From the November 2007 issue of Research Magazine • Subscribe!

Time for Tech

Software companies are finding demand growth and other opportunities, which should life stock prices, according to an equity analyst.

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Marc GeallCitigroup+44-20-7986-4026marc.geall@citi.com

Area of coverage: Software

Sector outlook: We believe now may be one of the best times to be invested in software as the sector has tended to outperform in the second half of the year. Valuation has retreated to 2007 lows; demand fundamentals are attractive on accelerating personal computer unit growth; and the sector is relatively shielded from mortgage-related credit woes.

Typically, the first half of the year is seasonally a period of weak demand for the software industry as corporate buyers work on finalizing their budgets and take time planning out their purchases for the full year. For software vendors, that means fewer large license deals and risks of earnings pre-announcements. This year, 2007, has been a little different -- at least on the demand side, though not reflected in stock performance. Many of the large tech vendors -- including IBM, SAP, Oracle, BMC Software and Computer Associates -- have reported healthy second-quarter software revenues and bookings.

While there were some conservative comments on second half of the year deal pipelines, the general sentiment was for a positive demand environment for the rest of 2007 -- aided by government customers' budget flush in the third quarter and enterprise flush in the fourth quarter. In addition, fewer companies pre-announced negatively in the first half of the year.

In contrast to strong fundamentals, stock performance for the software sector has been lackluster year-to-date through the end of July -- on average, the sector is up a mild 2.1 percent (versus the Nasdaq Composite's 5.4 percent gain) and price-to-earnings multiples are at 2007 lows.

Given expectations for continued healthy fundamentals and a robust mergers and acquisitions environment (2007 median enterprise value/sales multiples up over 40 percent vs. 2006), we believe that the second half of 2007 will prove rewarding for software investors.

Seasonality has been investors' friends in the past four years (2003-2006), with the sector up 22 percent on average for the August-December period. This year seems well set up as the sector's price-to-earnings ratio of 22.0 times earnings is the lowest of 2007. Mergers and acquisition valuations are up in 2007 (3.9 times EV/S vs. 2.7 times in '06), though they could moderate.

Keep an eye on software vendors' exposure to the financial-services industry, which represents roughly 20 percent of overall IT spending and could be influenced by mortgage-related losses.

Buy recommendations: Adobe Systems (ADBE), Akamai (AKAM), Autonomy (AUTN.L), BEA Systems (BEAS), Business Objects (BOBJ), Check Point Software (CHKP), Microsoft (MSFT), Nuance Communications (NUAN), SAP (SAP) and Symantec (SYMC).

About SAP: The buzz on SAP concerns the pending release of new software product A1S. SAP hosted a launch event in New York on September 19 and memos described it as "a key milestone in SAP history." The A1S announcement was focused on the naming and branding of the product; the pricing strategy; partner relationships; and customer endorsements. The challenge will still be to scale the business to $800 million-$1 billion in less than three years, making it the fastest ever software product release to reach this level, if successful. For now, A1S should be viewed as a short-term distraction from the primary growth driver in 2008. A1S will not have a meaningful earnings impact until 2010.

Current financial market focus is on the pending A1S launch, which has possibly become a distraction to the current challenges and opportunities SAP faces. Earnings in 2008 will be driven by SAP's core software. It is the potential functional upgrade and cross-sell of the core SAP software offering that is expected to deliver growth in 2008 and 2009. The more important, and almost forgotten, short-term growth driver that should help accelerate business in 2008 is the full-product portfolio release on the business process platform (BPP) expected at the end of this year (and following the successful ERP6.0 launch in 2006).

Now that customers have migrated to a stable core (ERP6.0), there is an opportunity to cross-sell new products and new users. The mid-market is an important additional growth leg but is unlikely to have a meaningful impact until 2009-2010. The immediate challenge is therefore to grow share of wallet in the existing customer base -- a profitable opportunity if executed against.

We estimate that the license potential for SAP could be between EUR3.5bn and EUR24bn from the existing core enterprise customer base.

SAP has 41,200 customers and has generated EUR26.5bn in license revenues since 1994. This implies EUR643,000 in licenses per customer. If we assume EUR1.5bn in total A1/B1 licenses this implies approximately EUR1.5m in licenses per enterprise customer. Since the revenue opportunity over the next two to three years is going to come from increasing share of wallet, we need to assess the revenue opportunity from successful execution of its BPP strategy: drivers include new users, new products, and increased scope.

SAP's stock is trading 20 times our 2008 earnings per share estimate, and we forecast a three year earnings per share compound annual growth rate of 19.2 percent. This is a discount to the sector for a global industry leader, and we would expect improved momentum in the second half of 2007.

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Clifton Linton is a Bay Area-based writer specializing in energy markets.

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