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Shopping for Software Stocks

Web services and Internet security are on the leading edge of the software industry these days. So says Jonathan Rudy, an analyst for Standard & Poor's covering software stocks. S&P's favorites in Web services, Rudy reports, are Microsoft (MSFT) and IBM (IBM) In Internet security, the top choices are Check Point Software (CHKP) and Symantec (SYMC), both rated accumulate by S&P.

The chief concern about software stocks at the moment, according to Rudy, is the high valuation of many. He's unsure whether the fundamentals of software companies in general will improve sufficiently to justify the present high prices in relation to earnings.

These were some of the points Rudy made in an investing chat presented Sept. 9 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Jonathan Rudy is an analyst with Standard & Poor's Investment Advisory Services. He has no affiliation with or ownership interest in any companies under discussion. Other S&P affiliates may provide services to the companies under discussion.

Q: Jonathan, was today's market dip just profit-taking? Will stocks resume their very welcome climb?

A: I can't speak for the broader market, but a number of software stocks have had quite a run recently. So it wouldn't be surprising to see some profit-taking. However, as far as a resumption of the recent performance, we believe that some of the excessive valuations in the software sector will prevent a number of companies from outperforming the market going forward.

Q: What is your view on Microsoft (MSFT)? How high do you think the stock will go this year?

A: We have a buy recommendation on Microsoft, and we continue to think the company will do quite well, particularly with the recent uptick in PC unit-shipment forecasts from industry groups such as Gartner and IDC. MSFT continues to generate very strong cash flow and invest significant amounts of money in research and development, which should continue to spur future growth.

Q: What do you think Microsoft might do with all its reservoir of cash -- besides the dividend it instituted?

A: With approximately $50 billion in cash and short-term investments, we were somewhat disappointed that the company didn't substantially increase its dividend in the most recent quarter (ended June 30). However, one of the main reasons that Microsoft has cited for not paying out a larger dividend is due to all the legal issues surrounding the company, most notably the outstanding litigation with Sun Microsystems (SUNW) and the European Union.

Until these issues get resolved, we believe that the company will use its cash mainly for share repurchases and small acquisitions. However, longer-term, with the company generating about $1 billion in free cash flow every month, we believe that the door is open to substantial dividend increases down the road.

Q: Are there any small- or mid-cap software stocks that S&P is currently recommending?

A: We have a buy recommendation on Sybase (SY). We have accumulate recommendations on Check Point Software (CHKP), Symantec (SYMC), and Electronic Arts (ERTS). They are not really small-cap companies, but those are some of the other names we like.

Q: Is Oracle (ORCL) positioned for the possible increase in capital spending? What's the upside potential?

A: We have a hold recommendation on Oracle. And while Oracle will benefit from a pickup in capital spending, we believe that the whole situation with PeopleSoft (PSFT) will keep a lid on Oracle's shares until the situation is resolved one way or the other. Thus, at this point, our target price for Oracle is $14 per share.

Q: What's on the leading edge of innovation in software now, Jonathan?

A: Web services will be a key driver going forward for the software sector. And companies that are well-positioned in that area are Microsoft, BEA Systems (BEAS) (which we have a hold recommendation on), and IBM (IBM). I don't cover IBM, but our analyst Megan Graham-Hackett has a buy recommendation on it.

Another key trend is Internet security, with the continuation of virus outbreaks and variations in viruses, such as worms, as the recent Blaster and SoBig worms illustrate. Internet security will continue to be crucial to the future of e-commerce. And in this area, we still like Symantec and Check Point Software.

Q: Which stock will be paying the highest dividend in 2003? But do any of your stocks pay dividends, except for MSFT and its recent introduction of a payout?

A: Microsoft pays a dividend, as you just mentioned. Autodesk (ADSK) pays a $0.12 dividend, Computer Associates (CA) pays an $0.08 dividend -- that's it in the software universe.

Other companies that I cover that pay a higher dividend are PayChex (PAYX) and ADP (ADP). Those are the only two companies in my universe that have a yield over 1%. So despite Microsoft's announcement, no other software companies have really followed their lead yet. Dividends are currently not a primary factor in investing in the software sector.

Q: Does software buying kick in at the middle of an economic cycle?

A: The sector as a whole will benefit from any global economic recovery. However, there is still the overspending hangover of the late '90s and early 2000. So we don't view software growth snapping back as strongly as in previous cycles, and some companies will clearly benefit more than others.

