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Fitch: Record Debt & Event Risk Dominate U.S. Tech Industry Outlook.

NEW YORK -- Fitch Ratings is more cautious of 2007 credit and operating trends for most U.S. information technology (IT) sectors, even though the overall industry is expected to remain stable. A continuation of elevated event risk related to leveraged buyout (LBO) interest, managements' greater emphasis on increasing shareholder value, and debt-financed acquisitions is anticipated. As consolidation declines for the communications equipment industry, Fitch believes such activity continues to be necessary for the EMS and software sectors, particularly as potential acquirers' balance sheets are strong and cash positions remain high. Fitch also expects the industry trend of weakening credit metrics (mostly driven by higher debt levels) will continue with operating margins, free cash flow, and working capital efficiency potentially peaking in 2007. All aforementioned financial results have improved substantially the last few years and have reached or exceeded 'pre-bubble' levels achieved in 1999-2000.

Record Debt Levels

Industry financial flexibility remains strong as cash balances are close to $200 billion, flat since year-end 2003, and annual free cash flow remains at approximately $60 billion. For 2007, Fitch believes excess cash and free cash flow will continue to be used aggressively for stock buybacks, although it will be challenging to sustain the pace of increases since repurchasing activity has nearly doubled every year since 2003, exceeding more than $90 billion in 2006. Dividends will remain an option of last resort for excess cash in 2007, according to Fitch, even though more established, strong investment grade companies continue to balance stock repurchases with increases in dividends.

Total industry debt is expected to increase to record levels again in 2007, surpassing $140 billion compared to $100 billion of debt at the beginning of 2006. Fitch believes a majority of 2007 technology debt issuance will be driven mostly by refinancings with industry bond debt maturities of more than $10 billion in 2007 and $15 billion of bank credit facilities due, although LBO activity and debt-financed acquisitions are expected to contribute to record technology industry debt levels. New debt issuance is expected to remain strong for secured bank facilities and term loans, which could continue to negatively affect the ultimate recovery prospects of unsecured bondholders.

Technology LBOs

Technology LBO activity will continue in 2007 as private equity firms remain comfortable with certain technology sectors' maturing growth rates (although still growing faster than worldwide gross domestic product (GDP)), consistent free cash flow, and conservative capital structures. In addition, while the list of attractive technology targets remains short, Fitch believes LBO speculation and activity will be driven by strong private equity fund inflows, a favorable credit environment, and relatively stable demand for IT. However, Fitch believes additional technology LBOs are currently limited by comparatively high enterprise valuations, fewer obvious cost reduction opportunities, and a belief that the technology cycle could be peaking (most notably for semiconductors). Fitch expects strategic buyers will be the primary consolidators of the technology industry, similar to what has occurred for the communications equipment and software sectors, potentially precluding LBO activity. Clearly, the prospects for additional LBO activity can increase default and recovery risk for bondholders.

Ratings Momentum

Fitch believes the majority of rating actions for the U.S. technology sector in 2007 will occur in the IT distributor and IT Services sectors. Component IT distributors are the most likely to achieve strengthened operating and credit profiles, potentially resulting in positive rating actions. Although operating margins remain thin and opportunities for meaningful debt reduction appear unlikely, IT distributors have demonstrated less volatile operating performances and improved working capital efficiency, resulting in recurring free cash flow during growth periods. The credit outlook for IT Services is mixed as Fitch believes increasingly leveraged capital structures and aggressive share buybacks could lead to further negative rating action for companies such as Affiliated Computer Services (ACS) and Computer Sciences Corp. (CSC). However, Fitch believes stronger operating fundamentals and market presence may result in positive rating actions for companies such as EDS and Convergys. Fitch continues to focus primarily on the quality and sustainability of free cash flow and investment requirements for contract signings.

2007 Market Outlook

Fitch's expected IT market growth rate for 2007 is approximately 2 times (x) worldwide GDP estimates of 3.0% with the expectation that the industry will experience growth rates consistent with a more mature cyclical industry. Market indications and trends suggest the worldwide IT spending environment will be lead by the more than $700 billion IT services and software sectors with hardware being up slightly. Fitch believes a less favorable macroeconomic environment in 2007 could reduce IT growth as slower U.S. GDP expansion (Fitch forecasts 2.5% growth in 2007 down from 3.2% in 2006), relatively high energy costs, and a pressured housing market may potentially lower consumer and enterprise technology spending. From an industry and end-market perspective, IT growth will remain dependent on financial services, manufacturing, and government spending, with the small and medium business market continuing to be a source of growth and an area of strong focus.

