Written by Michael Brush
"Software should lead the tech recovery"
Look for established names selling money-saving software to profit first when technology turns around. They have no inventory to unload, and upgrades are hard for buyers to put off.
If you're putting your toes back in the tech waters, consider this simple safety tip. While firms that sell tech hardware -- like Cisco Systems (CSCO, news, msgs) -- still have a lot of inventory to work through before they can post solid profit gains, software companies don't face this obstacle.
This implies that when corporations turn the information technology spigot back on, software firms should be among the early beneficiaries. "Unlike Sun Microsystems (SUNW, news, msgs) and Cisco, which have their servers and routers all over eBay, we are not seeing that with the products from enterprise software vendors," says Kenneth Klein, the chief operating officer at Mercury Interactive (MERQ, news, msgs).
"The software business in this sense is a lot simpler and a lot more responsive," says Bill Beecher, the chief financial officer at i2 Technologies (ITWO, news, msgs). What's more, says Beecher, corporations that clamped down hard on software spending in the first quarter are going to have to pick it up again at some point to stay competitive. "You can put stuff off for a month, or two, or three. But when there is a need for software, the budget for the project will come back. A deferral is a slipped deal, but not a lost deal."
Not all money managers buy this clear-sailing-on-the-inventory-front theory -- and we'll get to their reasoning in a moment. But assuming it's true, and it does make sense, here are the kinds of software stocks that should benefit first.
"The likely winners"
Software firms that sell less expensive apps will come back sooner. "There has been a lot of spending in the past two years on expensive enterprise applications," says Greg Tuorto, a senior technology analyst at Dreyfus. "At this point, it is hard for an IT manager to go back to a chief financial officer and say, 'I want to spend another $5 million on software.' The big-ticket items could be in jeopardy over the next three months."
Roughly speaking, this means that deals under $1 million are more likely to get approval, but not the larger, multimillion dollar, enterprise-wide packages. That may be a negative for a database vendor such as Oracle (ORCL, news, msgs) in the near term, says Tuorto. But it's a positive for firms selling lower-priced critical apps, such as storage-software vendor Veritas (VRTS, news, msgs).
Another area of potential strength is software firms selling small-ticket items to consumers, says John Faig, a technology analyst with American Express. This includes companies such as security software vendor Symantec (SYMC, news, msgs) or design software company Adobe (ADBE, news, msgs).
Look for software firms that generate savings. There are lots of software companies you could put on this list. But one that fits the bill and sells relatively low-cost software to boot, Tuorto says, is Peregrine Systems (PRGN, news, msgs). The company sells "infrastructure management software" that helps companies do things such as order supplies or manage fleets of trucks better. "Peregrine saves companies money, and that is an easy sell in this environment," Tuorto says.
Another example is i2 Technologies, whose supply-chain software helps companies plan for demand, optimize logistics and get the most out of resources. Tuorto, however, is less optimistic about i2 in the near term because the company had been gearing up to book big contracts. "They were hunting elephants," Tuorto says. "They were looking for big contracts of $25 million or more, and I don't know if those elephants are going to be out there for the next couple of months."
A smaller name you might overlook is Cognizant Technology Solutions (CTSH, news, msgs), which offers "offshore" management and maintenance of business software systems. The catch is that offshore means workers telecommute from India, where labor is cheaper. Billing rates at the New Jersey-based Cognizant run anywhere from 25% to 30% of rates charged by competitors, says Chief Financial Officer Gordon Coburn. The company also has good earnings visibility. About 90% of revenue for the next quarter is already booked. And about 80% and 70% of the following two quarters is already signed on, as well.
Go with the bigger, well-recognized names. Why? Because that is what the big spenders are doing. "If you are an IT manager, you won't make a bet on a software company if you are not 100% confident it will be around for a while," says Gus Zinn, a software analyst with Waddell and Reed. So even though a smaller software company may sell products with more features, IT managers will still favor the bigger company. "No one will get fired for picking the top companies," Zinn says. This means investors should lean toward leaders in customer management and enterprise software such as Siebel Systems (SEBL, news, msgs), SAP (SAP, news, msgs), PeopleSoft (PSFT, news, msgs) and i2, at least until the economy gets back on track.
