Technology Industry Report Industries Insider

2012 SONOMA COUNTY

2012 Technology Industry Report July 2012 The Sonoma County Economic Development Board (EDB), in partnership with the Sonoma County Workforce Investment Board, is pleased to present the 2012 Technology Industry Report for Sonoma County. Our research partner, Moody’s Analytics, provided the research for this report. Highlights of the 2012 Technology Industry Report include: • Local tech firms are reporting improved sales and profits. Production is expanding across tech sectors, including medical device manufacturers, electronic measurement equipment producers, telecommunications, and renewable energy technologies. • However, in line with the rest of the labor market, Sonoma County technology companies have lost steam in recent months. Local tech payrolls bottomed in late 2010 and accelerated through mid-2011. Since then, however, tech industries have failed to achieve measurable job gains despite tech payrolls having grown in the rest of the state and U.S.; employers remain cautious and are waiting to see firm signs of a sustainable U.S. recovery. • The future for the Sonoma County tech industry rests in high-value-added manufacturing and product research and development. Since 2000, computer and other electronics product manufacturing’s share of total county employment has fallen by more than half as lower-end manufacturing functions migrated to areas with less expensive labor costs. • Increasing adoption of cloud-based data platforms for business and consumer applications would provide a boost for Sonoma County’s broadband equipment designers and manufacturers. Thank you for your interest in the Economic Development Board’s research. For additional information, questions, comments, or suggestions please contact us at (707) 565-7170 or visit www.sonomaedb.org. Sincerely,

Ben Stone Executive Director

©2011 Sonoma County Economic Development Board. The Economic Development Board (EDB) believes all data contained within this report to be accurate and the most current available, but does not guarantee its accuracy or completeness. Use of data from an outside source does not represent an endorsement of any product or service by the EDB, its members or affiliates. This publication can be made available in alternative formats such as Braille, large print, audiotape, or computer disk. Please direct requests to (707) 565-7170 and allow 72 hours for your request to be processed. This report was prepared by Joel Hayden Wilson.

Sonoma County: Technology Industry Report Recent Trends

Macro Drivers

In line with the rest of the labor market, Sonoma County technology companies have lost steam in recent months. Local tech payrolls bottomed in late 2010 and accelerated through mid-2011. Since then, however, tech industries have failed to achieve measurable job gains despite tech payrolls having grown in the rest of the state and U.S.; employers remain cautious and are waiting to see firm signs of a sustainable U.S. recovery. Nevertheless, local tech firms are reporting improved sales and profits. Pro-duction is expanding across tech sectors, in-cluding medical device manufacturers, elec-tronic measurement equipment producers, telecommunications, and renewable energy technologies.

The U.S. economy is expected to grow at a middling rate around 2.5% through mid-2013, before accelerating to 4% by mid-2014. At this pace, enough jobs will be created that full employment, defined as an unemployment rate just under 6%, should be achieved by late 2015. Europe’s turmoil and the emerging world’s slowdown are hurting the U.S. economy. Global trade and bank lending are weakening, but a much bigger problem is the slide in stock and credit markets, which undermines business confidence. The nightmare memories of the Great Recession are still vivid, and any sign of a return to those days causes firms to pull back on investment and hiring. U.S. hiring weakened in the spring. Monthly payroll job gains, which averaged about 250,000 between December and February, were closer to 100,000 between March and May. Some of the slowing was payback from a warm winter, but businesses have also turned more cautious. Firms have not increased layoffs, but they have delayed hiring while they wait to see whether Europe unravels. Some may also be anticipating political battles as Washington confronts the so-called fiscal cliff and the Treasury once again nears its statutory debt ceiling in early 2013.

The improvement in Sonoma County tech output is evident in the performance of its two largest local tech employers, Agilent Technologies and Medtronic. The Santa Rosa-based Electronic Measurement Group of Agilent Technologies was instrumental in the company’s success in the second quarter of fiscal 2012 (January to March). Division revenues advanced 5% from a year ago, while orders were up by 13%. Agilent, the county’s largest high-tech employer with about 1,150 workers in Santa Rosa, is experiencing an acceleration in its measurement business after growing just 1% in the first quarter. Revenues and orders reached their highest level since 2001, helping the group achieve an operating margin of 23%. Strong demand for EMG’s cell phone testing equipment was the leading driver of growth. But emerging market demand for other products also remained strong. Banking on the strong demand for its products, Agilent recently acquired the test-and-measurement business of local semiconductor supplier Centellax.

