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In Software, Stick with the Leaders

As the economy recovers, there's potential among the software stocks -- but market leaders with "strong earnings prospects and balance sheets" could be the best bets. So says Jonathan Rudy, industry analyst for Standard & Poor's, who covers the stocks of software and commercial-services companies.

Rudy is highest on companies in Internet security, storage, and customer relationship management (CRM) software. Among the names he singles out are Check Point, Symantec, and Siebel Systems. He says BEA Systems is currently the leader in Web-application servers, with IBM a close No. 2 and "gaining ground."

On Microsoft, Rudy makes the point that it has weathered the downturn in PC sales well, with a diversified revenue stream now. However, he says the giant is now losing about $100 for every Xbox game console it sells, though in the future it should reap impressive profits from games that are played on the Xbox.

Rudy's comments came in a chat presented Mar. 12 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts from the chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Jon, is the market in a sustainable rally? Some of the techs took it on the nose today.

A: I can only really speak for technology and software in particular. However, it does appear to be very choppy right now, and we believe, particularly in the software sector, that it will be important to stick with market leaders that have strong earnings prospects and balance sheets (see BW Online, 3/15/02, "It's Too Early for a Tech-Stock Rally").

Q: What is the story on Check Point (CHKP)? Buy, sell?

A: I have an accumulate recommendation on Check Point Software. It may be the most volatile stock that I cover. However, it is extremely profitable and financially rock-solid, with about $1 billion in cash and short-term investments and no debt. We remain positive on the company for the long term, despite current concerns over competition.

Q: What's your long-term outlook for SEBL

[Siebel Systems]?

A: Siebel is one of my top picks. It's the market leader in customer relationship management software, and it should do well as CRM remains a high priority for IT departments. Siebel is also financially rock-solid, with over $1.6 billion in cash and short-term investments and very low debt levels.

Q: What is an example of a commercial-service stock?

A: It can include a systems integrator such as Electronic Data Systems (EDS), a payroll processor such as Paychex (PAYX), or a data processor such as First Data (FDC). It's a pretty broad category.

Q: Are those some of your favorites in that group?

A: EDS and Paychex are. I don't cover data processors, but First Data is an S&P accumulate recommendation.

Q: Which large-cap high-tech stocks are worth investing in for the long term? Any more buys or accumulates in your turf, Jon?

A: Sure. I'll keep it large-cap first. In the large-cap arena, Siebel. I have an accumulate recommendation on Microsoft (MSFT) and on Oracle. In more of the mid-cap area, I have strong buys on Electronic Arts (ERTS) and Symantec (SYMC), and an accumulate on Check Point (CHKP) and Autodesk (ADSK).

Q: Any thoughts on BEA Systems (BEAS)?

A: I have a hold recommendation on BEA. I think it's a very well-run company. However, I have concerns over competition from IBM and potentially Microsoft, and the valuation is high right now.

Q: The stocks you're recommending are all up in price. Are there any valuation issues here, Jon?

A: Valuation is always a concern. However, again it's important to stick with the market leaders with strong financials that will really benefit as the economy recovers.

Q: You mentioned Microsoft (MSFT) a minute ago. How does it look to you now?

A: Microsoft has weathered the PC downturn extremely well, with a much more diversified revenue stream. However, the days of 25%-plus growth from Microsoft are over, and we believe that it's a low-teen grower over the long term. Yet with $38 billion in cash and short-term investments, you never want to underestimate its prospects.

Q: Opinions on RATL

[Rational Software]?

A: I have a hold recommendation on Rational. Rational should benefit from Microsoft's rollout of Visual Studio.Net. However, our only concern with Rational right now is valuation.

Q: What's the year's outlook for BMC Software (BMC)?

A: Overall, I'd say it's positive. However, I do have some concerns over slower-than-expected growth in the mainframe software market, and I think BMC's real opportunities lie in storage and systems management away from the mainframe.

Q: What are your thoughts on CA

[Computer Associates]?

A: Computer Associates is a very interesting situation, to say the least. While the shares have been battered recently, the company always seems to step into situations. So therefore, we would not add to positions if you do not own CA. However, if you own the shares, it's probably due for a bounce, and we would recommend holding the stock.

Q: What's your yearend target for PSFT


A: I don't have a specific target. I have a hold recommendation on PeopleSoft and feel that despite strong execution by the company, its valuation is a bit excessive here. We would be more excited about the stock in the high 20s.

Q: Jon, what do you see as the leading growth factors for the software companies you cover? Any new frontiers of technology?

A: Not necessarily new frontiers of technology. However, certain sectors such as Internet security, storage software, and CRM software will likely take a share of the overall IT budget. And that's where you'll likely find some growth despite a challenging economic environment.

Q: Does this count as a technology frontier? Any thoughts on interactive TV with companies like Liberate Technologies (LBRT)?

A: I don't cover Liberate, but Microsoft had a lot of difficulty in that space, as well as problems with their WebTV unit. So while the technology may be appealing, it will likely be very difficult to be very successful in that space.

Q: In similar vein, do you see any income that can be generated with videoconferencing software from companies like FVCX

[First Virtual Communications]?

A: I don't cover that company. However, Ari Bensinger covers Polycom (PLCM), and he has a strong buy on the shares.

Q: Are the rivals to MSFT in operating systems going anywhere?

A: Linux as a platform has had some success. However, it will likely remain more of a niche platform than anything else. Microsoft's biggest competition in the enterprise remains Unix. But Microsoft is competing very well there.

Q: Do you see any clear leaders in the CRM software segment?

A: Absolutely, Siebel. PeopleSoft has done a good job in that space. E.piphany (EPNY), SAP (SAP), and Oracle (ORCL) have been competing.

Q: Have there been any interesting changes, up or down, in your rankings recently?

A: I recently downgraded Legato Systems (LGTO) to a sell from a hold recommendation, primarily due to a recent acquisition and concerns over valuation.

Q: It might be helpful to the audience for you to explain your -- and S&P's -- criteria for covering a company.

A: For coverage, one of the top ones is it should be in one of the S&P indexes, ideally. Market capitalization also plays a role in the process. It's usually the float outstanding of a particular stock that has an influence. Usually, to get into an index, earnings are looked upon favorably. However, it's not a requirement for our coverage universe.

Q: What about MANU

[Manugistics] and ITWO

[i2 Technologies]?

A: I cover i2, and I have an avoid recommendation on the shares, primarily due to valuation and concerns over the company's move of some of its research and development workforce to India. With regard to Manugistics, I do not cover them, but they have been executing extremely well and are a competitor to i2. Overall, in the supply chain management (SCM) market, it has been disappointing as implementation has proven to be lengthy and expensive, and a number of companies have had difficulty realizing the cost savings from supply chain implementations.

Q: What's the outlook in the security software arena?

A: It's very bright. It's a mission-critical component of a company's business nowadays, and we're very positive on the space, particularly Symantec (SYMC) and Check Point.

Q: Who is the leader in Web application-server software -- BEA (BEAS) or IBM (IBM)?

A: BEA is the leader, but IBM has been gaining ground quickly and is a close No. 2, depending on what survey you see.

Q: Does it appear that Microsoft (MSFT) will make a profit from its Xbox experiment?

A: Not in the near future. It's losing approximately $100 for every Xbox console sold. However, in the end, it should do extremely well in the highly profitable software games tied to the console. That's where the true profits will be.

Q: Give us a refresher before you have to leave on your top choices right now, Jon.

A: Top picks include Electronic Arts, Symantec, and Siebel, and we would recommend that in this volatile market, investors stick with profitable market leaders that generate a lot of cash and have strong balance sheets.

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