Sector Outlooks

IT Services (Stable Outlook):

Fitch believes the 2007 operating outlook for the IT services industry is stable with a negative bias as several issuers present a mixed credit outlook. In general, Fitch expects a continuation of significant share repurchase programs and increased likelihood of debt-financed acquisitions. Pricing pressure driven by growing demand for offshore services could curb IT services industry growth, resulting in stagnant stock prices and even greater demand for actions designed to increase shareholder value. Total gross share repurchases for Fitch's IT services universe in the first nine months of 2006 increased nearly 40% to $8.9 billion relative to the year-ago period. In addition, there could be ramifications of the ongoing Securities and Exchange Commission's (SEC) investigations into historical stock option grants at ACS and CSC with respect to liquidity and potential debt refinancing requirements.

Fitch believes the stable operating environment continues to be supported by total IT services market growth in the upper-single digit range supported by a healthy pipeline of transactions particularly from the government sector, and the long-term nature of outsourcing and infrastructure services contracts, which results in a recurring revenue base and consistent cash-generation even in a lower growth environment. However, increasing competitiveness and scope of services offered by India-based vendors, escalating commercial demand for offshore services, greater use of multi-sourcing, and declining average contract duration, lead to an increasingly challenging operating environment for the industry.

Hardware (Stable Outlook):

Fitch believes the credit outlook is stable for hardware in 2007. The primary concern for this sector continues to be constant pricing pressures due to intense competition. Companies with lower financial flexibility have less capacity to be price competitive and could be susceptible to further credit erosion, such as Eastman Kodak. Fitch expects acquisition activity will continue as companies seek to diversify into higher-margin offerings, such as software and IT services. Hardware revenue in 2007 is expected to be slightly up in the low single digit range due to moderating personal computer (PC) and server demand and continued pricing pressure. Fitch expects growth in enterprise spending to be led by storage and related software as storage requirements have increased due to more stringent regulatory document retention policies and for enterprises that manage digital rich media for consumer markets. Fitch also believes vendor performance in the PC market is becoming increasingly bifurcated by end-market and region with the PC market increasingly reliant on emerging markets for growth as U.S. demand, accounting for approximately 30% of worldwide unit sales, is likely to moderate in 2007.

Semiconductors (Stable Outlook):

The outlook for the semiconductor industry is stable for 2007, even though the focus continues to be on event risk. Fitch believes Freescale's successful debt offering to support an LBO was a watershed event for the industry that could pressure other semiconductor makers to re-evaluate capital structures and potentially emphasize more shareholder friendly strategies going forward. Nonetheless, Fitch remains positive on certain industry names. For example, Fitch believes continued share gains by AMD, supporting the strength of AMD's technology roadmap, and successful integration of ATI Technologies could lead to positive rating actions.

Following nearly 10% growth for 2006, Fitch believes the global semiconductor industry will expand at a more moderate mid-single digit rate in 2007, driven by continued solid unit demand for consumer electronics, increasing semiconductor content across a wide range of end markets, and ongoing benefits of generally more disciplined capacity additions through the recent expansionary period. Some indicators point to a potentially peaking and overheating semiconductor cycle, mostly in more volatile sectors, mainly chips for personal computers. However, book-to-bill and inventory metrics remain within rationale ranges by historic standards, and Fitch believes any correction is likely to be significantly less severe than the more than 30% decline experienced in 2001.

IT Distributors (Stable Outlook):

Fitch believes demand for IT wholesale and component distributors in 2007 will be stable with market growth inline with worldwide GDP growth. Fitch expects distributors' revenue growth in the Asia-Pacific region to continue to outpace Europe and the Americas as this region becomes increasingly important for US-based distributors looking to gain share in a relatively fragmented market. Credit profiles are expected to remain stable overall with a bias toward positive for the component suppliers driven by improved free cash flow. While Fitch believes that meaningful upside to operating margins is unlikely after moderate increases in profitability in 2006, additional value added capabilities should enable the large distributors to continue to gain share from smaller and competitors, particularly within Asia-Pacific. Fitch remains concerned that IT distributors will use excess cash for significant acquisition activity and/or shareholder friendly transactions. In all these respects, Fitch continues to monitor Avnet and Arrow which could both benefit from positive ratings action in 2007.

