Upgrading the Info Tech sector

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Canadian Market Strategy
Upgrading info tech in the TSX
Upgrading the tech sector to overweight
The Canadian info tech sector has performed remarkably well over the last five
months, on its way to be becoming the undisputed TSX performance leader in H2.
Over that time, the sector has outperformed the broad market by an impressive
31.8 percentage points (see Chart 1). We believe that the sector’s
outperformance is likely to continue ahead as fundamentals improve. We review
the primary drivers behind our sector upgrade below.
Tech’s leverage to global growth...
One of the primary factors driving our move to overweight tech is the fact that the
Canadian sector remains highly leveraged to growth outside of North America.
This leverage should become useful next year as we expect global growth rates
(ML real global GDP forecast 4.5%) to solidly outperform North American growth
rates (ML real GDP forecasts: 2.1% Canada, 1.7% US). On balance, the tech
sector’s foreign exposure (its 35% in foreign sales places the sector second
overall within the TSX; see Table 1) should keep it well positioned to offset the
expected slower growth rates in North America. Furthermore, according to a
recent report issued by the ML tech team entitled “2007 – The Year Ahead Vista:
time to focus“, the sector should also benefit significantly from worldwide PC
revenues, which are expected to grow at their fastest pace in three years (see
Table 2). Overall, we see both these factors as significant contributors to tech
earnings growth and performance ahead.
... and business capital spending key advantages
From a macro point of view, the tech sector is also smartly leveraged to business
capital spending, which we expect to grow solidly in 2007. Indeed, business
investment in Canada and the US (ML 7.1% CAN / 5.1% US) is expected to be a
solid contributor to growth next year, while largely outperforming the softer
consumer (ML 3.4% CAN / 2.2% US) and contracting housing sectors
(ML -2.0% CAN / -21.4% US). Meanwhile, our bullish view on tech is also shared
by our colleague, David Rosenberg, as he highlights in his recent note entitled
“Tech earnings estimates–output and exports improve sharply”. He cites upward
earnings revisions, elevated tech production and slowing productivity growth as
catalysts for potential US tech outperformance (see Chart 2). In our view, the
performance of the tech sector south of the border should positively impact
Canadian tech earnings as we anticipate some spillover effects – especially given
the Canadian tech sector’s elevated exposure to the US (see Table 3).
Investment Strategy
Investment Strategy | Canada
06 December 2006
David D. Wolf +1 416 369 8764
Economist & Strategist
Merrill Lynch (Canada)
d_wolf@ml.com
Kevin Cheng +1 416 369-8741
Economist & Strategist
Merrill Lynch (Canada)
kevin_cheng@ml.com
Chart 1: Tech the performance leader for H2
S&P TSX H2 performance (%, data to Dec 1, 06)
-10 0 10 20 30 40 50
Energy
Health Care
Cons. Staples
Utilities
Cons. Discr.
Industrials
S&P TSX
Financials
Telecom Serv .
Materials
Infotech
Source: Bloomberg, Merrill Lynch
Table 1: Tech highly leveraged to global growth
% o f s a le s
o u ts id e o f N A *
M a te ria ls 4 2 .0
In fo rm a tio n T e c h n o lo g y 3 4 .7
H e a lth C a re 1 5 .9
C o n s u m e r D is c re tio n a ry 1 3 .4
In d u s tria ls 1 2 .7
F in a n c ia ls 1 2 .6
E n e rg y 1 1 .3
U tilitie s 4 .7
C o n s u m e r S ta p le s 1 .3
T e le c o m m u n ic a tio n S e rv ic e s 0 .0
*C a lc u la te d b y m e m b e r w e ig h t
Source: Factset Aggregates, Merrill Lynch
Chart 2: US tech production ramps up
-20
-10
0
10
20
30
40
50
60
98 99 00 01 02 03 04 05 06
-80
-60
-40
-20
0
20
40
60
80
100
Industrial Production: High-technology industries (LHS, y /y %)
S&P 500 Info tech (RHS, y /y %)
Source: Haver Analytics, Merrill Lynch

2. Canadian Market Strategy
06 December 2006
2
Table 2: ML annual PC forecast by geography
Revenue Growth (y/y%) 2000 2001 2002 2003 2004 2005 2006E 2007E 2008E
