Time to Reload Software?

S&P is neutral on the overall sector, but analyst Jonathan Rudy does have some picks, including Microsoft and Sybase

Investors keen on software stocks should proced with caution, says S&P's Jonathan Rudy, the industry analyst covering that sector. S&P is still neutral on the area as a whole, Rudy reports, but he looks for a second-half recovery on the basis of recent price action.

The stocks to pick in software, according to Rudy, are those that have maintained profitability despite the tough environment for spending on information technology, and which are market leaders with strong balance sheets. Not surprisingly, one of his buys is giant Microsoft (MSFT ). The only other buy at the moment is Sybase (SY ). However, Rudy has accumulate recommendations on CheckPoint Software (CHKP ), Symantec (SYMC ), Oracle (ORCL ), and Electronic Arts (ERTS ).

One area of software to keep an eye on is Web services, notes Rudy, who also points out that data storage and security are also significant specialties with continuing potential.

These were among the points Rudy made in an investing chat presented May 27 by BusinessWeek Online and Standard & Poor's on America Online, in the course of replying to questions from the audience and BW Online's Jack Dierdorff. Edited excerpts from this chat follow. A complete transcript is available on AOL at keyword: BW Talk.

Q: Jon, investors came back from the long weekend and did quite well. Will the broad market do better as the year progresses?

A:

I can't really discuss the broader market in general, but the recent runup in software stocks appears to be pricing in a recovery in the second half of this year.

Q: When will Microsoft (MSFT ) start moving up? Good to buy now?

A:

The first question is difficult to answer. We do have a buy recommendation on the shares. We feel that, at these levels, it's an attractive entry point. Recent news has been discussing Steve Ballmer's recent sales of Microsoft shares. However, since he hasn't sold any shares in about 12 years...we would not be too concerned with these recent sales. And with Microsoft's strong cash flow and balance sheet, we believe this is an attractive opportunity going forward to get into a great company at a reasonable price.

Q: Red Hat (RHAT )?

A:

I don't cover Red Hat, and it's not in S&P's coverage universe. However, as Linux goes, Red Hat should benefit or decline, depending on how that operating system continues to do. One point of concern that we would have is that it could be very difficult to make any long-term sustainable profits from what essentially is a free product.

Q: Oracle (ORCL )?

A:

We have a 4-STAR [in S&P's Stock Appreciation Ranking System, or STARS] or accumulate recommendation on Oracle, due primarily to its strong balance sheet, with about $6 billion in cash and no debt and its strong profitability, and we believe that the shares are attractive around these levels.

Q: Isn't there a lot of deflationary pressure in software?

A:

It really depends on the product area. For example, some pricing pressure for enterprise software has come from Linux. However, some markets, like antivirus software for Internet security, have been able to increase pricing. So it's very difficult to say that software across the board has been coming under pricing pressure. The most recent area of pricing concern has been in the enterprise application integration (EAI) space.

Q: What does the future hold for RSA Security (RSAS )?

A:

We have an avoid recommendation on the shares. However, the company has executed better than we expected so far this year. But at these levels, the shares are trading at a premium valuation to their peer group. We can't justify the valuation at these levels and would still avoid RSA.

Q: Is Siebel Systems (SEBL ) going to recover in the next year?

A:

We have a hold recommendation on the shares. This is due primarily to their attractive valuation compared to peers and their strong balance sheet, with over $2.2 billion in cash and low debt levels. However, we don't see any near-term catalyst to get the company growing again. Thus we believe that the shares will likely trade around these levels for some time.

Q: What about Check Point Software (CHKP )?

A:

We have an accumulate recommendation on Check Point, which is the industry leader in firewall and virtual private network software. It's extremely profitable, with about 60% operating margins, and has a strong balance sheet, with nearly $1.4 billion in cash and securities and no debt. We believe the shares are attractive at these levels.

Q: Jonathan, you mentioned Microsoft as a buy. Do you have others at the moment?

A:

Yes. The only other buy recommendation at the moment is Sybase (SY ), due primarily to its attractive valuation, strong balance sheet, and solid management team. We believe it's very cheap around these levels.

