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Software Stocks Shine and Soar

By Jonathan Rudy Software stocks have been strong performers lately, with the S&P Systems Software index climbing 14.1% in the last 13 weeks, vs. a 6.3% rise in the S&P 500-stock index. And on a year-to-date basis (through Nov. 30), the group has gained 7.1%, beating the 5.6% rise for the S&P 500.

Back on Nov. 8, we upgraded our outlook for the S&P Systems Software subindustry to positive from neutral. Our improved outlook was driven primarily by our 5-STARS, or strong buy, recommended stocks. Microsoft (MSFT

; recent price: $27), McAfee (MFE

; $29), and Veritas Software (VRTS

; $23). We have a number of 4-STARS, or buy, recommendations in this subindustry as well, including Symantec (SYMC

; $33), Check Point Software (CHKP

; $24), Sybase (SY

; $18), and Oracle (ORCL

; $13).

LEADERS OF THE PACK. A potential near-term catalyst that we see for system-software shares is the Dec. 2 distribution of Microsoft's $32 billion special dividend, in addition to the company's regular quarterly dividend of approximately $1 billion. We believe that while investors will likely reinvest most of the proceeds in Microsoft, a number of other software stocks could benefit as well.

Another potentially positive push for the systems-software group is Oracle reporting its fiscal second-quarter results on Dec. 16. We anticipate earnings per share of 14 cents, vs. 12 cents a year ago, an increase of approximately 17%. We see Oracle's revenues increasing about 8% year over year, driven primarily by continued strong results in its core database business.

However, we expect Oracle's application business to remain weak, highlighting what we see as the need for the company to acquire PeopleSoft (PSFT

; ranked 3 STARS, or hold; $23). While we were disappointed by PeopleSoft's latest rejection of Oracle's $24-per-share cash offer, despite the tender of approximately 61% PeopeSoft shares to Oracle, we believe that consolidation will happen in the software industry. In our view, it's just a matter of when, not if.

DIVIDEND SURPRISE. Microsoft remains one of our top picks in the systems-software group. The shares, trading at 21 times our calendar 2005 EPS estimate of $1.31, are at a discount to peers and have a compelling valuation, in our view. As we mentioned earlier, Microsoft paid out its $32 billion special dividend on Dec. 2, in addition to its approximate $1 billion regular quarterly dividend. It's also in the middle of a $30 billion stock buyback over the next four years.

With monthly free-cash flow of more than $1 billion, we believe Microsoft will continue to return value to shareholders over the long term. Based on our discounted cash-flow analysis, following the special dividend, we would buy Microsoft shares at a discount to our 12-month target price of $33.

Another of our top picks is McAfee. Formerly named Network Associates, the company was renamed McAfee to reflect its core McAfee Internet Security business following the sale of some noncore operations such as the Sniffer Technologies systems-management business and the Magic Customer Support and Helpdesk business. We believe that these strategic moves will help improve its profitability and growth rate over the long term.

SPENDING REBOUND. Our third top software pick is Veritas Software. We believe this leader in backup and recovery software continues to gain market share and will benefit from continued interest in backup and disaster-recovery software.

Veritas also has a strong balance sheet, in our view, with about $1.6 billion in net cash and investments, or approximately $3.74 per share. With Veritas shares trading at 24 times our 2005 EPS estimate of $1.02, and at a p-e-to-growth rate of 1.3 -- a discount to peers -- we believe that the shares of this market leader are attractively valued.

Overall, we expect IT spending on software to rebound in 2004 and 2005 from the depressed levels of the early 2000s with low to mid-single digit growth. And though many software stocks have already had a nice run recently, we believe investors may be rewarded by buying our favorite stocks given their solid business outlooks, possible consolidation, strong balance sheets, and attractive valuations.

Note: Jonathan Rudy has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at Analyst Rudy follows software stocks for Standard & Poor's Equity Research

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