Markets & Finance

A Sleeper in Software?


By Jonathan Rudy Note: Focus Stock will not publish on Dec. 23 and Dec. 30. It will resume its weekly publication schedule on Jan. 6, 2003.

When it comes to growth, database and enterprise infrastructure software outfit Sybase (SY) is casting its net a little wider these days. Its database operations are mature and unlikely to grow rapidly over the next few years. However, this core business generates significant cash flow, which has enabled Sybase to invest in other, higher-growth opportunities, such as enterprise integration, enterprise portals and m-business (mobile business) products.

So while Sybase may not be able to generate annual sales gains on the order of 20% to 25%, we at Standard & Poor's believe that the market is valuing its shares based on only minimal expectations for growth. And investors are not fully recognizing the company's solid cash flow and strong balance sheet. That's why we've given Sybase our highest investment ranking of 5 STARS (buy). Its shares are attractively valued, trading at a significant discount to both its peer group on a relative basis and its intrinsic value based on our

discounted cash-flow analysis.

FIVE LEGS. The database business is very competitive, with companies like IBM (IBM), Microsoft (MSFT), and Oracle (ORCL) jostling for market share. However, while not a dominant business for Sybase, it is a profitable one that generates strong cash flow, enabling the company to invest in other market opportunities. This business has helped Sybase maintain mid- to high-teen operating margins in a difficult environment for tech companies.

Dublin (Calif.)-based Sybase has five operating divisions: Enterprise Solutions, iAnywhere Solutions, Internet Applications, Business Intelligence, and Financial Fusion. The Enterprise Solutions division includes Sybase's flagship database-server, Adaptive Server Enterprise, in addition to products that help enterprises integrate, move, and manage large amounts of data and applications across diverse computing environments. iAnywhere solutions extend enterprise systems to remote and wireless devices that enable e-business and mobile business anywhere, anytime.

The e-Business division offers products and services that allow businesses to design, build, and deploy distributed and Web-based applications. The Business Intelligence division helps businesses consolidate and analyze large amounts of information from data warehouses to help managers make better decisions. And Financial Fusion provides e-finance products that enable financial institutions to integrate financial services, channels, platforms, technologies, and applications for delivery to capital markets and retail clients.

MANAGING RISK. International opportunities such as China, while lacking in market detail, could provide significant upside potential for U.S. technology companies such as Sybase as the country builds out its IT infrastructure and grows closer with the rest of the world as a trading partner.

We at S&P anticipate approximately 5% revenue growth from Sybase in 2003, with about 9% earnings per share (EPS) growth. While that's not an explosive near-term growth rate, Sybase has done a better job than most of its peers at managing its downside risk during the sharp tech declines in 2001 and 2002. We expect operating margin to improve to 16.1% in the third quarter of 2002, compared to 9.5% in the prior-year period. With continued operating margin improvement and lower shares outstanding, we believe that Sybase could attain low-double-digit earnings growth over the next couple of years.

Sybase was hurt in 2001 by $33.6 million of in-process research and development primarily from the 2001 acquisition of New Era of Networks, and $49.5 million in restructuring costs associated with the company's 2001 plan to streamline. We believe that these charges are one-time in nature and that Sybase will return to operating profitably in 2002. However, these charges have clouded its 2001 core earnings, making impact from stock options look a lot more substantial on a percentage basis than we believe it will be going forward.

BIG DISCOUNT. Sybase's balance sheet, with approximately $3.85 per share in cash and investments -- and no debt -- provides a great deal of flexibility for share repurchase programs or potential acquisitions. Sybase bought back nearly $40 million of its stock during the third quarter of 2002 and had an additional $60 million remaining on its current repurchase authorization as of September 30, 2002.

Trading at a price-to-earnings ratio of 12 times our 2003 earnings per share estimate of $1.13, and an enterprise value to sales (EV/S) ratio of 1, Sybase is at a notable discount to its peer group. Competitors IBM, Oracle, and Microsoft trade at an average forward p-e of 24 times estimates, and an EV/S of 4.9 times. While we agree that Sybase should trade at a discount to these leaders, a 40% discount to this peer average brings us to a 15 p-e multiple and a 2.9 EV/S multiple for the shares -- meaning they're still undervalued in relation to other industry players. At 15 times our 2003 EPS estimate, we arrive at a value of $16.95.

On a discounted cash-flow basis, we arrive at a fair value of $16.05. Blending the DCF and relative valuation techniques gives us an average value for the stock of $16.50, or 25% above the current price.

While it may not be the most explosive growth story in technology, Sybase is a solid company trading at very reasonable valuation levels. Based on a number of measures, we believe the shares represent an attractive opportunity at a notable discount to their fair value. Analyst Rudy follows software stocks for Standard & Poor's


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