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 IT: Don’t hold your
breath ::
By Russell Muldoon
7 May 2008
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| PORTFOLIO POINT: Cyclical IT companies have been hit by a softening economy, and their share prices might not recover for some time. |
Economic cycles are as certain as the seasons themselves. Although their frequency, timing and length cannot be predicted with any degree of certainty, it is very important to understand approximately where our economy is on the economic cycle.
It is safe to say we are close to or at an economic peak, and many bets are now pointing towards those sectors outside resources entering the period between the peak and the trough – the contraction phase.
Let’s explore these economic cycles and any potential impact they may have on three highly cyclical IT-related businesses: DWS, Oakton and Seek.
Figure 1
As shown in Figure 1, these three businesses have experienced a material swing from out-performance to underperformance in the past six months due to a significant “de-rating” by market participants. This de-rating has resulted in what would seem, on face value, to be favourable discounts to StockVal’s estimates of intrinsic value. Just how dramatic the de-rating has been in recent months can be seen in Figure 2 (note: the blue line represents StockVal’s current estimate of intrinsic value).
Figure 2
Investors must understand that these three businesses and many others listed on the ASX are exposed to the health of our economy. Unlike non-cyclical businesses – those that have the ability to generate profits regardless of economic gyrations because they produce or distribute goods and services we always need, such as food, power, water and gas – the sales of cyclical businesses depend on the strength of the economy. To this end, sales will thrive during periods of economic prosperity and decline when the economy slumps. Their ability to make profits and continue to experience high levels of profitability is just like the Australian economy: prone to cyclicality.
We need to establish why DWS and Oakton’s shares have fallen 58% and Seek’s by 48%, a crash in anyone’s language.
Share prices falling in this manner suggest something has caught many market and equity analysts off-guard
Table 1
Table 1 summarises the research compiled three weeks ago from various industry analysts when shares in DWS, Oakton and Seek first began appearing at wide discounts to StockVal’s estimate of intrinsic value. These numbers can be used to provide guidance for each businesses future estimated performance as measured by Normalised Return on Equity (NROE)
As recently as April 16, equity analysts at various brokerage and research firms were predicting strong increases in profitability and dividends into the foreseeable future.
Inputting these figures into StockVal as forecasts for 2008F, 2009F and 2010F, we get the above performance charts. StockVal’s numbers convert the story of a very bright future, as told by a range of highly experienced analysts, into a perspective that an owner can understand. After-tax profits, the level of fully franked dividends and shareholders equity are all forecast to grow materially in the next few years. Likewise, forecast business performance, as measured by NROE, appears set to remain at attractive levels.
But a disconnect appears to be occurring between analysts’ forecasts and what is occurring in the real world, a disconnect potentially masked by the excellent performance of our economy to date.
When our economy is growing, employment is stable and interest rates are low, high levels of discretionary spending occurs, fuelled further by easy credit conditions. When people spend a large proportion of their disposable income on consuming “wants” rather than saving, businesses (depending on how adequately they are managed) are likely to experience high levels of profitability and excess cash flow. Rising profits encourage businesses to re-invest profits back into the business. IT infrastructure and software are just some of the areas that may be targeted by managers.
This investment is an important source of revenue for those who provide services, including DWS and Oakton. Anecdotal evidence and official statistics suggest business confidence and conditions are deteriorating, which may have a material impact on businesses willingness to spend in the future. In turn, the potential impact on the economic performance of cyclical service supply companies such as DWS and Oakton may likewise be material – something that current analysts forecasts may be failing to capture.
Recent surveys show that business confidence has fallen to its lowest levels since September 2001 (our last period of economic contraction) and new forward orders have fallen quite sharply, reflecting the deteriorating willingness of businesses to invest. If companies begin to rein in spending on investment in IT, for example, this may completely undermine current profitability forecasts for DWS and Oakton as presented before. What these businesses are intrinsically worth today may differ significantly in the future, should this eventuate.
In the case of Seek, cyclicality is also an issue. When business confidence is high and the economy is growing, employment levels tend to be strong, which in turn leads to high levels of job advertisements and low levels of unemployment.
With record levels of participation in the workforce and deteriorating business conditions/confidence, employment levels are likely to only go one way. In this event, a company that earns a large portion of its revenue base from companies advertising jobs will be vulnerable. A fall in job advertisements on the back of a contracting economy would undoubtedly lead to lower advertising levels and so lower revenue and underlying profit. Again, this would lead to a significantly different intrinsic valuation from StockVal’s estimate today.
So are we being optimistic in our business valuations? Or are we being conservative enough, and now is the time to be investing into cyclical businesses?
The risk here is whether or not these companies will actually be able to achieve anything near what the analysts, in aggregate, are predicting. Our recent research and a potential contraction in the economy makes us highly sceptical and cautious.
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