Skip to Content
Stock Strategist

Our Outlook for the Software Sector

Software investors don't need to look for the next big thing to find opportunities.

Mentioned: , , , ,

<< Return to Main Market Outlook Page

As the overall IT industry continues to mature, large companies are unable to innovate quickly enough to renew the double-digit growth rates they once had. Many of these large software companies have been aggressively amassing a collection of related companies, defending their turf and hoping to gain enough cost synergies to justify the prices they are paying. We don't expect these "old world" software companies to grow in the double digits over the long haul, excluding the impact of acquisitions. Meanwhile, a smaller number of specialty software vendors have been posting double-digit growth, well in excess of the overall industry. Unfortunately, we think many of these companies owe their success to serendipity more than competitive advantages, so we tend to view many trends in the software world under a skeptical lens.

In this environment, software vendors need to adapt to customers that expect software investments to drive additional revenue or a reduction in operating expenses. Bells and whistles don't matter. Although we believe this investment environment is overly focused on growth potential, we prefer to focus on long-term competitive advantages. We are attracted to both high growth and lower growth opportunities, provided they trade at a margin of safety from our fair value estimates. Fortunately, the whims of investors change as often as the weather, so patience can allow anyone to invest in both high and low growth companies at reasonable prices.

Valuations by Industry
Our average star rating for the software industry is 3.03--neither hot nor cold. We have, however, noticed an investment theme.

 Software Valuations by Industry
Segment

Average
Star Rating

Average
Price/Fair Value
Stocks Covered
Business Applications  3.12 1.00 34
Development Tools 2.36 1.19 14

Entertainment/
Education Media 

3.50 0.88 4
Systems and Security 2.67 1.12 12
Data as of 03-15-07.

Today, valuations of "software as a service" (SaaS) companies are overly optimistic. The Internet has revolutionized many industries, and the software world is no exception. However, we believe these companies are being priced as truly "disruptive technologies," a term that was coined by Clayton Christensen in his book, The Innovator's Dilemma. Even if SaaS is a disruptive technology, we think the companies with the widest economic moats have the luxury of reacting slowly and, perhaps, clumsily. Benefits of disruptive technologies don't only flow to the first "disruptor." They flow to the companies with distinct competitive advantages, particularly some of the large software companies.

We think SaaS companies have been successful primarily because they have exploited a very specific market segment. SaaS is easy in a self-contained, one-product world. SaaS companies may hit a roadblock when they sell upstream to larger and more complex customers. When customers have multiple points of integration and customization, companies will be hard-pressed to rid themselves of their "old world" vendors. In many cases, this "disruptive technology" needs permission from the large software vendors to be disrupted. We think the pendulum has swung too far away from the lumbering giants toward the upstarts.

 Picks & Pans--Software
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Technology

Oracle $22 Wide Average Old World
Symantec $23 Narrow Average Old World
Microsoft $34 Wide Below Avg Old World
Google $315 Narrow Average "Disruptive"
Salesforce.com $34 Narrow Average "Disruptive"
Data as of 03-22-07.

In our view,  Oracle (ORCL) boasts one of the widest moats in our software universe. The company has undertaken an aggressive acquisition strategy, targeting companies that fit into its overall strategy for providing applications, database software, and middleware that glues them together. Databases and middleware provide the bulk of Oracle's profits, and these two segments are unlikely to be displaced by any SaaS upstart. Given the company's deep integration at its customers, we believe Oracle will be able to navigate technology shifts better than almost all of the software companies in our universe.

 Microsoft (MSFT) is another company where investors have turned overly fearful, in our opinion.  Google (GOOG) and a host of startups have launched very noisy efforts to provide word processing and spreadsheet capabilities in a SaaS framework. However, Microsoft has formidable network effects from additional programs that tie in to the Microsoft environment (such as an invoicing program that has the ability to generate invoices in Microsoft Word or Excel). Additionally, we expect the company to offer a lower-tier SaaS offering for smaller businesses, effectively providing better customer and product segmentation. Furthermore, Microsoft's server and operating system products are unlikely to be threatened by SaaS for the foreseeable future.

We highlight  Symantec (SYMC) for two reasons: 1) the company is cheap, and 2) SaaS will do very little to alleviate security concerns for the foreseeable future. In spite of the overall slowdown, Symantec's dominant position in the security market is not dissipating. The company has managed to grow in the consumer security segment, even in the face of free offerings from broadband service providers (such as  Comcast (CMCSA)) and a new Microsoft product. Although growth in Symantec's storage segment has been tepid recently, even a mild resurgence makes this stock extremely attractive.

 Salesforce.com's (CRM) valuation has really gotten ahead of itself. We think the company typifies the herd mentality that has chased SaaS. In spite of innovative technology supported by easy-to-understand pricing, there is a great deal of murkiness about this company's profit potential. Perhaps even more significantly, the company has begun adding additional levels of pricing in an attempt to extract more dollars from its customers. These additional pricing levels increase complexity, and may cause a backlash among the company's customer base.

We think  Google (GOOG) is a great Internet search company, but we would avoid the stock. Based on our fair value estimate, Google is overvalued by approximately $50 billion. In our view, many investors are overly excited about the potential for Google's new SaaS offerings, including word processing and spreadsheet products. Google's efforts pale in comparison with Salesforce.com, a company we think is worth $4 billion. By comparison, it is likely that Google's software potential is being overestimated. Building a global support organization to deliver and support software applications is challenging, and we hesitate to give Google too much credit at this point.

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager. And you can get Morningstar's complete take and regular updates on these and more than 1,900 other stocks, as well as our complete list of 5-star stocks, by taking a free 14-day Premium Membership trial.

Other Sector Outlook Articles

<< Return to Main Market Outlook Page

Rick Summer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.