Part 2: S&P's 2007 Tech Sector Outlook

A look at S&P analysts' expectations for key IT industries in the coming year—and their top picks within those groups

by Scott Kessler

Here is the second of a two-part rundown of Standard & Poor's Equity Research information technology analysts' 2007 outlooks for selected tech subindustries and stocks, covering application software, systems software, home entertainment software, it consulting and data processing services, and Internet software and services. Part 1 featured outlooks on semiconductors, semiconductor equipment, computer hardware, electronic manufacturing services, and computer storage and peripherals (see BusinessWeek.com, 12/21/06, "S&P's 2007 Tech Sector Outlook").

Application Software

Analyst: Zaineb Bokhari

Standard & Poor's expects corporate spending on enterprise software to continue to grow at a mid- to high-single-digit rate in 2007, comparable to growth seen in 2006. We expect corporate spending in areas such as business intelligence, customer relationship management, and enterprise resource planning to do well, as we expect IT budgets to remain healthy for these programs. At the high end, we think there is some pent-up demand for application software due to the recent consolidation of several major players by Oracle (ORCL) and the expected delivery of new products and upgrades by large vendors such as SAP (SAP) and Oracle, which will likely take place in the 2007-2008 period.

We expect large purchasers of software to continue to exercise great discipline in their buying decisions and maintain a keen focus on return on investment and total cost of ownership. In this buyers' market, we think software vendors face intense competition and ongoing pricing pressure.

As a result, many vendors who have traditionally catered to the high end are looking to the underserved small and medium-size business (SMB) market as an area of growth. SAP plans to introduce new products targeted at the SMB market in the first half of 2007 and is adding features to its on-demand offerings to capture some of the growth seen by newcomer Salesforce.com (CRM; ranked 2 STARS, sell).

We have a strong buy recommendation on the ADRs of SAP partially because the company has been posting strong, largely organic growth in license revenues despite its massive size. We believe there are drivers currently in place for SAP to continue to grow at above-average rates. It has been making notable progress in the SMB market, in our view, and we like the company's largely organic product strategy, which has been less disruptive to customers than one driven by acquisitions.

By our analysis, this has promoted add-on sales of newer product introductions. We note that the recent weakening of the U.S. dollar relative to the euro is a concern to us, as it could affect reported growth rates.

Based on our optimistic outlook for future success of the company's current acquisition strategy, we have a strong buy recommendation on Oracle shares. While we think the company's acquisitive strategy comes with significant risks, we like Oracle because of its considerable technology assets, significant installed base, sizable maintenance revenue stream, high profitability, and attractive valuation relative to peers.

Systems Software

Analyst: Jim Yin

We forecast that PC growth in 2007 will be aided by the release of Microsoft's (MSFT) Windows Vista. Although most computers sold to consumers will have Vista as their operating system, we believe its adoption by businesses will be gradual and occur over several years as they evaluate and review compliance before upgrading from prior versions of Windows. As such, we view the launch of Vista as a positive, but not a major catalyst for increased IT spending.

We have a positive outlook on the systems software group as we enter 2007. One company that we like, and which is ranked strong buy, is Citrix Systems (CTXS). We expect Citrix to benefit from increased worker mobility, which requires remote connectivity from home and mobile devices. The company plans to release new products in the first half of 2007, which we expect to accelerate its revenue growth in the second half of the year. Citrix derives approximately 46% of its revenue from international operations and could benefit from the expected weakness in the U.S. dollar. We believe Citrix shares are undervalued following a recent price decline.

We have buy recommendations on two CAD/CAM companies: ANSYS (ANSS) and Autodesk (ADSK). ANSYS develops, markets, and supports software for design analysis and optimization. We expect its software license revenue to increase 43% in 2007, aided by the acquisition of Fluent. We see additional revenue growth coming from cross-selling opportunities as a result of the Fluent acquisition and a broader product portfolio.

Autodesk has seen strong demand for its 3D products, as sales increased 36% year-over-year for these products in the most recent quarter. We think its 3D products are in the early stages of a long-term growth cycle, with only 10% of its 2D installed base having been upgraded. We expect revenue growth of 15% in fiscal year 2008 (January) and operating margin expansion of 4% through better economies of scale.