Our Outlook for the Software Sector
This sector offers enticing opportunities for long-term investors.
Stock Strategist
<< Return to Main Market Outlook Page
It is no secret that the software sector, in general, has recently been a safe haven for investors looking for firms with limited exposure to the subprime mortgage industry. The Federal Reserve interest rate cut has brought a temporary jolt of cheerfulness to the market, placing subprime concerns on the back burner--at least for now. Nonetheless, as companies start reporting third-quarter results in the upcoming weeks, their true exposure to the subprime market will become clearer. Doomsday feelings are likely to feed Mr. Market's fickle temperament.
The next months should show exactly what effect the financial-services problems have imparted on software firms. Although estimates vary, the financial-services industry is projected to spend up to $490 billion on information technology during 2007. Of that amount, about 33% goes to the purchase of software and IT services. As financial-services companies plan their budgets for next year, there are concerns about significant cutbacks on IT spending. However, the financial-services industry depends heavily on the use of IT not only to conduct day-to-day operations, but also to provide better customer service (e.g., online banking). We believe that the industry will continue to look for ways to cut down operating costs, thus driving further demand for IT services such as business process outsourcing.
Valuations by Industry
The following table displays the relative valuations of the aggregated software companies in our coverage universe, by subsegments.
| Software Valuations by Industry | |||
 | | | |
| Segment | Average | Median Price/Fair Value | Stocks Covered |
 | |||
| Business Applications | 3.02 | 0.96 | 55 |
| |||
| Development Tools | 2.42 | 1.11 | 12 |
| |||
| Entertainment/ | 3.33 | 0.96 | 4 |
| |||
| Systems and Security | 2.38 | 1.05 | 14 |
 | |||
| Data as of 09-19-2007. |
As of mid-September, the overall software industry remains slightly overvalued by our estimates. However, looking below the surface, we have uncovered solid businesses with sound long-term fundamentals that are trading at a significant discount to our fair value estimate. We believe that temporary issues have prompted the market to unduly punish the shares of these software companies, presenting enticing buying opportunities that should handsomely reward patient investors. After all, at Morningstar, we believe that there is no better time to buy pieces of businesses than when they are on sale.
Software Stocks for Your Radar
Among the bargains in the sector, we think investors should consider the following list of stocks.
| Stocks to Watch--Software | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | % Below Fair Value |
| |||||
| EDS |  | $46 | Narrow | Average | 53 |
| |||||
| Ness Technologies | | $19 | None | Above Avg | 45 |
| |||||
| WNS | | $27 | None | Average | 39 |
| |||||
| Microsoft | | $34 | Wide | Below Avg | 13 |
| |||||
| Take-Two Interactive |  | $20 | Narrow | Above Avg | 15 |
| |||||
| Data as of 09-25-2007. |
Electronic Data Systems is one of the largest providers of software applications, business process outsourcing, and network services. We believe that multinational companies and government agencies will continue to increasingly seek outsourcing solutions. In the view of analyst Mike Ford-Taggart, the company has been moving in the right direction, but the market seems to remain anchored on the firm's past stumbles and near-term outlook. The stock has moved into 5-star territory since we highlighted it in our previous outlook, making the stock even more attractive. The company's shares are trading about 52% below intrinsic value.
Similarly, Ness Technologies , a global provider of a wide range of IT services, is another 5-star stock that we like. Despite the unsatisfactory second-quarter results, Ford-Taggart mentioned that: "long-term investors who may be considering Ness' stock at its current 5-star price should invest the time to take a more thorough look at the firm. ... There is a lot to like." A string of shrewd acquisitions has allowed the company to expand its array of services and global presence, and thus grow at a fast clip.
WNS is a business process outsourcing company that generates most of its revenues from services provided in the United Kingdom and Europe, but conducts its operations in low-wage countries like India. We believe that the market has overreacted to the recent loss of a mortgage client, causing its stock to trade well below our fair value estimate. Despite providing low-end services, the company is very profitable. The stock is currently 37% below our fair value estimate.
Microsoft's (MSFT) sheer size has prevented it from exploiting new opportunities fast enough to react to emerging threats (e.g., Google (GOOG) is now the dominant search engine). However, the software industry is in perennial change, and advantages can shift. New trends like the software-as-a-service (SaaS) model (in which applications are delivered on-demand over the Internet and customers pay for software usage instead of owning it) present a new set of opportunities and challenges. Analyst Toan Tran recently wrote: "The infrastructure cost required to provision SaaS on a large scale could total in the billions, and this will be a significant barrier to entry. While Microsoft is not always an innovator, and its first attempts often fail, the firm's persistence is impressive." Moreover, the company remains highly profitable, generating more than $1 billion in cash per month.
Take-Two Interactive Software (TTWO) is a leading developer and distributor of interactive video games. Its flagship game, Grand Theft Auto (GTA), has been a worldwide hit. While the company will not have the next version of this game ready for the upcoming holiday season, analyst Sunit Gogia mentioned: "We do not expect this delay to have any long-term impact on GTA sales." The stock is currently on the border of 4-star territory, and a worthwhile candidate to keep on your watch list.
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.
Other Sector Outlook Articles