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U.S. Tech Sector Outlook Strong Despite Equity Volatility And Slowly Improving Supply Constraints


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U.S. Tech Sector Outlook Strong Despite Equity Volatility And Slowly Improving Supply Constraints

Strong Demand And Outlooks Will Support Tech Companies Despite Equity Volatility

Although we don't focus on equity markets, we believe recent price moves reflect a reset in valuations rather than a break in fundamentals. The tech companies we rate performed well in the December quarter and generally have bullish outlooks for 2022. Enterprise spending is picking up as companies release pent-up demand and as management teams gain confidence in the macroeconomic picture with the omicron wave waning and strong employment figures.

After several quarters of investing in personal computers (PCs) and collaboration software to facilitate work from home, enterprises are now focusing on updating their data center infrastructure and continuing their digital transformation plans. This will result in strong demand for public cloud, security, and networking solutions. Automotive and industrial markets are gobbling up available supplies that have been short in recent quarters, and even after supply eventually increases enough to meet their production needs, orders will remain strong as they rebuild dwindled inventory, helping NXP Semiconductors N.V. and Texas Instruments Inc. Communications spending is strong as wireless carriers build out their 5G networks, which has taken longer than some had expected following increasing penetration of 5G phones. Ciena Corp., Juniper Networks Inc., Lumentum Holdings Inc., and II-VI Inc. should benefit. 5G handsets are still growing fast, with Qualcomm Inc. estimating that 750 million 5G units will sell in 2022 compared with 535 million in 2021, as new Android models roll out. Increasing content in these phones is a boon for wireless semiconductor makers like Qualcomm, Broadcom Inc., Skyworks Solutions Inc., Qorvo Inc., and memory suppliers. We see 2022 shaping up to be a strong year, with global information technology (IT) spending above 6%, down from above 10% in 2021, but still above normal levels.

Supply Conditions Will Ease At Different Paces But Will Remain Tight

We predicted that the December quarter would represent peak supply constraints based on lead times, and this seems to be playing out, even with the temporary omicron disruption. We expect that conditions will ease at different paces for different markets, though most markets should see shorter lead times by the end of 2022. Even so, they will remain tight throughout the year, and a return to normal is not yet in sight.

PC and mobile are the markets that should improve the quickest. Consumer and education demand for PCs is waning as kids return to school in person, and inventories are above pre-COVID-19 levels. While enterprise demand for PCs is picking up, we see unit growth moderating in the current year to 2% from 15% in 2021. We also think demand will be weighted to the first half, so supply could reach normal conditions in the second half of 2022. Supply to meet needs in the mobile market is in good shape because the original equipment manufacturers (OEMs) are large and powerful buyers, and they have shifted capacity away from other product areas to support handsets during their peak selling season. In addition, the market should see some seasonal relief in demand after the Lunar New Year.

While PC and consumer electronics inventories are above pre-COVID-19 levels, other markets like automotive and industrial are still below normal. Although still tight, the supply constraints in these markets seem to have peaked, and there are some signs of easing. For example, General Motors Co. said that the first quarter should show some improvement over the fourth quarter and that semiconductor constraints should diminish in the second half of the year. Although we believe that supply conditions will improve through the year, they will remain tight throughout the end of 2022 as depleted inventories get rebuilt. For semiconductor manufacturers, supply additions will be coming online over the next several quarters. Texas Instruments will add some capacity in the third quarter and more in the first quarter of 2023. Also, many other semiconductor manufacturers that increased capital expenditures last year will have capacity coming online this year.

Wafer fabrication equipment (WFE) seems to be the exception. In this area, Lam Research Corp., Samsung Electronics Co. Ltd., and Microchip Technology Inc. see consistently lengthened lead times for equipment. Limited availability of equipment will slow the pace at which semiconductor lead times revert to normal. Given strong demand from 5G, automotive, industrial, data center, and WFE markets; low inventories in the most constrained markets; and long cycles for bringing on new capacity, we do not see supply conditions returning to normal until 2023 at the earliest.

