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BEA Systems: Beyond the Bad News

By Jonathan Rudy Shares of business-software outfit BEA Systems (BEAS

; recent price, $8.25) sold off sharply on May 14, following the release of fiscal 2005 (ending January) first-quarter results. We at Standard & Poor's Equity Research believe investors were primarily disappointed with the 2% year-over-year decline in BEA's license revenues to $120 million. Our revenue estimate prior to the report had been $128 million, or about a 6% difference from the reported number.

But we believe the selling was overdone, and that the recently depressed stock price presents investors with an attractive entry point. The stock carries Standard & Poor's highest recommendation of 5 STARS, or buy.

BEA is a leading application software infrastructure provider. Its WebLogic Enterprise Platform is designed to deliver a reliable, scalable, software infrastructure enabling companies to bring new services to market quickly, to lower operational costs by automating processes, and to automate relationships with suppliers and distributors. WebLogic Platform 8.1 became generally available in March, 2003.

GROWING SHARE. Historically, BEA's main product has been its application server -- the platform, or middleware, that connects application operations between users and a company's back-end applications, or databases. Industry research group International Data Corp. estimates that the application-server market will reach $2.5 billion in 2007, for a compound annual growth rate of 3.0%.

BEA's Weblogic Server is a standards-based server that provides a platform for deployment and integration of enterprise wide applications and Web services. Another variation of this technology is offered under the Tuxedo brand.

BEA WebLogic Integration product was one of the highlights of its first-quarter results, in our view. Integration revenue exceeded $20 million in the quarter, and according to the company, BEA's integration license revenue exceeded $100 million for all of fiscal 2004. According to a recent study by IDC, BEA's market share improved to third, from seventh in 2003. IDC estimates that the worldwide application integration market will reach $8.2 billion by 2006, a compound annual growth rate of 13.7% for the period from 2001-2006.

MITIGATING FACTORS. BEA WebLogic Portal is a rules-based infrastructure for rich user interfaces to a wide variety of enterprise data. IDC estimated that the enterprise portal market increased 20.3% to more than $800 million in 2003, and estimates that the market will reach $1.7 billion by 2007, for a compound annual growth rate of 20.7%.

We believe competition remains very intense in BEA's operating segments. Rivals include IBM (IBM

; S&P rank, 5 STARS; $87) and Oracle (ORCL

; 4 STARS, accumulate; $11), significantly larger companies with more resources than BEA. For example, IBM has a bundling strategy with its software division, and can include hardware and consulting services as part of any proposal. However, during its first quarter, BEA had 230 instances where customers adopted BEA offerings to run within the IBM WebSphere environment -- and it had 53 product wins with BEA's WebLogic replacing WebSphere outright.

As for the disappointing first quarter, we believe that there were a couple of key factors that impacted results. The first quarter is a typically weak one on a seasonal basis, and BEA was coming off of a strong final quarter of fiscal 2004. While seasonality itself should not be a major factor in the company's results, we believe that a more-dramatic-than-expected seasonal decline, combined with a re-organization in its U.S. sales force, contributed to the disappointing U.S. results.

VOLATILE HISTORY. As part of the reorganization, BEA created a new general accounts region in the U.S. in order to improve relationships with midsize businesses and value-added resellers. While creating some near-term disruption, we believe that these moves make strategic sense, and should boost profitability over the longer term; BEA will benefit from making these changes quickly, in our opinion. BEA is also in the middle of a product transition to the latest version of its flagship offering, WebLogic 8.1, which was introduced last year.

Additionally, we believe that enterprise software sales can typically be characterized as "lumpy" (i.e., not smooth or steady), which, along with long sales cycles, makes it more difficult to predict exactly when certain key deals will close from quarter to quarter. The enterprise-software market has a history of notable upside surprises and disappointments, varying from quarter to quarter.

