IT sector must try harder but e-learning industry moves to top of the class

In the US, two of the broadest indicators of sentiment in the technology sector, the Standard & Poor's technology index and the Nasdaq, are up 41 per cent and 39 per cent respectively since early September. The Davy technology index, which comprises 12 blue-chip international technology companies, has risen by more than 40 per cent. In Europe, the gains have been even greater, with the Dow Jones Euro tech index 65 per cent higher since September.

So are the good times back for the technology sector?

Given the poor outlook for fundamentals in the sector, this seems unlikely. Demand from the corporate sector, traditionally the main driver of revenue growth in the IT sector, is likely to remain weak until there are definite signs of a recovery in the broader economy.

Companies are unlikely to increase IT budgets when the outlook for their own corporate profits looks bleak, particularly in an area where they probably still have significant over-capacity after the IT investment boom in the late 1990s.

This does not mean that demand will continue falling. It means growth will likely be slow and gradual, particularly in areas where there is significant over-capacity, such as network equipment and semiconductors. Therefore, there will be some earnings growth in the sector, driven by the slight growth in revenues combined with likely further cost-cutting by IT companies.

In terms of valuation, the S&P and Davy technology indices are trading at almost 50 times 2002 forecast earnings, illustrating that the market believes there will be a strong recovery in technology earnings in 2002 and beyond.

This expectation is backed up by the fact that earnings in the S&P technology index are forecast to grow by 34 per cent in 2002, while earnings of large capitalisation technology stocks are expected to grow by 28 per cent over the next 12 months.

We believe that these earnings growth forecasts for 2002 look extremely optimistic in the current environment. Therefore, the recent rally in technology markets looks overdone and we would not be positive on the overall sector, particularly for the first half of 2002.

There is a view emerging in some quarters that as the outlook for 2002 is so poor, investors should focus on 2003 earnings. However, given that visibility on 2002 earnings remains so poor, it is difficult to justify buying technology companies on the basis of the even cloudier 2003 forecasts.

Despite this bleak outlook, there are a few areas of safety in terms of earnings, which can be bought at reasonable valuation levels.

Such areas include products or services that are relatively immune to a slowdown in spending because of government support and/or because the product or service offers a decent return on investment and a quick payback.

One such area is e-learning. Education spending in the US is receiving strong support from the government, and the overall market for instructional software in the schools market is forecast to grow by more than 20 per cent next year.

Riverdeep is now the second largest player in this market, with over 8 per cent market share. At 12.5 times 2002 forecast earnings, it is our top technology pick for 2002.

SmartForce also operates in the e-learning sector but concentrates on the corporate market, with companies using its products as a low-cost method of training staff as they restructure their business. At almost 40 times next year's earnings however, a lot of the good news in this story already appears to be discounted by the price. What about the rest of the Irish technology sector? Although Parthus remains a very attractive long-term story, it is likely to suffer from the poor environment in the semiconductor sector in the short-term. ITouch needs to continue to generate strong revenue growth to reach profitability. Iona also remains attractive on a long-term basis, although it looks overvalued on 2002 forecasts.

Both Trintech and Horizon need to see some improvement in their underlying markets before any significant revaluation can happen. Baltimore still poses some financial risk and until such time as its liquidity problems are resolved, this is one to avoid. Datalex, meanwhile, continues to suffer as a result of one of the worst recessions ever in the airlines industry.

Davy acts as stockbroker to Horizon, iTouch, Parthus and Riverdeep.