Table 1

Since last fall, S&P Global Ratings has revised its global information technology (IT) forecast downward twice following our economists' revision of their 2020 global GDP growth forecasts (see table 1). Consequently, as we cascaded our lower IT spending forecast to our U.S. tech portfolio, we have taken 46 negative rating actions (or 23% of the portfolio) since the COVID-19 outbreak. Only three of those negative rating actions were taken on investment-grade issuers (Corning Inc., TE Connectivity Ltd., and VMware Inc. [due to its relationship with Dell Technologies Inc.]), while the rest were taken on speculative-grade rated issuers due mostly to liquidity concerns and our expectation of weaker operating performance and deteriorating credit metrics over the next 12 months.

While S&P Global economists expect the drop in economic activity in the U.S. to be sharp but fairly short, the path to recovery remains highly uncertain as far as timing and trajectory, until an effective treatment or vaccine is in place.

Our key takeaways from first quarter earnings reports include:

• Significant revenue declines experienced by systems hardware vendors such as Cisco Systems Inc. and Hewlett-Packard Enterprise Co. in the current weak business environment highlights enterprise customers' preference for a flex consumption model to transactional sales model with high upfront costs.
• Server, storage, and networking equipment vendors experienced supply chain constraints due to lockdowns and factory closures in China, the Philippines, Malaysia, Europe, and the U.S.
• Hyperscale cloud and web-scale service providers such as Amazon Web Services, Microsoft Azure, and Google Cloud Platform expect to see continued capital spending growth to equip their data centers and support growing demand for cloud services; however, spending could diminish in the second half of 2020.
• The semiconductor industry reported better-than-forecasted earnings as strong cloud demand, increased IT purchases related to work from home, and inventory build by customers offset deteriorating enterprise spending and some supply-chain disruptions.
• Software vendors saw a drop in license sales activities and IT service providers found clients de-prioritizing projects with longer-term paybacks.

Why Have U.S. Investment-Grade Tech Issuers' Ratings Been So Resilient?

Most of the 49 U.S. investment-grade rated tech issuers have experienced stronger growth compared to global GDP growth over the past decade because technology continues to account for a greater portion of the overall economy. We attribute three key reasons for its ratings resilience during the COVID-19 pandemic thus far.

Reduced business cyclicality over time as tech industry matures

S&P Global Ratings has always considered the tech sector's cyclicality to be moderately high due to its exposure to the evolving nature of the industry characterized by investment-driven boom-and-bust periods such as the telecommunications and internet bubble of the early 2000s and the personal computer (PC)-driven cycle in the mid-2000s. For the hardware and semiconductors subsectors, the higher proportion of fixed costs (including research and development [R&D]) results in significant operating leverage that also amplifies margin and working-capital cyclicality. As such, we incorporate in our rating assessment our expectations for business cyclicality.

Even though we consider the tech sector's cyclicality to be moderately high, industry volatility has shown signs of waning over the years. As the industry matures, it has weeded out companies with weak business prospects and, in turn, has rewarded those with strong competitive positions and defensible intellectual property (IP) portfolios. IT spending is now much more broad-based with an increasing proportion tied to enterprise spending (which is steadier) rather than consumer spending. Increasing electronic content in end markets such as auto and industrial; product diversifications that have expanded beyond PCs to devices such as smartphones, wearables, and home security systems; and shorter product-release cycles reducing the feast-or-famine nature that is associated with longer product-refresh cycles, have all contributed to diminishing business volatility for tech companies.

Since 2009, we've seen our rated U.S. investment-grade tech issuers universe grow to 49 from 28 as companies have either grown in scale and profitability to earn investment-grade ratings or have engaged in debt-financed mergers and acquisitions (M&A) and therefore sought ratings from us. Most of these tech companies have strong product offerings and have substantially expanded their scale and scope, many benefitting from strategic M&As during the past five years, that further diversified their end market, product, customer, and geographic concentrations that dampened the effects from shocks such as the COVID-19 pandemic that's currently devastating the oil and gas, auto, and retail sectors, to name a few.

