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Software: A Money Machine That's `Firing On All Fronts'

Software: A Money Machine That's `Firing On All Fronts'

What made William H. Gates III the richest individual in America? What made Netscape Communications Corp. the most sizzling initial public offering in a decade? What fills ordinary investors' heads with dreams of overnight wealth? Software, of course.

No technology investment rewards its winners as handsomely as software, because the profits from a hit product are far greater than from a chip or a computer. It may take millions of dollars to develop a program, but it costs relatively little to crank out millions of disks, producing 15%-to-40% operating margins--a rate of return that is "off the scale" compared with industrial companies, says Richard C. Edwards, an analyst with Robertson, Stephens & Co. So are the rewards for investors: Microsoft Corp. stock has appreciated an astounding 10,000% since it went public in 1986.

No surprise, software companies command high multiples. Even established players, Oracle Corp. as well as Microsoft, sell for more than 30 times earnings. And promising newcomers are often priced out of the ballpark. PeopleSoft trades at more than 50 times projected earnings. Tivoli Systems' price has soared 164%, to $36--a huge 83 times projected earnings--since the company went public on Mar. 31.

Rich valuations reflect both rapid growth--most software makers are racking up 20%-to-50% annual revenue growth--and a wave of mergers and acquisitions. IBM's $3.5 billion purchase of Lotus Development Corp. and Computer Associates' $1.8 billion purchase of Legent Corp. have speculators looking around for the next deal.

Short term, the biggest factor driving software is Microsoft's Windows 95. The new operating system should kick off a buying surge for a whole range of PC programs. But there's also a long-term trend: As computers become consumer appliances--and the on-ramps to the Info Highway--whole new categories of programs are being invented, from multimedia games and Web-surfing programs to software that helps companies conduct business electronically. "The software industry is firing on all fronts," says Ann Winblad, a partner and co-founder of Hummer Winblad Venture Partners.

TO THE NET. One of the hottest areas is the consumer market, where companies including Broderbund Software, Edmark, and The Learning Co. are seeing sales of their "edutainment" titles grow by 30% to 50%. The trick: finding makers of quality programs, but without the sky-high valuations that often go along with them.

Another bright spot is client-server software. These programs let companies "downsize" from mainframes to more flexible networks of PCs and server computers. Budgets for client-server systems are growing 70% a year, says Paul V. Cubbage, an analyst with Dataquest. That's buoying the stocks of companies such as PeopleSoft Inc. and Baan Co. Database software leaders Oracle and Informix Corp. are among the chief beneficiaries. Oracle's stock has risen 987% in five years, while Informix' has surged some 3,400%. Another hot segment: programs to manage the growing tangle of computers and networks, the market that propelled Tivoli to fame. The latest entrant: Novadigm Inc. A public offering this month put its value at some 15 times revenues.

Lush rewards come with major risks. Bruce D. Smith, an analyst with Morgan Stanley Asset Management Inc., says the steepest valuations are warranted if a software maker has dominant market share, or the chance to control key standards. Microsoft got to the top by defining the software standard for operating systems--first MS-DOS, now Windows. One reason Netscape took off on day ene is investor confidence that it will set the software standard for the growing Internet market.

Few companies will wind up setting such standards. But virtually every player in software is jumping onto the Internet. Like the personal computer in the 1980s, it could spawn a multibillion dollar market. There's demand for "browsers" to view material on the World Wide Web as well as for the behind-the-scenes programming needed to help businesses set up shop on the Net, keep track of billing, make transactions safe, and cultivate virtual communities online. That's where Netscape expects to strike it rich: its Internet server programs sell for thousands of dollars while it mostly gives its browser away.

There are hundreds of Net software hopefuls, and most are still tiny and privately held. But any one of them--Vermeer, Spider Technologies, Connect, or Open Market--could be the next hot IPO. For now, that leaves few sure bets. Well, maybe one or two. William Gurley, a tech analyst with CS First Boston Corp., recommends Federal Express Corp. After all, someone will have to deliver all the goods ordered by cyber-shoppers.