Security Software Gets Mind Share, but Not Sales

When thoughts turned to security after Sept. 11, it seemed only natural for investors, by extension, to home in on security software as a source of hope in the beleaguered tech sector.

To some degree, those investors have been rewarded, but not because of Sept. 11. The tragedy may have heightened security concerns, but some security software stocks already were enjoying a boost because of a rash of viruses. And although security moved up to the No. 1 priority for information-technology spending among chief investment officers, any gains in some security stocks have been driven by consumer demand rather than corporate spending, mirroring broader economic trends. Since Sept. 11, the sector has trailed behind a very weak broader market.

Within days of the World Trade Center attacks, the FBI-backed InfraGard Web site warned of increased cyberattacks, which could only be thwarted by tighter computer security.

On the first day of trading after Sept. 11, a few security stocks posted early rallies -- Internet Security Systems(ISSX Quote) jumped 20% at one point Sept. 17 -- which faded with broader weakness in tech stocks. At that time, Legg Mason analyst Todd Weller suggested in a note that the early rally reflected investor opinion that the tragedy would drive business to network security vendors. But he also cautioned that while the events likely would increase awareness of the need to better protect networks and IT assets, he did not expect vendors to see a near-term sales jump.

"Nine-eleven has not had any effect on security software spending," said Lehman Brothers analyst Israel Hernandez, who covers the sector. "It raises awareness, but at the end of the day, it doesn't create dollars. At the end of the day, IT spending is difficult."

Instead of prompting companies to funnel dollars to security software makers, analysts say, Sept. 11 led to greater spending on physical protection -- things like security guards, guns and dogs.

Still, security software stocks have proven a far better bet than infrastructure software stocks since Sept. 11. One major reason: Security software sales are growing while enterprise software sales continue to shrink. Yet security software makers on average trade at a 32% discount to general software based on P/E and P/S ratios, according to a July 30 report by Lehman Brothers comparing an index of 14 security stocks against a broader index of 20 of the most widely held enterprise software companies.

Security Software Shines Brighter Enterprise packages take a back seat
	2002 y-o-y rev growth*	Q2 sequential rev growth	Q2 y-o-y rev growth	2003 P/E ratios	2003 P/S ratios
Security	7.7%	3.1%	10.9%	22.4	2.5
Enterprise	-9.5	-7.7	-12.7	29.5	2.3
*estimate Source: Lehman Brothers July 30 report

The outlook for security companies appears to be softening, although they still are faring better than enterprise software, Prudential Securities analyst Michael Turits said in an Aug. 1 note on the security sector. He cited a slashing of consensus forecasts for security software companies, but noted that the cuts were smaller than those for enterprise software companies.

Compared to larger indices, however, the performance of security software makers' stocks is less impressive. Since Sept. 11, an index of 29 IT security stocks was down 45% as of Aug. 27, while the Nasdaq was down 14% and the S&P 500 was down 21%, according to an analysis by JPMorgan H&Q.

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"Security has handily underperformed the Nasdaq," JPMorgan H&Q analyst Sterling Auty said.

So far, security software has held firm to its No. 1 position on CIOs' priority list. It moved to the top ranking in January after sitting at No. 2 in November, and has stayed there ever since, according to Morgan Stanley's latest survey of 225 CIOs, released in July.

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While IT managers say spending will continue to decline overall, security software spending will decline less or stay flat, Turits wrote in his Aug. 1 note.

After Sept. 11, IT security focused on backup and recovery and the ability to maintain business communications, rather than putting in firewalls or authentication, said Mark Bouchard, senior program director, global networking strategies, at research firm META Group. The only area of security software that may have really benefited, however, is intrusion detection, because of increased worries about a cyberterrorist threat, he said. That's an area dominated by Internet Security Systems, whose shares are up about 43% from their post-Sept. 11 low.

"An additional firewall wouldn't have prevented anything from happening on Sept. 11," echoed Josh Freedman, a technology analyst at Berger Financial Group. "Additional integration software might have," he added, referring to integration of information systems between agencies such as the FBI and Federal Aviation Administration.

Indeed, that's why it should be no surprise that enterprise software vendors such as Oracle(symbol Quote), Siebel Systems(SEBL Quote) and PeopleSoft(PSFT Quote) are peddling homeland security products. Similarly, security vendors are anxiously awaiting more government spending, but investors shouldn't expect too much too fast.

"The government cycle is not one of quick action," said Charles Kolodgy, IDC research manager, Internet security. "We think that's going to happen, to catch up, in the next year as program budgets that were created last summer get approved this fall."

So if corporate and government spending are not driving software security makers' performance, what is? Similar to the larger economy, consumers have been pushing these companies along.

That's especially true for Symantec(SYMC Quote), the maker of Norton antivirus products, which Lehman's Hernandez credited with having "an unequivocal blowout quarter" in its fiscal first quarter ending June 30.

Growing broadband adoption combined with outbreaks of the Code Red and Nimbda viruses last year have been boosting Symantec's consumer antivirus sales. But some analysts warn that slower broadband adoption, an increasingly penetrated antivirus market and weak PC sales may stall future sales.

Indeed, even Symantec CEO John Thompson has stressed that the company does not believe its consumer virus growth can continue indefinitely. That's part of the reason the company is setting its sights on more corporate sales -- the mainstay of competitor Network Associates(NET Quote). Symantec's enterprise security business grew 35% year over year in the most recent quarter.

Network Associates, meanwhile, is trying to gain a stronger toehold in Symantec's consumer market. That goal has driven the company's effort to acquire its Internet spinoff McAfee.com (MCAF Quote) in just one of many long-anticipated consolidation moves beginning to hit the security software sector.

Rather than a heightened awareness of security triggered by a tragedy like Sept. 11, Symantec needs an improvement in the economy and IT spending in order to gain a larger share of the enterprise market. And that's something that most tech companies have been praying for, but which continues to elude them.