For instance, we believe that Microsoft will benefit disproportionately. Areas like CRM [customer-relationship management] may take longer to come back, which is one of the primary reasons we are not positive on a company like Siebel Systems (SEBL).... We have a hold recommendation on Siebel. And while we do have questions over the CRM market's growth rate overall, SEBL has a strong balance sheet and generates solid cash flow. So we believe they will likely be a survivor. However, we don't believe that the company will return to its previous growth rates.

Q: To what extent are software sales hooked to PC sales?

A: The correlation is a lot more evident for a company like Microsoft, with its desktop software. However, for the rest of software, it really depends whether growth is business- or consumer-oriented. And particularly with the lack of business capital spending at this point, the enterprise-software providers could have a bit of a lag in their recovery.

Q: Are small-cap software stocks a good investment?

A: Depends. It's really difficult to broadly characterize software like that. It really depends on what particular type of software the company is involved in. For instance, one small-cap company that's currently not in our coverage universe, NetScreen Technologies (NSCN), has done extremely well in the Internet security software space.

Additionally, some of the smaller-cap interactive entertainment companies, like Activision (ATVI) or THQ (THQI), have done well of late, benefiting from the boom in next-generation hardware consoles. However, we currently have a hold recommendation on ATVI and an avoid recommendation on THQ.

Q: Are you recommending any software concerning the military?

A: I don't cover any software companies that deal with only the military. However, companies like Microsoft and Oracle do a decent percentage of their business with the federal government and should benefit from strength in federal IT spending.

Q: It's often said that the purchases made in anticipation of Y2K are obsolete already and will have to be replaced. Will that be a tonic for software?

A: To some extent. For instance, the PC upgrade cycle should benefit Microsoft. However, some areas that were heavily spent on in that period, such as CRM, never really proved their return on investment. So it's yet to be seen whether there will be any new growth cycle in that particular area. Web services, which will really be a key growth area going forward, is essentially a new area for software and really doesn't have that overhang to work off.

Q: Your thoughts on webMethods (WEBM)?

A: I don't cover webMethods. However, they are one of the primary vendors in the enterprise application integration (or EAI) space, along with Tibco Software (TIBX). This area will likely come under increasing pressure from growth in Web services, which will essentially allow software to interoperate more efficiently. And that could put pressure on the whole EAI sector, in our opinion.

Q: Is this momentum on techs -- or do fundamentals support the prices?

A: There has been some momentum investing in technology, which is evident. However, valuation in the software sector in particular prevents us from getting more positive on the sector as a whole, despite some improvement in fundamentals. We just don't know if this improvement will be sustainable in order to justify some of these lofty valuations.

Q: How about Red Hat (RHAT)?

A: I don't cover Red Hat, and it's not in our coverage universe. However, Linux as a whole continues to grow nicely -- and combined with Windows, in our opinion, it's taking share from Unix. However, we believe that the Linux operating system will continue to play a role in low-cost services. We're just not quite sure at this point that companies will run mission-critical operations on Linux operating systems yet. This could slow the recent rapid growth of Linux over the long term. I can't make any specific comments on Red Hat since I don't cover them.

Q: Can you comment on BMC Software (BMC), please?

A: I have a sell recommendation on BMC. This is primarily due to our concerns over the company's valuation, due to our belief that its mainframe business is a low-single-digit grower and yet the company trades at about 30 times our fiscal year '05 EPS estimate of $0.52. So we don't believe this valuation premium is warranted at these levels.

Q: What stocks do you think might be acquired?

A: It's always dangerous to speculate on that basis. However, with recent deals such as Oracle's bid for PeopleSoft and PeopleSoft's merger with J.D. Edwards (JDEC), in addition to EMC's purchase of Legato Systems (LGTO), consolidation in the software industry is clearly under way. We wouldn't buy a stock based purely on takeover speculation.

Q: How about reminding us of your top stocks, buys and accumulates -- and perhaps those we should avoid or sell?

A: Our buy recommendations are Sybase (SY) and Microsoft (MSFT). Our accumulate recommendations are Symantec (SYMC), Check Point Software (CHKP), Electronic Arts (ERTS). Our avoid recommendations are RSA Security (RSAS) and THQ (THQI). Our sell recommendation is BMC Software (BMC).

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