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Quarter-End Insights

Our Outlook for the Software Sector

Software stocks for turbulent times.

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With concerns over the near-term performance of the U.S. economy, we think this is an ideal time to call attention to software companies that are well positioned to weather a potential U.S. economic downturn. In our opinion, wide-moat software companies that generate stable revenues and benefit from economies of scale should continue to perform well and perhaps even consolidate their dominance of their respective markets. Companies such as  Autodesk (ADSK) and  Microsoft (MSFT) sell software that is essentially a "must-have" for their customers, and while their near-term growth in the United States may be tempered, revenues and profits are not going to tank. For instance, Autodesk's AutoCAD software is central to  General Motors(GM) ability to design new cars, and to  Nokia's (NOK) ability to design new cell phones. As long as its customers are developing new products, Autodesk should continue to see healthy sales of its products.

Economies of scale should also enable wide-moat software companies to run profitable operations in the face of slowing growth, while their competitors that lack economic moats struggle to contain costs in the face of declining revenues. The software industry has been in the midst of a consolidation wave; over the past year there have been several acquisitions by industry giants including  Oracle (ORCL) and Microsoft. We expect this trend to continue and perhaps even pick up steam in the event of a downturn, as larger players with stable revenue streams use their strong balance sheets to pick up struggling, smaller companies on the cheap. Thus, wide-moat software companies are well positioned not only to sustain healthy revenues and profits but also to capture additional market share and emerge stronger when the dust settles.

Valuations by Industry
The following table displays the relative valuations of the aggregated software companies in our coverage universe, by subsegments.

 Software Valuations by Industry
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Business Applications  0.84 0.99 -15.2
Development Tools 0.94 1.04 -9.6

Entertainment/
Education Media 

0.93 0.92 1.1
Systems and Security 1.03 1.03 0
Data as of 03-14-2008.

It is clear from the table above that the market has soured somewhat on stocks of companies that sell software to enterprises. This appears to reflect a general concern that some firms view IT as a cost center and near-term IT budgets in the U.S. could shrink as a result of belt-tightening. Although U.S. IT spending might indeed be lower in the near term, the same cannot be said for spending in other geographic areas such as emerging markets, many of which continue to grow at decent rates. As businesses in those markets expand to serve growing local needs, companies are likely to increase spending on software that enables superior product development and improves the overall efficiency and reliability of business processes. Thus, we can incorporate an element of growth in our stock selection process by adding geographically well-diversified revenues to our stock selection criteria. This, coupled with our premise of stability in wide-moat software companies, results in the list of software stocks below.

Software Stocks for Your Radar
 

 Stocks to Watch--Software
Company Star Rating Fair Value Estimate Economic
Moat
Risk

% Below Fair Value

Autodesk  $50 Wide Average 35
Oracle  $22 Wide Average 8
Microsoft  $35 Wide Below Avg 16
Dassault Systemes  $62 Wide Average 11
Electronic Arts  $61 Wide Average 21
Data as of 03-19-2008.

 Autodesk (ADSK)
Autodesk is the leading vendor of computer-aided design (CAD) software and continues to be one of Morningstar analyst Rafael Garcia's favorite companies in the software industry. The company dominates the CAD market, and its software products are the de facto standard in the digital design of physical products. Autodesk leverages a global distribution network to sell its products, and overseas sales accounted for over 66% of the company's 2007 revenues, with emerging markets comprising 14% of total sales. Autodesk's broad-based revenues and dominant market position should enable the company to continue growing profitably for the foreseeable future.

 Oracle (ORCL)
Oracle has been leading the consolidation wave in the enterprise software industry, and the company's pending acquisition of  BEA (BEAS) is testament to Oracle's sustained strong sales and profitability. The company's acquisition-fueled expansion into enterprise applications is driving growth in sales and profits, and we expect the pending acquisition of BEA should deliver synergies and create opportunities that further this trend. The company is geographically well diversified and derived about 57% of 2007 revenues from overseas sales. Investors would be well advised to monitor this stock for a good price from Mr. Market.

 Microsoft (MSFT)
Microsoft's stock, which has ventured into 5-star territory, is a compelling buy. While Microsoft faces various challenges from nimble competitors in the online space, the company's Windows and Office franchises continue to dominate the desktop PC software market. In 2007, international sales accounted for about 39% of the company's revenues, with particularly strong growth in emerging markets such as Brazil, Russia, China, and India. Microsoft's dominant market position and excellent international growth prospects should continue driving profits higher for a long time.

 Dassault Systemes (DASTY)
Dassault Systemes possesses a dominant position in product life-cycle management (PLM) and 3-D computer aided design software. Adoption of the company's products has expanded beyond traditional industries such as power plants and medical equipment to hitherto untouched industries, such as the Barilla Group--a pasta maker that uses Dassault products to develop new products faster and reduce lead times. Sales in Europe and Asia accounted for about two thirds of the company's 2007 revenues, and the upcoming release of the company's new V6 product should propel growth over the next few years.

 Electronic Arts (ERTS)
Breaking from the enterprise-software-focused list above, we would like to point to Electronic Arts as a solidly positioned consumer software company. Electronic Arts dominates the U.S. market for console games and has the best diversified games portfolio among video game publishers. While the company derives most of its revenues from developed markets in North America and Europe, the entertainment industry, including video games, has historically maintained healthy sales through economic downturns, as games offer a readily accessible escape from economic realities. This, coupled with EA's strong upcoming lineup of new games, positions the company well to deliver growth and profits to shareholders.

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Sunit Gogia does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.