Stocks of Internet security and storage companies are the two areas drawing the most attention in the software sector since the events of September 11. So says Jonathan Rudy, Standard & Poor's analyst covering stocks of software and commercial-services companies.
Rudy makes the point that any rallies in other software stocks are based more on expectations of a mid-2002 recovery than on any turn in the fundamentals. Corporate budgets for information technology are still down. But he does see some stimulus coming from the release of Microsoft's XP, and that prospect, coupled with the settlement of the Justice Dept. antitrust case against the software giant, justifies S&P's accumulate ranking on Microsoft stock.
Rudy currently lists only one stock, Symantec, as a buy, because of its strength in Net security. In the same subsector, he rates Check Point Software as an "accumulate," and in storage he likes Veritas Software -- which gets only a hold because of valuation concerns.
These were among the highlights of a chat on Nov. 6, presented by BusinessWeek Online and Standard & Poor's on America Online. What follows are edited excerpts from the exchange between Rudy, the audience, and the moderator, BW Online's Jack Dierdorff. A full transcript is available on AOL at keyword: BW Talk.
Q: Jonathan, before we get into software, what do you think of the market outlook now? It sure seemed to like Greenspan's latest rate cut.
A:Yeah. I really can't speak for the broader market as a whole, but software as a group responded really well to today's 50-basis-point cut.
Q: That brings up another question -- what was the impact of September 11 on the software group?
A:It really depends. Two subsectors of software that really stand to benefit are Internet security companies and storage companies. We feel that these two groups as a whole stand to benefit more than other software subsectors as a result of September 11.
Q: What security and storage stocks in particular?
A:Two of our higher-rated stocks include Symantec (SYMC ) and Check Point Software (CHKP ). Those are two Internet security names that stand to benefit and have reasonable multiples and good management. Symantec is rated 5-STARS [buy in S&P's Stock Appreciation Ranking System], and Check Point is rated 4-STARS [accumulate]. In storage software, the most likely beneficiary is Veritas Software (VRTS ). However, due to valuation concerns, we have a hold recommendation on the stock.
Q: You have Symantec as a buy now, Jonathan -- any others in your area with 5-STARS?
A:That's the only one. There are concerns over information-technology budgets going forward, and the recent runup on shares has already discounted a recovery in the second half of 2002.
Q: What about accumulate ratings? You've given us at least one -- any others from you?
A:I already mentioned Check Point Software. Other 4-STARS, or accumulate, stocks in my universe, which were recently upgraded, are EDS and Microsoft (MSFT ). The Microsoft upgrade was primarily due to very favorable terms reached in the settlement with the Justice Dept., which positions Microsoft to fully benefit from the Windows XP product cycle. Our only reservation there is the states' objection to the settlement at this point. EDS continues to post solid results, as outsourcing has remained a priority, especially after the September 11 attacks. Our target for EDS is in the mid-70s.
Q: Any comments on SEBL (Siebel Systems)?
A:We have a hold recommendation on Siebel. It's certainly the leader in CRM [customer-relationship management] software. However, due to excessive valuation at this point and deteriorating fundamentals on their earnings basis, we have a hold recommendation on the shares.
Q: Jonathan, how strong a correlation is there between software sales and the state of consumer spending and the PC market?
A:It's difficult to make a broad-brush comment. Specifically, where we believe that Windows XP will benefit on the consumer side is from upgrades of the installed base of Windows 95 and 98 users, as opposed to XP spurring PC demand, which requires, obviously, PC purchases. We just feel that the upgrade will have a significantly larger impact because of price points for discretionary spending.
Q: But right now both corporate and consumer spending are down, of course. Do you have any timetable for an upturn?
A:It appears that once the monetary and fiscal stimulus have their intended effects, you're probably looking at a rebound in mid-2002, excluding telecom-equipment spending.
Q: I am holding 1,000 ITWO (i2 Technologies) shares at prices 10 times the current level. What do you consider their current upside level?
A:We have an avoid recommendation on the shares, and we don't see i2 returning to 2000 levels anytime in the near future.
Q: Thoughts on BEA Systems (BEAS )?
