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Our Outlook for the Software Sector

A software acquisition spree is set to continue, for good reasons.

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Acquisitions in the software industry are nothing new. However, during the second quarter it seemed that the private-equity-fueled merger mania in the broader markets accelerated the pace of software deals. Several acquisitions were strategic, meant to use the acquired firm's technology or positioning to leverage an existing portfolio. For instance, Morningstar analyst Toan Tran wrote that  Microsoft's (MSFT) recent purchase of aQuantive was part of the larger firm's strategy "to extend the platform to offer functionality for advertisers across Microsoft's existing properties (such as MSN and Xbox Live), emerging businesses (like MSN Video and IPTV), as well as the Internet as a whole." Similarly,  CheckFree (CKFR) bought Carreker, adding that firm's topnotch payments-consulting and advisory services to CheckFree's first-class payments platform.

Another type of acquisition, which we expect to see more of, is intended to extend a firm's capabilities into related industries or offerings. In the never-ending race to have the next-greatest application in their portfolios, software firms are increasingly making a decision to purchase rather than develop. Increasingly, these deals look like an effort to catch up with prevailing industry trends. Microsoft's aQuantive acquisition could also be lumped into this category. In May,  Computer Sciences (CSC) agreed to purchase Covansys, with the express intent of gaining capabilities in Indian offshore outsourcing (something CSC lacked previously). 

Valuations by Industry
The following table shows the relative valuations of the aggregated software firms in our coverage universe, by subsegments. 

 Software Valuations by Industry
Segment

Average
Star Rating

Average
Price/Fair Value
Stocks Covered
Business Applications  2.79 1.05 48
Development Tools 1.92 1.18 12

Entertainment/
Education Media 

3.25 0.91 4
Systems and Security 2.58 1.14 12
Data as of 06-15-2007.

We continue to think the median software stock is slightly overvalued, which is not to say that there aren't any investment opportunities present within the groupings. The valuations in the table above have not changed materially in the past three months, with the average price/fair-value continuing to look expensive across most subsegments except entertainment (the video-gamers). 

Software Stocks for Your Radar
Despite our view that the software industry overall isn't cheap, we do have quite a few stocks that are worth putting on your radar.  

 Stocks to Watch--Software
Company Star Rating Fair Value Estimate Economic
Moat
Risk

% Below Fair Value

CheckFree  $53 Wide Average 24
EDS   $36 Narrow Average 23
Ness Technologies  $19 None Above Avg 33
Symantec $23 Narrow Average 13
Parametric  $23 Narrow Average 12
Data as of 06-22-2007.

CheckFree allows its bank clients to offer electronic bill payment to their customers. Analyst Brett Horn explains the source of the firm's wide economic moat: With the first-mover advantage, "the company has a marked cost advantage because of the scalability of the business. CheckFree actively exploits this cost advantage by sharing scale benefits with its bank customers, which induces the banks to promote electronic bill payments and push up consumer adoption. This should continue to drive growth in the coming years and lock in CheckFree's long-term market position." With only 30% of consumers using online bill payment and given the firm's recent acquisitions, we believe the company has plenty of opportunities remaining for profitable growth. The stock would have to appreciate 23% to hit our fair value estimate.

IT services firms continue to hold our interest, given their typically strong free cash flow generation and high returns on invested capital.  Electronic Data Systems (EDS) and  Ness Technologies (NSTC) are currently showing up on our lists as deep 4-star stocks. EDS, in our opinion, is making all the right moves strategically but is still weighed down by its now-distant past. Ness Technologies, on the other hand, is a fast grower that has recently experienced large management turnover, and it's worth noting here that we believe it does carry above-average business risk.

Another stock, which we highlighted in our previous outlook but that still deserves investors' attention, is  Symantec (SYMC). As we said then, "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 and a new Microsoft product." The company recently announced a $2 billion share repurchase program.

 Parametric (PMTC) provides product life-cycle management software that allows manufacturers to design and build their products faster and cheaper. We are confounded by its discount to our fair value estimate (approximately 12% undervalued, putting it close to 4-star territory), as the company seems to be hitting on all cylinders. Consider analyst Rafael Garcia's following remarks: "The company has finally straightened its course through a string of shrewd acquisitions, extended product offerings, and strong demand for its products. Parametric's recent turnaround has been successful." What's not to like?

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