Life has been particularly difficult as an investor in the e-commerce and e-customer relationship management software markets. With changing market dynamics, fundamentals for many of the companies have shown cracks after the seasonal difficulty of the September quarter forcing many earnings preannouncements.
The tech market downdraft since the Nov. 7 election has pounded technology shares in general. But the fundamentals for the leading e-business software vendors appear surprisingly strong going into the seasonally strong fourth quarter. While weakness can certainly continue to drag shares lower, we see many opportunities for technology investors looking for strong earnings growth and attractive valuations with earnings.
Stock performance has been punishing. The stocks under Banc of America Securities' coverage in the Internet software sector are down an average 39 percent this year. This compares somewhat unfavorably with the performance of the Nasdaq, which is down 33 percent.
Investors, in an effort to avoid exposure to this subsegment of the software market, have sold the entire sector on concerns that the slowdown in Internet retail e-commerce will affect all of the e-CRM companies. We believe that this wholesale sell-off has created an opportunity for investors to get involved in the quality software companies at considerably more realistic valuations.
But investors need to make adjustments to account for the changing dynamics in the market. Not all software companies are suffering. It is apparent to us that some of the best performers on the Nasdaq are in the software sector.
Consider BEA Systems (BEAS, $52.88, buy), up 51 percent year-to-date; Adobe Systems (ADBE, $64.78, market performer), up 93 percent; and Siebel Systems (SEBL, $77.50, strong buy), up 85 percent. But even a few of the bellwethers are returning to earth. Both Oracle (ORCL, $22.66, buy) and i2 Technologies (ITWO, $101.69, not rated) are back to where they started the year after significant gains in the first 10 months of 1999.
The broad market for software is alive and well. But only certain segments seem to be working. In our view, the performance of these software vendors has been strong because of the following factors:
1) These vendors started the year at attractive relative valuations.
2) There is less perceived risk by investors due to considerably longer operating histories and high levels of profitability.
3) Because of greater maturity, these vendors have significant existing customer bases and sizable sales forces.
4) Revenue growth is accelerating as software products are used to drive e-business.
The last point is most important. Despite a falloff in Internet retail infrastructure demand, businesses are automating interaction with customers and other businesses, which requires continued demand for e-business software.
Changing market dynamics
There is no doubt that the market and market demand are shifting, causing a much-needed shakeout. To compound matters, these changes are occurring in the September quarter, which is generally a little weak for software, particularly in Europe, as many would-be customers are on vacation. We believe that the following factors account for most of the changes in the market:
While demand for e-business solutions has remained strong in our estimation, emphasis has shifted dramatically from business-to-consumer-related applications to business-to-business applications. Customers are looking for a reliable solution that can streamline business processes.
Companies are making strategic software purchases rather than the tactical "quick fix" to get on the Internet. This is resulting in lengthening sales cycles as customers more carefully assess their needs. We believe that software sales cycles are likely to extend back toward historic six-month cycles from the recent three-month cycles. As sales cycles stabilize, revenue growth will accelerate. In addition, average deal sizes are increasing, which will balance lower sales representative productivity because of extended sales cycles.
With a more measured and methodical approach to software purchases, IT is reasserting itself into the purchase process. This appears to be benefiting established enterprise software brands such as Oracle and BEA Systems. IT professionals generally want to work with fewer vendors and purchase comprehensive integrated products when available. This should affect vendors providing limited point solutions or departmental solutions.
The demise of many dot-com businesses has negatively affected demand for retail-based business-to-consumer software. While we continue to believe that business-to-consumer software will continue to be necessary, this market is likely to consolidate rapidly as demand slows, driving a flight to quality. The dot-com slowdown has also created less urgency of demand. While businesses will continue to purchase customer-focused software to compete, there is no longer the fear of a start-up taking over the market.
Software solutions must address the online world in addition to offline process automation. Solutions cannot focus on the Internet as a channel to interact with customers and businesses exclusively. Software must integrate and ideally benefit the offline business as well as the online business. This is a much broader value proposition to a "clicks-and-mortar" company. This often requires a high level of domain expertise for vertical applications.
As always, execution is critical. Sales, marketing, and especially leverage from third-party providers such as systems integrators are essential.
A checklist for software buyers
While we do believe that the market is shifting, and vendors need to adjust, we do not believe that demand for e-business products are in decline. As outlined above, purchase criteria is changing, which will benefit some software vendors while holding others back. We believe investors should rank companies on the following criteria:
Proven track record selling to Fortune 500-type customers
ROI and significant value to both offline and online businesses
Support B2B and B2C capabilities
Possess market and mind share leadership
Broad product or platform (not a small-point solution)
Support from system integrators and significant partners
Based on these factors we continue to recommend companies with strong revenue growth driven by enterprise adoption for e-business solutions. Our favorite stocks in the software sector are BroadVision, Documentum (DCTM, $37.13, strong buy), Macromedia (MACR, $62.38, strong buy) and Verity (VRTY, $17.13, strong buy). All of these companies are profitable, and every one has been growing revenue recently greater than 50 percent year over year.
As these companies continue to grow, reaching greater economies of scale, we anticipate continued margin expansion, yielding greater levels of earnings.
Banc of America Securities LLC currently maintains a market in the following securities: ADBE, BVSN, DCTM, ITWO, MACR, SEBL, VRTY. Banc of America Securities LLC was co-manager of a public offering for the following companies in the last three years: BVSN, SEBL, VRTY. A member, allied member or employee of Banc of America Securities LLC is a director or officer of this company: SEBL.