The Softness in Software

After a number of disappointing first-quarter earnings reports, S&P's Jonathan Rudy is cautious about the sector overall

There's a bit of gloom in the software market these days -- but a few bright spots to offset it, in the view of Jonathan Rudy, Standard & Poor's analyst of software stocks. Rudy reports there have been a surprising number of disappointments from software companies preannouncing their earnings for the first quarter because of delayed deals and concerns over the global economy.

One problem, he notes, is the lack of a new killer application to stimulate sales. In addition, Rudy says it's too early to tell whether the long-awaited pickup in corporate spending on information technology is materializing. So he sees the near-term outlook for software stocks as "challenging."

However, Rudy does have two strong buys on his list: Cash-rich Microsoft (MSFT ) and McAfee (MFE ), a power in Internet security. He also lists as buys Check Point Software (CHKP ), Activision (ATVI ), Sybase (SY ), Oracle (ORCL ), SAP (SAP ), and RSA Security (RSAS ).

These were some of the points Rudy made in an investing chat presented on Apr. 12 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a complete transcript at keyword: BW Talk.

(Jonathan Rudy is an S&P equity research 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 on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Jon, how have the stocks you cover been doing in this generally down market?


It's been difficult for the software market so far in 2005. Coming off pretty strong fourth-quarter results, we were surprised by the number of disappointing [earnings] preannouncements for the first quarter of '05. So all in all, the disappointing performance in software stocks in the first quarter looks like it's going to reflect a challenging first quarter as far as company results.

Q: What has caused the first-quarter earnings to be disappointing?


As a whole, companies have generally cited delayed deals, an increase in the number of signings for approval, and general concerns over the global economy. It doesn't appear that there's a dramatic slowdown in software, but it has been pretty broad-based, and it looks like the near term could be difficult for these companies.

Q: What are your thoughts concerning Veritas Software (VRTS )?


We have a hold recommendation [3-STARS] on Veritas. This is primarily due to its pending merger with Symantec (SYMC ), which is also a 3-STARS recommendation. While we believe that both companies are technology leaders in their respective fields, we are concerned over the synergies of this combination. At this point, even though we think very highly of John Thompson, Symantec's CEO, and Gary Bloom, CEO of Veritas, we believe that this combination may prove more challenging than they anticipate. We believe it's best to stay on the sidelines at this point.

Q: What are your picks in this sector for the near and long term? Any buys?


Yes, we continue to like Microsoft and McAfee as the top recommendations -- strong buys [5-STARS]. We believe that MSFT continues to execute and generate prodigious cash flow, whereas MFE is in a very attractive area of the security market and has focused its operations purely on Internet security. We believe that both companies should outperform going forward.

Q: Do you expect Microsoft to expand its dividend payouts?


Considering its strong cash flow (it generates about $1 billion a month in free cash flow), Microsoft certainly has room to increase its dividend. However, it's still a technology company, and they invest quite a bit in research and development. So we would anticipate a mild dividend increase if there is one.

Q: You've given us two 5-STAR strong buys. Any 4-STAR buys, Jon?


Yes. Check Point Software, Activision, Sybase, Oracle, SAP, and RSA Security. RSA preannounced disappointing results last week. However, the company is still in an attractive market -- identity and access management -- in addition to mobile security. So, with a strong balance sheet, which is over $4-per-share cash in investments and no debt, and trading at a discount to peers on an enterprise value to sales basis, we still believe that shares are attractive at these levels, despite the disappointing execution of the company this quarter.

Q: Anything notable to say about any of the other buys?


Sure. Two themes that we continue to like as a whole are that the larger suite-software providers will continue to outperform the smaller niche providers, generally speaking, as customers continue to reduce their list of vendors. Thus, we continue to favor companies like Microsoft, Oracle, and SAP. We believe one of the reasons that Siebel Systems (SEBL ) preannounced disappointing first-quarter results was SAP's strong execution in the North American region, where they had historically been weak.

We have a 2-STARS [sell] recommendation on Siebel, primarily due to the disappointing execution by the company in the first quarter. We were particularly disappointed with its estimate of $75 million in application license revenue. This was well below our estimate. License revenue as a whole tends to reflect the overall health of a software company's business. Thus, despite having a strong balance sheet, we would sell shares of Siebel at this time.

Q: How have the stocks of companies with disappointing earnings reacted to the news?


It has been mixed, as a whole. Some companies like RSA experienced severe sell-offs. However, for example, BMC Software (BMC ), which preannounced disppointing results last night, was actually up today. This was primarily due to some announced cost-cutting plans. However, as a whole, software shares have sold off on these preannouncements. Zaineb Bokhari, the analyst who covers BMC Software, has a hold recommendation on the shares.

Q: There have been forecasts of increased corporate IT spending. Have you seen any signs of that yet?


