A Cloudy Season for Software
By Jonathan Rudy, CFA
The weather is getting warmer, and flowers are blooming on Wall Street. But springtime also brings the first-quarter earnings preannouncements -- and this season is turning out to be pretty gloomy for software providers.
The bad news really began for the software sector with Oracle's (ORCL ) earnings disappointment in mid-March. However, Oracle has had a number of operating challenges lately, such as increasing competition in its core database business from IBM (IBM ) and Microsoft (MSFT ), as well as the departures of key executives, leading the investment community to believe that this was purely a company-specific event.
Preannouncements generally start near the end of a quarter, as companies close their books and hope to find that they have beaten, or at least met, Wall Street's estimates. As of the morning of Apr. 1, with the closing of the first quarter of 2002, everything appeared to be fine in the software world. Only a handful of companies had lowered previous guidance by that point, and some thought the worst was finally behind the sector.
All of the positive feelings toward the software sector vanished with PeopleSoft's (PSFT ) announcement after the market close on Apr. 1 that its license revenue would be nearly 20% less than previously predicted, though it would still hit the Street's earnings estimates.
What made this news so shocking for the investment world is that PeopleSoft (ranked 3 STARS, or hold, by S&P) had been one of the few standouts in 2001, achieving its original guidance during a very difficult year for the rest of the technology world. Making matters worse, Check Point Software (CHKP ) preannounced disappointing results on Apr. 4, citing delays in purchases of its security software.
The recent bad news has led many market watchers to believe that the recovery in technology, even in software, may be much further off than previously thought. While S&P shares concerns over the sluggishness of the recovery in the sector, we do believe that certain long-term positive trends remain through companies' leveraging of existing hardware infrastructure. And we think particular areas of software should do better than others.
Since PeopleSoft is an enterprise-software company, most of its sales to corporations have high average selling prices and usually occur at the latter part of the quarter, which creates a "back-end-loaded" phenomenon. The nature of back-end-loaded quarters leads to a great deal of uncertainty for these companies while the economy is trying to recover, especially as corporations hesitate to spend on technology until their profitability outlook improves.
However, while there are particular risks in any area of software, S&P believes investors should try to diversify within the sector as much as possible. While the news from PeopleSoft and Oracle raises concerns over the near-term levels of spending for the enterprise-software segment, we continue to recommend Siebel Systems (SEBL ). Acknowledging the sector-specific risks with any enterprise-software provider, S&P believes that over the long-term, this financially strong, customer-relationship management (CRM) leader will continue to outperform its peers.
Other software sectors that should outperform over the long run despite this difficult environment are particular areas of Internet security and entertainment software. Security software makers should benefit over the next few years as corporations allocate a larger percentage of their information-technology budgets to this area, while entertainment software makers are bolstered by the continued strength in consumer spending.
STICK WITH LEADERS.
S&P's favorite name in the security software category is Symantec (SYMC ), a market leader that has strong profitability and a solid balance sheet (see BW Online, 3/27/02, "Symantec Finds Strength in Security"). The company provides security solutions to both the corporate and consumer markets, and its exposure to the consumer sector should help offset the challenges in the corporate market that most technology companies are experiencing.
And despite Check Point's disappointing news, S&P kept its 4 STARS (accumulate) recommendation on the belief that spending on security will be strong. Also, Check Point has approximately $4 per share in cash and investments and no debt. With operating and net margins over 60%, S&P thinks this market leader remains attractive at 17 times a lowered 2002 estimate of $1.18, with 20% long-term growth rate.
In entertainment software, our favorite is Electronic Arts (ERTS ), the leader in this area, boasting a broad library of strong brand names. S&P still thinks the stock (rated 5 STARS, or buy, by S&P) is attractively valued and should continue to outperform the market over the next year. (For more information on Siebel Systems, Symantec, and Electronic Arts, see BW Online, 2/15/02, "Stay Selective in Software".)
Analyst Rudy follows software stocks for Standard & Poor's