Category: Economy

The numbers are coming out, and it is clear we are moving to a low growth environment for corporate IT spending in terms of dollars spent. Companies spent too much in the 90s and are being cautious about how they spend their hard-earned cash. Total cash and savings for companies in the S&P 500 have doubled since 1999 and is equal to half a trillion dollars which means companies have added almost 300 billion dollars to their balance sheet in the last 5 years. While companies have so much more cash these days versus 5 years ago, they are spending roughly the same amount on IT. What gives? Reports cite how executives are still worried about the economy or terrorism. However, one other interesting aspect to consider is the effect of commoditization on IT spending. Here we are monitoring year over year growth on actual, nominal dollars spent on IT, hoping and waiting for an uptick in spending which will fuel more growth. After all there is a ton of cash out there and corporates have to invest the cash or give it back to shareholders. The funny thing is that the commoditization trend means that companies can do more with less. What that means is that companies can keep the same IT budget and accomplish the same amount or more without increasing their capital expenditures. In addition the competition for the customer’s dollars is fierce which means that the customer has complete control these days in terms of pricing. Both of these factors obviously work against significant increases in IT spending. In fact, customers have so much power these days (and rightly so) that companies like GM are forcing vendors like Sun and Microsoft and Cisco and Microsoft to work together, to standardize and integrate with one another.

Here is a quote from Fed Ex’s CIO in a recent New York Times article:

The information technology strategy at FedEx, the package delivery service, points to that conclusion. “Technology is coming to us in much smaller bundles that cost a lot less,” said Robert B. Carter, the company’s chief information officer, whose budget is slightly more than $1 billion. “Our intent is to hold the line on I.T. spending and get more bang for the buck.”

The flat spending does not suggest any lack of enthusiasm for technology at FedEx, a sophisticated corporate user of technology. Mr. Carter reels off a series of projects for helping customers use the Web, e-mail alerts and wireless messages to track inbound and outbound packages, trim inventories and fine-tune operations.

“The global interconnectedness and technology services available are growing at an unbelievable pace,” he said. “We are at an inflection point in the adoption of these technologies.”

This theme of doing more with less continues to echo in my brain as I meet with more and more CIOs and technology arhitects. As I mention in an earlier post, it seems that many in corporate america are going through a fundamental rearchitecture of their systems to a service-oriented model, one that will take a number of years, but one in which startups will have plenty of opportunities to thrive even with flat to limited growth in IT spending. Trust me, it would be great if corporations continue to grow their IT budgets. However, I am not worried as the great news is that new architectures and hardware equals lots of new software opportunities. There will be plenty of chances to make great investments in this environment.

As you know, I like to stay abreast of the economy and IT spending, searching for leading indicators of how the markets and my companies may perform in the future. It is clear that given the current market, people are quite excited about the prospects of IT spending growth in 2004. Given that backdrop, I found an interesting graph in this weeks Goldman Sachs Software Scoop report

showing the linkage between employment growth and IT capital spending. According to Goldman, this graph shows “companies are likely to view tech capital spending the same way they do employment–add when you are confident of the sustainability of the recovery and only when you have to.” As you can see, there is pretty close correlation between the two sets of data. What it tells me is to keep a close eye on employment data and potentially use that as another leading indicator for IT capital spending. When companies are feeling good about themselves and the economy, they spend more. It will be interesting to see how this graph looks in the future as more companies look to outsource non-core capabilities and continue to cut costs and improve earnings. For example, will capital IT spending begin to spike above employment growth in the next 5 years and by how much?