Electronics Manufacturing Services (EMS) (Stable Outlook):

Fitch believes that credit profiles for the U.S. tier one EMS providers will be stable but pressured by limited profitability improvement, potential acquisition activity driven by the need for industry consolidation, and rising cash conversion cycle days driving higher working capital needs. Profitability for tier one U.S. EMS vendors is expected to remain challenged by low cost Asian EMS and original design manufacturers (ODM) providers, such as Hon Hai, and excess manufacturing capacity, particularly in high cost regions. Fitch expects competitive trends along with customer program volatility to contribute to another year of low visibility and high volatility of financial results with several EMS vendors continuing to struggle to increase revenue. Fitch expects further restructuring will occur in 2007 as EMS vendors address inefficiencies in manufacturing footprints. The EMS industry will grow in the upper single digits during 2007, driven largely by increased penetration, according to Fitch. In addition to above average growth in non-traditional end markets, Fitch expects continued strong momentum for the EMS industry in the mobile handset and consumer electronics markets with increasing design contributions from EMS vendors with ODM services.

Communications Equipment (Stable Outlook):

Fitch believes credit profiles for communications equipment providers will be stable in 2007 as the industry will be characterized by solid profitability, positive free cash flow and further efforts to diversify product portfolios. Although Fitch believes the wireless communications equipment market will be sluggish over the near term, with additional pressure expected from certain wireline equipment segments, the stable outlook is also supported by Fitch's expectations that industry participants' more efficient cost structures will result in stable credit protection measures. For certain companies, the prospects for further operating improvement are superior due to market share positions, more diversified product portfolios, and greater geographic reach. Fitch estimates wireless equipment demand will be flat in 2007 as wireless service providers in North America and Asia/Pacific slow capacity additions, following aggressive build-outs over the past few years, even as data services upgrades continue and subscriber growth remains fairly robust, especially in developing markets. Investment in third-generation networks and demand from the emerging markets, particularly India and China, are also expected to support growth.

Fitch will publish a full special report 'Segmenting the Technology Industry: Record Debt and Event Risk Dominate 2007 Outlook' in early January 2007.

A list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. technology sector follows.

IT Services/Software:

-- Affiliated Computer Services, Inc. ('BB'; Rating Watch Negative);

-- CA Inc. ('BB+'; Outlook Negative);

-- Computer Sciences Corp. ('A'; Outlook Negative);

-- Convergys Corp. ('BBB-'; Outlook Positive);

-- Electronic Data Systems Corp. ('BBB-'; Outlook Positive);

-- International Business Machines Corp. ('AA-'; Outlook Stable);

-- Oracle Corp. ('A-'; Outlook Stable);

-- SunGard Data Systems Inc. ('B'; Outlook Stable);

-- Unisys Corporation ('BB-'; Outlook Negative);

Hardware:

-- Dell Inc. ('A'; Rating Watch Negative);

-- Hewlett-Packard Company ('A'; Outlook Positive);

-- Eastman Kodak Company ('B'; Outlook Negative);

-- Intermec Inc. ('BB-'; Outlook Stable);

-- Seagate Technology HDD Holdings ('BBB-'; Outlook Stable);

-- Sun Microsystems, Inc. ('BBB-'; Outlook Stable);

-- Xerox Corporation ('BBB-'; Outlook Stable);

Semiconductors:

-- Advanced Micro Devices, Inc. ('B'; Outlook Positive);

-- Freescale Semiconductor, Inc. ('BB+'; Rating Watch Negative);

-- International Rectifier Corp. ('BB-'; Outlook Positive);

-- Spansion Inc. ('B-'; Outlook Negative);

-- Texas Instruments Incorporated ('A+'; Outlook Stable);

IT Distributors:

-- Anixter Inc. ('BB+'; Outlook Stable);

-- Anixter International Inc. ('BB+'; Outlook Stable);

-- Arrow Electronics, Inc. ('BB+'; Outlook Positive);

-- Avnet, Inc. ('BB+'; Outlook Positive);

-- Ingram Micro Inc. ('BBB-'; Outlook Stable);

-- Tech Data Corporation ('BB+'; Outlook Stable);

Electronics Manufacturing Services (EMS):

-- Celestica Inc. ('BB-'; Outlook Stable);

-- Flextronics International Ltd. ('BB+'; Outlook Stable);

-- Jabil Circuit, Inc. ('BBB-'; Rating Watch Negative);

-- Sanmina-SCI Corp. ('B+'; Rating Watch Negative);

-- Solectron Corporation ('BB-'; Outlook Stable);

Communications Equipment:

-- Corning Incorporated ('BBB'; Outlook Stable);

-- Lucent Technologies Inc. ('BB-'; Rating Watch Positive);

-- Motorola, Inc. ('A-'; Outlook Stable);

Financial Services/Other:

-- First Data Corp. ('A'; Outlook Stable);

-- Moneygram International Inc. ('BBB'; Outlook Stable);

-- The Western Union Company ('BBB+'; Outlook Stable).

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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