Our Outlook for the Software Sector
Plenty of opportunities among software firms.
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We believe the stocks of many software companies have come under pressure recently for two primary reasons. First, many investors fear that financial-services firms will cut back their IT spending in 2008. Second, many foreign-based firms are experiencing margin pressures as their currencies strengthen against the U.S. dollar.
We believe that the first concern can create investment opportunities for investors willing to look at intrinsic value rather than one year's results. We are also dubious that any IT spending cuts from financial-services firms will materially affect the software sector as a whole: After all, financial-services companies are simply one group of customers, and--especially for the IT services providers--there are other forces driving revenue growth. The second concern is more fundamentally based, but thus far foreign firms are managing the currency pressures very well, in our opinion.
Looking ahead, we believe that stock prices for most business-related software firms are already priced for a slowdown in business IT spending. We also believe that in 2008, consolidation and globalization will persist as the big backdrop themes for many software firms, just as they did in 2007. Many solutions firms, such as IBM (IBM), and consolidators, such as Oracle (ORCL), are likely to continue purchasing smaller, niche software providers in order to build out their product portfolios to meet client demands. As software firms look to control costs and increase their global reach, we expect them to continue outsourcing research and development or building their own facilities in low-cost areas such as India, China, and Latin America. While 2008 could see a slowdown in U.S. IT spending on software, we believe software firms' share prices will be buoyed by acquisitions and global growth.
Valuations by Industry
The accompanying table displays the relative valuations of the aggregated software companies in our coverage universe by subsegments.
| Software Valuations by Industry | |||
 | | | |
| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
 | |||
| Business Applications | 0.99 | 0.96 | 3.1 |
| |||
| Development Tools | 1.04 | 1.11 | -6.3 |
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| Entertainment/ | 0.92 | 0.96 | -4.2 |
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| Systems and Security | 1.03 | 1.05 | -1.9 |
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| Data as of 11-15-2007. |
Looking at the software sector on an industry-by-industry basis as of mid-November, it is clear that the overall sector remains fairly valued by our estimates. However, there are several 4- and 5-star stocks in the mix, most of which are in the IT services segment of the business applications industry.
Although many firms, financial and otherwise, may cut back on their overall 2008 IT budgets, one way to get a bigger bang for your buck is to outsource application development and maintenance overseas. While offshoring IT services continues to grow rapidly, the trend could actually accelerate in a period of tightening corporate spending. Globalization also helps IT services firms, because as multinationals continue to move into new countries they typically take their services team in with them. We are not arguing that a slowdown in spending from financial-services firms would not affect top-quality IT service providers, but we do believe there are other, more powerful trends that will keep revenue growth strong for years to come.
Indian-based IT services firms have had to endure a double punch from the market because in addition to the above concerns, they are also dealing with the strengthening Indian rupee relative to the U.S. dollar. For the past few years, some investors worried that long-term Indian-based IT services firms would face margin pressure due to skyrocketing Indian wages. But that concern was superseded this past summer by the currency issue. Again, we believe that times have been so good for so long at the Indian-based firms that there is plenty of room for belt-tightening when the need arises. Already, these firms are pulling levers to offset the currency effects, and we believe that their high profitability will hold up in 2008 despite a likely continuation in the rupee's strength.
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 |
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| Ness Technologies | | $17 | None | Above Avg | 45 |
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| Cognizant |  | $42 | Narrow | Average | 20 |
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| Infosys | | $54 | Narrow | Average | 19 |
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| Wipro | | $18 | Narrow | Average | 18 |
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| Data as of 12-11-2007. |
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 our view, the company has been moving in the right direction, but the market seems to remain anchored on the firm's near-term outlook. The stock has moved deeper 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 53% below intrinsic value.
Similarly, Ness Technologies , an Israel-based global provider of a wide range of IT services, is another 5-star stock that we like. The firm is growing nicely and making good strategic acquisitions to broaden its array of services and to expand its global presence. We are convinced that long-term investors who take the time to take a deep look at the company and its new management team will find a lot to like.
Cognizant Technology Solutions (CTSH) is a U.S.-based IT services firm that primarily operates out of India. As such, most investors treat it as an India-based company. The firm's stock fell into 4- and 5-star territory after its outlook on the third-quarter conference call spooked Mr. Market. We believe this was an overreaction to management's comments that 2008 revenue growth would slow. Their comments still imply growth above 30%, and we are comfortable with our 2008 forecast of 35% revenue growth. This is a neat business that places a great emphasis on having onsite, client-facing professionals and instills an entrepreneurial spirit in its workforce. Long-term investors should be rewarded handsomely by picking up this stock.
Infosys (INFY) recently hit 5-stars for the first time since we have covered it at Morningstar, though it has since appreciated back into 4-star territory. As the largest Indian-based IT services firm that we cover, Infosys is suffering in the market from concerns about its exposure to the U.S. financial-services industry and about the appreciating Indian rupee. We visited Infosys in the spring and came away more impressed with its management team, its long-term market opportunity, and its operations. Long term, we believe that Infosys (along with EDS, Accenture (ACN), IBM (IBM), and Wipro (WIT)) will be counted among the handful of high-quality IT services firms with global reach and end-to-end IT solutions. The offshoring trend will not abate anytime soon, and Infosys will continue to be a key beneficiary for many years to come.
Wipro (WIT) is the second-largest Indian-based IT services firm that we cover, but we don't believe it plays second-fiddle to Infosys. It's just slightly smaller revenue-wise. As with Infosys, we visited Wipro's main campus in Bangalore and came away with our head spinning at the company's smart management, significant market opportunity, and keen execution. Another beneficiary of the offshoring trend, Wipro was a bit slow to take measures to protect itself from the rupee's appreciation, but it has significant leverage capability. With a couple of non-Indian acquisitions in the past year, Wipro is setting itself up strategically for a continued great run that, in our opinion, investors shouldn't pass up.
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