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Stock Strategist

High Tech Expectations Bode Well

Better-than-expected tech earnings and positive outlooks are good signs for the broader economy.

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Third-quarter earnings season continues to be dominated by a single theme: firms beating expectations. With a few notable exceptions (such as  eBay (EBAY)), companies are reporting that their quarters were better than most analysts were expecting, and in many cases better than even management had hoped for.

But even more surprising than third-quarter results, many management teams have turned positively bullish on the prospects for the rest of 2009 and into 2010. One notable example was  Caterpillar (CAT), where management is expecting a robust recovery next year as the economy picks up and infrastructure spending expands. This doesn't just seem like pie-in-the-sky optimism either. Senior equity analyst Adam Fleck thinks that the projected 10%-25% top-line growth is attainable, and he raised his fair value estimate to reflect the improved economic situation.

Another industry that has robust expectations for the coming quarters is tech. After suffering through the double whammy of lower consumer and business demand for tech products, appetite for new, shinny gear is beginning to build again. This week's launch of  Microsoft (MSFT) Windows 7 is providing another impetus, particularly for consumers, to upgrade their systems. Considering the anemic uptake of Microsoft's Vista operating system, a significant number of people could be sitting on old XP computers waiting for the new OS before making the big purchase.

Even before the release of Windows 7, Microsoft turned in decent quarterly results. Sales were off 4% year over year, but cost-cutting and share buybacks pushed earnings per share up 8%. Associate director of equity research Toan Tran is excited about the Windows 7 launch and he points out that "strong product cycles are often a harbinger of good things for Microsoft stock." He currently rates the shares 4 stars.

Of course, computers need more than just an operating system to run. Chipmaker  Intel (INTC) also had a better-than-expected quarter and raised guidance for the fourth quarter. Analyst Andy Ng points out that if the firm hits its guidance, sales will have rebounded to roughly pre-downturn levels. The success seems to be stemming particularly from sales of chips used in mobile PCs.

Intel's success in the mobile space points to another broad trend--consumers are still willing to pay up for the convenience of a full featured mobile computing experience.  Apple (AAPL) was able to move a record number of iPhones despite the phones' relatively high price-point and pricey data plans. The halo effect from the iPod and the iPhone also continued to impact the Mac business, which also had record sales in the quarter. These huge numbers helped Apple blow earnings estimates out of the water. The stock popped this week, rising over 8% to hit an all-time high. Apple gives notoriously conservative guidance, but management comments indicated that they believe their new products will continue to deliver sales performance.

iPhone sales are also a big help to Apple's largest wireless carrier,  AT&T (T). The firm activated 3.2 million iPhones, and according to associate director Mike Hodel's estimates, almost 18% of the firm's lucrative post-paid customers are currently using the iPhone. Despite growth in wireless, AT&T's fixed-line business continues its terminal decline as consumers cut the land line. Hodel believes that AT&T will continue to throw off solid cash flow and that the dividend is safe (shares currently have a projected yield of 6.4%).

Outside of the hardware universe, Internet companies have had much better than expected results and positive outlooks.  Amazon (AMZN) likely had the biggest surprise, and shares surged more than 25% on Friday on the news. The biggest growth driver was better media sales, and profitability improved on lower fulfillment and research-and-development expenditures. However, analyst Larry Witt warns that although these are impressive results, the firm's long-term prospects are going to be hurt by the digitization of media. He sees the shares as overvalued at more than 50 times forward earnings.

Even  Yahoo (YHOO) had a less-bad quarter than expected as it finally saw stabilization in its core advertising business and appears to have put the worst behind it. Still, Witt warns that the firm continues to face long-term challenges, and he expects them to continue to lose share to  Google (GOOG). In an interesting bit of related news, Carl Icahn said late Friday that he was resigning from Yahoo's board--possibly signaling that the activist investor doesn't believe a lot of additional value can be added at this point.

Although tech is only one slice of the economy, it shows how corporate America is starting to recovery from the recession. An uptick in consumer demand is driving manufacturers to start restocking inventory. This in turn will stoke more demand and create a virtuous cycle that should help the economy grow in the second half of 2009 and into 2010.

On Tap
Here's what we'll be looking for as earnings season continues next week:

 Boardwalk Pipeline (BWP)
With pipelines returning to standard operating pressure over the quarter, we expect a sequential cash flow bump. We'll also look for updates on Boardwalk's newest pipelines, and when it may get the go-ahead to raise operating pressures with compression additions.

 McGraw Hill (MHP)
The firm should show improvement in economically sensitive businesses.

 National Oilwell Varco (NOV)
We'll be looking for details on new equipment ordering trends, including from Brazil.

 Waste Connections (WCN)
We expect the firm to hold the line on pricing, helping to keep profitability intact.

Alcon (ACL)
We expect Alcon's earnings momentum to continue in the third quarter, adjusted for seasonal factors.

 Apollo Group (APOL)
We expect continued enrollment growth.

 Boston Properties (BXP)
Higher unemployment, the weak economy, and tenant bankruptcies will weigh on results.

 Johnson Controls (JCI)
Expect to see improved results in the auto segment.

 AvalonBay Communities (AVB)
Tenant trade-downs probably spell weaker earnings for AvalonBay.

 ConocoPhillips (COP)
Weak refining margins and lower natural gas prices will drag on earnings.

 Wellpoint (WLP)
Will the "commercial" segment catch up with the "consumer" segment?

 Avon (AVP)
Weak consumer spending around the world may continue to pressure Avon's third-quarter sales.

 Brunswick (BC)
We don't expect a much-improved third-quarter operating environment, so we'll focus on the firm's liquidity position.

 Expedia (EXPE)
Improving consumer confidence may boost growth and profitability.

 ExxonMobil (XOM)
Higher oil prices should boost upstream earnings, but weak refining margins plague downstream.

 Motorola (MOT)
Expect another dismal quarter for the handset business.

 Duke Energy (DUK)
A strengthening third-quarter economy could provide breathing room.

Jeremy Glaser has a position in the following securities mentioned above: MSFT. Find out about Morningstar’s editorial policies.