First, some good news about the software sector:

The unexpected bloodbath three months ago -- when about 20 companies rolled out warnings -- is not expected to occur again in the third quarter.

And now some bad news:

Investors who are expecting software sales to pick up in the fourth quarter -- and loft software stocks accordingly -- may want to brace themselves for a teary January, when fourth-quarter results become public. That's because companies are not projected to increase software spending significantly at the end of the year as much as in years past.

"I'm expecting some preannouncements

in the third quarter, but I'm not expecting as much of a bloodbath in stock reactions," said Steve Roth, an analyst with the

( NTTFX)John Hancock Technology fund. "I don't think we'll have as many just because some management teams were able to reset expectations last quarter."

The software industry's wild card, of course, is

PeopleSoft

(PSFT)

, which has been fighting a hostile takeover attempt by rival

Oracle

(ORCL) - Get Report

. The drama took another surprising twist on Friday, when PeopleSoft's board said it has lost confidence in Chief Executive Craig Conway and will let him go. The development increases the odds that Oracle will succeed with its $21 a share bid for PeopleSoft, or raise the offer.

PeopleSoft won't provide official guidance for the third quarter because of all the uncertainty resulting from the Oracle saga. But in Friday's announcement of Conway's departure, PeopleSoft Chief Financial Officer Kevin Parker said preliminary results for the quarter ended Sept, 30, 2004, suggest the company had "great success with both new and existing customers." He said licensing revenue for the third quarter is expected to exceed $150 million.

For analysts fearing a disaster at PeopleSoft, Parker's words were good news. But Sanford C. Bernstein software analyst Charles Di Bona noted that $150 million represents a 6.5% year-over-year decline, and surmised that PeopleSoft is still executing poorly.

"This is not a growth company," he said in an interview. "Conway really screwed up with the acquisition of J.D. Edwards. He took two flagging companies and put them together to get a bigger flagging company."

PeopleSoft acquired J.D. Edwards, a smaller vendor of software designed for manufacturing companies in 2002. The two companies operated as one for two and a half months during the year-ago quarter. That makes the just-concluded quarter the first one in which it is possible to make a meaningful year-over-year comparison of the beefed up PeopleSoft. (Sanford C. Bernstein does not have an investment banking relationship with PeopleSoft.)

In any case, software stocks have been roughed up so severely that there may be little room for them to fall further, said Standard & Poor's software analyst Jonathan Rudy. The Goldman Sachs Software Index has dropped 7.2% since July 1, before the first second-quarter preannouncements hit July 2. That's a bigger drop than the 6.0% decline suffered by the broader tech-heavy Nasdaq Composite and the 1.9% decline in the Dow during the same period.

In fact, expectations for software stocks are so low that share prices may actually increase on preannouncements -- as happened recently in other sectors with such companies as hardware makers

Texas Instruments

(TXN) - Get Report

and

National Semiconductor

(NSM)

and communications-equipment maker

Andrew

( ANDW).

"I believe we could definitely see that type of action

in software," Rudy said.

Because software companies close most sales at the end of the quarter, they could start rolling out earnings warnings as early as Friday.

Analysts are currently projecting

Microsoft

(MSFT) - Get Report

sales for its fiscal first quarter -- which corresponds to the calendar-year third quarter -- will actually decline sequentially by 3.3%, according to Thomson First Call. Last year, the software bellwether posted a 1.9% sequential increase in the calendar third quarter.

The difference between this year and last is even more pronounced for other companies, such as

Veritas

(VRTS) - Get Report

, whose second-quarter preannouncement took most observers by surprise. Analysts are projecting that Veritas sales will edge up only 1.2% sequentially in the third quarter, compared with a 9.4% sequential increase last year.

Still, Rudy believes both Veritas and Microsoft are probably safe from posting disappointing third-quarter results, because both have been relatively consistent performers. He has a hold rating on Veritas and a buy on Microsoft, which he calls "Mr. Consistent."

"I anticipate them to be conservative in their guidance as usual, and that could be the primary risk in the stock going forward," Rudy said of Microsoft.