Business investment spending on equip-ment and software will grow in the near term after surpassing its prerecession peak in the third quarter of 2011. However, growth will slow from the period immediately following the recession when businesses released pent-up demand for IT equipment.

Employment Has Disappointed of Late Manufacturing employment, % change yr ago, 3-mo MA

Medtronic’s Santa Rosa-based vascular business similarly contributed significantly to recent growth in the company. New product launches in the U.S. and international markets helped boost the local division’s sales by 12% in fiscal 2012 (May to April). Sales for the fourth quarter of fiscal 2012 also jumped more than 10%. The Santa Rosa unit makes stents and stent graft systems to treating artery disease and has one of the world’s highest market shares in coronary stents.

Miscellaneous Computer and electronics products

20% 15% 10% 5% 0% -5% -10%

Sonoma County’s smaller tech firms are also expanding. In the three months to March, revenues for wound treatment developer Oculus Innovative Sciences Inc. increased 26% while revenue for the full fiscal 2012 jumped up 30%. Petalumabased provider of broadband communications equipment and software Calix Inc. had its revenues increase 10% from a year ago during this period as strong demand was complemented by continued broadband stimulus spending.

-15% -20% -25%

09

10

11

12

Sources: BLS, Moody’s Analytics

Sonoma County tech employment has failed to contribute to growth in the past few months. Employment has lagged that of the U.S. and other tech centers in California. The slack in hiring is more evident in the computer and electronics product manufacturing segment as companies uncertain about the staying power of the U.S. recovery wait cautiously before ramping up their equipment purchases. Miscellaneous manufactured commodities—which include medical equipment—have had less of a slowdown. Near-term growth in employment will be sluggish until the U.S. recovery firms.

Increased earnings, profits and mergers in the tech sector have not resulted in tech job gains in Sonoma County, and office and in-dustrial vacancies in the county have been trending up since mid-2011. Firms, however, do have enough cash on hand. The missing catalyst is confidence. As soon as employers feel that the U.S. economy is on a self-sustaining path to expansion, they will start hiring.

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Moody’s Analytics Technology Industry Report Macro Drivers The rate of growth in IT investment from 2012 to 2016 will also be slower than that of the last expansionary period from 2003 to 2007—4.8% and 6.1%, respectively.

The county is also home to a growing solar equipment distribution base that is gaining strength from recent mergers. An important driver for the county’s med-ical device equipment manufacturers is demo-graphic trends. The domestic population is rapidly aging, which will help fuel demand for medical devices in the years ahead. This is es-pecially the case for cardiovascular disease, which is the specialty of Medtronic’s Santa Rosa division. Medical equipment manufacturers will also benefit from overseas demographic trends that create additional demand for their products.

Recent productivity gains by tech firms will fade in the near term, spurring hiring of tech workers nationally and in Sonoma County in order to keep up with still-robust levels of demand. However, the offshoring of low-value-added manufacturing and increasingly higher-value-added research and design functions will mean that the county will lag the U.S. in getting back to its prerecession peak tech employment level. Surpassing its all-time high of 2001 will take even longer.

The U.S. healthcare reform law has the potential to benefit Sonoma County’s medical device makers. The increased number of in-sured households will increase the pool of po-tential recipients of medical devices designed and manufactured in the county. California in particular is well ahead of other states; it was the first to pass legislation authorizing the public exchanges for uncovered residents and to begin the process of establishing them.

Venture capital remains a vital input for Sonoma County’s start-up tech firms. The amount of venture capital placements in the county fell to $67 million in 2011 from $200 million in 2010, according to the Dow Jones VentureSource. The medical sector received most of the funds, followed by information technology, consumer web startups, business and financial services, and renewable energy. Support from exports will be weak in the near term. Sonoma County’s leading exports are computer and electronics products, accounting for nearly 30% of total exports. Europe is the main downside risk. The U.S. and Japan are doing better but are still fragile, putting the impetus for global growth on emerging economies. In China and India, however, growth is starting to flag, setting the world economy up for a period of slower growth while Europe sorts out its problems.

