We are downgrading Tech Data Corporation (TECD) to Neutral from the previous Outperform rating as there could be some softness in demand stemming from weakness in the European market. More than 50% of the company’s total sales come from the European region. Therefore, if conditions worsen, near-term revenues and earnings will be considerably pressured.
 
Moreover, the weakening of Euro against dollar will hurt IT spending in the second half of 2010, thereby negatively impacting sales. Intense competition and weak industry pricing remains a concern.
 
First Quarter Results
 
Tech Data reported better-than-expected earnings for the first quarter of 2011, beating the Zacks Consensus Estimate of an income of 75 cents, posting a surprise of 17.33%.
 
Net income was $45.6 million in the quarter compared with $31.8 million in the year-ago quarter. Earnings per share were 88 cents compared with 63 cents in the year-ago quarter.
 
The primary reasons for the improvement in net income were a stronger demand for technology products, an outstanding effort in working capital management, coupled with an effective operating cost control and a weak U.S. dollar. The company highlighted that the quarter represents the highest first quarter net income and earnings per share in its history.
 
Improving demand combined with the weak dollar positively impacted sales. Tech Data witnessed stability in IT spending. Total revenue for the reported quarter was $5.62 billion, an increase of 12.6% from $4.99 billion in the year-ago quarter, largely driven by better-then-expected European revenues.
 
Outlook
 
With strong earnings momentum, continued cost-cutting initiatives, diversified customer base, significant operating efficiency, share repurchases and strong fundamentals, we remain positive on the company’s long-term growth.
 
Research firm, Gartner, has trimmed its worldwide IT spending forecast in 2010 to reach $3.35 trillion, a growth of just 3.9% from 2009. This compares with the previous expectation of a 5.3% increase from 2009. Gartner cited that the European economy debt crisis is having a severe impact on the outlook for IT spending.
 
Moreover, the U.S. dollar has strengthened against the euro during the second quarter of 2010, which will likely continue in the second half of 2010 as well, thereby putting a downward pressure on U.S.-dollar-denominated IT spending growth. While IT industry will return to growth in 2010, the market will not recover to 2008 revenue levels before 2012, according to Gartner. Therefore, slower-than-expected recovery in IT spending may hurt Tech Data’s business.
 
Tech Data has a diversified customer base within both the North American and European operating segments. The company’s diversified customer base helps to smooth out sales if there is a slowdown in the North American or European region.
 
Tech Data shares currently trade at a premium to industry leader, Ingram Micro Inc. (IM). We have lowered our price target to $37.00 from $48.00. Our price target is based on a P/E multiple of 9.6X our 2011 EPS estimate.
 
We have a Zacks #3 Rank on Tech Data, which translates into a short-term Neutral recommendation.
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