Instead of Hexing the Market, i2's Warning Works Like a Charm

Maybe things aren't as bad as you think.

Just look at i2 Technologies(ITWO Quote), which rallied as much as an unlikely 17% Monday after the supply-chain software company issued a profit warning. Yeah, that's right. In more recent trading, the stock was up $1.31, or 9%, to $15.81. Remember, though, the stock is off 84% from its 52-week high of $99.44.

The gain was the result of widespread expectations that i2 -- along with the rest of the software sector -- would cause the sun to be as black as sackcloth before releasing a horde of locusts on the market. As it turned out, the company merely said it experienced a spot of famine -- nothing to get too concerned about, considering these economic times.

"From what I heard on the call, I came away feeling a lot better, not worse," says Richard Williams, an analyst at Jefferies who rates i2 shares a buy. "This was a better report than widely feared." (Jefferies hasn't done underwriting for the company.)

In a release and during a conference call Monday, i2 said it anticipates 2 cents per share in earnings for its fiscal first quarter, off from the nickel that analysts were expecting, according to Multex.com. Revenue, however, is expected to come in slightly higher than the $350 million analysts were expecting, at $355 million. The shortfall will mean that i2 may lay off as many as 10% of its 6,100 employees.

The profit warning was the first during a week when many software companies are expected to pull out the red flag. Ariba(ARBA Quote), Commerce One (CMRC Quote) and Siebel Systems (SEBL Quote) are all on analysts' short lists of potential warning candidates.

Already on Monday, Art Technology Group(ARTG Quote), the middleware software company that was expected to weather the economic downturn better than most, warned it would show a loss instead of a profit for its quarter. Shares of Art were off more than 50% on the news.

Given that backdrop, i2's preannouncement was relatively benign.

"All things considered, they did a very good job. The metrics didn't fall off a cliff," says Brent Thill, an analyst at Credit Suisse First Boston, who rates i2 shares a buy. He cites the 100 new contracts the company said it completed in the quarter, as well as the $2 million average deal size i2 reported. (His firm has done banking business with the company.)

Even after the dramatic selloff this year, shares of i2 still trade at a still not-cheap 46.5 times analysts' 2001 earnings estimates. If the company takes its financial guidance down lower -- which it indicated it could -- the stock could become even more expensive, even if its price sinks further.

"The question is if there's any 'E' left in the P/E ," says Jefferies' Williams.

The rally in shares of i2 is reminiscent of Tibco Software (TIBX Quote) two weeks ago. After beating lowered expectations for its quarter, shares of the integration-software maker jumped, because they had been beaten down so dramatically in anticipation of the news. As was the case then, analysts also said short-covering could be responsible for i2's rally.

Before you start feeling too good about i2's numbers, though, think about this: i2 beat revenue estimates but said that earnings would be lower than expected. That means the company didn't have as tight a handle on costs as it thought it would.

Translation: More people are going to lose jobs. On its conference call, the company said it could potentially lay off 10% of its workforce, or 600 people. Since the beginning of the year, the company has hired 500 people, it said. Now, it looks like many of those will have to put their resumes back in circulation.

Yet i2, which was founded in CEO Sanjeev Sidhu's apartment in 1988, has been around longer than many other companies doing business in the enterprise software sector, and i2's management may have more practice managing the numbers. If they can't get it completely right, that could signal deeper problems at less-established firms.

"They were able to control costs to some extent because of the infrastructure they have in place," says CSFB's Thill. "At some of the younger software companies where they don't have the pre-established infrastructure, controlling costs is going to be very hard."

All this means bad news at some companies might be received better than bad news at others. For instance, sentiment right now on Ariba is arguably at a nadir, with investors expecting so much bad news that the stock could rally if just a little bad news comes out.

But other companies like Veritas Software (VRTS Quote) and BEA Systems(BEAS Quote), on which investors still have high hopes, could get hit hard if things are even a little bit worse than once thought. In other words, software isn't out of the woods yet.

"No one is immune in the software world," says Thill. "There will probably be more pain to come this week from other vendors. Even in i2's case, I'm still not comfortable telling people we've hit the bottom."

In other words, don't stop construction on your ark just yet.