The Investment Column: Time for a reboot in the IT sector

Underperformers will make the running

It is five years since businesses large and small were on their millennial spending spree. The splurge on new computer systems left IT directors sated and their bosses suspicious over whether the latest brand-spanking new technology really was worth all that money, and the subsequent collapse in spending was brutal. But is it worth betting now that spending will recover this year, and is it worth investors venturing back into the ravaged software and computer services sector? The answer is yes, but investors will need to be discriminating.

It is five years since businesses large and small were on their millennial spending spree. The splurge on new computer systems left IT directors sated and their bosses suspicious over whether the latest brand-spanking new technology really was worth all that money, and the subsequent collapse in spending was brutal. But is it worth betting now that spending will recover this year, and is it worth investors venturing back into the ravaged software and computer services sector? The answer is yes, but investors will need to be discriminating.

Five years on, there are just seven software or IT services groups among the UK's 350 biggest quoted companies. And only Sage, the weather-beaten but solid giant of the accountancy software industry, clings on in the FTSE 100.

Sage sells vital software to a client base of almost 4 million small businesses. It is as dull as tech gets, but extremely lucrative and the company has squeezed out profit growth every year. US trading ought to improve this year, making the acquisitions of recent years look well-timed. The shares are not rock-bottom cheap (nothing in this sector ever seems to be), but with a fair wind they will put in a good performance this year.

Software prices, particularly for products used by big corporations, are still locked firmly in deflationary mode, and that also goes for a lot of the IT services, like helpdesks and maintenance work which can be done offshore. Competition in IT services is set to get even more intense, as the big computer makers, such as Hewlett-Packard, realise they would do better to install and maintain their products rather than cede this higher-margin business to resellers such as Computacenter, which is struggling.

Investors ought to look for companies able to offer more complicated systems integration services (such as, outside the FTSE 350, Morse), can operate a very low-cost business model (such as the Asia-based Xansa), or are likely to generate value in some other way this year (such as Misys, which ought soon be able to spin off its financial advisory business).

There are nerves surrounding the 2004 figures due soon from LogicaCMG, the UK's biggest services company, but on balance it looks as if 2005 could be a watershed year. Government efforts to slim down Whitehall are predicated on improved IT systems, so Logica's position in the public sector will act as a bulwark while it awaits an upturn in private sector work in continental Europe and decides how to improve efficiency in its once-fêted telecoms software business, which has lost market share in the transition to 3G mobile services. Its shares are worth buying.

Those of a brave disposition might also want to punt on iSoft. It has suffered accusations of imprudent accounting, but answered them to most analysts' satisfaction, but the shares are depressed. With revenues coming soon from contracts to supply the National Health Service with electronic patient records and appointments software, and opportunities abroad, the shares could soar if it turns out there is no fire when the smoke clears.

Underperformers will make the running

Investors need to be careful to choose the right stocks in the IT hardware sector in 2005, because this is a diverse sector and, as happened last year, the big players could go in contrary directions. The sector as a whole was the worst on the stock market in 2004, falling by 19 per cent.

Part of the problem was that the semiconductor cycle ­ the ebb and flow of demand for microchips ­ appeared to have peaked, barely months after investors realised it was on the up. This blink-and-you'd-miss-it cycle leaves the UK's semiconductor firms sitting on precarious stock market valuations.

ARM Holdings, whose chip designs are used in the majority of the world's mobile devices, has always looked expensive and attractive only to those who can put it away for a decade and forget about it. There was a buying opportunity after it announced its acquisition of Artisan August, a deal which went down like a lead balloon. The strategic rationale is sound (Artisan designs other bits of the microchip, meaning the pair together will be able to offer a fuller design to electronics firms, helping them cut the time it takes to invent new products) but the price was way too high. Now that ARM shares have rebounded, the risk of disappointment is again high.

At Cambridge Silicon Radio, whose Bluetooth chip technology allows electronic devices to talk to each other, royalties from increasing product sales are now coming through, but the prices are going to be driven down and down, and the risk is the net effect will be less positive than the market thinks.

The real stars this year could be the dogs of the previous five years, the telecoms equipment makers. An industry plagued by overcapacity ought to get back into balance as telecoms companies begin to spend on their networks again. For example, BT in the UK has already launched a big programme to upgrade in readiness for the heavier volume of entertainment downloads coming through its wires. Buy Marconi, buy Spirent.