The Software Trick: Find a Niche

S&P favors Citrix Systems because of its focus on the growing mobile workforce; design vendors such as Autodesk benefit from hot growth in Asia

In the fiercely competitive software area, finding a niche and sticking with it can be a road to success. So says Jim Yin, who follows systems and applications software companies for Standard & Poor's Equity Research. His favorite stock at the moment is Citrix Systems (CTXS), which makes software that allows workers to easily and securely work from home or on the road. He's also high on design software vendors like Autodesk (ADSK).

Not all software stocks behave the same way, so investors should choose carefully. In fact, year-to-date through Apr. 20, systems software stocks have been flat, while applications software stocks have risen 7.5% vs. a 4.7% gain for the S&P 500 index, Yin notes.'s Karyn McCormack spoke with Yin on Apr. 23 about his favorite software stocks. Edited excerpts from their conversation follow:

Note: Jim Yin is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here 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.

What's your investment opinion for the systems software group?

I have a neutral outlook on the systems software industry. First, my overall view of the economy is things are still progressing along, but we're seeing some weaknesses in the U.S. The IT (information technology) spending environment is solid and we think it will grow moderately. IT spending is expected to grow in the low- to mid-single digits, and we think software will probably get a larger piece of the total IT budgets. Based on IDC data, we think software spending will be up 5% to 8% this year.

Even though I'm optimistic for strong revenue growth of network security, we think that's offset by increasing competition, especially from some of the hardware makers like EMC (EMC) and Cisco Systems (CSCO)—which is trying to get into the security software space. Their entrance will pressure Symantec (SYMC) and McAfee (MFE), which provide anti-virus and other security software. We think that anti-virus should be part of the complete solution that includes firewall, data backup, and recovery. Competition should increase among the players as they expand their product offerings.

We're also seeing continued growth of Linux. So far its presence has been limited predominately to servers, displacing Unix. Red Hat (RHT) has prospered from the growth of Linux. However its future has been clouded by the entrance of Oracle (ORCL), and the partnership between Microsoft (MSFT) and Novell (NOVL). Eventually, we see Linux as a possible competitor to Microsoft Windows on the desktop. Dell (DELL) is considering putting Linux pre-installed on PCs as an option based on users' feedback.

What are your some of your favorite stocks, and why?

The software business is highly scalable, and once you become a leader you can become the de facto standard. I like companies that have a strong market niche so that other companies can't displace them.

I like the CAD/CAM (computer-aided design and computer-aided manufacturing) software group. I have buy recommendations on three companies: Autodesk (ADSK), ANSYS (ANSS), and Parametric Technology (PMTC). I see increased demand for their software, driven by the rapid growth of manufacturing and construction in Asia. Most of their business comes from outside the U.S., including the Asia-Pacific region where the economy has faster growth than the U.S. In addition, these companies benefit from the weakness in the U.S. dollar—that could be as much as 2% to 3% benefit to their total revenue when international revenues are converted to U.S. dollars, and potentially a higher percentage to earnings per share.

One of the big drivers for Autodesk is its introductions of 3D versions of its products. We think these products are in the early stages of a long upgrade cycle because only about 15% of its customers have migrated from the lower-priced 2D products. Autodesk is also benefiting from around 10% sales growth of animation in media and entertainment, such as the development of video games. We believe the company is gaining market share by displacing some of the smaller competitors.

Competing against Autodesk is Parametric Technology, a leader in mechanical design automation. In addition to the same favorable trends for Autodesk—growth in overseas economies, especially in Asia and China—Parametric has broadened its products to include collaborative solutions that let companies manage product development from original concept to manufacturing. We believe Parametric should improve its operating performance as a result of recent acquisitions.

Another company that should benefit from the factors mentioned above is ANSYS, a developer of engineering software that simulates physical response to varying levels of stress, pressure, temperature, and velocity. ANSYS has partnerships with leading CAD vendors including Autodesk and Parametric Technology.

Are there any other stocks you like?

I'm also positive on Citrix Systems—I have a strong buy opinion on it. Citrix has benefited from increased worker mobility, which requires remote connectivity from home and other locations outside the office. The company's main product, Citrix Presentation Server, enables an enterprise to run applications on a central server. This enhances data security and reduces the costs of managing separate applications on every user's desktop.

Citrix has expanded its products that accelerate performance, improve security, and balance load on servers. Some of these products, along with an updated version of Presentation Server, will be introduced in the first half of 2007. We expect product licenses revenue to increase 9% in 2007, with stronger growth in the second half of the year as channel partners become more familiar with new products. Despite being a market leader in server-based computing, Citrix estimates its market penetration at 15%. We see revenue increasing 13% and EPS (earnings per share) by 15% for the next three to five years.

Citrix shares have been strong this year, and we have a 12-month target price of $39. We believe the company's better-than-average growth opportunity is not reflected in the stock.

What about Microsoft?

We believe Microsoft's three main businesses—Windows operating system, Microsoft Office product suite, and servers—are growing near 10%. However we see growth in them slowing down. Obviously, investors would like to see how the company plans to drive more growth in other businesses such as cell phones, smart phones, and other mobile devices, and in its online business.

I think Microsoft needs to outline what they will do to grow. There's increased competition from other market leaders such as Google (GOOG), and Apple (AAPL) with its iPod and iPhone. We have a hold recommendation on Microsoft shares with a 12-month target price of $32.

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