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Part 2: S&P's 2007 Tech Sector Outlook

A look at S&P analysts' expectations for key IT industries in the coming year—and their top picks within those groups

Here is the second of a two-part rundown of Standard & Poor's Equity Research information technology analysts' 2007 outlooks for selected tech subindustries and stocks, covering application software, systems software, home entertainment software, it consulting and data processing services, and Internet software and services. Part 1 featured outlooks on semiconductors, semiconductor equipment, computer hardware, electronic manufacturing services, and computer storage and peripherals (see, 12/21/06, "S&P's 2007 Tech Sector Outlook").

Application Software

Analyst: Zaineb Bokhari

Standard & Poor's expects corporate spending on enterprise software to continue to grow at a mid- to high-single-digit rate in 2007, comparable to growth seen in 2006. We expect corporate spending in areas such as business intelligence, customer relationship management, and enterprise resource planning to do well, as we expect IT budgets to remain healthy for these programs. At the high end, we think there is some pent-up demand for application software due to the recent consolidation of several major players by Oracle (ORCL) and the expected delivery of new products and upgrades by large vendors such as SAP (SAP) and Oracle, which will likely take place in the 2007-2008 period.

We expect large purchasers of software to continue to exercise great discipline in their buying decisions and maintain a keen focus on return on investment and total cost of ownership. In this buyers' market, we think software vendors face intense competition and ongoing pricing pressure.

As a result, many vendors who have traditionally catered to the high end are looking to the underserved small and medium-size business (SMB) market as an area of growth. SAP plans to introduce new products targeted at the SMB market in the first half of 2007 and is adding features to its on-demand offerings to capture some of the growth seen by newcomer (CRM; ranked 2 STARS, sell).

We have a strong buy recommendation on the ADRs of SAP partially because the company has been posting strong, largely organic growth in license revenues despite its massive size. We believe there are drivers currently in place for SAP to continue to grow at above-average rates. It has been making notable progress in the SMB market, in our view, and we like the company's largely organic product strategy, which has been less disruptive to customers than one driven by acquisitions.

By our analysis, this has promoted add-on sales of newer product introductions. We note that the recent weakening of the U.S. dollar relative to the euro is a concern to us, as it could affect reported growth rates.

Based on our optimistic outlook for future success of the company's current acquisition strategy, we have a strong buy recommendation on Oracle shares. While we think the company's acquisitive strategy comes with significant risks, we like Oracle because of its considerable technology assets, significant installed base, sizable maintenance revenue stream, high profitability, and attractive valuation relative to peers.

Systems Software

Analyst: Jim Yin

We forecast that PC growth in 2007 will be aided by the release of Microsoft's (MSFT) Windows Vista. Although most computers sold to consumers will have Vista as their operating system, we believe its adoption by businesses will be gradual and occur over several years as they evaluate and review compliance before upgrading from prior versions of Windows. As such, we view the launch of Vista as a positive, but not a major catalyst for increased IT spending.

We have a positive outlook on the systems software group as we enter 2007. One company that we like, and which is ranked strong buy, is Citrix Systems (CTXS). We expect Citrix to benefit from increased worker mobility, which requires remote connectivity from home and mobile devices. The company plans to release new products in the first half of 2007, which we expect to accelerate its revenue growth in the second half of the year. Citrix derives approximately 46% of its revenue from international operations and could benefit from the expected weakness in the U.S. dollar. We believe Citrix shares are undervalued following a recent price decline.

We have buy recommendations on two CAD/CAM companies: ANSYS (ANSS) and Autodesk (ADSK). ANSYS develops, markets, and supports software for design analysis and optimization. We expect its software license revenue to increase 43% in 2007, aided by the acquisition of Fluent. We see additional revenue growth coming from cross-selling opportunities as a result of the Fluent acquisition and a broader product portfolio.

Autodesk has seen strong demand for its 3D products, as sales increased 36% year-over-year for these products in the most recent quarter. We think its 3D products are in the early stages of a long-term growth cycle, with only 10% of its 2D installed base having been upgraded. We expect revenue growth of 15% in fiscal year 2008 (January) and operating margin expansion of 4% through better economies of scale.

