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