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Software's Malaise Isn't Spreading

By Jim Kerstetter Tech investors can exhale now. It doesn't appear as though the industry is headed for another big fall. On July 20, several major computer manufacturers and chipmakers, including EMC (EMC), Motorola (MOT), Texas Instruments (TXN), and even Sun Microsystems (SUNW) reported improved second-quarter results. The positive earnings news comes a week after more than 20 corporate software makers stunned Wall Street with the worst string of bad earnings in three years.

There are plenty of theories for software's malaise: The industry lacks innovations to bring new customers to the table, or perhaps buyers were spooked by shaky economic news in the quarter's closing weeks. But the most likely reason is the software sector is finally undergoing massive consolidation. Customers are determined to limit their number of suppliers. As a result, leaders like Microsoft (MSFT), Oracle (ORCL), Symantec (SYMC), and SAP (SAP) are doing just fine as they gain market share from smaller rivals. Symantec is set to report earnings July 21, and Microsoft on July 22.

PARTICULAR WORRY. Good earnings news is also coming from the world of big dot-coms, even if those companies are unlikely to catch a break from investors. (AMZN) and eBay (EBAY) will face the same challenge confronting Yahoo! (YHOO), whose stock fell 8% on July 8 after reporting second-quarter profits that more than doubled, simply because the portal only met expectations.

Indeed, on July 21, eBay reported that second-quarter profits jumped 107%, to $190.4 million, on a 52% rise in sales, to $509.3 million. Both sales and profit growth slightly exceeded analysts' estimates. But investors knocked eBay's stock down 4%, to $76.60 a share, before the report on a bad day for the overall market -- and it was plunging even more in after-hours trading late Wednesday.

When Web retailer Amazon reports on July 22, it's expected to earn $77 million, reversing a year-ago loss of $43 million, on a 30% jump in sales, to $1.43 billion. Amazon is a particular worry for analysts because overall retail sales growth is slowing, and Amazon already trades at about 34 times next year's earnings. Barring the unlikely event that the usually slow second quarter turns out to be a barnburner, says Piper Jaffray & Co. analyst Safa Rashtchy, "I don't really expect much upside."

With positive news percolating out of big computer companies, investors will likely take comfort seeing that software's troubles aren't spreading to other parts of techdom. For example, computer makers, having gone through massive consolidation in the 1990s, are on a different road for growth. Granted, it's not exactly the Autobahn. Tech capital spending and overall info-tech budgets are expected to increase 2.3% in 2004, according to a July 16 survey of chief information officers by Goldman Sachs.

While that's hardly the 9% annual growth the tech industry enjoyed even before the dot-com bubble, it's a sign that spending is at least headed in the right direction. "This is the recovery, enjoy it," Oracle CEO Lawrence J. Ellison told analysts on July 14.

"SLOW BUT STEADY." And although the recovery may not have the industrywide momentum many would like, some companies are enjoying it more than others. On July 20, Massachusetts-based storage equipment giant EMC said revenues increased 33% from last year, to $1.97 billion. Excluding acquisitions and currency effects, it would have been a 15% jump. That includes a 64% leap in software revenues, which now account for 36% of EMC's sales, and a 45% hike in services revenue.

EMC's revamped line of low-end storage gear saw sales increase better than 40%, as well. Gross margins also rose to 50.6% of revenues, up from 50.1% the previous quarter and 43.5% a year ago.

EMC CEO Joe Tucci says the IT spending environment is "slow but steady" and should hold at about 4% growth in the third quarter. So, expect to suffer neither highs nor lows because of it -- unless you're one of the unlucky many in software. "The industry has beaten the hell out of the hardware players," Tucci says. "It's software's turn in the barrel."

MOTORING MOTO. Chipmaker Texas Instruments also saw a surprising revenue jump. Sales were up 39% year-over-year, to $3.24 billion, with net income rocketing 264%, to $441 million. Gross margins of 45.7% were up 0.7 points from last quarter and 8.2 points from a year ago. For the third quarter, TI is expecting flat to higher revenue of $3.2 billion to $3.4 billion and higher net income.

Likewise, Motorola, the world's second-largest cell-phone maker, saw revenues jump 41% from a year ago, to $8.7 billion, well ahead of Wall Street's $8.44 billion expectations. The Schaumburg (Ill.) company had a $203 million loss, thanks to the spin-off of its semiconductor business. Without that, operating earnings were $845 million, up from $171 million a year ago. "We accomplished strong results despite an extremely competitive market," says CEO Edward J. Zander. "We had a really good quarter."

Finally, consider the curious case of Sun Microsystems. An optimist would say Sun's results, reported July 20, were a good first step toward restoring the Silicon Valley icon to health (see BW Cover Story, 7/26/04, "Sun: A CEO's Last Stand"). After 12 straight quarters of year-over-year declines, revenues grew 4.3%, to $3.11 billion -- well above Wall Street expectations of around $2.88 billion. The gain was aided, in part, by a 3% currency impact.

Nonetheless, that's good news for a company that has struggled so much in recent years. Sun execs are particularly excited about a 46% increase in the number of servers sold. "We are driving unit volume in a way that we weren't, quite honestly, post-bubble," CEO Scott McNealy said in a post-earnings report call with Wall Street analysts.

CREDIT IS DUE. A pessimist, however, would point to several problems. Excluding nearly $2 billion from its landmark legal settlement with Microsoft, Sun would have lost $169 million for the quarter -- about 20% more than Wall Street expected. Also, analysts worry that improved low-end sales are cannibalizing more profitable high-end systems. Gross margins for the quarter were 39.4%, down 4.3 points from a year ago.

So who's right? Give McNealy & Co. some credit. No doubt, Sun is well behind the torrid growth seen at companies like EMC and TI. But after three years of decreasing sales, Sun is finally pointed in the right direction. Execs say they can cut another $500 million from expenses in the current fiscal year, making that break-even point easier to meet. And they have their most coherent product strategy since the dot-com bubble days.

Sun's progress is a long way from the growth seen at other big tech companies. But it's a start. And tech investors can rest a little easier this week. The disappointments in software aren't spreading to other parts of the tech industry. With Andrew Park in Dallas and Robert D. Hof in San Mateo, Calif.

Kerstetter is a correspondent in BusinessWeek's Silicon Valley bureau

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