Aided by a Windows XP refresh cycle and solid growth in smartphone sales in 2014, the technology sector outperformed the US High Yield index last year. Recent developments, however, make us more cautious, says Audra Stundziaite, Analyst at Hermes Credit.
1. PC market weakens after XP refresh cycle in 2014
In the last few years, the PC market has shrunk due to the proliferation of smartphones and tablets. In 2014, this decline has slowed amid the XP refresh cycle (see figure 1). Since IBM stopped providing support for Windows XP in April 2014, businesses have been forced to upgrade to newer machines that could efficiently run modern operating systems, such as Windows 7 or Windows 8. This refresh cycle boosted the 2014 operating results of companies in PC supply chain, including original equipment manufacturers and chipmakers. In 2015, however, the trend is reversing. According to Gartner, 2Q15 global PC shipments declined 9.5% y/y, the steepest decline since 3Q13. The fall is being exacerbated by the pause in sales through August ahead of the launch of Windows 10 in 3Q15. The strong USD dollar is not helping either, and increases in prices to protect margins are suppressing demand outside of the US. Recent commentary from Intel raises further concern: in its 2Q15 earnings release, the company’s management forecast a high-single-digit drop in sales across the PC market, up from a previously anticipated mid-single-digit decline.
Figure 1. The decline of worldwide PC shipments
Source: Barclays as at April 2015
2. Smartphone growth slowing as the China market matures
Smartphone shipments continue to grow, driven by demand for lower-priced models in south-east Asia, the Middle East and Africa, and by premium demand in China. However, after robust growth of 39% in 2013 and 29% in 2014, growth expectations are moderating at 11.8% for 2015. The slowdown is primarily driven by China, with 2015 being the first year in which Chinese market growth, currently at 2.5%, is expected to be slower than the worldwide rate. Similar to other markets such as the US, UK, Australia and Japan, smartphone vendors now have to convince Chinese consumers to upgrade their devices, which is more difficult to do than attracting first-time buyers.
Figure 2. Global smartphone sales growth is slowing
Source: Barclays as at May 2015
3. Weak results from bellwethers signal trouble for the supply chain
Challenging dynamics in key end markets are leading to disappointing results and lower guidance across the broader supply chain in the technology sector. Notable examples include:
- Intel lowering 2015 revenue guidance twice this year, citing weaker than expected demand for desktop PCs and increasingly challenging macroeconomic and currency conditions, particularly in Europe
- Advanced Micro Devices pre-announcing negative 2Q15 results due to weaker than expected consumer PC demand
- Samsung providing guidance that 2Q15 results could fall below expectations due to continued weakness in the company’s mobile and semiconductor businesses
- Apple reporting that 2Q15 iPhone shipments were below expectations
- Qualcomm lowering its 2015 forecast yet again due to lower than expected demand for high-end devices.
Disappointing results from such bellwether names make us cautious about the results due to be announced by other companies in the technology supply chain in the remainder of the 2Q15 earnings season.
4. Semiconductor consolidation is accelerating
With about $80bn in announced deals through the first five months of the year, consolidation has notably picked up in the semiconductor industry. This M&A activity is primarily being driven by the need to offset slowing top-line growth due to challenging dynamics in the key end markets of computing and wireless, and the need for scale as the costs of manufacturing chips continue to increase. Some of the recent headline deals include:
- Intel announcing its intention to acquire Altera for $16.7bn, allowing it to expand into data servers and thereby the internet of things market
- NXP announcing its intention to acquire Freescale for $16.7bn, creating a powerhouse in automotive chips
- Avago acquiring Broadcom for $37bn, strengthening its position in semiconductor chips for mobile phones.
What does this mean for credit investors?
Strong operating results boosted by the PC upgrade cycle, and strong growth in smartphone sales, drove the high-yield technology sector to gain 6.8% in 2014, notably more than the 2.5% return of the broader US high-yield index . Now that these dynamics are reversing, we are more cautious on the technology space this year. We remain underweight companies with outsized exposure to the PCs or those in the handset supply chain. Instead, we prefer chipmakers that have recently strengthened their operating profiles through M&A and stand to benefit from more diversified end markets, meaningful synergies and commitments from management to pay down debt.