Year to date through February 6, the S&P Computer Hardware industry index advanced 4.1%, outpacing the S&P 1500, which gained 2.8%. The outperformance for the hardware index compares with slight underperformance in 2003, when the index increased 26.0%, versus a 27.4% advance for the S&P 1500. We think recent gains reflect growing optimism that there will be a strong recovery in information technology (IT) demand. A sharp turnaround in sales has not yet occurred, but we see some early signs that the demand environment has improved. However, we remain neutral on the group; we do not see valuations as compelling, in light of our projections of 5% to 8% IT spending growth and 8% global PC unit growth for 2004. Although unit demand seems to have improved, we think that competitive pricing has limited the industry's recovery.

We see long-term fundamentals in the computer industry remaining attractive, as we think a global appetite for technology products should boost productivity and communications. Global competition is forcing companies to be more productive; we think this is being achieved largely through technology. Many vendors have also streamlined operations recently; we see this boosting profit potential when demand picks up.

The benefits of Internet-related computing for the computer industry may be in their early stages. Demand for Internet-based applications is growing, we think because they offer companies opportunities to reduce costs and improve customer service. Although some initial deployments have been made to capitalize on this opportunity, we think the evolution of the platforms could pace another wave of investment as Internet use matures. For example, the processing power required for analysis of a wide variety of data collected by websites could boost demand to expand existing computing infrastructures. Indeed, the growing complexity of these infrastructures could lead to investments in hardware that has self-management features. Furthermore, as price pressures in the PC industry have intensified, hardware vendors have been seeking to offset the negative impact on EPS by offering wider-margin services, servers and storage.

--Megan Graham-Hackett