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Enterprise Software's Growth Pockets

Security and business-intelligence software should continue to do well, says S&P's Zaineb Bokhari, who likes Oracle and Business Objects

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Although enterprise software is a mature industry, some niches are poised to grow faster than others, says Zaineb Bokhari, analyst at Standard & Poor's Equity Research. Terrorist attacks, hackers, worms, and viruses, and the widespread use of the Internet and e-commerce make security software a top priority for businesses, she says. Business intelligence software, which allows companies to gather and analyze data and reports throughout their systems, has also become vital for the required financial disclosures to comply with Sarbanes-Oxley (see BW Online, 5/15/06, "Business Intelligence Gets Smarter").

Bokhari has two stocks in the enterprise software arena ranked buy: Oracle (ORCL) and Business Objects (BOBJ). On the other hand, she thinks companies that make software for mainframes will not show as much promise. Rather, she sees more consolidation in the group, which she thinks will be primarily small-scale, "tuck-in" deals, rather than mega-mergers.

BusinessWeek Online's Karyn McCormack recently spoke with Bokhari about her outlook and the challenges ahead for enterprise-software companies. Edited excerpts from their conversation follow.

What's your overall outlook for software makers? What are the challenges for the group?
For 2006, we expect corporate spending on enterprise software to grow at a mid-single-digit rate, with some areas growing at above-average levels. We expect large buyers of software to exercise great discipline in their purchasing decisions and see large deal volumes remaining comparable to 2005.

As for the challenges, the growing popularity of low-cost alternatives to traditional software will continue to exert some pressure on margins. In this moderate growth environment, we see some consolidation likely because we view the industry to be overcapitalized.

Economic growth remains a key driver for the software industry overall, as does capital spending. We believe that software will benefit as companies invest in new hardware and attempt to leverage their existing hardware investments by installing and upgrading new software.

What kinds of software are showing the most promise for growth?
In spite of our view that enterprise software is a maturing industry, we believe that there are several segments that will show attractive growth rates and continue to rank high on the list of spending priorities of chief information officers and other executives involved in the purchasing decision, including security software and business intelligence software. Customer relationship management (CRM) has recently reemerged as an area of growth after several years of stagnation -- although this may have been brought on by the rising popularity of on-demand delivery of CRM software.

These segments are expected to display above-average growth in future periods. For example, IDC projects a 14% compounded annual growth rate (CAGR) in revenue for security software from 2004 through 2009. For business intelligence tools, the CAGR forecast is 9.2% for the same period.

Following big deals such as Oracle buying Siebel Systems, do you see more consolidation coming?
We continue to believe the enterprise software industry is ripe for consolidation. Three key trends that should continue to drive software M&A include intense pricing pressure, overcapitalization, and vendor rationalization by corporate clients (see BW Online, 5/9/06, "Upping the Ante at SAP". The acquisition of a software peer can help a company gain sizable installed customer bases or market share, acquire best of breed technologies, or obtain industry specific expertise.

We expect smaller tuck-in acquisitions to be more common than mega mergers for the obvious reason that there are many more of them available. We believe small deals allow a software company to acquire complementary technology without the need to make a broad-based integration of products and people (see BW Online, 11/17/05, "Oracle Keeps on Making Deals". We also think that public software companies are cognizant of the wariness their customers and investors have toward large software deals following disappointing experiences in the late '90s.

Which stocks do you like?
Two of our picks in the enterprise software area include Oracle and Business Objects -- both are ranked 4 stars (buy). We like Oracle because we believe the company has a significant installed customer base, best-of-breed technology assets, high profitability, considerable free cash-flow generation, and it is still growing organically despite its massive size. Even after 11% year-to-date appreciation, we believe the shares are attractively valued. Another item of note is [that] stock option expense amounts to a modest 4 cents a share.

Business Objects is the current market leader in business intelligence, an area of the enterprise software market that we believe will post above-average growth. We believe that revenue growth in 2006 will continue to be driven by ongoing customer migrations to several recently introduced products. We believe the company has managed itself well through this transition. Following the recent sell-off, the shares look attractive.

Which stocks should investors avoid?
Following recent corrections in the market, valuation is less of a concern that it was just a few months ago. We don't have any sell recommendations in enterprise software right now. But we're guided by our outlook for growth by different end markets and how this compares to our broader outlook for enterprise software.

For example, we have less favorable growth outlooks for companies with significant exposure to the mainframe, which we see posting flat to modestly negative growth in 2006. Companies with notable exposure to the mainframe include BMC Software (BMC), which had 32% of license and maintenance revenue from the mainframe in the most recent reported quarter; CA Inc. (formerly Computer Associates) (CA), which had about 50% of revenue from the mainframe in fiscal year 2005 (ended March); and Compuware (CPWR), which had 41% of license and maintenance revenue from mainframes in the most recent reported quarter. All of these stocks are ranked hold.

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