It's too early to tell. However, broadly speaking, due to the disparate types of software companies that have preannounced disappointing results, it looks like 2005 may be a much more challenging year than investors had anticipated for the software sector as a whole.

Q: You named Siebel as a sell. Any other software names investors should unload?


We actually downgraded shares of Interwoven (IWOV ) to a sell from hold today. IWOV has a 12-month target price of $7. Our analyst who covers IWOV is Scott Kessler.

Q: Any serious rivalry to Microsoft? What's your current thinking on Linux and stocks such as Red Hat (RHAT )?


Linux has proven to be quite successful at carving a niche for itself, despite the competition against Windows. It appears to have a bright future at this point in time. We have a hold recommendation on RHAT.

Q: What about Apple (AAPL ) and software for the Mac platform?


We have a hold recommendation on shares of AAPL. The analyst is Megan Graham-Hackett. As far as the software side, we believe that Apple has a solid operating system that has been to this point relatively immune to virus attacks. So this has been a key benefit for Mac users. However, it remains to be seen whether more viruses will target the Mac platform in the future, or if they'll continue to focus predominantly on Windows. Security continues to be a major concern with the Windows platform, as far as the number of patches that have to be constantly downloaded.

Q: How much is Microsoft itself doing to combat the increasingly virulent viruses hitting Windows?


They continue to improve their software. However, it's quite common to see the announcement of various vulnerabilities and the need to download corresponding patches. Over the past couple of years and more recently, Microsoft has acquired a couple of small security companies. However, we believe at this point these security products will generally target more of the low-end customers, and people who want more in-depth, comprehensive security solutions will continue to look to Symantec, with its Norton brand, and McAfee.

Q: Do you see anything out on the leading edge of software technology that we should be watching? And any stocks to go along?


Generally speaking, that has been the major problem with software at this point. There is no killer application at this point in time that really appears to drive future growth. Attractive areas of software have been the video-game sector and Internet security software. However, with the next generation of hardware gaming platforms expected to be released later this year and early next year, the video-game software sector as a whole could be more challenging over the near term, despite the positive recent catalysts of Sony's (SNE ) PSP and Nintendo's DS, which have really benefited the handheld gaming market.

Q: Who are the leaders in video game software now?


The 800-pound gorilla is Electronic Arts (ERTS ). However, they preannounced disappointing results for the March quarter about two weeks ago. So it looks like they had a more challenging holiday season than anticipated. However, games like Halo2, which is by Microsoft, and Grand Theft Auto: San Andreas by Take-Two Interactive (TTWO ), have been extremely successful. It appears that ERTS did not have the right combination of titles for this past holiday season. However, the company still has the most diversified portfolio of brands in the industry, in addition to a very strong balance sheet. So we don't expect this to be a long-term problem for the company. We have a hold recommendation on ERTS.

Q: Has the spread of wireless telephony and devices such as the iPod had any impact on the software business?


To this point, it hasn't had a material impact on the software companies that I cover. However, one area that looms as a potential trouble spot down the road is wireless security. And we believe a company like RSA could be a beneficiary from that trend. As far as music software, we still really haven't seen the killer application to compete with iTunes. The competition is still pretty fragmented at this point in time.

Q: Is RealNetworks (RNWK ) going to settle its suit against Microsoft, as so many are?


I don't want to speculate on specific outstanding lawsuits with MSFT. However, one trend that I can mention has been that MSFT has been eager to remove a number of outstanding lawsuits with settlements -- most recently, the settlements with Gateway (GTW ) and (BRST ). Additionally, the company indicated that it would increase its legal reserves by $550 million for the quarter. So, clearly, MSFT wants to resolve as many legal issues as possible in order to remove the litigation risk that hangs over the stock.

Q: Has there been softness in the end markets for both consumer and corporate software products, Jon?


It appears that this quarter's disappointments so far stem from the enterprise side of the business. However, Electronic Arts' preannouncement is purely on the consumer side. But, again, that could be more reflective of changing tastes in software games, generally speaking, rather than a broad consumer-related sell-off. We are concerned about the weakness in the enterprise software side going forward in 2005 because it was so broad-based and affected so many different kinds of software companies.

Q: Which software companies are pushing their platforms most effectively in the interactive cell-phone market?


I guess video-game software companies would be the most effective. However, it's still a new market. So financially speaking, it's not really a material impact for most video game software companies at this point. But down the road, it could be a significant market for video games.

Q: What is S&P's current weighting on tech, including software?A: We are market weight on technology. And in software, we are neutral on the application software subindustry and home entertainment subindustry. However, we are still positive on the systems software subindustry, which reflects positive outlooks for companies like MSFT, Oracle, and McAfee.

Q: As software is embedded in the chips inside our appliances, will the software market as we know it disappear?


Possibly. That's the risk of technology investing. It can always change in ways that you can't anticipate. It doesn't appear as if that's the way software industry is headed at this point in time, but you never know for sure.

Edited by Jack Dierdorff

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