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Our Outlook for the Software Sector

International growth should continue to benefit software companies.

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Software companies have remained largely unscathed amid a teetering U.S. economy, thanks in part to their strong and growing international operations. The IT industry has learned not to depend on the American economy for growth, one of the painful lessons from the dot-com debacle. Accordingly, many large software firms have taken advantage of the inherent operating leverage of their operations and have aggressively expanded their global presence to guard against declining demand in their domestic markets.

Europe has proved a particularly fertile ground. Over the last year, software companies have benefited not only from the solid economic growth of several Eastern European economies, but also from the sharp appreciation of the euro against the dollar. In general, the weak dollar has been an advantage for U.S. software firms, allowing them to speed up their international expansion and increase profits.

In this environment, software companies with strong international operations offer attractive growth opportunities and represent a hedge against the declining value of the dollar. Admittedly, international revenue growth is only one side of the equation. However, software companies have done a remarkable job at revamping their cost structures over the last few years. Most software firms now outsource their research and development operations to low-cost countries. In addition, operating expenses, such as sales and marketing, are regularly incurred in local currencies, thus reducing foreign exchange exposure.

Additionally, Brazil, Russia, India, and China (BRIC) are rapidly building up their technological infrastructure to support growth in their manufacturing, communications, and retail sectors. Therefore, we expect these countries to remain an important source of growth for software companies in the near term.

Contrary to other industries whose fortunes are tightly coupled to the health of the U.S. economy, we expect the software industry to continue to benefit from strong international expansion.

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

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Business Applications  0.90 0.84 7.1
Development Tools 1.00 0.94 6.4

Entertainment/
Education Media 

0.97 0.93 4.3
Systems and Security 0.95 1.03 -7.8
Data as of 06-13-08.

As the table above shows, the software industry remains slightly undervalued, but overall, the price of software stocks has increased and the discounts to our fair value estimates have decreased over the last three months. Nonetheless, we continue to see solid companies with strong operations selling at a significant discount to our fair value estimates. We believe that the market remains concerned that businesses will tighten their IT budgets and will only selectively invest in software solutions that promise to deliver an immediate return on their investment. However, these concerns have unjustifiably penalized the shares of strong companies that, we believe, are well positioned to weather the effects of a weak economy.

Software Stocks for Your Radar
 

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

Price/
Fair Value

Wipro $18 Narrow Medium 0.69
Autodesk $50 Wide Medium 0.74
Accenture $52 Narrow Medium 0.75
Electronic Arts $61 Wide Medium 0.77
Microsoft $35 Wide Low 0.81
Data as of 06-20-08.

 Wipro (WIT)
Wipro has capitalized on the IT offshoring trend and India's low labor cost advantage. The company derives the majority of its operating profits from providing IT services to U.S., European, and Japanese clients. However, the company's edge does not necessarily come from low-cost labor but from its capable management team's focus on execution. Analyst Mike Ford-Taggart believes that the company is well positioned to weather a slowdown in IT spending--if it ever materializes--by U.S. financial-services firms. While the company still generates almost half of its revenues from U.S. clients, over the last four years, international revenue has been growing at a significantly faster pace than it has in the U.S. If the global economic environment worsens, companies are likely to accelerate their plans to offshore their noncore IT functions, which in turn would be a boon for Wipro.

 Autodesk  (ADSK)
As the leading vendor of computer-aided design (CAD) software, Autodesk remains a strong beneficiary of the global infrastructure build-out. Its wide range of solutions is the de facto standard not only in the design of digital mock-ups, but also increasingly in model simulation. For example, Autodesk's software allows architects to model a building's energy consumption and lighting requirements well before construction begins. While estimates fluctuate, design errors can account anywhere from 2% to 5% of construction costs. The software enables architects to catch design flaws early in the design process, thus saving time and money. The same concept applies to the design process of cars, consumer electronics, and practically any object that can be designed and built. The company's revenue from emerging economies, which accounted for about one sixth of total revenue during fiscal 2008, has increased at a 30% compounded annual growth rate over the last five years. We expect this trend to continue and perhaps even accelerate as developing countries continue to invest in infrastructure projects.

 Accenture ACN
Accenture is a global provider of IT services and remains one of Morningstar analyst Mike Ford-Taggart's favorite companies in the IT industry. The firm has solid international operations, which account for nearly two thirds of its revenue outside the U.S. Furthermore, Ford-Taggart remains convinced that a slowing U.S. economy will not slow down demand for IT consulting and outsourcing services. In his view, Accenture's services have become too critical to its clients' operations, and companies can't simply put off investments in IT when the economy falters. Accenture's operations, which encompass software application development, have benefited from the company's international expansion. Over the last four years, the respective compounded revenue growth from its European and Asian operations has grown five and 10 percentage points faster than the revenue growth in the Americas region.

 Electronic Arts (ERTS)
Electronic Arts is a consumer-oriented software company that dominates the U.S. market for console games. The firm's competitive advantage stems from its ownership of game franchises, a loyal customer base, and economies of scale in global distribution. While higher operating expenses and costs associated with two recent acquisitions caused the firm to post operating losses, analyst Sunit Gogia believes that the acquisitions will bolster the company's video game development capabilities and enhance its collection of internally owned game franchises. Although the company has experienced anemic expansion in Asia over the last three years, the growth rate of its European operations has far outpaced that of its North American operations during the same period. In our view, the firm has the ability to develop new console games with international appeal that can be sold through its global distribution channel.

 Microsoft (MSFT)
Microsoft has been a primary beneficiary of the increasing use of software around the world. Therefore, it isn't surprising that the company's international revenues have grown twice as fast as its U.S. revenues during the last four years. Although the company faces multiple rivals that have embraced the software-as-a-service (SaaS) business model, and its failed efforts to acquire  Yahoo (YHOO) to strengthen its presence in the online space show that Microsoft no longer rules the entire software industry, we believe that its Office and Windows products will continue to dominate PC software for a while. Furthermore, the company stands to benefit as people and companies in developing economies adopt Microsoft's products, which, after all, still command the largest market share.

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