Exposure To Secular Trends Bodes Well For Long-Term Growth Prospects

We believe the value proposition for technology products, whether hardware or software, will continue to grow in prominence. Cloud computing, fifth generation technology standard for cellular networks (5G), artificial intelligence, big data, internet of things (IoT), and digital transformation, all parts of the 4th industrial revolution that will shape the global economy and determine which countries will prosper or fade away in the 21st century. As a result, enterprises, and nations in some cases, will invest heavily to be one of the leaders. In all, we believe the tech industry will continue to grow as a percentage of the overall economy. The tech industry's credit prospects should be stronger than that of overall corporates as a result.

Leadership in an enabling platform such as 5G, for example, can help define and shape the evolution of the global tech landscape beyond existing supply chains and capital spending on telecom equipment. We believe achieving market leadership in 5G deployment to be a key success factor to a vibrant economic environment for countries and regions. It provides opportunities and financial incentives to develop business and consumer use cases that can increase the global competitiveness of telecom and tech companies, as well as the industries they support. As history has shown, the successful U.S. deployment of the first 4G networks in the early 2000s offered a platform for accelerated innovation, continued investment, and sustained leadership positions for many U.S. technology firms. Examples include Apple Inc.'s success in smartphones and tablets, Google LLC's achievement in advertising through development of its ubiquitous Android mobile operating systems including its Google Chrome browsers, and Qualcomm Inc.'s patents in wireless mobile phone designs and mobile baseband chips. The same was true of Europe's 2G adoption in the early 1990s and Japan's 3G adoption in the early 2000s. We believe the leaders in 5G adoption will have an edge in the development of the next wave of technology innovations such as cloud computing, the IoT, and autonomous vehicles.

Many of our investment-grade rated tech issuers are vendors or service providers or owners of critical IPs of these important tech evolutions who will benefit from secular growth trends. We expect many of these companies to improve from their existing market positions, both organically and via acquisitions, broaden their customer bases and product portfolios, and further their ability to capitalize on scale advantages such as product distribution capabilities and efficient R&D spending.

Chart 1

Chart 2

Flexibility provided by stronger balance sheet and liquidity

We believe the U.S. technology sector has generally maintained a stronger balance sheet than those of other corporate sectors as a cushion against potential industry volatility because it's rapidly evolving and subject to technological obsolescence, which may render their competitive positioning moot. Apple doesn't need nearly $83 billion in net cash under any economic downturn, and its balance sheet may be viewed as inefficient by some investors. But we believe Apple maintains this liquidity level to invest heavily in new products to replace the iPhone as its primary growth driver in the future, and should it miss the opportunity to invest in the right product, its balance sheet should allow it to acquire its way into the "next big thing." Even when excluding highly rated issuers such as Microsoft, Apple, and Alphabet, many issuers in the 'BBB' category maintain low or no leverage. As a result, we find the leverage profile of U.S. investment-grade rated tech issuers to be relatively stronger than those of other corporate sectors.

Chart 3

Rated U.S. investment-grade tech issuers' debt balance rose significantly since the mid-2000s, with reported debt ballooning to almost $600 billion by the end of 2019 from $100 billion a decade ago (see table 2). While the amount of debt increase appears alarming, it was accompanied by substantial growth in tech companies' revenues, profitability, and cash and investment balances leading to only moderate increases in leverage. The biggest credit risk to the U.S. tech sector followed the implementation of the U.S. Tax Cuts and Job Act in late 2017, which removed a major barrier to the repatriation of overseas earnings, and potentially opened the gates for increased share repurchases with the sudden boost in domestic liquidity. Indeed, many U.S. tech companies implemented significant share repurchases in 2018 and 2019 but only two negative ratings actions (Oracle Corp. and Qualcomm) occurred because those share repurchases mostly depleted excess liquidity and consumed some of the leverage capacity within the companies' respective ratings.