Overall, the third quarter may be one that more clearly delineates the winners and losers. Other consistent areas of strength in the software sector have been companies that collect revenue on a subscription basis, security companies and business intelligence vendors. Companies expected to perform strongly in some of those categories include

Symantec

(SYMC) - Get Report

and

RSA Security

( RSAS), said Roth, whose fund holds both stocks.

Most at risk, Roth believes, are enterprise application software companies.

Lawson Software's

( LWSN) preannouncement earlier this month was one early signal that that corner of software will continue to suffer weakness.

Last quarter, customers unexpectedly deferred signing contracts, citing uncertainty about the economy, said Jim Shepherd, vice president of research for AMR Research, in a call with Prudential investors Wednesday. "The situation appears to have continued through Q3," Shepherd said. "We're just not seeing much activity here."

To compound matters, software vendors are offering "ludicrous discounts" to close deals, while customers are taking "virtually everything" to their boards of directors for approval, lengthening decision times, Shepherd added.

Companies suffering as a result of such trends include both

Siebel Systems

( SEBL) and Peoplesoft, which have both been hit by a spate of analysts trimming estimates in recent weeks.

PeopleSoft recently took a jab at its aggressor by announcing its quarterly license revenue had already surpassed Oracle's last quarter -- even though PeopleSoft still had about two weeks left in its quarter, when many deals typically close.

Rather than being reassuring, however, that news had just the opposite effect on Rudy, who noted that Oracle set a pretty low bar with only $69 million in new application software license sales last quarter. "If they're using that $69 million as a bogey, it doesn't sound like it's going to be a good quarter for them," said Rudy, who acknowledged that his $135 million estimate for PeopleSoft application sales will probably turn out high. (He has a hold recommendation on PeopleSoft; S&P doesn't do investment banking, but affiliates of S&P may provide other services to companies that Rudy is unaware of.)

German behemoth

SAP

(SAP) - Get Report

, however, is expected to remain the bright spot in the troubled enterprise software market. As in the second quarter, through execution and milking its large installed base, SAP may pull off another decent quarter, Shepherd said. But, "It's going to be difficult for any of the other major vendors to do much in Q3," he added.

Despite such clouds hanging over software, many investors and analysts are still counting on companies and their stocks to rebound after the fourth quarter, when tech customers typically make big purchases as they flush out their budgets at the end of the year.

"We do not anticipate a major meltdown in spending in the next four months and are optimistic that Santa will bring some budget flush to stockings in December," Merrill Lynch analyst Jason Maynard wrote in a note this week.

But other analysts disagreed. "Our conversations with IT consulting and software industry contacts continued to indicate that they do not anticipate a strong 'budget flush' effect in their business this calendar fourth quarter," A.G. Edwards senior analyst Yun Kim wrote this week.

Chuck Jones, who covers software and hardware for Stein Roe Investment Counsel, suggested another factor blamed for weak second-quarter results -- compliance with Sarbanes-Oxley -- could also temper this year's fourth-quarter budget flush.

"I think it

Sarbanes-Oxley is a bigger impact than what the surveys are showing," Jones said, calling it a "mini-Y2K effect."

Jones noted that Y2K, while admittedly a bigger impact on IT spending before 2000 than Sarbanes-Oxley, dampened IBM's typical fourth-quarter software sales boost in 1999 -- and that was a good year for tech.

But AMR Research's Shepherd said he doesn't believe Sarbanes-Oxley audits pending at the end of the year are delaying software purchases, though they may be a "distraction factor." Rather, he calls the fourth quarter a wild card, with little buying expected before the November elections.

After that, with many deals ready to be signed, sales growth could follow a steeper hockey-stick curve than in past years, Shepherd said.

On the other hand, "We're going to see an all-out fire sale in Q4

on software prices," Shepherd added. "A lot of managers ... haven't made numbers and are unsure about employment. They're going to look to flush everything they can through the system regardless of margin."

For investors, that means waiting until January to find out whether that fire-sale flush will be enough to stem the software bloodletting and resuscitate the ailing sector.

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