A Flat Year for Software Stocks?


For investors keen on software stocks, patience and attention to valuation are the keys now, according to Jonathan Rudy, Standard & Poor's analyst for software and commercial-services stocks. Although stocks in that sector did pretty well in the final quarter of 2002, Rudy thinks it was primarily because companies were spending down their budgets for information technology and that 2003 will be essentially flat.

In this environment, Rudy still has a few S&P buys, including giant Microsoft (MSFT) and Symantec (SYMC), which is in the crucial business of Internet security. He says S&P also has accumulate recommendations on Oracle (ORCL), Check Point Software (CHKP), and PayChex (PAYX). Another on the accumulate list is Electronic Arts (ERTS), a leader in software for video games, which is otherwise an area Rudy sees as lagging.

These were a few of the points Rudy made in a chat presented Feb. 11 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Jonathan Rudy is an equity analyst with Standard & Poor's Investment Advisory Services. He has no affiliation with or ownership interest in any company under discussion today. S&P's other affiliates may provide services to the companies under discussion.

Q: Jon, the market just isn't going anywhere. Does S&P blame nervousness over Iraq, as almost everyone else seems to be doing?

A: It definitely plays a role, there's no doubt about it. Some of the underlying earnings news isn't so bad, but the Iraq situation is casting a cloud over the entire market.

Q: How have the software stocks been doing in the meantime?

A: As a whole, they had a pretty solid fourth quarter. Where we're a little bit concerned is that the market seems to be extrapolating better-than-expected fourth-quarter numbers out into 2003. And at this point, we believe that there was more of a seasonal fourth-quarter budget flush (spending of any leftover money in the IT budget) than many people expected.

Q: Comments on Siebel Systems (SEBL)?

A: Siebel finished up with a decent fourth quarter after a very difficult 2002 as a whole. Valuation-wise, the company looks interesting, but we're concerned over their product divisioning at this time, and thus rate the shares a hold.

Q: Should I hang on to Check Point (CHKP), the Israeli software company?

A: We have an accumulate recommendation on Check Point, mostly due to its strong balance sheet, solid profitability, and market leadership. We continue to like Check Point at these levels, as Internet security as a whole remains quite solid despite the challenging economic environment.

Q: Here's a very direct question: Buy what?

A: We have buy recommendations on Symantec (SYMC), Microsoft (MSFT), and Sybase (SY). With Symantec and Microsoft, our primary reasoning is that they're market leaders that are taking share and executing in a difficult environment, and they should emerge from this downturn in a stronger position than ever.

For example, Microsoft is putting over $5 billion into R&D this fiscal year, and the next closest competitor is Oracle (ORCL), which should put about $1 billion into R&D this year. This is quite a competitive advantage for Microsoft. Sybase is primarily a valuation call -- trading at a significant discount to its peers, despite generating significant cash flow.

Q: As a follow-up, are you recommending Oracle as well?

A: We have an accumulate recommendation on Oracle, primarily due to its strong balance sheet and solid profitability in this environment.

Q: Back on Microsoft, what was the market reaction to the announcement of a dividend and a stock split?

A: The shares sold off -- primarily, in our opinion, due to a reevaluation of the multiple, the market is willing to pay for a slower-growing, more mature tech company. The stock split announcement at these levels was, and is, baffling at this point. We don't have a good explanation why they decided to split their shares at these levels, but the market did not receive the news positively. However, our long-term positive opinion of Microsoft remains intact.

Q: What should we avoid?

A: We have avoid recommendations on RSA Security (RSAS) and Legato Systems (LGTO), and we have a sell recommendation on BMC Software (BMC). Our primary concern with all three is valuation. However, BMC and Legato posted better quarters than we anticipated.

Q: Your thoughts on Veritas Software (VRTS)?

A: I have a hold recommendation on Veritas. We're positive on its long-term prospects as the storage-software leader. However, our primary concerns are valuation and the recent news that Veritas is acquiring Precise Software (PRSE).

Q: Are there any companies that were hot in the Internet bubble and managed to survive, besides obvious ones like MSFT?

A: That's a tough one, because all of the companies I cover were affected by that.