Asia Pacific 32.2% -4.7% -0.2% 7.0% 11.9% 13.3% 13.0% 14.6% 11.3%
Japan 17.8% -17.2% -13.3% 2.5% 3.4% 0.2% -6.1% 5.5% 6.2%
Rest of World 17.5% -5.4% -5.9% 5.1% 26.6% 26.2% 16.3% 15.6% 11.5%
USA 0.7% -22.1% -14.4% -2.9% 4.2% 7.0% 3.8% 9.7% 1.0%
Western Europe 8.8% -9.4% -6.7% 6.5% 11.5% 3.0% -3.0% 1.8% 10.4%
Worldwide 9.7% -14.3% -9.3% 2.8% 10.2% 8.9% 4.6% 9.3% 7.7%
Source: IDC, Merrill Lynch Estimates
Table 3: Tech sector leverage breakdown
% W e ig h t in
T ic k e r C o m p a n y C a n a d a U S O th e r th e in d e x
A A H A a s tra T e c h n o lo g ie s L td 5 .4 1 7 .3 7 7 .3 1 .0
G IB .A C G I G ro u p In c ., A 6 0 .7 3 1 .8 7 .6 4 .3
C S N C o g n o s In c . 7 .4 5 0 .5 4 2 .1 8 .6
E M E E m e rg is In c . 8 9 .0 1 1 .0 0 .8
M D A M a c D o n a ld , D e ttw ile r 3 0 .8 3 7 .2 3 2 .1 3 .4
N T N o rte l N e tw o rk s C o rp . 5 .5 4 9 .5 4 5 .1 2 1 .0
O C X O n e x C o rp o ra tio n 1 4 .3 3 7 .2 4 8 .5 5 .6
O T C O p e n T e x t C o rp o ra tio n 7 .6 4 0 .7 5 1 .7 2 .2
R IM R e s e a rc h in M o tio n L td 8 .6 6 4 .6 2 6 .7 4 9 .0
A m e ric a s O th e r
C L S C e le s tic a In c . 3 5 .7 6 4 .3 4 .4
W e ig h te d A v e ra g e (e x C e le s tic a ) 1 1 .4 5 2 .3 3 2 .2
% o f s a le s in :
Source: CPMS (based on latest fiscal year data), Merrill Lynch
Robust balance sheets could lead to increase in capex
After four years of double-digit earnings growth, corporations now boast rock-
solid balance sheets and stockpiles of cash. Recently, they have put that extra
cash to use via share buybacks; however, we anticipate that some of those funds
could be earmarked for capital investments in the coming year as investment in
equipment & software (as a percentage of total assets) remains at historic lows
(see Chart 3). In addition, according to ML’s latest Global Fund Manager Survey,
37% of the respondents also remain keen on increasing capital spending – a
moderate decline over the last 12 months, but still well above levels seen in
2001-03. And companies may already be listening, as US demand for high-tech
products (which has posted an impressive 65% correlation to the Canadian tech
sector since 2000) has seen a modest uptick in recent quarters (’06 YTD +7.0%
y/y vs ’05 YTD 5.1% y/y; see Chart 4), thereby implying further sector
outperformance ahead.
Softer CAD another catalyst to earnings growth
The sector also stands to benefit as the Canadian dollar is expected to weaken
next year. In a recent report, our global FX team downgraded the USD-CAD
outlook for the end-2007 to 1.18 (currently 1.14), while offering a more
aggressively negative view on EUR-CAD 1.57 (currently 1.53) and CAD-JPY 91
(currently 101). Given its high foreign exposure, the tech sector should profit from
a weaker CAD (especially against overseas currencies) as Canadian tech
company products and services would become more attractive to foreign clients
and boost overall tech earnings. In addition, the CAD’s performance has also
served as a solid leading indicator to tech performance. As Chart 5 shows, the
CAD (advanced by six months) has exhibited a strong negative 80% correlation
Chart 3: US nonfarm nonfinancial corporations
2.0
2.5
3.0
3.5
4.0
4.5
5.0
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
14
15
16
17
18
19
20
21
Cash and cash equiv alents (LHS % of total assets)
Equipment and Softw are (RHS, % of total assets)
Source: Haver Analytics, Merrill Lynch
Chart 4: US cap-ex suggests tech outperformance
-100
-50
0
50
100
150
200
00 01 02 03 04 05 06
-20
-15
-10
-5
0
5
10
15
20
TSX Infotech sector (LHS, y /y %)
US GDP: Information equipment & softw are (RHS, y /y %)
Source: Haver Analytics, Merrill Lynch
Chart 5: Softer CAD points to tech outperformance
-100
-75
-50
-25
0
25
50
75
100
125
150
01 02 03 04 05 06 07
-20
-15
-10
-5
0
5
10
S&P TSX Infotech (LHS, y /y %)
CAD (RHS, y /y %, inv erted, adv anced 6-mths)
Source: Haver Analytics, Merrill Lynch

3. Canadian Market Strategy
06 December 2006
3
with tech performance over the past 5 years. Taken as a whole, this proxy,
combined with ML’s forecast of a weaker CAD, implies a likelihood of further
outperformance by the tech sector heading into 2007.