Inside "business intelligence" software, IT managers are more likely to go with a leading vendor like Business Objects (BOBJ, news, msgs) over competitors such as Brio Technology (BRIO, news, msgs) or MicroStrategy (MSTR, news, msgs), according to this theory. Business intelligence software helps firms extract knowledge from their databases. Levi's, for example, uses Business Objects software to learn about consumer spending patterns by analyzing credit card databases, says Thom Weatherford, the CFO at Business Objects.
The "infrastructure" stocks should recover faster than those that sell applications. Businesses that have recently spent a lot to buy applications are now focused on getting the most out of them. They can hold off on buying even more applications for now. Tuorto says this helps explain why business is strong at testing and monitoring software company Mercury Interactive.
"Our software helps companies with inventory overhang to get Oracle, Siebel, SAP and BEA Systems applications deployed and doing productive work," says Mercury Interactive's Klein. "We put those applications on a treadmill to make sure they are going to function well." The company's software also carries out monitoring and diagnosis.
Other "infrastructure" plays include security software vendors such as Check Point Software Technologies (CHKP, news, msgs), VeriSign (VRSN, news, msgs) and Symantec. Storage software company Veritas also fits into this group. Software firms that may take longer to recover because they focus on selling applications include Siebel, Ariba (ARBA, news, msgs), Commerce One (CMRC, news, msgs), PeopleSoft and SAP, analysts say.
Business at telecom software companies should remain strong. It's no secret that telecom companies have dramatically cut back spending on hardware such as routers and switches. "But on software side, you don't see the same kind of slowdown because there is the need for software applications that grow their revenue base," says Alan Black, the CFO at Openwave (OPWV, news, msgs), which sells applications used on wireless phones. Openwave sells wireless Internet browser software and software that lets users send e-mail, set up unified messaging and download custom ring tones and screensavers. Business is also strong at customer care and billing software companies like Amdocs (DOX, news, msgs) and Comverse Technology (CMVT, news, msgs).
"Risk factors"
What are the risks to buying business software stocks right now?
- First, there is the chance that the zero-inventory overhang theory is wrong. "I don't buy it," says American Express' Faig. "At least for enterprise software, sales are bound to the sales of servers, desktop computers and network equipment. So it would be hard for enterprise software to rebound without some strength in some of the other groups. There must be corresponding hardware sale." Zinn points out that there actually may be an inventory overhang of software, in the sense that businesses bought so much of it in the past two years, they haven't gotten around to using it all yet.
- Next, many of the leading business software stocks have already moved up a good 60% or more since the April 4 lows. Siebel, for example, now trades near the 18-month price target of $44 set by CIBC. Even sell-side analysts are saying the fundamentals have not improved enough to justify this kind of move. So it may be better to keep a list of top picks and buy on pullbacks. "You have to position yourself for a 2002 recovery, but you don't want to do it too early," says Waddell & Reed's Zinn.
- Few analysts expect software stocks to give back all of their recent gains. But the earnings warning season is just around the corner, starting around the middle of May. Then when earnings come out, high-profile names could surprise with a big miss at the last minute, given that half of a software company's business for a quarter can get booked in the last two weeks. After that, tech stocks may drift lower during the seasonally slow summer months, especially after earnings news slows down following the third week in July.
- Finally, if a weak consumer tips the economy into a deeper downturn, software stocks would get hit. "From my vantage point we really bottomed out in the December, January, February time frame," says Mercury Interactive's Klein. "We saw a pickup in April, and my sense is that is going to continue. But the risk is that we go from basically flat growth and start sliding into a depression. Then all bets are off."
At the time of publication, Michael Brush owned or controlled shares in the following equities mentioned in this column: Siebel Systems, i2 Technologies and Ariba.
Disclaimer
Please note that this does not represent an endorsement of the writer's investment views or recommendations.
