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IT Hardware Gets a Second Life—and a Double Upgrade

Although enterprises have been shifting software applications to the cloud, several catalysts are converging to give IT Hardware a new lease on life—and possible double-digit earnings growth in 2018.

The last three years have not been kind to many IT Hardware companies, which some investors have deemed obsolete in the era of cloud computing. While it’s true that enterprises are shifting software applications from on-premise data centers to the cloud, there’s much more to this year's story.  

The last two technology cycles were driven primarily by the consumer, but industrial innovation could further drive demand for IT Hardware.

We estimate that 44% of computing workloads will be done in the cloud by the end of 2021, up from 21% today. Meanwhile, every $1 of revenue growth for the largest cloud service has resulted in about $3 of revenue decline for the major legacy technology companies.

However, several catalysts are converging to give IT Hardware a second life—and drive double-digit earnings growth in 2018. For this reason, our team recently gave the IT Hardware group a double upgrade, shifting our view from cautious to attractive.

IT Budgets Bounce Back

Ironically, one of the biggest detractors of growth hasn't been the actual migration of computing to cloud, but rather decision-making around the cloud.  For the last few years, enterprises have been putting IT Hardware spending on hold while they grapple with decisions around how, when and how much of their workloads to move to the cloud.

With plans now coming into focus, companies are ready to make necessary upgrades to their IT Hardware. Our proprietary AlphaWise survey of 100 CIOs indicates faster planned IT budget growth than three months ago.

The upshot: While companies plan to migrate a larger share of their workloads to the cloud, they aren't abandoning on-premise computing. Instead, many are adopting a hybrid IT model in which applications move between a public cloud and their own internal data centers.

Recent changes to U.S. tax law further support a recovery in IT Hardware spending growth as companies repatriate cash and consider the benefits of accelerated depreciation. Against a backdrop of economic growth, enterprises have additional incentive to increase their capital expenditures and depreciate 100% of the costs in year one.

Margins Expand, Taxes Decline

The outlook for IT Hardware is further bolstered by a weaker U.S. dollar, declining memory prices and improving revenue scale. This adds up to an average 60 basis point gross margin expansion for the group, the largest improvement since the initial recovery out of the recession.

Companies in this group also stand to benefit from a lower effective tax rate. We expect them to put some of this savings, as well as repatriated cash, toward share repurchases and other investments.

Next Up, Multiples

Given that IT Hardware is a diverse group, ranging from mobile handsets and ATM equipment to data storage, there are many ways investors can play this recovery. That said, we favor enterprise stocks that continue to be priced for zero or declining growth. Against a perfect storm of positive drivers, we think many of these companies can do better.

Meanwhile, there may be potential for multiples to move higher. Enterprise stocks with declining growth baked into their outlooks recently traded around 10 times 2018 earnings, versus about 14 times earnings for those priced for modest growth. This gap could close as investors rethink the outlook for IT Hardware.

Of course, this is just the base case. In a more bullish scenario, IT Hardware could benefit from a secular trend of “capital deepening" as companies shift their focus to enterprise technologies aimed at improving productivity.

While the last two technology cycles were driven primarily by the consumer, an era of industrial innovation—marked by such advances as automation, artificial intelligence and the Internet of Things (IoT)—could further drive demand for IT Hardware.

For more Morgan Stanley Research on key Tech, Media and Telecommunications themes, ask your Morgan Stanley representative or Financial Advisor. You can also visit the TMT 2018 page.