What's IT done wrong? Er, nothing

IS THE European information technology industry heading for recession? Investors seem to think so. Monday's profits warning from Baan, the Dutch software group, marked the end of a rotten few months for IT stocks. Since the beginning of July, the UK's newly-formed index of computer software and services companies has fallen from a peak of 1,820 to about 1,000 - wiping out all the gains the index made since it began at the start of January.

Strangely, however, nothing has really changed. Before Baan's bombshell, companies had almost without exception delivered strong profits and encouraging growth prospects. Even after Baan's warning, British IT firms are optimistic.

The Dutch group shocked investors by cautioning that it would make a loss in the third quarter. It blamed about 30 customers delaying large orders because of the global economic turmoil. It also said some customers decided that they needed to devote resources to the year 2000 computer bug. Baan shares promptly lost almost a third of their value.

Baan supplies software packages which link together various parts of a company, from purchasing to accounting and personnel. Like its larger German rival SAP, it has grown exponentially as companies introduce integrated computer systems to improve efficiency.

Such a serious setback should have sent shock waves through the industry. But analysts caution against assuming that the warning has wider implications. "My understanding is that there is a lot of price competition in that market," one said. "Besides, SAP didn't mention those factors when it issued a trading update a few days earlier."

Most analysts are at a loss to explain the wholesale dumping of IT shares in the past two months. The main worry among investors seems to have been IT companies' exposure to the financial services sector, and the concern that upheaval in stock markets would lead to orders drying up.

However, they seem to have overreacted. Ross Jobber, an IT services analyst at Deutsche Morgan Grenfell, says: "Sure, companies like Admiral have exposure to the financial services sector. But you're not going to tell me that providing training for Barclays Bank is the same as building a dealing desk."

Having pushed valuations to ridiculous levels in their rush to buy shares at the beginning of the year, it now seems that fund managers have overreacted again.

Nevertheless, the vagaries of the stock market mask a more pressing question - what will happen to IT spending if the economy goes into recession?

The issue is complex, because growth rates have been pushed to record levels by the extra spending required to fix the 2000 bug and prepare computer systems for the introduction of the euro. According to industry analyst Richard Holway, the UK's software and computer services market will be worth pounds 17.4bn this year - an 18 per cent rise over 1997.

Clearly this growth cannot last. Mr Holway predicts the market will return to growth rates of below 10 per cent once the effects of the Millennium bug and the euro have worked their way through.

Mr Jobber feels this is likely to have a significant effect. "The IT services companies have been gaining massive market share off their principal competitors - the internal IT departments - which have been preoccupied with the Millennium," he says. "Once that is out of the way, what are internal IT departments going to do?"

But industry executives reject this view. Martin Read, the chief executive of Logica, points out that many IT companies now have skills that in-house departments do not. "If you are putting in a billing system for mobile phones, do you want to get your in-house people to do it or are you going to go to a company that has already done 15 installations?"

Clay Brendish, the chairman of Admiral, agrees. "It's true that you can't knit yourself into the fabric of a company. But I'm sure that our clients will continue to need the expertise we have."

And what if the economic climate becomes tougher? According to Albert E Sharp, the stockbroker, some parts of the computer industry may even thrive if the economy goes into reverse. It has researched the pattern of the last recession and found that, over the 1987-1992 period, the software and services segments of the markets continued to expand.

"What happens is that companies accelerate their use of outsourcing and install more software in an attempt to be more productive," says Albert E Sharp analyst, Glyn Lloyd. At the moment, IT suppliers still account for a relatively small part of companies' total spending - in the financial services industry, just 12 per cent of IT budgets are spent externally. As a result, the shift to third party suppliers is likely to continue, ensuring the industry's continued growth.

Although the boom in the IT industry is likely to slow from the inflated rates of the past few years, the outlook remains optimistic. Even the most gloomy forecaster is merely predicting a slowdown in growth rather than a downturn. Compared to other parts of the economy, the IT industry looks set to remain a growth sector. UK fund managers, however, have yet to realise this.