Vista to play an important role
Another potential near-term catalyst for the tech industry is the fact that Microsoft
will release Vista in January 2007, its first new operating system (OS) in 5 years.
The past two OS releases (Windows 2000 and Windows XP) appear to have
catalyzed stronger tech investment (see Chart 6), though other factors were
clearly at work as well. We expect the launch of Vista could similarly catalyze
higher spending ahead – as noted by our tech team in a recent report entitled
“2007 – The Year Ahead Vista: time to focus.”
“The average age of a PC has inched up in the last few years, perhaps due to the
delays in the launch of Vista. This means that Vista could be a catalyst for an
upgrade cycle just based on aging consideration.”
Furthermore, recent results from the ML CIO Survey also broadly coincide with
this view, as a significant portion of CIOs intend to upgrade to Vista within the
next 12 months (see Table 4). Overall, the tech sector could see an additional
bounce in earnings if initial reviews of Vista are largely positive and corporations
accelerate capital expenditure plans.
Table 4: Do you plan to upgrade to Microsoft Vista when available?
Jan-06 Apr-06 Jul-06 Oct-06
Yes, in 2007 14% 8% 15% 14%
Yes, in 2008 12% 13% 19% 9%
Yes, in 2009 6% 4% 8% 9%
W aiting for clarity 65% 75% 39% 58%
No NA NA 19% 9%
Source: Merrill Lynch CIO Survey
Risks to the view
There remain a variety of risks to the tech sector, as noted below. The first and
foremost risk is that investing in the sector at this point will involve chasing
performance – the sector is up 14.1% in Q4, 40.6% in H2 and 21.9% YTD (see
Chart 7). The robust performance, however, does suggest continued momentum
over the near term and the sector still remains 89% below peak values seen in
2000 (see Chart 8).
The second risk that investors should be attentive to is the sector’s relatively high
volatility and lack of breadth. The sector has only 10 constituents (versus 78
constituents on the S&P 500) and with the recent removal of ATI (due to AMD
merger), sector weights are now even more concentrated among Nortel (NT;
C$25.14; C-2-9) and RIM (RIMM; C$155.54; C-1-9) – combined they account for
70% of the index. Therefore, any company-specific events could have a
significant impact on overall sector performance.
And lastly, if the expected slowdown in overall growth in the US and Canada next
year turns more severe than expected, companies could delay capital
expenditure plans, resulting in slower earnings growth and/or earnings
compression within the tech sector. On balance, despite these aforementioned
risks, we believe that the risk/reward ratio remains favourable for the tech sector
and have moved our recommendation to overweight.
Chart 6: New O/S potentially beneficial to
spending
-20
-15
-10
-5
0
5
10
15
20
95 96 97 98 99 00 01 02 03 04 05 06
US Inv estment in information technology (y /y %)
Window s 2000 launch
Q1'07 scheduled Vista launch
Window s XP launch
Source: Haver Analytics, Merrill Lynch
Chart 7: Tech up in ’06 ...
100
150
200
250
300
350
400
03 04 05 06
S&P TSX Info tech (index )
Source: Bloomberg, Merrill Lynch
Chart 8: ...but still a long way to go
0
500
1000
1500
2000
2500
99 00 01 02 03 04 05 06
S&P TSX Infotech (index )
Source: Bloomberg, Merrill Lynch

4. Canadian Market Strategy
06 December 2006
4
Important Disclosures
Investment Rating Distribution: Global Group (as of 30 Sep 2006)
Coverage Universe Count Percent Inv. Banking Relationships* Count Percent
Buy 1325 44.76% Buy 434 32.75%
Neutral 1420 47.97% Neutral 412 29.01%
Sell 215 7.26% Sell 48 22.33%
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Risk securities); 3 - Sell (negative return); and 6 - No Rating. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend
considered to be secure); 8 - same/lower (dividend not considered to be secure); and 9 - pays no cash dividend.
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5. Canadian Market Strategy
06 December 2006
5
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