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Software Stocks to Load

"Volatile" is the word for the market in software and computer-services stocks, and it's too soon to jump in unless the price is really right. That's the word from Jonathan L. Rudy, industry analyst for Standard & Poor's, who covers those sectors. Even some companies doing well are still too highly valued to warrant buying, Rudy says.

He reports, however, that S&P has two strong buys in his area: Check Point Software and Symantec, based at least in part on their position in Internet security, which he sees as something to stress in an era when worms like Code Red are on the loose. Among stocks rated "accumulate" by S&P, Rudy lists names such as Electronic Arts, Oracle, and Autodesk.

With the growing boom in wireless devices, Rudy sees Microsoft in the strongest position among software companies, thanks to its strategy of developing a platform that can work for all such devices.

Rudy's comments came in a chat presented Aug. 7 by BusinessWeek Online and Standard & Poor's on America Online. He was responding to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts from the chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Jon, before we start shopping for software stocks, the market looked better today -- what's the S&P view on the outlook?

A: Generally, right now, we believe that the market is in a trading range. However, we believe that things will pick up toward the end of 2001 and into 2002.

Q: And how has the software sector been behaving?

A: Volatile -- that's the one word I have to describe it. Typically, companies are seeing dramatic swings in their stock prices on a daily basis as people keep trying to pick a bottom in technology.

Q: When will Microsoft (MSFT) have the next stock split? And is the stock a good bet now?

A: I can't predict when the stock will split. However, at these levels, I feel that all of the recent positive news about the trial and the anticipation of the rollout of WindowsXP and Xbox are currently reflected in Microsoft's stock price.

Q: How about BEA Systems (BEAS)?

A: We currently have a "hold" rating (3 STARS in S&P's Stock Appreciation Ranking System) on BEA Systems. The company has a very bright future. However, near-term, they're coming under increasing competition from IBM, and so that will likely keep pressure on the shares. Longer-term, we're very positive on the company's outlook.

Q: What are your thoughts on CHKP

(Check Point Software)?

A: Check Point is currently a strong buy, or 5 STARS. It's one of the two top names in my universe right now. It's reasonably valued at about 32 times my EPS [earnings per share] estimate for this year. For a company that has been able to grow between 30% and 50% consistently and is one of the most profitable companies I've ever seen, with 60% operating margins, return on equity well over 40%, approximately $800 million in cash, and no debt, I'm very positive on Check Point at these levels. Symantec (SYMC) is also a 5-STAR, my other top name.


(i2 Technologies) and SEBL

(Siebel Systems) -- will they lead the rebound for tech?

A: I'll start with i2. It's the supply-chain leader. However, I was disappointed at how rapidly their business evaporated, due primarily to their exposure to the technology and manufacturing sectors. That said, long-term they continue to be well positioned, and supply-chain software provides crucial operating functions that businesses will need going forward.

Siebel is the leader in CRM [customer-relationship management] software. While they hit their numbers last quarter, they lowered their outlook going forward for the remainder of this year. With their valuation still high/expensive, we wouldn't add to shares at this time. We have a hold rating on the stock.

Q: ITWO just got beaten down badly -- would this be a good entry point at 10?

A: We have a hold on i2. Our only concern at this point is that we're projecting losses through next year, and that gives us pause with the valuations at these levels, because it is vulnerable to the downside here. However, the company still has ample cash and will continue to be a market leader. We just wouldn't add to positions here or start new ones at these levels.

Q: You gave us two 5-STAR (buy) names -- anything on the next rung down, 4-STAR or accumulate?

A: Yeah, my 4-STARS in software are presently Electronic Arts (ERTS), Oracle (ORCL), Autodesk (ADSK), RSA Security (RSAS), and Rational Software (RATL). I also cover computer services, with two 4-STARS: Paychex (PAYX) and Automatic Data Processing (ADP).

Q: Maybe you can tell us a little about what's to like with some of those stocks. Oracle is the best-known, of course.

