Markets & Finance

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.

In terms of who will dominate, we won't really know until a few years out. It's remarkable to see both companies do well by pursuing such different strategies. Having said that, I do think that enterprise applications is a mature market and is overcapitalized, so there are many companies chasing after customers' dollars. Consolidation is a natural next step.

Are there any other companies that you like in the applications area?

Lawson is a much smaller company, with a market cap of about $1.8 billion. About a year ago, Lawson acquired Intentia, which helped it increase its geographic scope, expand its customer base, and raise its profile to become a top-five player in enterprise resource planning. The company serves the fast-growing small and midsize business segment, which we think is underpenetrated and underserved.

On a valuation basis, the shares look attractive. They recently traded at $10, a discount to peers based on enterprise value-to-sales.

What are the major trends to watch in software heading into yearend and early 2008?

We expect M&A to continue for the reasons mentioned above, essentially because it's a mature market and overcapitalized. We also expect the big vendors to push into the domain of smaller pure-play companies in areas such as business intelligence, the on-demand delivery of software. We also think large vendors will try to serve the smaller and midsize business area, which is growing faster than large enterprises.

Something else to watch out for going into yearend is we'll learn more about the impact of recent troubles in the financial-services sector and how they will affect IT budgets in the coming year. Right now we're recommending companies with large, diverse customer bases and products and international exposure, because those markets will offset slower economic growth that we're seeing in the U.S.

How have software stocks performed this year? Do you think they will continue to have momentum, and why?

Through Sept. 21 the application software group was up 10.8%, while the Standard & Poor's 500-stock index rose 7.6% year-to-date. There has been notable buyback activity in the group, along with M&A. The group is also benefiting from the fact that they have a lot of international exposure, so they're less vulnerable to a slowdown in the U.S.

There's been a rotation into tech in light of what's happened recently. Many people regard tech as a safe haven from the fallout in the financial sector.

For the moment, I think corporations will continue to look to software as a way to increase productivity of their workforces. And we've come through a hardware upgrade cycle that's been pretty robust—and that bodes well for software. What's more, the companies are fairly healthy and have good balance sheets.

However, I have a neutral fundamental outlook for this group because a lot depends on yearend spending, plus the stocks have already run up. It's difficult to say that we won't see some kind of scaling back in IT spending. Also, our view has been that software itself is a mature industry. Growth is not in the teens or twenties anymore—it's a steady-Eddie industry growth in the mid-to-high single digits.

That's why we favor companies that compete in attractive markets and have overseas exposures and diverse customer bases. Even though I'm neutral on the subindustry, I do like a few stocks that I think will outperform the group. They include Oracle, as well as buy-recommended stocks Lawson, Adobe Systems (ADBE), Business Objects (BOBJ), and Informatica (INFA).


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