COVID-19 Impact In The Second Quarter Was Better Than Feared

U.S. technology sector credit held up to the COVID-19 pandemic in the second quarter better than expected because shutdowns disproportionately hurt small and midsize businesses (SMB) and local firms. The companies we rate have less exposure to these segments than the broader economy.

Enterprise spending was weak, but it held up much better. For example, revenue from Cisco Systems Inc.'s SMB customers was down 23% year over year while enterprise was down only 7%. The COVID-19 pandemic even drove strength in several areas including e-commerce on brick-and-mortar shutdowns (evident in the results for Amazon.com Inc. and eBay Inc.), PCs on work from home (WFH) and remote learning, and hyperscale and some pockets of networking on increased data traffic and streaming.

We believe some portion of the WFH trend is permanent. It has accelerated the shift to cloud computing, which provides customers with increased flexibility for numerous and changing working models. It has also increased networking needs to handle higher and more complex data traffic as at least a portion of work hours will be remote. This will be to the detriment of on-premises spending, particular on technology hardware.

We saw weakness in verticals directly affected by COVID-19, including travel and entertainment, and strength in defensive verticals that provide basic services such as financial services, telecom, and government. On a regional basis, Asia-Pacific and particularly China was the strongest, Europe the weakest, and North America somewhat less weak. The pandemic also increased costs including freight, factory underutilization, and protective equipment, partly offset by savings in travel and entertainment spending.

Finally, we believe the bottom is in on technology spending by the automotive industry as global auto production rebounds, which should support several semiconductor companies including NXP Semiconductors N.V., Analog Devices Inc., and ON Semiconductor Corp.

Weak Enterprise And Cloud Spending Expected In The Second Half

Second-quarter enterprise spending was better than expected due to support for WFH, but we expect weakness in the second half as customers delay discretionary projects. The PC market was strong, driven by WFH, and Chromebook demand was high for remote learning. We expect this market to be weaker in the second half as demand was pulled forward into the second quarter. Enterprise demand for public cloud workloads remains robust and COVID-19 has accelerated the transition from on-premises workloads, but strong spending by hyperscalers in the first half sets up a digestion period in the second half. We think cloud spending is likely to pick up again in 2021. Since end-user demand is increasing so quickly, we believe digestion periods are not likely to last more than two or three quarters.

The software market is at lower risk from slower enterprise spending because these products are embedded in customers' operations and the recurring revenue portions are not as sensitive to swings in quarterly demand because they must be paid to keep the lights on. Perpetual license revenue is at risk because it represents new purchases, as opposed to maintenance revenue that supports past purchases. But software providers have been transitioning their revenue models to subscription pricing over the last several years, so the perpetual piece is much less important than it was.

For example, for the quarter ended May 31, Oracle Corp.'s license revenue was down 22% year over year, but its total revenue was down only 6% because recurring revenue was stable and made up 70% of the total. Furthermore, we see software-as-a-service (SaaS) providers benefiting from the current environment since SaaS provides more flexibility. Salesforce.com Inc. revenues for the quarter ending July 31 were up 29% from a year earlier.

5G Phones Coming First; Network Spending Will Ramp Up In 2021

iPhone revenue was stronger than expected, up 2% year over year, but non-Apple Inc. mobile was weak, exemplified by Samsung Electronics Co. Ltd.'s 18% drop in mobile. We think Apple did relatively well because it is exposed to the higher end of the consumer market, which was less affected by job losses in the quarter. It also debuted the second generation of its more affordable SE model. Nevertheless, we think new 5G models are likely to drive mobile growth across the entire market in the second half. We note Apple pushed out the release of the next iPhone model by a few weeks. This will shift some revenue for Apple and its suppliers, notably Qualcomm Inc. and Broadcom Corp., from the calendar third quarter into the fourth.

Comments from Ericsson and other wireless network suppliers suggest 5G network spending is likely to accelerate in 2021. We also believe the 5G investment cycle is likely to be longer with a less pronounced peak as fixed wireless and internet of things products ramp up in a staggered fashion.

Memory Price Recovery Will Revert To Normal Erosion

We think the reversion in the PC market is likely to weigh on memory as demand was pulled forward into the second quarter due to WFH. We think weaker demand from public cloud providers and enterprise data center buyers will also be headwinds. Gaming and mobile markets will provide partial offsets, as social distancing and new console models from Microsoft Corp. and Sony Corp. support the gaming market and new 5G models drive smartphone demand. The dynamics for DRAM and NAND should be similar as firm pricing in the first half is likely to revert to normal erosion during the second. Nevertheless, supply remains rational as we detected no suppliers aggressively increasing their capital spending plans, which could set up a stronger pricing environment in 2021.

U.S. Tech Ratings Will Mostly Hold Up Through Slower Enterprise Spending, With Pockets Of Weakness

The acceleration of the shift to the cloud should increase the creditworthiness of SaaS companies and the burden for on-premises hardware companies. In addition, we took several negative rating actions (including many negative outlook revisions) on speculative-grade companies in March and April due to COVID-19 concerns, most of them in the 'B' category. Given that the COVID-19 impact is turning out to be less severe than expected, we could see positive rating momentum over the next 6-9 months among these companies.

Interesting company-specific implications:

• Dell Inc.'s operating performance should weaken through the second half given continued pressure on enterprise information technology (IT) spending, but we believe it should have enough cushion to its 4x downgrade threshold. On the other hand, long-term credit risk captured by the negative outlook is heightened by the potential split with VMware Inc. in 2021.
• Weaker IT spending could compound Avnet Inc.'s operating challenges and lead to a downgrade out of the investment-grade category after we placed our 'BBB-' rating on CreditWatch with negative implications in August.
• The negative outlook on our rating on Oracle is due to our uncertainty about the company's appetite for continued share buybacks and our view that it will likely cross our downgrade threshold over the next 5-8 quarters if it maintains its buyback pace. The outlook has less to do with operating performance, so weak IT spending is not likely to cause a downgrade; the strength of its recurring software model is bearing out.
• Despite high exposure to the automotive end market, we upgraded ON Semiconductor in August and declined to take a negative action on NXP Semiconductors notwithstanding modest cushion to our mid-2x downgrade threshold. We believe the second quarter represents the trough for the automotive end market and that there will be a good second-half rebound. NXP's buybacks are on pause until leverage is closer to 2x, and this credit-friendly financial policy also supports the rating.
• We upgraded Advanced Micro Devices Inc. in August due to improving profitability and market share gains against Intel Corp., which we expect it to sustain in the face of weak IT spending due to its compelling product roadmap.