However, as we believe the strong fourth-quarter fiscal 2004 results should not have been interpreted as a harbinger of boom times ahead for BEA, we also believe that the fiscal 2005 first quarter showing should not be seen as a sign of a company in decline. BEA remains a technology leader that we think will benefit as corporate IT departments open up spending on large-scale infrastructure deployments in 2004.

As Web services and integration become more and more important to global corporate operations, we believe that BEA has the leading-edge technology to provide the scale, reliability and interoperability that will be critical for corporations going forward in an e-business world.

STRONG CASH FLOW. At recent stock-price levels, we believe that BEA's valuation is attractive relative to its peer group, and on a

discounted cash-flow basis. The company continues to generate substantial amounts of cash. Cash flow from operations in the first quarter increased over 100%, year over year, to $82 million. This follows approximately $212 million in free cash flow generated in fiscal 2004, and $182 million in the prior fiscal year.

BEA's balance sheet remains solid, in our view, with approximately $1 billion in net cash and investments, or approximately $2 per share. The primary debt-related securities on the balance sheet are $550 million in convertible notes, and $192 million in long-term debt for land lease.

In addition to the strong cash flow generated by BEA in the first quarter, we were pleased with its continued improvements in profitability. Pro forma operating margin, which excludes amortization and one-time charges, widened, year over year, to 19.4%, from 16.9%.

We also believe that BEA will benefit later in 2004 as corporations begin to spend IT budgets on larger-scale deployments. Data from technology leaders such as Microsoft (MSFT

; 5 STARS; $26) and Cisco (IBM

; 5 STARS; $22) indicate that corporate IT demand continues to improve, and we expect that a rising tide will benefit BEA as well. At recent valuation levels, we think expectations are very low for BEA in 2004.

PONDERING THE OPTIONS. At BEA's e-World expo the week of May 24-28 in San Francisco, we believe that it could unveil its latest platform, WebLogic 9.0, along with its additional features and functionality. Our estimate of S&P Core Earnings -- which reflect, among other things, potential expensing of employee stock options -- for BEA in fiscal 2005 is a loss per share of 5 cents, vs. our operating EPS estimate of 38 cents. While options have a potentially significant impact on BEA's earnings, we believe that this is not dramatically different from other enterprise-software providers and not as egregious as some BEA competitors.

BEA trades at a discount to its closest enterprise software peers based on enterprise value-to-sales, price-to-sales, and p-e-to-growth metrics. BEA's enterprise value-to-sales multiple of 2.3 is well below to its peer average of 3.7. On a price-to-sales basis, BEA trades at 3.0 times, versus a peer average of 4.3 times. On a p-e-to-growth (PEG) basis, using our forward EPS estimate of 38 cents and a 15% long-term growth rate, BEA has a PEG of 1.4, vs. a peer average of 1.7. Based primarily on enterprise value-to-sales valuation, which incorporates BEA's solid balance sheet, we arrive at a fair relative value of approximately $13.50.

Additionally, we use discounted cash-flow (DCF) analysis in order to derive our target price for BEA. Using a five-year free-cash-flow forecast of approximately 20%, vs. 24% free-cash-flow growth from 1999-2003, and a weighted average cost of capital of 11.8%, we arrive at a fair value of $15.67.

REWARDS -- AND RISKS. Blending our relative valuation target of $13.50 and our DCF-derived target of $15.67, we arrive at our 12-month target price of $15 per share.

There are significant risks, in our view, to our investment thesis and target-price projection. A rapidly changing technology landscape can lead to the obsolescence of market-leading technology quite rapidly. One specific technological risk to BEA is the open-source movement. In the application server market, open-source products such as JBoss and Apache compete directly with BEA.

Additionally, the enterprise-software industry is characterized as having intense competitive pressures. In BEA's case, IBM and Oracle are formidable competitors with much greater resources than BEA due to their economies of scale. Analyst Rudy follows stocks of software companies for Standard & Poor's Equity Research

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