Table 2

We don't believe any of our U.S. investment-grade tech issuers face significant debt refinancing risks, thanks to the low interest rate environment in recent years that has allowed companies to extend debt maturities. However, the pandemic certainly provided a strong test of the strength of U.S. tech companies' balance sheet and liquidity because capital markets were on the brink of collapse ahead of the significant policy measures announced by the U.S. Federal Reserve in late March. The Fed endeavored to intervene in the primary and secondary corporate debt markets, providing lifelines to many corporate debt issuers, benefiting many U.S. tech companies to further boost their liquidity at highly attractive interest rates.

Table 3

Companies such as Intel Corp., NXP Semiconductors N.V., Hewlett Packard Enterprise Co. have already announced the suspension of their share repurchases and Western Digital Corp. has also announced a pause in its dividend payments. We believe all tech issuers will also reevaluate their cost structures and pursue actions such as reductions in force, salary cuts, corporate real estate consolidations, lower capital expenditures, and other cost-savings initiatives to right-size spending to meet near-term growth trajectories. With that said, ample liquidity should allow companies to minimize operational disruptions and preserve critical R&D investments, and permit certain companies to pursue strategic M&A.

Chart 4

Biggest Risks To Investment-Grade Tech Ratings

The two biggest downside risks to ratings are much slower-than-expected IT spending recovery from the pandemic and escalating U.S.-China trade tensions.

Significantly reduced global IT spending due to a longer path to recovery

Unprecedented measures from the U.S. government and Federal Reserve will be sure to mitigate the effects of the sharp decline in economic activity due to COVID-19, but the path to recovery remains uncertain both in terms of timing and trajectory. Our current base case uses government authorities' estimates of the pandemic peaking around midyear, with lockdown measures in place until at least June in the U.S., and a gradual lifting and reopening of economic activities in stages through the third quarter as consumer demand revives and firms rehire workers, fill back orders, and restock inventories. However, we've already seen bouts of COVID-19 reoccurrences in countries such as China and Korea, after they began reopening their economies. Until an effective treatment or vaccine is in place, significant uncertainties surround the resolution of the pandemic and its effects.

Our base case assumptions for the U.S. tech sector include:

• The software subsector will grow in the low-single-digit percentage area in 2020 and many software companies' credit metrics will remain near pre-pandemic levels.
• Most hardware and semiconductors vendors and IT services providers won't see their credit metrics return to pre-pandemic levels until the second half of 2021 or later.
• Equipment purchase or upgrade decisions are either delayed or cancelled because of IT budget cuts. Spending on growth initiatives will likely be postponed due to heightened business uncertainties.
• Associated implementation service or maintenance contracts will be pushed out. It's currently unclear how much of the delayed equipment purchases will be permanently lost.

Besides closely evaluating the COVID-19-related health measures and government policies to contain further spread of the virus, we'll also gauge business and consumer confidence and assess IT spending patterns over the next few years. Many tech issuers' capacity to absorb weaker business performances or take on incremental debt without affecting ratings had already shrunk post-tax reform and after incorporating the effects of COVID-19 to date. If we believe there's a higher risk of an extended global economic slump, such that tech issuers' longer-term growth prospects will be impaired or we don't believe they have levers to pull to maintain their financial risk profiles, we would consider further downgrades, not only to sponsor-owned issuers in the 'B' category but higher-rated companies including investment-grade issuers.

Ratcheted-Up U.S.-China Trade Tension

On May 15, 2020, the U.S. Department of Commerce (USDC) announced new rules that would effectively restrict Huawei Technologies Co. Ltd. (not rated) from accessing semiconductors using U.S. technology. If implemented, this would prevent U.S. semiconductor manufacturers such as Micron Technology Inc. and Intel from selling to Huawei and foundries such as Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) from supplying chips to Huawei, because their chips are manufactured using U.S. wafer fab equipment (WFE). This follows the actions taken by the USDC in May 2019 to place Huawei on the USDC's Entity List and signals the ongoing deterioration of the U.S.-China relationship. We believe this game of brinksmanship will continue for the foreseeable future and alter the global technology landscape, especially the semiconductor and hardware markets, as the two countries vie for tech leadership, and ultimately, the next economic growth engine in the 21st century.

Huawei has a leading market share in global communications infrastructure equipment (above 30%) and is the second largest global smartphone manufacturer (around 17%). Huawei is also estimated to account for about 5% of global semiconductor consumption (nearly $20 billion based on 2019 global semiconductor sales).