Home Entertainment Software

Analyst: Clyde Montevirgen

The S&P Home Entertainment Software Index increased approximately 9% year-to-date through Dec. 8, vs. a gain of about 13% for the S&P 1500. Video game makers have been enduring highly variable sales and margins as the subindustry undergoes the transition to next-generation video game consoles, including Microsoft's Xbox 360, Sony's (SNE) PlayStation 3, and Nintendo's (NTDOY) Wii. However, share prices have rebounded dramatically from their midsummer lows in anticipation of improving fundamentals aided by expected growth in the installed bases for these consoles over the next few years.

We currently have a neutral outlook on home entertainment software companies. We believe near-term uncertainties will persist in the first half of 2007, as game makers decide how much to spend on developing and marketing games to support various platforms. We also think that as the profile of the video game player broadens and reflects that of the average consumer discretionary demographic, video game purchases will likely be more cyclical than in past cycles.

We expect sales and market-share growth to be driven primarily by releases of hit titles during the early stages of the console transition. But we see more robust growth in the second half of 2007, when installed bases for newer consoles should grow at more predictable rates and be large enough to entice developers to release titles more aggressively. We continue to favor companies with reasonable valuations and with a library of hit titles that appeal to a broad range of game players.

We have a buy recommendation on Activision (ATVI), hold opinions on Electronic Arts (ERTS) and THQ (THQI), and a strong sell on Take-Two Interactive (TTWO).

IT Consulting & Other Services; Data Processing & Outsourced Services

Analyst: Dylan Cathers

We expect the IT consulting and outsourcing subindustry to continue to benefit in 2007, as companies look for ways to reduce the costs of running their businesses. Companies in nearly all industries have continued to shift the burden of noncore tasks, such as finance, human resources, and customer service to third parties. The most notable trend in the industry has been the move to outsource these tasks overseas to areas with low-cost, high-quality workers.

No country has benefited from this trend as much as India. Indian IT outsourcers have routinely posted revenue growth in the 30% range, while their U.S. counterparts have typically seen revenue growth at 10% or less during the past couple of years. To try to compete with the Indian outsourcers, U.S. companies, such as IBM (IBM), Electronic Data Systems (EDS), and Accenture (ACN; ranked 3 STARS, hold), have opened facilities on the subcontinent to try to take advantage of the labor arbitrage opportunities. The problem has become, however, that as demand for these skilled workers has grown, the supply of workers has begun to dwindle and wages have been on the rise.

One strong buy-ranked stock in the group is Automatic Data Processing (ADP). We believe the company will be better positioned to grow its mainstay employer services business now that is has sold its claims services business and announced plans to spin off it brokerage services unit. Further, the company's balance sheet remains strong, in our view, with $2.9 billion in cash and marketable securities and nearly no debt.

Other picks include Electronic Data Systems and SRA International (SRX). We believe EDS is in the midst of a recovery, after being battered by unprofitable contracts and rising costs. The company has spent over a year restructuring, lowering its cost structure, and it has been active in increasing its use of less-expensive overseas labor, particularly in India.

SRA International specializes in providing services for the U.S. federal government, with a focus on the defense community. We believe that the company stands to benefit as the government ratchets up spending for defense and Homeland Security in the face of budget constraints.

Internet Software & Services

Analyst: Scott Kessler

It was a challenging year for many Internet companies and stocks in 2006. Year-to-date through Dec. 8, Internet software and services was the worst performing subindustry in the technology sector, and Internet retail was the second-worst performing subindustry in the consumer discretionary sector. We believe this underperformance reflects notable competition among Internet bellwethers, traditional companies, and startups. However, we expect 2007 to be better, in part due to intact fundamentals, strong balance sheets, and more reasonable valuations.

EBay (EBAY) is our only strong buy-ranked stock in Internet software and services. We believe its brands and businesses (including PayPal and Skype) have notable growth potential, especially outside the U.S. We also believe advertising could provide upside to 2007 forecasts.

In Internet retail, we have a buy opinion on (PCLN). We recently upgraded the shares to reflect what we see as compelling international opportunities and an attractive relative valuation.

We have a strong sell opinion on VeriSign (VRSN), due largely to our concerns about organic growth, potential troubles in communications services, aggressive and perhaps excessive mergers-and-acquisitions activity over the past few years, corporate governance issues including options backdating, and a valuation we consider excessive (VeriSign's p-e and p-e-to-growth notably exceed those of the S&P 500 Technology sector).

In addition, we recently downgraded CNET Networks (CNET) to sell, from hold, owing in part to unfavorable traffic trends, substantial management turnover in 2006, balance sheet challenges, and well-above-peers p-e and p-e-to-growth-rate ratios.

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