It looks like the economy in Q3 grew even faster than we initially thought, 8.2% annual rate versus 7.2%. It was not too long ago that the Department of Commerce released numbers showing 7.2% annualized GDP growth for Q3. If you take a closer look, “equipment and software” spending was at a 15.4% annualized rate. I obviously have concerns about the revised 8.2% GDP growth and certainly do not believe that is sustainable due to one-time factors like tax cuts and mortgage refinancings. While it is nice to see a 15.4% annualized growth rate in “equipment and spending” for Q3, let’s not assume that this is the beginning of a huge ramp-up in IT Spending. To bolster my thinking, I like to look at a number of data points. For one, Goldman Sachs recently issued its October IT Spending Survey. Its latest survey calls for an increase of 2% spending for 2003 versus a December 2002 survey which forecasted a decline of 1.1% for 2003 spending. So it is nice to see that the trend reversed in terms of IT spending, and that it looks like there is a small rebound happening. That being said, the October 2003 survey forecasts spending growth of only 1.3% for 2004, down from an August 2003 spending survey forecast of 2.3% growth for 2004. That is a negative trend and does not promise earth-shattering returns to IT Spending in the bubble years. As Goldman Sachs mentions, hopefully there is just a lag in terms of how the economy performs and where each company is in its budgeting process. If this is the case, we shoud keep an eye out for data from future surveys.

Another data point that I look at is how the fund’s 30+ portfolio companies are performing. We have a number of companies in the Enterprise IT space selling security, storage, network management, wireless, and other related software. Some companies are performing extraordinarily well and others are close to budget. The fact that most of my companies are close to budget is a far cry from 2001 and 2002, years plagued by numerous reforecasts of revenue and expense projections. In general, sales pipelines are building momentum giving better visibility for the next two quarters. While I cannot say that all of the fund’s portfolio companies are growing like wildfire, in general the sentiment across the board is positive. As you can see, I am more in the Goldman camp of IT growth than what the GDP numbers reflect. The conclusion I draw is that even with 2% expected growth in IT Spending next year, as always, there will continue to be pockets of huge opportunity like security, business intelligence, and systems management allowing companies to protect their mission critical assets, report in real-time (or near real-time), and better manage the IT assets they already possess and do more with less. Call me a moderate optimist, if you will.

It is easy to blame China for our domestic problems. The argument from Bush and the US Goverment is that because China is keeping the Yuan artificially low against the dollar, the US is losing jobs and running a huge trade deficit. The US Government is asking the Chinese to float its currency against the dollar to help solve this fundamental problem. However, the big issue is that our economy is extremely vulnerable to China, and there is much more at stake than losing jobs to China. By keeping the Yuan low, the Chinese are keeping our interest rates low as they are huge buyers of US Government bonds (as of May 2003, China held $121.7 billion in US Treasuries ranking it 3rd in foreign ownership behind Japan and Britain). From your economics 101 days, you will remember that interest rates and bond pricing work in inverse order. Heavy purchasing of Treasuries increases the price and conversely lowers the interest rate. If China ever decides to sell these bonds it could start a massive chain reaction which would be detrimental to our economy. One of the big reasons for this is that our country is a huge net borrower, corporate-wise, individually and fiscally. All is well and good when we are borrowing at low interest rates heavily financed by foreigners. This certainly drives near term growth. Just look at how the refinancing boom has spurred incredible consumer demand over the last year. However, given the amount of borrowing that we do as a country, we are extremely vulnerable to interest rate risk.

Bill Gross, Pimco’s bond guru, paints a scenario in which a devaluation of the Yuan could trigger some nasty consequences:

“A more likely course would posit reduced Asian and U.S. purchases of Treasuries, a diversification into Eurobonds, a stronger Yen and Yuan over the next few years, more expensive U.S. imports after a lag, a sapping of consumer spending power, gradually rising intermediate and long-term rates, a declining housing market and yes a near body blow to America’s financed-based economy for all the reasons outlined in previous pages.”

So before we get too excited about domestic growth and the great performance in the stock market this year, let’s remember that our economy is not as invincible as we may think. We are potentially vulnerable to the Yuan and other Asian currencies which are indeed overvalued and need to be corrected. When this happens and how this happens will obviously determine the effects on our own economy.

Why is this important for those in technology? Even though technology stocks have performed incredibly well this year and even though Google is talking about going public next year (see an earlier posting), I just do not want us to get too excited about a return to the earlier bubble period. Some of us may have forgotten already as you can see from this NY Times piece yesterday about investors’ appetite for risky stocks. What is important is that we do not use the market as our sole proxy for the strength of our economy as it can be deceiving. Companies still have to generate meaningful earnings and cash flow. This macroeconomic backdrop certainly has implications about what types of companies I believe will have a better chance of performing during the next few years. I hope to address this topic in a future posting.