Rewind to 1996 and you'll get a glimpse of software's outlook this year. That was the take of Oracle ( ORCL) Senior VP George Roberts, head of North America sales, at the company's recent analyst day, and many software industry watchers agree it's a fair characterization. After all, 1996 was before Y2K and the dot-com boom drove tech spending -- and share prices -- into the stratosphere. These days, IT budgets have moved back to levels of leaner times. Merrill Lynch estimates a recovery in software will trail the economy and be more muted, with IT spending flat to up 3% in 2002 from 2001. But that's not to say software technology isn't moving forward, too. Software is still "almost absurdly profitable" with high gross margins and little capital investment required, concluded Merrill Lynch's global software research group in a weekly newsletter published earlier this month. Security and analytics are proving to be software bright spots. But investors beware: There's plenty of hype surrounding security, as well as the latest software sector du jour in software -- Web services. Integration is another popular buzzword, but there's debate about the long-term fate of middleware software suppliers in the wake of Web services. Meanwhile, the has-beens from the '90s business-to-business area will have to morph into supply-chain management specialists to survive. Here we take a closer look at those major areas of the software market and their prospects for the next year or so.
The Bush administration's recent emphasis on homeland security, including cyberterrorism, in the next fiscal year federal budget has fed the flames that have made security stocks hot. Even if IT spending is flat in 2002, security will show healthy growth in 2002 because companies are shifting their dollars in that direction, said Sterling Auty, an analyst with JP Morgan H&Q. So why be cautious? Douglas Sabo, manager of government relations at Network Associates ( NET), said the president has proposed $4.2 billion specifically for cybersecurity -- a 60% increase from a year ago. Network Associates, however, draws only a small portion of its revenue from the federal government, he noted. In addition, Congress hasn't passed any appropriations bills yet, so the numbers can change, said Israel Hernandez, a senior analyst with Lehman Brothers. And security-software makers are unlikely to sustain their substantial sequential growth in the fourth quarter -- pro forma earnings for Network Associates more than quadrupled -- because that was largely driven by virus attacks. Still, "those seem incessant in nature," said Hernandez. "There's enough growth there to sustain valuations." Hernandez rates Network Associates strong buy and Symantec ( SYMC) buy because he likes both stocks' valuations. He also has a buy on Internet Security Systems ( ISSX), which he said is more expensive but still has strong fundamentals. Of those three, his firm has done banking business with only Network Associates.
A less sexy software area poised to take off is analytics, which pulls together information from multiple sources to provide detail such as which customers are most profitable -- without forcing an executive to wade through several reports to figure that out. There's no strong leader, but big players such as Oracle, PeopleSoft ( PSFT), Siebel ( SEBL) and SAP ( SAP) are battling against smaller pure-plays such as Informatica ( INFA), Business Objects ( BOBJ) and Cognos ( COGN). Since Jan. 1, Business Objects shares have increased 16.6% and Cognos has gone up 14%, while Informatica has fallen 21.3%. "Companies have spent millions and millions of dollars putting in ERP Enterprise Resource Planning and CRM Customer Relationship Management systems. They're great. They're the backbone of the enterprise," explained Jon Ekoniak, a senior research analyst with U.S. Bancorp Piper Jaffray. "But they generate a ton of information: It creates information overload." Joshua Greenbaum, a technology consultant and principal at Enterprise Applications Consulting in Daly City, Calif., thinks the recent Enron debacle also will fuel more interest in analytics. "The whole issue of oversight is becoming even more critical, and it's not just oversight on a quarterly basis from the CFO side. It's oversight of the entire business," he said. "I think these analytics are going to become much more popular as companies say, 'I don't want to be Enroned by my own company.' "
The Big Guys
Overall, the big enterprise-software makers have expressed optimism about the full year. That goes for CRM giant Siebel, expected to increase earnings 20.4% this year, and SAP, expected to boost earnings 33.3%, according to Thomson Financial/First Call. PeopleSoft CEO Craig Conway also is among the enterprise-software executives who have used the "O" word. And for good reason: Wall Street expects PeopleSoft to increase earnings 23.7% this year. Oracle is the only big player whose earnings are forecast to be flat for the year, because its application business has stumbled and its database business has suffered competition from IBM ( IBM) and Microsoft ( MSFT). While those are formidable foes, Oracle may be taking the conservative route. "Oracle is still considered the gold standard in the database market," said technology consultant Greenbaum. "Its users are everywhere. The people who have trained on Oracle are all over the market." He also praised the company's latest integration technology. "If they can go out and execute sales and marketing, they've got the technology to do it," he said.
