Inordinate Spending on Technology Comes Back to Haunt the Sector

One reason for the unprecedented length of the economic boom that appears to be ending was that increasing investments in technology resulted in increasing levels of worker productivity. Greater productivity, in turn, allowed for further growth with little inflation.

Even when the economy appeared to be in danger, as it did during the Asian financial crisis in 1998, productivity gains from technology investments pulled us back from the brink, many economists say.

But the situation appears different this time around. The information technology sector itself has been hit hard, as many companies have markedly decreased capital spending on hardware and software. Even Federal Reserve Chairman Alan Greenspan cited the slowdown in capital spending on technology when the Fed lowered interest rates in February.

The immediate results can be seen as tech companies line up to announce layoffs and to issue quarterly earnings that fall far short of expectations.

Chip giant Intel Corp. announced on March 8 that it would cut its work force by 6%, or about 5,000 jobs, and that it expected revenue to fall by around 25% in its first quarter. The next day, networking gear maker Cisco Systems Inc. said it would eliminate 3,000 to 5,000 full-time positions and 2,500 to 3,000 part-time and temporary jobs.

Software generally has been hit less hard than hardware, thanks in part to the fact that many companies are shifting spending from hardware to software to save money. But it’s clear that the whole technology sector has been affected.

The question is, why now?

“We simply over-invested in technology over the past half-decade,” said Edward Yardeni, chief investment strategist for Deutsche Banc Alex. Brown in New York. “During that time, spending on computers and communications equipment grew at 50% per year. That’s really quite extraordinary.”

So extraordinary that many companies overspent, creating too much technological capacity. Now, they’re either abandoning investment plans altogether, or they’re negotiating bargain-basement prices.

Part of the blame can be placed at the feet of venture capitalists and investment bankers, said Daniel Murphy, who co-manages the Frontegra Growth Fund for Northern Capital Management: “There was an enormous amount of capital that was poured into all these new companies that were coming out of the woodwork.”

In the wake of the investment orgy of the last few years, “now it’s all dried up.”

The problem seems to go beyond the business cycle. In the last few years of the 1990s, businesses spent like drunken sailors to prevent the Y2K computer bug from mucking up their computer systems. That spending, by some estimates about $50 billion combined in 1998 and 1999, seems to have done its job, but it also depleted the technology budgets of many companies.

At the same time, technology companies got used to corporate America’s profligate spending on their products, often failing to remember that Y2K was a temporary phenomenon.

Thanks to “the madness of crowds,” Yardeni said, the Y2K spending “misled a lot of analysts into thinking that something fundamental had changed” in the economy.

Of course, the dot-com shakeout also has had a big effect on the investment downturn. All those Internet companies, once awash in venture capital, spent big on computer equipment and software. As they fall by the dozen, expectations for investment spending fall with them.

And there’s another effect: A couple of years ago, many so-called old-economy companies felt under siege, and industry pundits kept warning them that the dot-coms were going to eat their lunch. So they spent big to install the necessary equipment to launch their own Internet initiatives.

With the dot-com threat largely abated, big companies can breathe a little easier--and think more carefully before making big investments in technology.

Two surveys released in March from major brokerages provide mixed messages on the prospects for technology spending.

“Technology budgets are very fluid,” concluded a Morgan Stanley Dean Witter survey of 225 chief information officers on their capital spending plans for the coming year. Only 35% of them called their tech budgets “fixed.”

In other words, many executives are waiting to see how bad things get before deciding on how much to invest in new technology.

Despite the well-documented troubles at companies such as Cisco and 3Com Corp., 43% of the CIOs said that planned purchases of network equipment would be the least likely to be abandoned in a slowdown. Also relatively safe: customer-service applications and e-commerce software.

Among the areas most in danger are consulting services (59% of tech-consulting budgets probably will be cut), wireless initiatives (41%) and upgrades for Microsoft Windows desktop software (39%).

Still, such surveys should be taken as tentative, at best. Another report from Merrill Lynch concluded that spending on wireless projects and Windows upgrades would increase.

However uncertain the short-term prospects of tech investing may be, it’s clear that technology will remain a crucial component of overall economic growth for the foreseeable future.

During the 1990s, tech spending went from 3% of the gross domestic product to 5.7%, according to Salomon Smith Barney. And the productivity gains that flowed from that increase encouraged further growth.

“Clearly, now that capital spending is slowing, that will directly affect productivity,” Yardeni said. “The flip side is that when we recover--and we will recover--there will be a rebound in productivity.”