Software Stocks That Still Shine

S&P analyst Jonathan Rudy says to look to security and game companies. He especially likes Symantec and Electronic Arts

Software stocks, like those of many other companies in the world of technology, await a revival in corporate capital spending for their own revival. But two areas of software -- Internet security and video games -- are ripe for investment now, according to Jonathan Rudy, Standard & Poor's industry analyst covering software and commercial-services stocks.

Rudy gives strong buy rankings to one company in each of those niches: Symantec in security and Electronic Arts in game software. Just one level lower down, with accumulate ratings, are companies such as giant Microsoft, which Rudy sees as still a growth stock -- although he expects its growth to be in the low double-digits instead of the 20% or more of the past. Still, that is "impressive compared to the rest of its peer group," Rudy adds.

Other stocks in his coverage area drawing accumulate recommendations are Check Point Software, Oracle, PayChex, and THQ. However, Rudy notes that S&P suggests investors underweight technology in general as a portion of their portfolios and adds that "stock selection is critical in this type of environment."

These were some of the points Rudy made in an investing chat presented Oct. 8 by BusinessWeek Online and Standard & Poor's on America Online. He was responding to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Jon, the market alternately scared and pleased us today, but it wound up ahead -- what do you at S&P see as the near-term outlook for the broad market?


I can't speak for the broader sector, far as technology, we're still underweight. And as such, stock selection is critical in this type of environment.

Q: How have the stocks you cover -- software and commercial services -- borne up under the selling pressure?


It has been tough. My software group -- my coverage universe -- is down 58% year to date. And the payroll processors I cover under commercial services are down 36% year to date. So it has been very challenging.

Q: Let's go to a giant in your turf -- is Microsoft (MSFT ) still a growth stock?


Yes, it is. However, the days of 20% growth are over. Most likely, Microsoft will grow in the low double digits. But despite this challenging economic environment, it's still growing approximately 10%-plus, which is impressive compared to the rest of its peer group.

Q: Is Siebel Systems (SEBL ) a buy?


We have a hold recommendation on SEBL, which has gotten hammered lately after announcing a very disappointing second quarter. We expect the environment to continue to be difficult for Siebel. However, with the shares trading at $5.65, with over $4 per share in cash, we would still hold Siebel at this time.

Q: To follow up on Siebel's second-quarter disappointment, do you have any hopes for revived earnings in your coverage area? Or does corporate capital spending have to revive first?


For the enterprise-software providers, they're absolutely dependent upon corporate info-tech spending at least stabilizing, which we have not seen in this environment. Therefore, estimates continue to come down for companies like Siebel, PeopleSoft (PSFT ), Veritas (VRTS ), and Oracle (ORCL ). However, other areas such as Internet security and video-game software do not necessarily need corporate IT spending to rebound.

Q: I'm interested in your opinion on Check Point Software (CHKP ) and Citrix Systems (CTSX ).


I don't cover Citrix. However, we have a 3-STAR, or hold, recommendation on the shares. However, I do cover Check Point and have a 4-STAR, or accumulate, recommendation on the shares. Check Point has nearly $5 per share in cash, with no debt, and is extremely profitable, with net margins around 60%. We continue to like Check Point and believe that this leader in the firewall and VPN [virtual private networks] markets will continue to take share.

Q: You mentioned this one -- where do you see PeopleSoft (PSFT ) going? Fairly priced now?


We have a hold recommendation on the shares, primarily due to its strong balance sheet, with over $5 per share in cash and relatively little debt. However, near-term there will likely be pressure on the shares, as estimates will likely continue to get cut due to the challenging global economy.

Q: You referred to Oracle just a minute ago, and several people are asking what you think of ORCL now.


I have a 4-STAR, or accumulate, recommendation on the shares. It's another software company that has a very strong balance sheet, with over $6 billion in cash and practically no debt. It's also extremely profitable, with 30% operating margins and a return on equity of over 30%. Its database business is very solid. However, our primary concerns with the company are its weak applications business and continuing concerns over Larry Ellison's management style. But despite that, we believe the shares are still attractive.

Q: SAP (SAP ) has really been hit! Are things worse than usual for that company?


I don't cover SAP analytically. However, from a competitive perspective, it has been an extremely difficult environment for the enterprise-software companies. And the latest shoe to drop has been in Europe, which affects SAP significantly more than companies like Siebel and PeopleSoft.