The healthcare reform legislation is not all positive, however. The major downside to the reform will be a 2.3% excise tax on medical device manufacturers beginning in 2013, which could drive some future production to lower-cost areas in the U.S. and abroad.

Industry Drivers

150

Sonoma County’s broadband equipment firms will experience reduced growth in 2012 as funds from the federal government’s broadband stimulus gradually taper off. Manufacturers will still benefit from continued spending on rural broadband networks, but growth will be slower than at the peak of stimulus spending. The rate of growth will slow further once stimulus spending runs out. Overall, outlook is positive; the Federal Communications Commission recently approved a plan to expand high-speed internet access in parts of the U.S. that currently have slower connections.

120

Uncertainity Weighs Investments in Tech Venture capital placements, % change yr ago, 4 qtr MA Telecommunications Medical devices Industrial/energy

90 60 30 0 -30 -60

Expected strong growth in smartphone sales is a positive driver for Sonoma County’s testing equipment makers. Falling average prices, increasing functionality, and cheaper data plan options are among the factors driving the adoption of the latest generation of smartphones. A survey by Forrester predicts that the number of smartphone users will cross the 1 billion mark by 2016.

-90

09

10

11

12

Source: PWC?Venture Economics?NCA MoneyTree Survey, Moody’s

Lingering uncertainty about the near-term U.S. outlook and the full impact of the unfolding European crisis has discouraged venture capital inflows into Sonoma County’s emerging tech firms. Investments into Silicon Valley firms had rebounded nicely following the recession, according to the PWC/Venture Economics/NVCA MoneyTree Survey. Until financial markets find firmer footing, investment capital will remain an obstacle for young tech companies. This could work to slow near-term growth in the county's tech cluster, especially for new ventures in green industries.

Growth in solar technology will provide another driver for the county’s tech firms. County residents have been among the most enthusiastic users of clean energy state and federal tax incentives. The county is among the state’s top counties in terms of installed or in development solar capacity, ahead of several larger Bay Area and Central Valley counties.

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Moody’s Analytics Technology Industry Report Pricing

Some nonlabor expenses are firming. Ma-terials costs are on the rise, translating into a higher cost of manufacturing tech products.

The pricing environment for tech-producing companies will remain subdued in the near term. New production methods and increased outsourcing will limit increases in communication and computer equipment pricing. Companies also have limited pricing power given the shaky recovery and nervous consumers.

Profitability

Prices for medical equipment will rise faster than those for computer equipment. After slowing modestly over the last several quarters, price growth will accelerate in 2013. At that time, the new tax on medical devices will take effect and device producers will try to pass some of the tax on to consumers.

The outlook for the profitability of Sonoma County tech firms will remain positive in the near term. Strong demand for electronic testing equipment, medical devices, and electronic medical records technology will help firms to offset slowly rising costs even as earlier productivity gains are exhausted and firms begin to hire new workers to keep up with demand. Firms will increasingly diversify to emerging markets, particularly in Asia, and the share of profits from these markets will rise.

Operating Expenses

Long-Term Outlook

Sonoma County tech companies will remain cautious and will try to keep costs contained for as long as possible in the near term. However, firms will no longer be able to rely on mass layoffs, as past productivity gains are exhausted. Instead, firms will likely increase the outsourcing of lower-value-added manufacturing and R&D functions to lower-cost areas of the U.S. and foreign countries to offset increasing payrolls.

The future for the Sonoma County tech industry rests in highvalue-added manufacturing and product research and development. Since 2000, computer and other electronics product manufacturing’s share of total county employment has fallen by more than half as lower-end manufacturing functions migrated to areas with less expensive labor costs. After a brief uptick in output as a result of temporarily competitive labor and other production costs, the long-term outsourcing trends will resume. The county’s tech manufacturing employment will eventually plateau, although tech manufacturing output will grow, reflecting the long-term shift toward higher-value-added production.

