Software Sector

Outlook

Global markets appear to be shaking off the recent unprecedented withering of the financial system and are looking for an upturn. But is it sustainable or is it a short-term event?

So far, a string of drastic actions by the Federal Reserve and both the Bush and Obama administrations has yet to turn around a bunker mentality. Banks fear lending money to each other and to their customers. Businesses are reluctant to hire and boost capital investments. Consumers have hunkered down.

All the economy's problems are feeding off each other, creating a vicious cycle that Washington policymakers are finding difficult to break. Even if the turmoil gripping Wall Street were to let up and badly shaken confidence in the banking system were fully restored, a "broader economic recovery will not happen right away."

Obviously, the technology industry is not immune to the current economic downturn. Companies in technology groups will not only be impacted by the downturn, overall technology spending may also be curtailed significantly going forward. While lower prices on consumer electronics may help carry the tech industry through a difficult holiday shopping season, corporate spending on computer servers, PCs and business software is entering a period of slower growth that may last well into next year.

The impact on businesses is also not encouraging: Forrester is projecting that overall business information-technology sales will grow 6 percent in 2009, compared with 5.4 percent in 2008 and 7.2 percent in 2007.

Software Sector

While software stocks have suffered in kind with the market recently, we believe they generally represent a compelling opportunity, even if we are in a recession, especially relative to other technology sectors. Part of this is because many of them cater to corporations, not consumers, and corporations will likely continue spending money on maintenance even if they reduce spending on new software licenses.

The overwhelming majority of the current profit of corporate software companies is driven by maintenance, not license or consulting services. As such, profits at these companies will likely suffer less, and relative to most other technology sectors against a difficult economic backdrop.

Business and corporate across various sectors like finance, retail, telecommunication, etc. are deploying IT-enabled business solutions in order to increase their productivity and keep themselves updated with the rapidly changing global IT industry trends, translating into a high demand for IT-enabled business solutions. Other than this, the shooting rates of Internet adoption across the world and rising threats on Internet (like malware, spam and hack attacks) are bolstering the demand for IT security solutions and related software.

Opportunities

In spite of the bleak outlook, companies in the Application/Business Software sector are making only modest spending cuts so far. According to Gartner Inc., a market research firm, spending on technology won't increase the previous forecast 5.8%, but it won't decline either. Gartner is looking for a modest increase of 2.3%, mostly pushed up by emerging markets. The firm expects the U.S. to be flat, and Europe to be slightly negative.

While most software companies are implementing a series of internal cost-cutting measures, these are steps that companies typically take in an economic downturn -- a hiring freeze, no non-essential travel, and so on. Generally speaking, a downturn is when investment in IT is most critical because these investments can make operations more efficient. This idea is one reason why we think that the tech sector would weather a downturn better than other parts of the economy.

Software giant SAP ( SAP - Analyst Report ) is apparently not halting its own tech spending. Instead, the company continues to make strategic investments in IT projects that directly impact its ability to grow business globally. SAP expects its customers and prospects to continue strategic IT spending over the next months, while somewhat narrowing their focus more to IT projects that deliver quick returns.

More importantly, what would help many of these companies to withstand economic headwinds are category leadership, performance based marketing offerings, higher international exposure, strong & seasoned management team, product innovations and a strong balance sheet. Companies that may fit the bill are Fiserv ( FISV - Analyst Report ) and Intuit ( INTU - Snapshot Report ) .

Weaknesses

The biggest risk to the tech market comes not from the Wall Street collapse, but from a collateral U.S. recession. While tech spending grew 8% in the U.S. in 2007, Forrester was forecasting tech purchases to be up 5% in 2008, and up 6% in 2009. Given that the economy is still in a recession mode, this represents the second downward economic cycle for the IT sector in recent times.

Each Internet and Application Software company is at a different phase of its evolution in terms of scale, market share, investment in IT infrastructure, geographical expansion, operating leverage, new product release, pricing model and strength of balance sheet. A recession will be felt harder by those companies that have been delivering extremely high organic growth rates, have high operating leverage, or are approaching minimum operating scale levels in 2008/2009.

Also, due to the US dollar appreciation, Internet Software companies with significant non-US revenues such as Digital River ( DRIV - Snapshot Report ) and VeriSign ( VRSN - Analyst Report ) are continuing to experience FX headwinds in addition to a slowing international economy.