Q: Do you think Sapient (SAPE ) can make it back up to $10?


I don't cover Sapient. However, it was recently dropped from our coverage universe due to low price levels. I would have to say the odds are against Sapient ever getting back to $10. Once a stock hits the $1 level, not many companies make it back.

Q: What about ITWO (i2 Technologies)?


I did cover i2 Technologies and recently had to drop them from coverage due to shares trading below $1. We had carried an avoid recommendation at the time.

Q: Understandably, you have a lot of stocks ranked hold, and you've mentioned one or two accumulates. Are there any buys in your coverage now?


Sure. Our two top-rated stocks are Symantec (SYMC ) and Electronic Arts (ERTS ). Symantec is a leader in Internet-security software and continues to do very well in its consumer antivirus business, as it makes progress in the enterprise-security market. It trades at a reasonable valuation with a p-e-to-growth rate of around 1.1 times, which is very reasonable in the software universe.

Electronic Arts (ERTS ) is the leader in video-game software and has the strongest and most diverse brands of any company in that field. We continue to like both of these companies very much and have price targets in the upper 30s for Symantec and mid-70s for Electronic Arts.

Q: What about ISSX (Internet Security Systems)?


I recently initiated coverage on ISSX with a hold recommendation. They are the leader in intrusion-detection software. However, our primary concern at this point is valuation and their dependence on the enterprise market.

Q: Why the hold recommendation? Isn't security software at its highest demand now?


It depends on the type of security software, such as antivirus, intrusion detection, or firewall security. Our primary concern with ISSX is its valuation.

Q: What about the prospects for PMTC (Parametric Technology)?


I have a hold recommendation on Parametric with the shares trading near cash with no debt. We would still hold Parametric. However, near-term prospects remain challenging.

Q: What is your take on RATL (Rational Software)?


We have an avoid recommendation on the shares. Despite trading below cash levels, this is another software company that has a higher debt-to-equity ratio than its peer group. Also, there are management concerns, which would lead us to avoid the shares at this time.

Q: What about BEAS (BEA Systems)?


I have a hold recommendation on the shares. BEA remains a leader in the application-server space. However, IBM (IBM ) has proven to be a formidable competitor for BEA, and we would hold shares at this time.

Q: How about VRTS (Veritas)? It seems to have been beaten down unnecessarily.


I have a hold recommendation on the shares, primarily due to their premium valuation, but also due to their vulnerability to estimate cuts in this environment. We think Veritas has a very bright future and a very strong balance sheet, with nearly $4 a share in cash and almost no debt. However, with recent management turmoil, such as the CFO leaving under difficult circumstances, we would not add to positions at this time.

Q: Can you refresh us on the stocks you give 4-STARS to? Accumulates?


Sure. Check Point Software (CHKP ), Oracle (ORCL ), Microsoft (MSFT ), THQ (THQI ), and PayChex (PAYX ). Basically, the common theme with these companies is strong balance sheets, strong cash flow from operations, solid profitability, and market leadership -- all of which are important characteristics in this difficult environment.

Q: What about ADSK (AutoDesk)?


I have a hold recommendation on the shares. Despite their reasonable valuation, I have been disappointed with recent management execution and would not add to positions at these levels.

Q: How do you and S&P select software companies for coverage? Do sales and market caps, for example, play a role?


Absolutely. Those are two of the criteria. Additional criteria include whether or not it's an index company, stock-price levels (i.e., over $5 a share), and a float balance.

Q: Judging from all the questions here today, there's still a lot of interest (online anyway) about tech stocks and, in this case, software. Do you think it's justified, Jon?


Absolutely. In regard to software, it's important to focus on the leading companies with strong balance sheets, cash flow, and earnings. Companies that have those qualities should survive and emerge from this downturn stronger than ever. For example, Microsoft is increasing its R&D budget by approximately 20% this fiscal year, to over $5.2 billion, which is larger than the revenues of the majority of the software companies in my universe. It can continue to innovate while others have to retrench, which will be a distinct competitive advantage going forward.

Q: The question is, what you should buy now? And what should existing investors hang on to?


Just to reiterate, I have 4-STAR or accumulate ratings on Check Point Software, Oracle, Microsoft, THQ, and PayChex. And I have strong buys on Symantec and Electronic Arts.

Edited by Jack Dierdorff

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