Q: What's your opinion about AutoDesk (ADSK)?

A: We have a hold recommendation on AutoDesk, primarily due to a reasonable valuation despite some recent questionable execution by management. However, the company has a solid balance sheet and should survive this downturn.

Q: What do you think about BEA Systems (BEAS)?

A: We have a hold recommendation on BEA. We like the positioning of this market leader. However, concerns over valuation and competition from low-end application servers have us more cautious at this point.

Q: On today's news, how vulnerable is Microsoft to the new antitrust complaint against it in the European Union?

A: We didn't feel that this news was as notable as The Wall Street Journal portrayed it to be. What's interesting is that the complaint was filed by an American trade association on behalf of primary competitors Sun (SUNW), Oracle, and America Online (AOL). So we wouldn't read too much into this complaint as a gauge of the EU's opinion on Microsoft.

We still believe that the most likely scenario is that Microsoft will have to pay a cash fine, and with $43 billion in cash and short-term investments, Microsoft has ample resources to cover such a potential penalty.

Q: How about game software, Jonathan? Is that still a hot market?

A: Game software has cooled off dramatically for the past couple of weeks, with companies like Activision (ATVI) and THQ (THQI) struggling with the most recent quarter. However, leaders like Electronic Arts (ERTS) posted a very strong quarter and should continue to do well with its strong brand names such as Madden, the Sims, and Lord of the Rings.

We have an accumulate opinion on Electronic Arts and hold recommendations on THQ and Activision -- primarily due to their strong balance sheets.

Q: Is anything new coming along in software that would be of investor interest?

A: At this point, Web services is the general broad theme directing most of the application development at this time. Integration and interoperability will be the key issues going forward. However, there's no killer app immediately on the horizon. Probably the most interesting trends right now, outside of Web services, are wireless connectivity and Internet security.

Q: What have you learned from the tech bubble bursting? Has it made you more conservative?

A: Conservative as far as a lot more focus on strong balance sheets and strong cash flow, as opposed to the bells and whistles of a hot product at a particular point in time. So, yes, from that perspective, I'd say we're more conservative. However, the main lesson of the Internet bubble was that valuation does matter.

Q: How do you decide whether to cover a software company?

A: Our first criterion is that it's in one of the S&P indexes, and from there we try to cover obviously the largest market-cap issues, as well as companies with significant investor interest.

Q: Have you added or subtracted any recently?

A: Probably our most recent addition was Internet Security Systems (ISSX), and we initiated coverage with a hold recommendation. We think they're an interesting company. However, they stumbled a little bit recently, and we just wouldn't add to positions at this time.

Q: What are your thoughts on SAP (SAP) and Computer Associates (CA)?

A: I don't cover SAP. However, from a competitive perspective vs. Oracle, Siebel, and PeopleSoft (PSFT), they've done a much better job competing against these companies, particularly in North America. SAP remains a solid competitor, and that's all we can say at this point.

We have a hold recommendation on CA. And while they've done a much better job with recent execution, there are still some lingering questions in our mind over previous management missteps. And at this point in time, CA needs to produce a couple more quarters of solid results, as they have been doing. But the jury is still out at this point.

Q: Is there any sign of demand for software picking up, or are consumers and business holding back?

A: There was some pickup in the fourth quarter of last year, but at this point it's tough to say whether you can extrapolate those results into this year, because it looks like info-tech spending will be flat at best this year. So we're concerned that first-quarter results will be weaker than investors are expecting at this point. And unless companies are taking market share, it will continue to be a challenging environment.

Q: Does that mean that it might be a good idea to wait for lower prices to pick up some of these stocks?

A: We wouldn't go chasing any high-valued names in this environment because it doesn't look like any companies in software are going to run away from you at this point in time. Patience and focus on valuation are very important in a market like this.

Q: As our hour draws to a close, remind the audience of the buys you have in the software arena, Jonathan. And perhaps accumulates as well.

A: We have buys on Symantec, Microsoft, and Sybase. We have accumulate or 4-STAR recommendations on Oracle, Check Point, Electronic Arts, and PayChex.


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