Sector Spotlight: Dot-Bomb or Not, Software Companies Look to the Net

In the past few months, practically every Internet-related company that hasn't closed its shutters has had to chug some poison -- shrinking markets, humiliating warnings, huge layoffs.

Yet some established software companies are looking squarely at the Net for future revenue and growth.

Software companies Microsoft (MSFT Quote) and Intuit (INTU Quote) are tying their future to the Net, transforming themselves, at least in part, into brainy application service providers, or ASPs, that deliver software-as-a-service via the Web.

The potential is large: The Gartner Group predicts that the global ASP market will surpass $25.3 billion by 2004. But there's no model for predicting whether Web-based delivery will drive growth. And while the early results from Intuit are tantalizing, they don't provide enough to extrapolate from. Analysts admit they're guessing.

Web publishing-software maker Adobe (ADBE Quote) has linked its future to the Net by making products that are used to design, edit and print Web sites, digital photos and documents. Video game maker Electronic Arts (ERTS Quote) has a Net strategy as well, seeking to dominate the online delivery of games through the Web.

In Microsoft's emerging .Net ("dot-net") program, consumers rent programs on the Net, rather than purchase shrink-wrapped software. The Redmond, Wash., colossus is setting out to reinvent itself, since more than 70% of its revenue is tied to the deflating PC market.

Exactly how much is Microsoft staking on .Net? "One hundred percent. This is the big bet," said Mister Softee Chief Executive Steve Ballmer at a recent industry dinner in Silicon Valley. He was speaking of new Microsoft products that will be based on open industry standards and support non-Windows devices and applications.

"The company is starting to transition all of their products to .Net. Even the shrink-wrapped software they sell will have .Net-compatible features. Everything they do will be under that umbrella," says Crowell Weedon analyst Jim Ragan, who rates the stock a buy. (His firm hasn't done underwriting for the company.)

That's quite a gamble.

"It's impossible to quantify how much .Net will drive growth," says Merrill Lynch analyst Henry Blodget, who projects the company's long-term revenue growth will be 10%, about 5% lower than Street estimates. "If .Net is successful, then applications on all devices will be floating on Microsoft's .Net operating system. But it's very hard to know if that will happen," says Blodget, who rates the stock an accumulate. (His firm hasn't done recent underwriting for the company.)

So far the .Net strategy has been much hyped but only loosely defined. Though analysts say material revenue gains are at least a year away, .Net is starting to show vital signs. Last week, cyber auctioneer eBay publicly backed the initiative, announcing that it will use .Net technologies starting later this year.

If Microsoft's software-as-a-service strategy is still in its infancy, then Intuit is a toddler. Intuit, the maker of Quicken personal finance software and the TurboTax tax prep programs, bases projections on only three years in Internet service delivery. So far, those figures look promising. Last year, Intuit's online tax filing service, TurboTax for the Web, attracted 1.4 million users. This year analysts expect two to three times that figure.

"The CEO Intuit hired last year [Stephen Bennett] has brought more focus to the company, emphasizing Internet strategy as well as the small business and tax units," says Goldman Sachs analyst Michael Hodes, who rates the stock a trading buy. (Goldman hasn't done recent underwriting for Intuit.)

In a recent report, Deutsche Banc Alex. Brown analyst Justin Post lauds the company's high-growth and profitable online businesses, payroll and mortgage, but explains that the company has the "conflict of building an Internet business (lowers operating margins) focusing investors on increasing profitability (30%-35% operating income growth guidance given for fiscal 2001.)" Intuit management told analysts on Friday that the company is still considering Internet-related acquisitions in its small business and professional tax arenas. Post expects 17% revenue growth for 2002 and maintains a strong buy. (His firm hasn't done recent underwriting for the company.)

Adobe, the desktop publishing leader, is pedaling fast to become Web publishing's top dog. Though it isn't an ASP model, users can download most Adobe products directly from its Web site. About 31% of Adobe's sales are tied to more traditional publishing, but expansion of the Web and multimedia design are responsible for driving growth estimates.

"All of the company is tied to the Net. Growth of the Internet is the underlying driver of the company," says Robertson Stephens analyst Sasa Zorovic, who rates the stock a buy. (His firm hasn't done recent underwriting for the company.) "But how fast that will be is really a guesstimate."

Despite slightly disappointing revenue results on Thursday, analysts generally agree that Adobe's product breadth, technology and strategy are sound. "Zorovic estimates 17% revenue growth for 2001, and 16% earnings-per-share growth. For 2002, he pegs revenue growth at 26% with flat EPS growth for the year. ("I padded marketing expenses for the year. I think they overdelivered on EPS this year," says Zorovic.)

Adobe's fastest-growing unit, Epaper, sells mainly the popular Acrobat products that allow users to publish and view documents on the Web. Epaper delivers about 20% of overall revenue. Robbie Stephens' Zorovic expects that segment to grow 50% in fiscal 2001.

In April, the company will release the latest version of Acrobat 5.0, on schedule. Acrobat is the de facto Internetwide standard. According to Zorovic, publishers need Acrobat to integrate Web and paper publishing workflow to increase productivity and decrease costs.

Merrill Lynch analyst Jay Vleeschhouwer expects Adobe to continue leveraging its existing Web-related franchises for future growth. Vleeschhouwer rates the stock a buy. (His firm hasn't done any recent underwriting for Adobe.)

Electronic Arts, already the top video game maker in the country, seeks to become the dominant video game delivery source from the Net. Electronic Arts is looking to deliver its popular video games, such as Madden NFL 2001, to users for a subscription fee. In 1999, the Redwood City, Calif.-based company took control of America Online's gaming channel and last October it launched online site EA.com. So far subscriptions have contributed only a relative crumb to revenue, but industry experts are enthusiastic about the company's online strategy. Among many deals designed to strengthen its online presence, the company recently bought private online gaming company, Pogo.com.

"We believe EA has the most complete online strategy in the interactive software space," says UBS Warburg analyst Mike Wallace, in a recent report. (He rates the stock a buy and his firm hasn't done recent underwriting for the company.) "We expect an IPO of EA.com in 2002," wrote Wallace.