Of course, all of the major players are betting big-time on Web services, but no one more so than Microsoft. Today, the Redmond, Wash., giant launched a $200 million advertising campaign for its .Net initiative, promising businesses a way to integrate all of their business systems through Web services. But there's still disagreement about what, exactly, Web services are. To some, they're no more than the XML standard that allows different applications to talk to each other. Daryl Plummer, Gartner Dataquest's group vice president for software infrastructure, considers Web services one step along the way to delivering software as a service with steady revenue streams rather than as a shrink-wrapped, off-the-shelf product. But most agree that there are still plenty of hurdles, including security issues and the longevity of legacy systems, which some predict will survive for still 20 more years. That means Web services is unlikely to take off in any major way this year. And then there are skeptics like Greenbaum, who considers Web services just another software integration play. "I think Web services is a shadow game trying to become the next big thing. I think it's the next small thing," he said. "The next big thing is there is no next big thing."
Software integrators such as SeeBeyond ( SBYN) and WebMethods ( WEBM) also have jumped on the Web services bandwagon but make a point of saying Web services is no panacea. These firms, which also include Tibco ( TIBX), Vitria ( VITR) and Iona ( IONA), could benefit from Web services because they've been integrating software for years, or they could be replaced by them. Greenbaum thinks the latter ultimately will occur as integration becomes a feature of larger products from the likes of Oracle and SAP. Integrators already are getting swallowed up, he says, pointing to IBM's acquisition of CrossWorlds Software last year. Gartner's Plummer, however, calls integration "the only strong area" in software because it leverages existing IT resources, which are popular in tough economic times. But which middleware company to invest in? Erick Brethenoux, an analyst with Lazard Freres, favors Irish software maker Iona, which he believes has one of the strongest platforms. Iona saw revenue grew 18% in 2001 but lost $3.27 a share. Shares of the company, which has filed for a follow-on offering of 5 million shares, have fallen 15% since the beginning of the year. Brethenoux's firm hasn't done any banking business with Iona.
Companies also are looking inward to manage their supply chains better, but this may present a bigger opportunity for small, private start-ups than public companies. That's because companies are looking for specific products -- rather than spending more money on broader products provided by such companies as i2 Technologies ( ITWO) and Manugistics ( MANU), said Greenbaum. "They can't grow. They're shrinking because they can't have a lot of small deals," he said.
B2B a Bust?
To survive, B2B will have to be more closely linked to supply-chain management, industry analysts say. Ekoniak expects the ERP and supply-chain companies to develop the functionality that B2B companies have been banking their business on -- particularly marketplaces. Conversely, B2B companies such as Ariba ( ARBA) and Commerce One ( CMRC) are going to have to incorporate more supply-chain tools into their offerings. "There's a huge opportunity still in supply-chain management," said Philip Lay, senior managing director of the Chasm Group, which provides strategy consulting to high-tech companies. "It only has the surface scratched." He characterized the current B2B market as quiet but expects that to change soon. "Over the next six months, we'll find out if Ariba comes into the market and gets any new traction and gets large customers," he said. Lay expects the next year to determine whether the B2B companies are anything more than one-product wonders. "They don't have the survivability of a public company, so they're trying to build it in real-time," Lay said. "They should all really be private companies." But then, that would be so 1996.