Siebel Systems ( SEBL) got the fourth-quarter earnings season off to a sprightly start Wednesday, preannouncing stronger-than-expected revenue and earnings . And other major software vendors also are likely to make or perhaps exceed expectations.

But don't let last quarter's results fool you.

The first half of 2005 isn't likely to duplicate the rally that pushed the Nasdaq up 24% and the Goldman Sachs Software Index by 37% in the last five months of the year. "Q4 was great, now what do you do for an encore?" asked Rich Parower, portfolio manager of the Seligman Global Technology Fund.

Indeed, the first three days of trading in the new year were disappointing as the Nasdaq slipped nearly 4%, amid worries about inflation and the price of oil. Add to that concerns over higher interest rates and the weakening dollar -- not to mention potentially overheated M&A expectations -- and the picture for software investors becomes unusually complex.

It's no news to experienced software investors that the first quarter is normally the seasonally weakest of the year. But the first quarter of 2004 was stronger than average, making year-over-year comparisons with this year's first quarter fairly tough.

Moreover, "a lot of companies gave conservative guidance for the fourth quarter and that led to the run-up," said Ryan Tansey, an analyst with John Hancock. With solid fourth-quarter results largely baked in, Ryan is expecting a "buy the rumor, sell the news" reaction.

The muted reaction to Siebel's upside surprise certainly lends some credence to Tansey's thinking. Despite handily beating consensus for total revenue and license revenue, as well as a jump in operating margin, the stock ended Wednesday's session with a loss of 27 cents, or 2.7%, to $9.61.

To be fair, a number of sell-side analysts saw the company's performance as an indication that the turnaround efforts of Mike Lawrie, who became CEO last year, are beginning to be felt. Investors will get a better idea of his progress on Jan. 27, when Siebel reports final fourth-quarter results, and more significantly, gives guidance for the first quarter and the fiscal year.

In any case, there are larger factors at play than any software company's ability to execute:

  • Sales are going to be hindered by anemic IT spending in 2005. A fall survey by Goldman Sachs found that spending is expected to grow by just 3.7% this year, despite a reasonably healthy economy.

  • Higher interest rates will have an impact on many companies, and some will sharply lower EPS estimates as they begin to treat options as a compensation expense, said Chris Bonavico, a fund manager at Transamerica Investment Management.

  • Software companies that do business in dollars have benefited from the greenback's continuing weakness. Richard Williams, of Garban Institutional Equities, noted that without currency effects, Siebel would have missed its EPS target by a penny.

    But a currency tailwind has become routine for many companies, and despite repeated warnings from Williams and other analysts who think the sliding dollar masks fundamental weakness, investors don't seem to care. So for now, the soft dollar remains a plus for most software companies.

    Consolidated Gains

    With Oracle ( ORCL) finally winning the long fight to acquire PeopleSoft ( PSFT), and Symantec ( SYMC) executing a friendly merger with Veritas ( VRTS), investors finished 2004 fixated on consolidation in the sector.

    Has it gone far enough? "There are still too many software companies," Bear Stearns analyst John Diffucci said during a recent interview on CNBC.

    Diffucci believes the software companies most likely to be acquired include Sybase ( SY), Retek ( RETK) and Lawson Software ( LWSN).

    But Siebel and BEA Systems ( BEAS), both widely considered to be takeover targets, are too expensive, at least for now, Diffucci said.

    The ever-present prospect of more mergers has added a takeover premium to a number of stocks, said Bernstein analyst Charles Di Bona. And one beneficiary could be a company that has no chance whatsoever of being purchased -- Microsoft ( MSFT). "I think over the next half year as people get disillusioned with the underlying growth, and M&A turns out not to be as lucrative as they hoped, there will be a rotation back to Microsoft," Di Bona said. (Bernstein doesn't do investment banking; its parent, Alliance Capital, holds Microsoft shares.)

    Di Bona is not alone in his call on Microsoft, and even though the software giant won't ship its next generation of operating system software until 2006, it's starting to look like a safe haven once again.