2004: Software's Turn to Shine

If 2003 was the year investors rekindled their romance with hardware stocks, 2004 could be software's turn as belle of the tech ball.

After lagging behind the Nasdaq Composite's impressive gains this year, the software sector is poised to become the main attraction in 2004, presuming information technology managers loosen their purse strings.

"I think software will do better, although I don't think hardware will do poorly" next year, predicted Kevin Merritt, a software analyst with Fiduciary Trust Co. International in New York. Software "has got the most leverage in it, if anyone starts spending again."

Software companies typically boast higher margins than hardware vendors -- with the exception of some select chip companies -- because there are no incremental manufacturing costs since software is really just code, distributed to customers on CDs or downloads. So, increases in software sales typically lead to an even larger boost in the bottom line since there's no corresponding rise in expenses.

The problem in 2003 was companies kept a tight rein on IT spending, keeping a lid on software sales and minimizing the size of deals that did get done. Meanwhile, consumers forked over tons of money for things like digital cameras and laptop computers, fueling strong results in the hardware sector.

Consequently, software giants such as Siebel Systems(SEBL Quote) and Oracle (ORCL Quote) are still suffering year-over-year license revenue declines, while hardware heavyweights like Intel(INTC Quote) and Dell(DELL Quote) have been projecting double-digit revenue growth.

The dichotomy was reflected in the performance of the two sectors. As of Dec. 10, the Goldman Sachs Software Index was up about 35% in 2003, far better than its 44% decline in 2002. But software still trailed well behind the 57% jump in the Philadelphia Semiconductor Index, the 41% gain by the Goldman Sachs Hardware Index, as well as the nearly 38% climb in the Nasdaq Composite.