Q: So how about S&P accumulate ratings in software?

A:

Sure. Check Point, Oracle (ORCL ), Symantec (SYMC ), and Electronic Arts (ERTS ) are our only 4-STAR recommendations in my universe.

Q: What makes your buy and accumulate choices stand out?

A:

We try to focus on companies that maintained solid profitability levels despite this challenging IT spending environment and that have market-leading positions and strong balance sheets -- companies that generate strong cash flow. Additionally, we're trying to focus on reasonable valuations despite this recent run in technology.

Q: Thoughts on PeopleSoft (PSFT )?

A:

We have an avoid recommendation on PeopleSoft. While the company has maintained reasonable profitability and has a solid balance sheet, we're primarily concerned over the company's recent double-digit license-revenue declines. We believe the company is becoming more of a service-related technology company, with services dominating the revenue mix, and thus believe that the company deserves a discounted valuation to its peer group.

Q: What do you think of Indian software IT companies like Wipro (WIT ) and Infosys (INFY )?

A:

I don't cover any of the Indian software companies. However, more and more of the companies in my universe are looking to outsource operations in India due to the cost benefits. These Indian-based companies have been very effective at competing on price, primarily in IT services, and thus have put pressure on their U.S.-based competitors.

Q: What about Veritas Software (VRTS )?

A:

We have a hold recommendation on the shares, due primarily to valuation concerns. However, it's a solid company that's in a sector (i.e., the storage sector) that has held up relatively well, but we just can't justify buying shares at these levels.

Q: You mentioned the storage sector -- anything look good to you there?

A:

Well we recently upgraded Legato Systems (LGTO ), due primarily to better-than-expected execution. We recently upgraded Legato to a hold from an avoid. However, at this point, we have no buy recommendations in the storage-software sector, which in our universe is Legato and Veritas.

Q: Any new trends in software we should be alert to?

A:

New trends? Web services continue to be the key focus of most of the software leaders, which entails integration and interoperability. However, at this point, it's still a pretty broad concept, and it means a lot of different things to different companies. The main concept is to have all of these software applications able to work together. As far as other trends, Internet security and storage and data-backup sectors have remained strong. That's all I really see in software at this point -- as far as clear trends go.

Q: Do you see any serious threat to Microsoft's dominance in the industry you cover?

A:

Linux is a concern, and it has been growing rapidly off a small base. However, we believe at this moment that it's applicable mostly for certain specific deployments and that it's not a broad-based threat to Microsoft. But it's worth keeping an eye on that marketplace.

Microsoft's primary argument against Linux, other than being in opposition to the whole open-source movement, has been that when you look at the life of a project deployment on Linux vs. Windows, the lower total cost of ownership is on the Microsoft platform. This is due primarily to services and support costs over the life of the deployment.

Q: What are your parameters for covering a software stock?

A:

Primarily, we focus on whether it's in an index or not, but it also has to meet certain liquidity criteria if the company is not in an index. Additionally, stocks below $5 are usually not in our coverage universe, primarily because stocks below $5 tend not to be in an index or are typically removed from an index due to what's called lack of representation.

Q: Autodesk (ADSK )?

A:

We have a hold recommendation on Autodesk. And while we believe that the upgrade cycle for autoCad should benefit the company, we do have some concerns over the company's recent execution and thus would hold positions at this time.

Q: Jon, what's S&P's current recommendation on how much weight your sector should be given in a portfolio?

A:

We're currently neutral on applications and systems software. So we believe that stock selection is more important right now than overweighting the sector.

Q: And especially for the later arrivals, can you remind us of the S&P buys and accumulates among software stocks?

A:

Sure. We have buy recommendations on Sybase (SY ) and Microsoft (MSFT ). We have accumulate recommendations on Check Point Software (CHKP ), Symantec (SYMC ), Oracle (ORCL ), and Electronic Arts (ERTS ). We have avoid recommendations or 2-STARS on PeopleSoft (PSFT ), RSA Security (RSAS ), and THQ (THQI ). We have a sell recommendation on BMC Software (BMC ).

Edited by Jack Dierdorff

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