1) Overall IT fundamentals remain healthy, but watch PCs, smartphones and the supply chain

Consensus estimated 2022 EPS for the IT sector has been down slightly since the start of the first quarter earnings season on March 31. However, we believe that the lower EPS estimates do not necessarily reflect strong demand, as we believe that several macroeconomic and supply-side forces are holding back better estimate revisions.

Forecasts for software companies saw headwinds from a stronger US dollar. The software industry derives a significant portion of its revenue from foreign markets. The 6% gain in the dollar against the euro alone probably had a negative effect of around 2.5% to 3.0% on the group’s revenues and profits.

While the war in Ukraine has been mentioned frequently in first quarter earnings calls, the impact so far has been modest, but still in the range of 100 basis points of revenue and EPS. On the supply side, hardware companies have been hit by COVID-related shutdowns that have disrupted manufacturing in China. This was first pointed out by Apple in late April, and conditions have apparently deteriorated based on Cisco’s comments in its May 17 earnings call. Semiconductor companies continue to struggle with supply issues amid strong demand, with some exceptions for low-end PCs and smartphones. Our final view is that demand for enterprise computing and most semiconductor end markets remains robust. We continue to monitor geopolitical, inflation and interest rate headwinds, but remain comfortable with the broader corporate spending backdrop.

While we think the overall state of demand is reasonably healthy, we see reason for caution on smartphones and PCs. Weaker economic growth and slowing consumer spending are clearly impacting demand for smartphones in the world’s largest end market, with local brands particularly affected. PC demand is also weaker at the margin, although we believe most of the weakness is in the low-end Chromebook market.

2) But computing is now “less special” – relative graphics

While we believe the fundamentals are reasonably sound, we believe that in the current environment – ​​rising interest rates, high nominal GDP, inflation, Fed tightening – the tech sector is “less special”. The sector has barely outperformed the broader S&P 500 over the past two years.

While the sector has benefited from healthy IT spending and a supposed digital transformation rush, nearly all of the gains from the pandemic have reversed. As the chart below shows, relative EPS growth in the IT sector has actually lagged the overall market by nearly 500 basis points over the past two years.

3) Macro trumps micro — part 1 oil and computing
In previous notes, we pointed out that “…oil and water don’t mix, and neither do IT and energy…” because these two sectors have the highest negative correlation excess returns (i.e. the sector’s return minus the return of the S&P 500). We also wrote that we believe that “…the IT sector is unlikely to outperform the broader S&P 500 unless and until energy no longer outperforms…”

4) Macro trumps micro – pay attention to the duration of actions
Interest continues to dominate the performance of the IT sector. Longer duration IT stocks (i.e. stocks with the highest EV/FCF value) have underperformed their shorter duration counterparts since the December 27, 2021 peak for the sector. We think there could still be a further decline in interest rate-induced valuations, especially in the wealthiest cohort of the information technology sector.

5) Cheaper, but not cheap – watch out for recency bias
A comment we frequently hear in relation to the sell-off is that “equities are cheap now”, reflecting the -26% decline in the sector’s P/E from 28.2x at the end of December to 20.9x currently. We agree that IT stocks are cheaper, but we don’t think they are cheap. We believe that claiming the sector is “cheap” is an exercise in recency bias.

In our view, the P/E multiple from 2020 to 2021 represents some inflation due to lower rates and a premium placed on growing companies. While we believe businesses are embracing digitization and digital transformation, we believe that the overall dynamics of the IT industry are not much different today than the five years before the pandemic in 2014-2019. We continue to see the sector being driven by key enabling technologies such as cloud computing, augmented and virtual reality, artificial intelligence, big data and wireless 5G. Basically, the combination of the main drivers – IT and smartphone spending – is largely unchanged. On the contrary, we would say that the macroeconomic environment is demonstrably different (inflation, rising interest rates, hawkish Fed, strong oil), and that should argue for a lower growth and cash flow premium at long term.

Moreover, while the multiple has contracted in absolute value, we note that the sector still displays a fairly rich premium of 21% compared to the S&P 500, well above the average premium of 5% pre-pandemic 2014-2019 .

To learn more, ask your financial advisor for a copy of the report: Information technology in the United States: the overview in picturespublished on May 20, 2022.

Main contributors: Kevin Dennean, Reid Gilligan