08/2021

Corning Inc.

BBB+/Stable/A-2 BBB+/Negative/A-2 Specialty hardware
14 04/12/2021

Nuance Communications Inc.

BB-/Watch Pos/-- BB-/Positive/-- Application specific software
15 04/14/2021

Dell Technologies Inc.

BB+/Watch Pos/-- BB+/Stable/-- Enterprise hardware
16 04/22/2021

GlobalLogic Holdings Inc.

B/Watch Pos/-- B/Stable/-- IT services
17 04/23/2021

BY Crown Parent LLC

B-/Watch Pos/-- B-/Stable/-- Enterprise software
18 04/26/2021

MKS Instruments Inc.

BB+/Stable/-- BB+/Watch Neg/-- Semi cap equipment
19 05/04/2021

Avnet Inc.

BBB-/Stable/-- BBB-/Negative/-- Distributor
20 05/05/2021

QBS Parent Inc.

B-/Stable/-- B-/Negative/-- Application specific software
21 05/18/2021

Lumentum Holdings Inc.

BB-/Stable/-- BB-/Watch Neg/-- Semi - analog
22 05/24/2021

Transact Holdings Inc.

CCC+/Positive/-- CCC+/Negative/-- Application specific software
23 05/25/2021

Cvent Inc.

CCC+/Positive/-- CCC+/Developing/-- Application specific software
24 05/27/2021

Elo Touch Solutions Inc.

B/Stable/-- B/Negative/-- Specialty hardware
25 05/27/2021

Diebold Nixdorf Inc.

B-/Positive/-- B-/Stable/-- Specialty hardware
26 06/10/2021

Micron Technology Inc.

BBB-/Positive/-- BBB-/Stable/-- Semi - memory
27 06/16/2021

Electronics For Imaging Inc.

CCC+/Positive/-- CCC+/Negative/-- Specialty hardware
28 06/30/2021

Procera I L.P.

B-/Stable/-- B-/Negative/-- IT infrastructure software
Downgrade
Date Company To From Subsector
1 01/08/2021 Riverbed Parent Inc. SD/--/-- CC/Negative/-- Network equipment
2 02/10/2021

Pitney Bowes Inc.

BB/Stable/-- BB+/Negative/-- Specialty hardware
3 04/28/2021

SolarWinds Holdings Inc.

B/Stable/-- B+/Watch Neg/-- IT infrastructure software
4 05/06/2021

International Business Machines Corp.

A-/Stable/A-2 A/Negative/A-1 IT services
5 05/12/2021

Rocket Software Inc.

B-/Stable/-- B/Watch Neg/-- IT infrastructure software
6 06/22/2021

Oracle Corp.

BBB+/Negative/A-2 A/Negative/A-1 Enterprise software
Negative outlook change
Date Company To From Subsector
1 02/04/2021

AppLovin Corp.

B+/Negative/-- B+/Stable/-- Application specific software
2 02/10/2021

MKS Instruments Inc.

BB+/Watch Neg/-- BB+/Stable/-- Semi cap equipment
3 3/11/2021

Lumentum Holdings Inc.

BB-/Watch Neg/-- BB-/Stable/-- Semi - analog
4 3/31/2021

II-VI Inc.

BB-/Watch Neg/-- BB-/Stable/-- Semi - analog
5 4/15/2021 Rocket Software Inc. B/Watch Neg/-- B/Stable/-- IT infrastructure software
6 4/26/2021

j2 Global Inc.

BB/Watch Neg/-- BB/Negative/-- Internet-based services
7 6/2/2021

Cloudera Inc.

BB-/Watch Neg/-- BB-/Stable/-- Enterprise software
YTD--Year to date. Source: S&P Global Ratings.

Our S&P Global U.S. economist recently raised our real U.S. GDP growth forecast for 2021 and 2022 to 6.7% and 3.7%, respectively, from 6.5% and 3.1% in our March report. This is consistent with our view that U.S. tech companies' revenue growth is gaining momentum amid a strong demand environment not seen since 2018, which should allow their credit metrics to improve further, potentially leading to more positive rating actions.

The biggest risk to our favorable view on U.S. tech credits is aggressive M&A. Valuations for tech companies have gone up significantly over the past few years and excessive exuberance on business outlook could lead to credit profile impairment even if the rationale for an acquisition is sound. Mitigating factors include tech companies' strong cash flow generation, which was further helped by lowering financing costs via refinancing actions over the last 12 months, good liquidity positions, and an increasing appetite to use equity for acquisition financing.

We expect there to be more M&A announcements in the hardware and software sectors than in the semiconductors industry. Although it is very compelling for semiconductor companies to pursue M&A to further scale efficiencies and broaden the product portfolio that would otherwise be very difficult to achieve, we believe large transactions will be limited given regulatory scrutiny. For example, competitors may be interested in a potential tie-up with NAND semiconductor memory company Kioxia but regulatory roadblocks could be a gating factor.

In the hardware sector, pressure to increase functionality of product offerings could result in companies' search for acquisition targets with software capabilities such as data analytics and security to be incorporated into, or simply broaden, their product offerings. Xerox acknowledged it would pursue small and large M&A in areas such as artificial intelligence, augmented reality, predictive analytics, and robotics to develop new digital workflow and services to drive long-term growth and diversify print revenue streams.

