Software: Look Hard Before Leaping

S&P's Jonathan Rudy says he's neutral on the sector. But it has a few standout stocks, and he advises investors to pick carefully

Selectivity is the key to investments in software stocks right now, says Jonathan Rudy, who's the sector's analyst for Standard & Poor's. S&P is neutral on the software group as a whole, he reports.

But Rudy adds that S&P has buys on Microsoft (MSFT ), McAfee (MFE ), and Veritas Software (VRTS ). In the case of Microsoft, he notes, "it has been frustrating," with the stock stuck in a trading range even though it seems to be doing everything right in corporate governance and returning value to shareholders. McAfee's virtue is its position in Internet security, he says, and Veritas has strength in data storage, backup, and recovery.

Video games are another attractive area, says Rudy. He favors Activision (ATVI ) and Electronic Arts (ERTS ). On the controversial attempt by Oracle (ORCL ) to take over PeopleSoft (PSFT ), he thinks Ellison & Co.'s current bid is unlikely to be accepted -- but he doesn't dismiss the possibility that a deal might eventually be made.

These were some of the points Rudy made in an investing chat presented Nov. 2 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Karyn McCormack of BW Online. Following are edited excerpts from this chat. A full transcript is available on AOL at keyword: BW Talk.

Note: Jonathan Rudy is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies go to and click on "Investment Research," and then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: Before we get to your specialty, what's S&P's current view of the equity market?


I can't speak for the broader market, but we're neutral on application and systems software at this point. We feel that stock selection will be very important, going forward, in these areas.

Q: Why hasn't the market for Microsoft gone up with the forthcoming dividend? The price is low.


It has been frustrating. We have a buy recommendation on Microsoft, and the company is doing everything right, in our opinion, in terms of corporate governance and returning value to shareholders. However the stock has been stuck in a trading range for the better part of two years now. We believe that eventually Microsoft's fundamentals will be reflected in the stock, and shareholders should be rewarded. Our 12-month target price is $35 a share.

Q: Do you have any other 5-STARS (buy) ranked stocks?


Yes, I do. I have three overall: Microsoft, McAfee, and Veritas Software. McAfee has benefited from streamlining its operations to focus on its core Internet security solutions. We believe that the company will be able to obtain higher profitability levels and grow faster as a result. Our 12-month target price for McAfee is $32 a share -- shares are currently trading around $25.

We also believe that Veritas is well-positioned in the data storage and backup and recovery markets. The shares are attractively valued at approximately 22 times our 2005 EPS [earnings per share] estimate of $1.02. The company has a strong balance sheet and generates strong cash flow.

Q: Oracle raised its bid for PeopleSoft, saying it was its best and final offer. Will the deal go through?


At $24 a share, we believe that this offer was to get PeopleSoft's management team to the negotiating table. However, since PeopleSoft's board of directors had already rejected Oracle's earlier offer of $26 a share, we view it as unlikely that the deal will be completed at these levels and that Oracle may have to raise its bid. However, Oracle has gotten a lot further than we had anticipated, so we wouldn't count them out at this point.

Q: Is the software market preparing for any big operating-system releases in the coming months? Anything that will drive sales?


The next big Windows operating-system release is code-named Longhorn, and that's currently scheduled for release in calendar year 2006. Other than the continued growth in the Linux operating-system market, we would say that Longhorn's release is the next big thing.

Q: What's the biggest area of growth for software makers? You mentioned security with McAfee. What about wireless applications?


The biggest wireless-application growth will probably be in the video-game sector. However, it still hasn't proven to be a profitable business model at this point in time. So we would continue to focus on other areas such as Internet security, storage software, and the video-game industry for the current generation of hardware consoles such as XBox and PlayStation 2. Upcoming launches of Nintendo's Dual Screen, or DS, and Sony's (SNE ) PlayStation Portable (PSP) should generate renewed interest in the portable gaming market.

Q: How about some small [software] names?


Well, McAfee is about $3.8 billion in market cap -- it's more of a mid-cap name. Other than that, we have accumulate (4-STAR) recommendations on Sybase (SY ), which is about $1.5 billion in market cap, and Activision (ATVI ), which is approximately $2 billion in market cap.

Q: Do you like any video-game software makers?


Activision and Electronic Arts are our two favorite names in the video-game industry. This is primarily due to their diverse libraries of video-game brands and quality of titles. Overall, we believe that this current generation's hardware cycle is entering the later stages as we approach the anticipated launches of XBox 2 in late 2005 and PlayStation 3 in early 2006. Thus we would stick with the high-quality leaders that have strong balance sheets and multiple hit titles in their brand libraries in order to be as diversified as possible as we approach the next-generation cycle.

Q: What do you think of Adobe Systems (ADBE )?


I don't cover Adobe, but our analyst Scott Kessler has a hold recommendation on the shares and a 12-month target price of $58 per share.

Q: Will Computer Associates (CA ) recover?. It has already come back a bit.


I don't cover CA currently. However, we have a hold recommendation on the shares. Zaineb Bokhari is the analyst who covers Computer Associates now. Her 12-month target price is $30 per share. The company did acquire Netegrity (NETE ) recently, which is a leader in identity and access-management solutions -- a rapidly growing area of Internet security. So we feel that Internet security could be an eventual growth driver for CA.

Q: Do you see consolidation among any of the companies you follow?


Recently, as I'd mentioned, CA acquired Netegrity. And with the ongoing Oracle/PeopleSoft takeover battle there's some consolidation in the software industry -- but not to the extent that many have anticipated. We believe that it will likely take the resolution of the Oracle/PeopleSoft situation in order for merger and acquisition activity to pick up, with Oracle as a significant consolidator in the software industry.

We believe that likely acquisition candidates include Siebel Systems (SEBL ), Sybase, and BEA Systems (BEAS ). However, we would caution investors not to buy software stocks solely on takeover speculation and to look at the fundamentals of the companies first. If there's an acquisition, it's just an added bonus.

Q: What about all those international companies, and what about all the piracy that's going on?


First, I cover two internationally based software companies. Those companies are SAP (SAP ), based in Germany, and CheckPoint Software (CHKP ), which has dual headquarters in Israel and Redwood Shores, Calif. We have accumulate (4-STAR) recommendations on both companies.

As far as piracy, it's a serious issue overseas. According to the Business Software Alliance, the software industry as a whole lost over $13 billion in potential revenues in 2002. Piracy rates in Latin America and the Asia Pacific regions were about 55% of software in use. China had the highest piracy rate at approximately 92%.

Resolving this issue could result in substantial revenue opportunity for software companies. However, it's still a significant problem at this point.

Q: Which software makers should investors avoid or sell?.


We have avoid recommendations on THQ (THQI ), Take-Two Interactive Software (TTWO ), and Auto Desk (ADSK ). THQ and Take-Two Interactive are both smaller video-game companies that have relied on one or two particular hits, such as Grand Theft Auto for Take-Two and the WWE franchises for THQ.

However, we believe that as we transition to the next generation of video-game hardware, companies that have relied on one or two hit titles could [be] most [at] risk during this transition period. We would stay with more diversified companies such as Electronic Arts and Activision.

We have an avoid on Auto Desk primarily due to valuation. The stock has had a great run this year, and we feel it would be prudent just to be a little more defensive at this point. However, we do think it's a well-run company with a strong balance sheet and would find the stock more interesting at around $45 per share, which is our target price.

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