A:I really think that BEA is a great company. However, the company just preannounced last week, and we were forced to bring down our estimates significantly. With the shares trading at approximately 40 times our fiscal-year 2003 estimate, we wouldn't add to positions here. However, long-term, BEA is a winner in the application-server market.
Q: So for the most part, this is a time to wait before putting your money into software stocks?
A:Here and there -- I wouldn't say that generally. However, the recent increase in share prices has been based more on hopes of a 2002 recovery than on any turn in the fundamentals. We would just recommend being careful with trying to pick a bottom.
Q: What do you see as the next big thing in software? XP applications, or other things?
A:Yes, XP will have more of a gradual impact than anything else. However, opportunities in the application server market and Internet-security software have bright futures. I've mentioned BEA, Symantec, and Check Point in these areas. An additional company that will benefit from the hardware console upgrade cycle is Electronic Arts (ERTS ), which designs games for X-Box, PlayStation 2, and Game Cube. Electronic Arts will significantly benefit from these upgrades.
Q: SFNT (SafeNet) seems so undervalued as an Internet-security company. Your thoughts?
A:Sure. I don't cover them -- however, they are involved in VPN [virtual private network] technology, and in that space we like Check Point.
Q: Here's another Net-security name -- ENTU (Entrust). SFNT was down while ENTU was up 40%. I don't get it.
A:I don't cover Entrust. However, I believe...that there was speculation over Entrust receiving some government contracts. However, we would be cautious about chasing any stocks on potential rumors.
Q: Are there any avoids or outright sells in the stocks you cover?
A:Yes, I2 is an avoid, and we have a sell recommendation on J.D. Edwards (JDEC ), primarily due to poor management execution and continued expected difficulties in the supply-chain software market.
Q: Despite the sell-off in many stocks, are valuations of your stocks still unreasonably high?
A:Yes. A number of software stocks have had a strong October and early November, and valuation remains a concern at these levels.
Q: What's up with RHAT (Red Hat)? They seem to be doing everything right and making money.
A:I don't cover Red Hat. However, Linux as an operating system appears to be holding its own vs. Windows. I can't comment on the specifics of the company, though.
Q: Will anyone ever seriously challenge MSFT on operating systems, even Linux?
A:That's a great question. At this point in time, the best guess is -- unlikely. However, you can never say never.
Q: What does S&P think of Oracle (ORCL )?
A:We have an accumulate recommendation on Oracle, as the company remains the leader in database software and continues to make progress in their e-business applications software. We believe that at these levels Oracle is attractive.
Q: How does the future of e-business look to you at this point in the economy?
A:E-business still has a bright future. However, growth prospects have been significantly reduced from initial expectations. We believe that companies will continue to do business over the Internet -- and probably more so since the events of September 11.
Q: Why did BMC (BMC Software) do well today in spite of a bad earnings report?
A:Day-to-day fluctuations in the market are difficult to forecast. However, BMC likely benefited from the overall enthusiasm in the market. However, we were disappointed as well with their earnings release and would not add to positions here.
Q: Do you have any favorites among your holds, or all they all created equal, so to speak?
A:They're pretty much all created equal -- a hold's a hold! There are varying reasons why there's the hold recommendation, but typically there are equal arguments to the upside and downside.
Q: O.K., as time runs out, summarize what you'd buy or accumulate now.
A:Sure. Our buy recommendation in software is Symantec, because of their positioning in the enterprise-security market, reasonable valuation, and solid management. Accumulates include Check Point, Electronic Arts, Oracle, EDS, Microsoft, Autodesk (ADSK ), Paychex (PAYX ), and ADP (Automatic Data Processing). Paychex and ADP, which we haven't mentioned yet, are the leading payroll processors -- they are consistently profitable and have very sound management teams. We feel that both companies are attractive at these levels.
Q: Let's sneak in one final question, a name that hasn't come up yet -- PSFT (PeopleSoft)?
A:PeopleSoft has done extremely well this year. They've executed during some very difficult conditions. We've been very impressed with PeopleSoft. However, we would wait for any sell-off to get a better entry point. Thus, we have a hold recommendation on the shares.