We also find the payments and fintech area to be ripe for consolidation. We saw the three mega-deals in 2019 between Fiserv and First Data, Fidelity National Information Services and Worldpay, and Global Payments and TSYS. However, the fintech space is still highly fragmented with blurring lines between hardware and software, core transaction processing and additional functionality such as security and analytics, U.S. and cross-border, and adoption beyond financial services to other industries such as health care, retail and hospitality.

Software M&As, we believe, tend to carry lower execution risks because deal-sizes tend be smaller and acquisition targets tend to have product offerings that are complementary, limiting integration risks. Areas that are experiencing above-average growth and could be higher M&A activities include security, data analytics, devops, collaboration, software management tools.

Lastly, while we don't believe there will be a wholesale shift by tech companies to more aggressive financial policies, shareholder returns in excess of free operating cash flow generation could lead to negative rating actions. We recognize tech companies are comfortable with their near-term business trajectory and, in some case, enjoy an improved credit profile after having suspended dividends or share repurchases last year due to macroeconomic uncertainties. On one hand, for example, we view Qualcomm and NXP's sizable share buybacks in 2021 to be higher than usual but reasonable given the strong revenue growth and cash flow generation trajectory such that the shareholder returns would not lead to significant deviations from their current leverage levels. On the other hand, we view Oracle and Seagate's significant share repurchases to be shifts to a more aggressive financial policy. In the case of Oracle, it continues to repurchase shares materially in excess of its cash flow generation, which led to our two-notch downgrade on our rating on the company to 'BBB+' with negative outlook from 'A' with a negative outlook in early June. For Seagate (BB+/Stable/--), it pursued debt-funded share buybacks in December 2020, which led to downgrades by other rating agencies from investment-grade level to our 'BB+' equivalent. The action signaled the company's preference for shareholders' interest over other stakeholders including bondholders.

Financial policy shifts are difficult to predict but are of utmost importance in our ratings assessment, especially for investment-grade rated tech companies, as they tend to have significant cash on hand and could reclassify a portion of their cash as in excess of necessary to operate their business and thus available to return to shareholders.

Table 3

U.S. Tech Sector Non-Stable Rating Outlooks As Of June 30, 2021
Positive outlook
Company Current rating Subsector
1

Micron Technology Inc.

BBB-/Positive/-- Semi - memory
2

MACOM Technology Solutions Holdings Inc.

B/Positive/-- Semi - analog
3

Rackspace Technology Global Inc.

B/Positive/-- IT services
4

Diebold Nixdorf Inc.

B-/Positive/-- Specialty hardware
5

Atlas Midco Inc.

B-/Positive/-- Application specific software
6

LogMeIn Inc.

B-/Positive/-- Application specific software
7

Skillsoft Corp.

B-/Positive/-- Application specific software
8

Cvent Inc.

CCC+/Positive/-- Application specific software
9

Electronics for Imaging Inc.

CCC+/Positive/-- Specialty hardware
10

Transact Holdings Inc.

CCC+/Positive/-- Application specific software
CreditWatch Positive
Company Current rating Subsector
1

Maxim Integrated Products Inc.

BBB+/Watch Pos/-- Semi - analog
2

Analog Devices Inc.

BBB/Watch Pos/-- Semi - analog
3

Advanced Micro Devices Inc.

BBB-/Watch Pos/-- Semi - microprocessors
4

Dell Technologies Inc.

BB+/Watch Pos/-- Enterprise hardware
5

Tech Data Corp.

BB/Watch Pos/-- Distributor
6

McAfee Corp.

BB-/Watch Pos/-- Security software
7

Nuance Communications Inc.

BB-/Watch Pos/-- Application specific software
8

Intermedia Holdings Inc.

B/Watch Pos/-- IT services
9

BY Crown Parent LLC

B-/Watch Pos/-- Enterprise software
Negative outlook
Company Current rating Subsector
1

Oracle Corp.

BBB+/Negative/A-2 Enterprise software
2

AppLovin Corp.

B+/Negative/-- Application specific software
3

Balboa Intermediate Holdings LLC

B/Negative/-- IT infrastructure software
4

Magenta Buyer LLC

B/Negative/-- Security software
5

Shift4 Payments Inc.

B/Negative/-- Payment processor
6

Natel Engineering Co. LLC

CCC+/Negative/-- Electronic manufacturing services
7

Riverbed Parent Inc.

CCC+/Negative/-- Network equipment
8

SuperMoose Newco Inc.

CCC/Negative/-- Application specific software
CreditWatch Negative
Company Current rating Subsector
1

j2 Global Inc.

BB/Watch Neg/-- Internet based services
2

Cloudera Inc.

BB-/Watch Neg/-- Enterprise software
3

II-VI Inc.

BB-/Watch Neg/-- Semi - analog
Source: S&P Global Ratings.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:David T Tsui, CFA, CPA, San Francisco + 1 415-371-5063;
david.tsui@spglobal.com
Christian Frank, San Francisco + 1 (415) 371 5069;
christian.frank@spglobal.com
Secondary Contact:Andrew Chang, San Francisco + 1 (415) 371 5043;
andrew.chang@spglobal.com

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