Credit analyst likes Computer Associates, says avoid Arrow Electronics

By Ronda Fears

Nashville, Jan. 23 - CreditSights senior analyst Frank Lee recommends an underweight position in the tech sector, anticipating another tough year for the group. That said, however, he likes Computer Associates International Corp. as a relative value play and Hewlett-Packard Co. short-term with some reservations.

Electronic Data Systems Inc. isn't for the faint of heart given the troubles it faces, he said, but he suggested avoiding Arrow Electronics Inc. altogether because of lower debt protections measures and rating risks.

"For 2003, we believe the outlook has not altered dramatically from 2002; IT spending surveys taken by Street analysts have revealed that chief investment officers of major corporations remain cautious," Lee said in a report Thursday.

"The recent calendar 4Q earnings releases by Intel, Microsoft, and IBM were mediocre at best but more importantly, the outlooks put forth by these bellwether tech companies portend another tough year ahead.

"We recommend maintaining an underweight position in the tech sector for 2003."

Information technology spending is expected to be flat in 2003, the analyst said, noting that IT spending tends to lag corporate profits by one or two quarters. Even with marginally better results, he expects most companies will focus on improving balance sheets and reducing costs as top line performance remains weak.

Hardware and software segments will be the hard hit area, Lee said, noting that services and semiconductors should fare better.

Lee said he likes Hewlett-Packard (A3/A-) "in the short-term as the company wields significant operating leverage" through its cost-cutting program on the heels of the Compaq merger.

"The sore spot [for Hewlett-Packard] remains its PC operations, although this is mitigated by its crown jewel, the printer business," Lee said.

"After the cost cuts are completed, it remains to be seen if the company can perhaps transform into an IBM alternative."

For those who can accept higher risk, Computer Associates (Baa2/BBB+) "appears compelling based on relative value," Lee said, as its straight debt is trading cheap even based on the BBB curve.

In October 2000, Computer Associates changed the way it recognizes contract revenues so that now all new contract sales will now be recognized over the life of the contract instead of booking all revenues upfront. This is a main reason for the earnings volatility seen over the past two years, he said, but should level off over the next couple of years.

Liquidity is improved with Computer Associates' latest $460 million convertible, he said, along with its new $400 million revolver.

"However, risk remains with the ongoing SEC investigation regarding the alleged overstatement of earnings," Lee said, in addition to the possibility of goodwill writedowns associated with past acquisitions.

"We believe these risks are manageable and believe there is relative value in CA bonds."

Another name that is "not for the faint of heart," Lee said, is Electronic Data Systems (A3/A-) because of its now formal Securities and Exchange Commission inquiry in the face of declining service revenues and lower free cash flow.

"With the latest formal inquiry, no additional detail was provided by EDS, which leaves investors with much uncertainty and risk," Lee said.

"A downgrade by the agencies to high triple-B will trigger certain financial obligations for $170 million, increasing liquidity risk."

Lee said he continues to recommend investors avoid Arrow Electronics (Baa3/BBB-).

Arrow faces "tough top line performance in 2003, exposing investors to lower debt protection measures and rating risks," he said.

Arrow has a better liquidity profile than some of its peers, like Avnet Inc., he noted, which allowed it to acquire the industrial electronics division of Pioneer-Standard for $285 million in cash. But, he added, "while the acquisition made strategic sense, we believe preserving cash and reducing debt made more credit sense."

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