A: Oracle is very well positioned for its product-upgrade cycle, with a new database-software product and a new application-server product being rolled out. Additionally, despite [a recent] Wall Street Journal article taking a shot at their e-business software, they are making progress in that area and should see some accelerated growth in that product.

Electronic Arts is a company that has a very bright future, considering the actual hardware-upgrade cycle that's currently going on with Playstation 2, Xbox (due out this fall), and Nintendo's Game Cube, also due out this fall. We expect software companies such as Electronic Arts to benefit from intense competition among the hardware vendors. And Electronic Arts is a clear leader in this area. The only reason that it isn't ranked 5-STAR is the valuation at this point. Overall, we're very positive on Electronic Arts.

Q: Any comments on PeopleSoft (PSFT)?

A: Sure. PSFT had a great quarter. They've done an excellent job in diversifying their product suite into CRM and supply-chain software. My only hesitation with them at this point is due to valuation concerns. They currently trade at over 55 times our 2002 estimate, which is still expensive, despite their strong execution.

Q: Do you have a favorite in the storage-software market?

A: In storage software, it would be VRTS

(Veritas). They recently lowered their growth target for this year, from 40% to 50% to 25% to 30%. The shares were punished as a result. However, they're the clear leader in this field, and they will continue to benefit from intense price competition on the hardware side between EMC and Network Appliance (NTAP). That said, considering their slowing near-term growth prospects, we wouldn't add to positions at this time.

Q:Jon, what new software technologies should we be watching -- and which companies related to them?

A: I'm still very high on Internet-security companies going forward. The recent Code Red worm outbreak illustrates the importance of not only protecting your Internet operations but detecting and preventing future outbreaks as well. To repeat, Check Point and SYMC are our favorites.

Q: Which stocks do you see in software that will be a good buy for the long haul? Also for the short term?

A: Check Point, SYMC, and RSA Security, which is an accumulate, in the Internet-security space, and Electronic Arts in the gaming space. Oracle, we feel, is attractive at these levels. Short-term is very difficult right now. You have to look at the price you pay vs. the company's long-term growth prospects.... As an aside, in this market, high-valuation stocks that have disappointed have gotten killed in the marketplace because they were priced for perfection. And that's the real danger right now with investing for the short term.

Q: Any sense that the third quarter will be the earnings bottom for software stocks?

A: It's too early to say. What's been disconcerting is that every time people have thought that there was a bottom, there has been another down to go.... However, heading into 2002, there will be some easy comparable numbers for a number of software companies next year. That should help to bring a bottom in either the third or fourth quarter this year -- hopefully.

Q: Jon, what do you see as the impact on the software industry of the powerful trend toward wireless devices?

A: It's really going to force companies to develop platforms for a multitude of devices. And the primary model at this point is MSFT with their Net strategy -- to provide a basic platform to all types of portable devices. That will likely be the standard going forward. Openwave Systems (OPWV) is a leader in that space. I don't cover them, but presently Scott Kessler does and has a "hold" rating on them.

Q: Has the tech slump caused you to downgrade any of your previous top picks? Even to sell or avoid?

A: My two sells, which weren't my top picks, are Sybase (SY) and J.D. Edwards (JDEC). For Sybase, the reason behind our recommendation is concern over the recent Neon acquisition. We have some concerns with Neon. And we believe that Neon will have disappointing results going forward.

With J.D. Edwards, we actually downgraded early last week. That was due to concerns over the extended slump in the supply-chain software sector, and they ended up pre-announcing on Friday, due to exposure to manufacturing and distribution sectors, which caused their business to drop off dramatically.

Q: A good final question -- which tech companies do you feel will survive big-time?

A: I have a sneaking suspicion that MSFT and Oracle will be around. Some smaller names that will be long-term winners include Check Point Software, BEA Systems, Siebel Systems, PSFT, and Veritas....However, the one caveat is that the market has shown this year how important it is to pay attention to the price you pay for a particular stock. And while they may be winners in the long term, there can be some very sharp or dramatic moves in the short term.

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