Businesses will also change the composition of their remaining workers in order to control the growth in costs. Increased use of temporary workers will be one way firms will assemble a flexible workforce in order to efficiently adapt quickly to changing production and demand environments.

R&D work will generally expand further locally in the long run. Though this type of work employs fewer people, it generally offers better wages. Sonoma County has an advantage in attracting this type of work; there is a specialized labor pool and proximity to other tech hubs in California and the West. However, rising R&D capacity in developing countries will result in some of these jobs being transferred or created outside of the county.

Sonoma County tech workers will continue to receive higher than average wages. According to data from the Quarterly Census of Employment and Wages, the average worker in the computer and electronics product manufacturing industry earns over 8% more than the average worker nationally in that in-dustry. The gap for county workers in the medical equipment industry is even larger, with a greater than 60% edge, and the margin has generally been rising.

External Headwinds Pose Downside Risks California exports, $ bil, 12-mo MA

4.0

1.2

Computer and electronic products (L) 3.5

1.0

3.0

.08 Miscellaneous manufactured commodities (R)

2.5

07

08

09

10

11

12

.06

Source: Census Bureau, Moody’s Analytics

The European crisis remains the biggest threat to tech exports from Sonoma County. In addition to cutting down demand, an intensi-fication of the crisis will lead to a flight to safety among global in-vestors. This will strengthen the U.S. dollar and make Sonoma ex-porters less competitive. Growth in other foreign markets has also been shaky; China is slowing because of its deflating real estate bubble and slower export growth, while the Indian economy too has downshifted in recent months. www.sonomaedb.org 5

Moody’s Analytics Technology Industry Report Long-Term Outlook (cont.)

Downside Risks

Sonoma County is inexpensive from a business cost perspective. According to the Moody’s Analytics Cost of Doing Business Index, costs have dropped substantially in re-cent years, and it is now moderately cheaper to do business in the county than the national average. The business cost gap between other tech centers in the West is even larger. Much of the cost advantage in the county lies in af-fordable office space.

A tax on medical device manufacturers included in the recently passed federal healthcare reform legislation will go into effect in 2013, potentially curbing industry investment in Sonoma County. Moreover, it may also accelerate the movement of manu-facturing jobs overseas. Government oversight is also a key un-known for the telecom industry. The rollout of the Federal Communication Commission’s open internet rules is uncertain. Threats to li-tigate or block the rules could hinder the flow of internet content that has helped spur de-mand for broadband equipment. Prepared by Bodhi Ganguli June 2012

Some disadvantages in relation to the county and other tech hubs in the West do ex-ist. Mainly, the county relatively lags in terms of educational attainment; 32% of residents have a bachelor’s degree or higher, compared with nearly 45% in the San Francisco Bay Area and more than 40% in Seattle.

Upside Risks Increasing adoption of cloud-based data platforms for business and consumer applications would provide a boost for Sonoma County’s broadband equipment designers and manufacturers. The growing share of mobile broadband networks would also be a driver for equipment testing firms. Rising private demand for green technology offers a source of potential growth for technology-producing industries. Over the long term, this may include a broad set of industries that improve the efficient use of water; improve lighting, heating and cooling efficiency of buildings; or allow agriculture to make better use of land and water resources.

Renewed Investments a Welcome Support 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30 -35

10

Real fixed investment, annualized % change (L)

Sonoma County high-tech employment, ths (R) 06

07

08

09

10

11

12E

13F

8

Source: Census Bureau, Moody’s Analytics

Beyond the near term, stable growth in business investment will help drive the Sonoma County technology sector. The initial postrecession bounce back in equipment and software spending has now faded as most businesses have met their pent-up demand for equipment. At the same time, most U.S. companies have amassed huge piles of cash thanks to their high profitability. Once the U.S. recovery gathers steam, businesses will put this cash into use, re-suming spending on new technological equipment and hiring more workers to use them.

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With acknowledgement and appreciation to local key businesses supporting Sonoma County Economic Development: Director

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Economic Development Board 401 College Avenue, Suite D Santa Rosa, CA 95401 (707) 565-7170 www.sonomaedb.org

A G R I C U LT U R E INDUSTRY R E C R E AT I O N

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