ESG Factors For Tech Coming Into Focus

In December, S&P Global Ratings released ESG indicators for all publicly rated global tech companies (see "ESG Credit Indicator Report Card: Technology"). In our view, the tech sector has above average exposure to governance risks given that 49% of rated companies are controlled by private equity firms, small groups, or individuals, which we believe points to decision-making that prioritizes controlling owners' interests, particularly on maximizing shareholder returns. We believe that a handful of prominent issuers--roughly 5% of rated entities--have higher exposure to data security and regulatory risks. Examples include Apple Inc. and Alphabet Inc., which face antitrust scrutiny from global regulators; SolarWinds Holdings Inc. because of the Sunburst breach in 2020; Uber Technologies Inc. because of the employment status of its drivers; and MicroStrategy Inc. because of the uncertainty of future regulation on bitcoin. We believe environmental risks have a mostly neutral influence on credit because tech hardware and semiconductor companies are implementing product lifecycle and water efficiency programs and, along with software companies and those with large data centers, they also have significant greenhouse gas reduction plans.

Cloud Investment Poised To Accelerate In 2022

Capital expenditures (capex) from Microsoft Corp., Alphabet, and Meta Platforms Inc. grew 21% in 2021 as enterprises rolled out digital transformation initiatives after a cautious year in 2020 and as e-commerce and digital advertising benefited from pandemic-induced consumption trends. We expect capex for the cloud group to accelerate in 2022 from already strong levels in 2021. Despite revenue headwinds at Meta last quarter due to mobile platform privacy changes, it forecasts its capital spending to increase 70% in mid-2022 at the midpoint of the guidance range, while Alphabet also expects a "meaningful" increase. Demand supports large capital investments with revenue growth for the cloud portions of these businesses ranging from the high-30% area to the high-40% area in 2021, far exceeding the growth in capital spending. We see enterprise customers continuing their shift to the cloud as they develop their hybrid cloud approach. This provides a robust backdrop for semiconductor, hardware, and software suppliers--such as manufacturers Advanced Micro Devices Inc. and NVIDIA Corp., memory chip makers, and hard disk providers--to support cloud environments in 2022.

Large-Cash Acquisitions Picking Up

We expect that tech companies will have increasing incentives to use large cash piles for acquisitions in 2022 (see "Strong Fundamentals In U.S. Tech Allow Capital Allocation Flexibility"). Strong business performance throughout 2020 and 2021, improving macroeconomic conditions following the omicron wave, and strong cash flows are giving management teams greater confidence to deploy their excess cash--and they have a lot of it. In 2020, U.S. tech issuance hit a record $280 billion, which provided enhanced liquidity cushion during the early days of the pandemic, and it increased again to $335 billion in 2021, which was more opportunistic. Rising inflation adds pressure on companies to use cash earning low yields.

The strongest push for acquisitions is in software, where companies are trying to grow in end markets that process massive volumes of data. There are also significant opportunities for automation and artificial intelligence advancement in sectors such as health care. Oracle Corp. demonstrated this with its $30 billion deal for Cerner Corp., and so did Microsoft with its $20 billion bid for Nuance Communications Inc. earlier in 2021. Microsoft's $69 billion deal for Activision Blizzard Inc. was more company-specific in that it added content for its Xbox gaming platform, but it could portend more deals in the budding metaverse space.

Software companies and legacy hardware providers are also targeting public cloud software and services, and we could see more deals in certain spaces of the semiconductor market. Although unlikely in the already consolidated memory and semiconductor capital equipment spaces, deals are still possible in logic and analog because they are still fragmented. However, very large transactions will likely face strict regulatory scrutiny, particularly in China. On Monday, NVIDIA and SoftBank Group Corp. called off their deal for NVIDIA to buy Arm Ltd. because of significant regulatory challenges.

U.S. Tech Rating Actions To Become More Balanced

As we wrote in "Industry Top Trends 2022: Technology," after a volatile 2020, which was marked by significant negative rating actions in the first half due to the pandemic and gradual improvement through the second half, there were positive rating actions throughout 2021 as tech companies continued to benefit from accelerating digital transformation. This led to rising IT spending, which we expect to continue in 2022, underpinned by accelerating growth in the cloud, improved enterprise spending, and continued ramp-up of 5G smartphones and related infrastructure. Macroeconomic risks--such as inflation, rising borrowing costs, and the pace of recovery from the pandemic--bear monitoring, but we believe tech company ratings will continue to have an upward bias throughout 2022, albeit a more moderate trend compared to 2021.

This report does not constitute a rating action.

Primary Credit Analyst:Christian Frank, San Francisco + 1 (415) 371 5069;
Secondary Contact:David T Tsui, CFA, CPA, San Francisco + 1 415-371-5063;

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