Betting Again on Tech’s Potential

In search of robust corporate earnings growth in 2006, Wall Street is thinking retro: the technology sector.

Tech shares -- which soared in the late ‘90s, then plunged in 2000 to 2002 -- have led the stock market’s powerful advance this year amid rising expectations for healthy fourth-quarter profit reports and for more of the same in the new year.

Although energy companies are expected to post the biggest year-over-year gains when fourth-quarter reports begin to roll out in earnest next week, that sector’s strength may no longer be a surprise to investors, given record energy prices for most of the last year.

By contrast, the growth potential in the tech business was highlighted by some of the product rollouts at the International Consumer Electronics Show in Las Vegas last week and by Apple Computer Inc.’s surprise announcement Tuesday that its fourth-quarter sales had soared to $5.7 billion -- up more than 60% from a year earlier.

What’s more, because many U.S. companies are flush with cash, there are high hopes for continued growth in corporate capital spending on tech equipment and software in 2006.

“Earnings expectations for tech look pretty solid,” said Dirk Van Dijk, research chief at earnings tracker Zacks Investment Research in Chicago.

Tech companies in the blue-chip Standard & Poor’s 500 index are expected to report a 17% year-over-year gain in fourth-quarter operating earnings, on average, based on Wall Street analysts’ estimates compiled by Thomson Financial in Boston.

Among 10 major industry groups, that would be second only to the energy sector’s anticipated 45% profit gain.

For 2006, the tech sector’s expected operating profit growth rate is 16%, compared with 14% for energy and 13% for the average blue-chip company, Thomson data show.

The sector expected to show the biggest year-over-year earnings gain in 2006 is the so-called consumer discretionary group, which includes automakers. Analysts’ consensus estimate is for an 18% increase in profit. But that would be a rebound from dismal results in 2005.

The tech sector, by comparison, has posted strong earnings growth every year since 2003.

Yet many investors have been suspicious of tech stocks since the 2000-02 crash that followed the wild late-1990s bull market. This year, however, money has been pouring into the shares.

Despite a modest pullback in the market in recent days, Apple’s stock is up 19% this year, disk-drive maker Seagate Technology is up 21% and computer networking giant Cisco Systems Inc. is up 11%.

Corporate earnings growth overall naturally is decelerating as the U.S. economic expansion rolls on. S&P; 500 companies’ average year-over-year profit gain peaked at 20% in 2004, according to Thomson.

Although the low-double-digit S&P; 500 growth rate expected this year still would be a decent showing, the slowing pace gives investors more of an incentive to hunt for companies that have the potential to surprise with better-than-expected results.

David Garrity, research director at investment banking firm Investec in New York, said the fundamentals of the tech sector suggested that many companies could be poised to beat analysts’ current earnings estimates.

“It’s most likely that upward earnings revisions are going to be seen in tech,” he said.

Indeed, with earnings reporting season about to kick off, one trend in tech stocks’ favor is that the earnings previews that the industry has given for the fourth quarter have been more upbeat than downbeat compared with a year ago.

A total of 178 tech companies have said they expected to meet or beat analysts’ fourth-quarter estimates, up 7% from the 167 companies that had given such upbeat previews at this point a year ago, according to Thomson.

Meanwhile, 162 tech companies have said they expected to fall short of analysts’ estimates, down 26% from the 220 that had warned at this point last year.

“It’s been a very positive quarter so far for tech pre-announcements,” said John Butters, an analyst at Thomson.

Still, some money managers say the surge in tech shares this month may have dimmed their prospects for the rest of the year because the prices already may be reflecting strong profit growth.

Tech issues are far less expensive, relative to earnings per share, than they were in the late-1990s bull market. But they still often command above average price-to-earnings ratios compared with non-tech stocks.

Jim Collins, head of Insight Capital Research & Management in Walnut Creek, Calif., said it might be smarter for investors to wait for the market to calm down rather than jump into many tech issues now.

“We’ve seen a big move here,” he said of the new year’s rally. “I would say tech is a little ahead of itself.”

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Growth outlook

Here are analysts’ average estimated earnings growth rates for the 10 major industry groups in the Standard & Poor’s 500 index.

Est. profit growth:

*--* Industry Q4 2006 Consumer discretionary +3% +18% Technology +17 +16 Energy +45 +14 Financials +12 +14 Industrials +14 +14 Utilities +10 +14 Healthcare +2 +9 Basic materials -6 +9 Telecom +10 +9 Consumer staples +3 +8 S&P; 500 +13 +13

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Estimates are for year-over-year growth in operating earnings.

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Source: Thomson Financial