After enjoying a major run over the last month, software stocks have started to get hit by analyst downgrades based largely on valuation.

UBS Warburg downgraded its ratings Friday on

Mercury Interactive

(MERQ)

,

Tibco

(TIBX)

,

webMethods

(WEBM)

and

RSA Security

(RSAS)

.

RBC Capital Markets, meanwhile, downgraded

BEA Systems

(BEAS)

,

Computer Associates

(CA) - Get Report

,

Veritas

(VRTS) - Get Report

and

Quest Software

(QSFT)

. RBC's move on Veritas followed a similar downgrade Thursday by First Albany.

After reporting third-quarter numbers that were less dire than many expected, enterprise software application companies proved to be among the best-performing tech stocks in October, rising about 45%.

Shares of Tibco declined 13.4% in recent trading Friday, while webMethods was down 12.2%. Computer Associates shares fell 87 cents, or 5.5%, to $14.86 in recent trading; BEA dropped 38 cents, or 4.3%, to $8.56; and Veritas lost 91 cents, or 5.3%, to $16.21. Mercury Interactive and RSA were both down less than 3% in recent trading.

Pretty Steep

In a note this week, Kaufman Brothers Equity Research said that on average, software companies' forward price-earnings ratios of 26 are lower than their historical pre-Internet bubble levels, but still a premium to the

S&P 500's

P/E. The days of software companies missing expectations or dramatically lowering them are probably over, but valuations are not cheap, Kaufman enterprise software analyst Kevin Buttigieg wrote in his note Wednesday.

"As software companies are likely to lag a general economic recovery (but post better relative growth once one begins), we think it is difficult to argue that software stocks deserve a further premium," Buttigieg said.

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Analysts who have downgraded stocks this week agreed. "Following an impressive run in the stocks over the past several weeks, we are lowering ratings on four infrastructure software companies based entirely on valuation concerns," UBS Warburg analyst Jordan Klein wrote in a note Friday. "Despite fundamentals that seem to be stabilizing or even modestly improving as we head further into the seasonally strong Q4, we are uncomfortable maintaining certain ratings due to our expectations for limited further upside from current levels."

Klein lowered ratings on Mercury Interactive, Tibco and webMethods to hold from buy, noting they have either approached or exceeded his 12-month price target. He downgraded RSA to reduce from hold because its share price exceeds his price target by 40%. UBS Warburg hasn't done banking business with any of those companies.

Klein said he remained concerned about the sustainability of any potential rally, especially as the seasonally slow first quarter approaches. He said IT spending is showing signs of improvement in North America, but other regions such as Europe seem to be deteriorating modestly.

Not Deserving

RBC Capital analyst Sarah Mattson noted that the 15 software stocks she covers have soared an average of 50% in the past six weeks, excluding Thursday's drop, while growth prospects remain muted. She lowered BEA, Computer Associates and Veritas to underperform from sector perform and Quest to sector perform from outperform. Mattson's firm has done investment banking business with CA.

Mattson cited concerns about commoditization and open source competition hurting BEA's application server business in fiscal year 2004. Yet the company's stock was trading at 31 times 2004 earnings and an enterprise value-to-revenue multiple of 3.3, both representing a premium over other software stocks.

On CA, Mattson expressed concern about the company's mainframe dependence, decreasing contract values and debt load, while noting shares were trading at a whopping 61 times her 2003 calendar-year earnings estimate. On Veritas, Mattson pointed to deteriorating

Sun Microsystems

(SUNW) - Get Report

and

Microsoft

(MSFT) - Get Report

relationships, while noting the stock was trading at 31 times 2003 earnings estimates.

But unlike Klein, Mattson maintained her sector perform rating on Mercury Interactive and raised her price target to $32 from $27. While the stock is trading at 28 times her 2004 earnings estimate, Mattson noted that the company's testing business continues to perform despite tight IT spending and its application performance management business continues to grab market share.