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Software Stocks: Fleeting Firmness?

Tech investors have plenty of reasons to take a look at software stocks again. Field checks by analysts find more and bigger orders in the pipeline now than just a few months ago. Market researchers say corporate customers are calling to inquire about new programs once more. And securities analysts are increasingly confident that the seasonally strong fourth quarter will come in on track at most companies and that many of them will post year-over-year quarterly earnings growth. Evidence of these trends is an average 50% surge in leading software stocks since the end of September.

Of course, investors shouldn't fall head over heels for the sector just yet. In the context of a slowdown early this year and a subsequent near-collapse in software stocks, the recent improvements reflect an industry still struggling to regain its footing. The sales pickup, while welcome, is modest. And unless corporate-technology spending suddenly takes off (which analysts think unlikely), most software companies may be looking at single-digit revenue growth in 2003.

The two-month stock-price surge further complicates the picture: Software shares remain 40% below their highs of earlier this year, but the recent gains have inflated price-earnings ratios to a steep 30 times 2003 earnings, vs. a forward p-e of 17 for the Standard & Poor's 500-stock index.

PESSIMISM AS A RULE. As a consequence, "a lot of the stocks are bumping up against my price targets, and it's a little early to raise targets," says Jim Mendelson, a software analyst with Soundview Technology Group. Adds Brendan Barnicle, an analyst with Pacific Crest Securities: "Given the run we've had, valuations have outpaced fundamentals."

In fact, pessimism should rule the day for most investors, advises James Governor, principal analyst at software consulting firm Red Monk. He believes sales may never achieve their earlier, dougle-digit annual-growth trends, and he says the negative factors that have constrained sales for the past two years remain in place: Corporate customers are still trying to fully integrate pricey software packages they bought years ago with their older systems.

And while more deals are in the pipeline, ones that used to take two weeks to close now take 9 to 12 months. Companies that are inquiring about new products seem to be doing a lot of window-shopping. And because of past overspending, "IT people are cheapskates right now," says Governor. "Can you blame them?"

REVISED FORECASTS. Much of the investment community is still recovering from the shock of this year's first quarter, when software sales fell instead of growing the 15% that many experts anticipated. SAP's (SAP) slid from $2.3 billion in the fourth quarter of 2001 to $1.7 billion in the first quarter of 2002. Nearly every company in the sector suffered at least a dip in sales, and stocks lost half to two-thirds of their value. Oracle (ORCL) fell from $17 in January to $7 by June, though it's now back up to around $12, as of Dec. 3. "It was one of the most painful quarters I've lived through as an analyst," says Mendelson.

Indeed, analysts spent most of the year ratcheting back their forecasts -- and believe that their revised expectations are now in line with the new reality. Oracle will provide a crucial test on Dec. 18 when it announces results for its 2003 fiscal second quarter, which ended in November. Most analysts believe it will meet earlier guidance and report earnings of 8 cents a share, on revenues of $2.2 billion. And an upbeat commentary from management on prospects in the near term could give the sector enough oomph for the rally to last for a few more weeks, says Barnicle.

It's mainly the beginning of 2003 that worries analysts. That's partly because they got burned badly early this year but also because the first quarter is seasonally weak for the software industry. If the positive trend peters out and sales dip from the fourth, a stock sell-off could be sharp and painful.

WHERE TO BUY. Though it's risky to get in now, some select software names are worth considering, especially if it's possible to buy on a dip in price. Most analysts favor the companies that sell programs used in bolstering and simplifying corporate-IT infrastructure, rather than companies that sell business applications known by acronyms like CRM (for customer-relationship management).

Barnicle recommends BEA Systems (BEAS), as well as Microsoft (MSFT), which he owns, for their strength in infrastructure. Of the application suppliers, he says SAP and JD Edwards (JDEC), which serves midsize companies, are the leaders.

Mendelson gives his top ratings to Precise Software (PRSE) and Quest Software (QSFT), both of which sell products that improve corporate architecture (his firm has done investment banking in the past for both companies). He also recommends Oracle and Computer Associates (CA), which offer integrated software products. Longer-term, Mendelson likes application vendors PeopleSoft (PSFT) and SAP.

NEAR-TERM WARINESS. Governor of Red Monk highlights content-management company Documentum (DCTM), which has been able to increase sales each quarter for the past year. Although he isn't a stock analyst, he says Documentum is the kind of niche software stock that may be a good opportunity -- even though it has nearly doubled in the past two months, from a low of $10.39 on Oct. 8 to around $18 on Dec. 3.

Still, most analysts agree that software companies will be hard pressed to deliver significant sales growth in the foreseeable future. So with the stocks up so much in recent weeks, investors may want to wait for a little more proof that software's sales upturn has staying power. By Amey Stone in New York

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