Be Selective in Software Stocks

Oracle is the top pick of S&P's Zaineb Bokhari, who is turning cautious about some companies after the troubles in the financial sector

So far, software makers such as Oracle (ORCL) have not been hurt by the troubles in the housing, lending, and financial sectors. Mergers and acquisitions, along with stock buyback announcements, have also lured investors to software and other technology stocks lately (BusinessWeek, 8/30/07). "Many people regard tech as a safe haven from the fallout in the financial sector," says Zaineb Bokhari, who follows software companies for Standard & Poor's Equity Research.

However, as the September-quarter earnings season approaches, and stocks are already enjoying healthy gains, Bokhari is more cautious about the applications software industry. Although there's not much evidence of slower spending on technology yet, she's worried that IT budgets could be scaled back at financial and other companies as the U.S. economy slows. That's why she's being selective and recommending companies with an edge, such as Oracle and Lawson Software (LWSN).

BusinessWeek's Karyn McCormack spoke with Bokhari on Sept. 27 about recent trends in software. Edited excerpts of their conversation follow.

What did you take away from Oracle's earnings report (released on Sept. 20)?
We kept a strong buy opinion on Oracle shares after the company's earnings release. It had a fairly strong quarter, considering that the August quarter is typically its slowest. Oracle's revenue rose 25%, to $4.6 billion, $180 million above our forecast. The company had broad-based growth: Application revenue rose 32% on a non-GAAP basis, helped by acquisitions, and database and middleware revenue was up 22%, which shows that Oracle's core franchise remains strong.

Another key figure from Oracle is new software licenses—those were up 35%, to $1.087 billion, $86 million above our forecast—also helped by acquisitions. And free cash flow rose 40% in the quarter.

The important thing that I took away was that Oracle hasn't seen a slowdown in spending so far. After the turmoil in the financial-services sector, which can make up 10% to 15% of Oracle's sales, we might have seen something in the latest results. But the company said it didn't see any slowdown in spending, although it noted that layoffs in the financial industry may come down the road.

The other thing I liked about the quarter was that operating margins widened by 60 basis points from a year ago, to 36.6%. Oracle continues to enjoy one of the highest operating margins in the software space. It's a testament to their management. Typically, companies see deteriorating margins after acquisitions. But even after buying 30 companies over the past few years, Oracle hasn't taken a hit to operating margins. It's become a well-oiled machine when it comes to integrating acquisitions.

I expect operating margins to rise by 100 basis points in its current fiscal year ending in May, 2008. Our estimates could be conservative—the company has said that margins could widen by 100 to 200 basis points.

How is Oracle trying to compete against SAP (SAP) in the applications software area? Which one will dominate it?
These two companies are employing opposite strategies. Oracle is consolidating the space—it has been one of the most acquisitive companies in software. SAP has shown a reluctance to acquire big companies—it likes to buy smaller players.

They're fierce competitors. It's difficult to compare their market shares on an apples-to-apples basis. So based on data from researcher IDC, SAP continues to be the leader in enterprise applications based on license, maintenance, and subscription revenue, with a 9.5% market share in 2006. Oracle is the No. 2 player in enterprise applications, with a 5.9% share. In view of Oracle's ongoing acquisitions, these numbers may continue to shift.