Tech Sector Outlook 2008: Part 2

What S&P's equity analysts see ahead for application software, Internet software and services, home entertainment software, and consulting and data processing services

by Scott Kessler

Here's the second of a two-part rundown of Standard & Poor's information technology analysts' outlooks for tech subindustries and stocks, featuring outlooks on application software, Internet software and services, home entertainment software, IT consulting and data processing services, telecommunications services, and communications equipment. Part 1 covered semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software.

Application Software

Analyst: Zaineb Bokhari

As we enter 2008, we have a neutral outlook for the application software subindustry. We think the slowing U.S. economy will affect corporate spending on application software, although we do not think that growth in spending will slow much below a mid-single-digit rate (4% to 6%). While it is unlikely that corporations will curtail budgets entirely, we expect growth in the first half of 2008 to be muted, as firms continue to assess the impact of recent turbulence in the credit markets and of developing economic headwinds, thus likely making 2008 a back-end loaded year. The financial services sector has historically invested heavily in software to meet regulatory demands and to foster productivity. We do not think all software purchases are discretionary, but we think investors need to be mindful of this before viewing the subindustry as a "safe haven."

While we think that growth in licenses will slow as corporations delay purchases, we expect maintenance renewal rates to remain high. This will benefit companies that have strong recurring revenue bases and maintenance revenue streams, like Oracle (ORCL; $21), which carries our strong buy recommendation. Regions outside the U.S. have offset a domestic slowdown somewhat, and we expect this trend to continue, but we are not optimistic that this can continue indefinitely, particularly if the U.S. economy continues to weaken.

We recommend that investors be selective, choosing companies with broad product sets, diverse customer bases, sufficient geographic exposure, and a high degree of recurring maintenance revenues streams, as we think these companies will weather economic uncertainty.

We think Adobe Systems (ADBE; $42), which carries a buy recommendation, will continue to benefit from a well received product launch, with significant future potential to benefit from the growth of rich Internet applications and mobile media.

We also think the small and midsize business (SMB) segment, while not recession-proof, will likely continue to grow faster than the mature enterprise segment. For this reason, we recommend Lawson Software (LWSN; $9), a provider of enterprise resource planning (ERP) software and ranked buy, primarily to the SMB segment.

We expect M&A to continue in 2008, particularly of small- and mid-cap players with strong product offerings in appealing niches. We think Informatica (INFA; $18), which also carries a buy recommendation, could be an attractive acquisition.

We think the pace of M&A could moderate from 2007 as financing mega-acquisitions could become more difficult for some vendors. Partly offsetting this is our view that smaller vendors, who struggle in a slowing economy, could become easier targets for larger vendors.