We believe near-term risk to the semiconductor industry to be manageable for investment-grade-rated semiconductor issuers. However, it adds incremental pressure on an industry that we already forecast will shrink by 7% in 2020 due to the direct, and indirect, effects of the COVID-19 pandemic. U.S. semiconductor manufacturers have gradually reduced their exposure to Huawei over the past year due to the Entity List enforcement although many continue to sell to Huawei through loopholes found within the current rules. Huawei could potentially suffer market share losses if it's unable to procure certain high-end chips from TSMC for its 5G-enabled smartphones and communications equipment, but we believe overall semiconductor market consumption should be minimally affected as Huawei's share losses would likely be offset by incremental share gains by the likes of Samsung Electronics Co. Ltd., Apple, and Chinese original equipment manufacturers (OEMs; in smartphones), as well as Nokia Corp., Ericsson (Telefonaktiebolaget L.M.), and Cisco Systems Inc. (in communications gears).

First quarter earnings indications

Calendar first quarter earnings by semiconductor issuers were generally in line or better than expected due to incremental demand for public cloud services and various hardware as employees and students work from home and online traffic increases as well as some inventory build by nervous customers. These factors partially offset weakening enterprise demand and some supply chain and production issues in China. With the new USDC announcement, there's a risk that double-ordering, which could accelerate inventory build over the next quarter or two, especially by Chinese OEMs, could portent a significant decline in semiconductor shipments in the second half of 2020 compared with the first half.

In particular, the USDC's announcement may directly hinder U.S. WFE manufacturers such as Applied Materials Inc., Lam Research Corp., and KLA Corp. if their foundry customers, such as TSMC and Semiconductor Manufacturing International Corp. (SMIC), pull back on capital spending in anticipation of reduced Huawei orders. Micron's Huawei exposure (already lowered to an estimated near mid-single-digit percent of total revenues versus more than 10% in prior years) would also be at risk if Huawei looks to Samsung Electronics or SK Hynix Inc. as potential replacements. On the other hand, companies such as Qualcomm could benefit as shares shift from Huawei to other Chinese OEM phone makers who are license-paying customers and generate higher revenues per phone.

Table 4

Longer Term View

Semiconductor segment 

Longer-term implications are more complex, and mostly negative, for U.S. investment-grade semiconductor issuers. China accounts for 20% to 25% of global semiconductor output, based on its consumption of various products from phones and laptops to autos. Lingering trade disputes and aspirations for IP leadership will continue to push China to develop its own semiconductor ecosystem consisting of raw materials procurement and manufacturing and design capabilities. China announced in late 2019 that it set up a new $29 billion national semiconductor fund, larger than the one launched in 2014 that kick started the nascent industry for China. SMIC, China's leading foundry, also recently announced it's seeking a stock listing on the Shanghai Stock Exchange and that Chinese state funds will invest $2.25 billion in a new factory.

TSMC's announcement in May 2020 that it intends to build a $12 billion fabrication facility in Arizona also speaks to diverging sovereign strategies and the need to appease U.S. policymakers. We believe China-native semiconductor firms will take many years, if not longer, to catch up to industry leaders such as Intel and Samsung Electronics in designing and manufacturing leading-edge memory and logic products. Despite the challenge, we expect China will continue to invest heavily to close the technology gap to meet domestic demand, despite unfavorable economics until they move up the technology curve. This transition will also disrupt the global semiconductor ecosystem, especially U.S. semiconductor companies, as China turns to European and Asian chip makers as an alternative to the U.S. manufacturers. Over the longer term, S&P Global Ratings' view that the semiconductor industry has become less volatile over the past decade due to broadening end market demand and rational supply, could be upended.

Wafer fab equipment segment 

Implications for U.S. WFE companies are mostly negative for the next several years. In the best case scenario, potential lower demand from Huawei due to U.S. restrictions may be offset by share gains from other customers, thereby keeping revenues steady for the next year or so. On the other hand, any restriction on U.S. WFE exports to Chinese semiconductor manufacturers would eliminate one of the key industry growth factors because China's semiconductor manufacturers represent about 10% to 15% of overall WFE spending and an above-industry growth rate. KLA, which has the highest logic (advanced integrated circuits) exposure among the top three U.S. WFE manufacturers, would suffer most in this scenario. It's unlikely that China's semiconductor manufacturers would retaliate against U.S. WFE makers at this time because substitution is difficult. But over the longer term, we could see WFE market share shift to Japanese or European companies.

Hardware segment 

Deteriorating U.S.-China- trade relations could potentially alter the hardware industry landscape too. In May, China's Global Times commented after the USDC's announcement that Qualcomm, Apple, Cisco, and Boeing Co. could be targets of retaliation should the U.S. go through with new restrictions on Huawei. Hardware companies make easy targets for China should it choose to retaliate, but we don't believe at this time there's significant near-term risk for S&P Global Ratings-rated hardware vendors. We believe Apple's market share in China, currently estimated at 9%, is safe for now because it has a relatively loyal customer base and we don't expect China would retaliate against Apple, which is estimated to currently employ hundreds of thousands of domestic workers and support millions of jobs tied to the Apple iOS ecosystem. Retaliation against U.S. PC makers such as Dell and HP Inc. is also possible. While Dell and HP would be hurt, we believe it would have a lesser impact on other PC component makers because it would be difficult to replace processors made by Intel and Advanced Micro Devices Inc. (AMD) and hard drives made by Western Digital Corp. and Seagate Technology Inc., not to mention operating system and software dominated by U.S. tech companies. It's likely that China will focus on its retaliation efforts outside of the tech sector where the pain felt by U.S. companies will be greater.

New investment by China in homegrown tech

Similar to the semiconductor industry, we believe China will continue to invest in homegrown technologies, both hardware and software, to limit its dependence on the U.S. over time. We believe China's chance of success is high given their large population, growing middle class and enterprises and, more importantly, full support from its government to help nurture and grow the tech ecosystem. National champions such as Huawei, Alibaba Group Holding Ltd., Tencent Holdings Ltd., and Baidu Inc. (not rated) are good examples that give hope to DRAM memory maker Changxin Memory Technologies (CXMT, and previously known as Innotron; not rated), NAND memory maker Yangtze Memory Technologies Co. (YMTC; not rated) and semiconductor manufacturer SMIC. While not any time soon, we can envision dual or multiple technology ecosystems based on sovereignty, and a slow migration from the current global supply chain that maximizes comparative advantages.

U.S. vendors will find manufacturing alternatives

From U.S. hardware vendors' perspectives, it would be logical for risk management reasons to slowly break away from the current heavy reliance on China for manufacturing and assembly, even at higher costs. The supply-chain disruptions caused by the pandemic and the U.S-China trade spat over the past two years expose their vulnerabilities. While U.S. tech companies have begun diversifying their manufacturing footprint to limit reliance on China, it's our view that it will be a long process, with or without any financial assistance from the U.S. government. The tech supply chains have been in existence for more than two decades. There are few alternatives to the abundance of China's skilled labor force, still low labor costs, and close proximity to other tech-component makers that the country currently offers. As such, it appears that U.S. and Chinese tech companies will have to face the consequences of the unpredictable political climate for longer.

Investment-Grade Tech Issuers Most Exposed To Negative Rating Actions

We believe the tech issuers that are at greatest risk of downgrades are hardware companies that are most sensitive to the macroeconomic outlook and have relatively tight cushions within our ratings to absorb more economic shock such as another wave of the coronavirus infection that might lead to on-and-off lockdowns. Additionally, U.S. tech companies that compete directly against Chinese national tech champions; that is, Huawei (and its semiconductor subsidiary HiSilicon), YMTC, or CMXT could potentially see their businesses damaged if U.S.-China trade tensions escalate further.

Table 5

Related Research

• As Global IT Spending Falls, Tech Ratings Pressure Rises, April 29, 2020
• Global Credit Conditions: Rising Credit Pressures Amid Deeper Recession, Uncertain Recovery Path, April 22, 2020