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Software companies rise above tech pessimism

A curious thing has happened during the high-tech industry's latest slump: Some software companies are booming.

    A curious thing has happened during the high-tech industry's latest slump: Some software companies are booming.

    While PC hardware companies suffer from their slowest growth quarter in history, companies that make business applications and infrastructure software used by corporations have resoundingly bucked the technology market's generally downward trend.

    To be sure, analysts do not expect software companies to see triple-digit growth going into 2001. When Microsoft, the world's largest software maker, reported its earnings last week, the company projected third-quarter revenue and earnings would be less than its second quarter numbers.

    And Tuesday, business application maker SAP beat analyst expectations, but said the company would take a quarter longer than expected to meet its sales projections.

    Nonetheless preliminary numbers from the fourth quarter of 2000 suggest enterprise software firms fared better financially than hardware makers. This begs an obvious question: Given that software and hardware companies operate together, how can one sector thrive while the other languishes?

    Experts say the explanation is one of basic need. Corporations are willing to postpone hardware improvements during economic declines, but software and application purchases are not expendable because they often translate into immediate cost savings and revenue growth.

    "Right now there's a big focus on business efficiency and productivity," said Kris Tuttle, a software analyst at Wit SoundView. "Companies are focused on automating some of their business functions and reducing costs, which ends up being with a software application. The payback on those is typically a year or less."

    Before the stock market plunge last April, businesses often addressed the need for faster Web sites and 100 percent operating time by buying more hardware. Mike Gilpin, vice president at Cambridge, Mass.-based Giga Information Group, said companies would often buy five times more hardware than was needed to support their peak load as a guarantee against failure.

    In these leaner times, however, more companies have bought software to improve their networks as a less expensive alternative. "I think there's clearly a trend now to stop throwing hardware at the problem and instead deploy more intelligent optimization (through software)," Gilpin said.

    And while the current dot-com slowdown has cooled off sales for both hardware and software makers, Fortune 500 firms are still spending, and they're buying new software.

    "It's not the dot.coms," said David Osborne, chief technology officer with Plural, a New York-based e-business consulting firm serving Fortune 500 companies. "It's blue-chip companies like the GMs and GEs. They can afford to buy software, and they're buying from established names, even in terms of the newer e-business kind of software. If they're buying it, they're buying it from established players like Microsoft."

    Makers of server hardware, including Sun Microsystems, Hewlett-Packard, and IBM, are bracing for lower sales in 2001. Likewise, PC shipments grew at a slower than normal pace. Sales of PCs grew 6.4 percent in the United States and 10.1 percent worldwide in 2000, according to research house Dataquest. Although analysts say they are confident that companies will upgrade their hardware, they don't expect that to happen until later in the year.

    By contrast, revenue from application server software grew 175 percent to 1.6 billion in 2000, and application integration software revenue grew 60 percent to 2.4 billion, according to Giga Information Group. Companies buying this software are hoping their products will result in savings--in such areas as supply management or sales force automation--or revenue growth in areas such as customer relationship management, or CRM.

    GE Capital, for example, recently invested in a software application that automates reservations for its Penske Truck business, Tuttle said. The company now saves about $1.50 per truck reservation in administrative costs.

    "They've now automated that to mere pennies," Tuttle said. "They claim they've spent hundreds of millions of dollars on these applications because the more they spend, the more they think they can take off their general administrative expenses. That's pretty compelling."

    Such stories make it easy to understand why Microsoft launched a $200 million advertising campaign Monday to promote its business software. Revenue from Microsoft's desktop applications fell to $2.14 billion in the September quarter of 2001 from $2.21 billion a year earlier. But enterprise software revenue rose 9 percent to $1.04 billion during the same period.

    "The market is shifting in terms of who's buying this software stuff," said David Osborne, chief technology officer with Plural, a New York-based e-business consulting firm serving Fortune 500 companies. "It's not the dot-coms. It's blue-chip companies like the GMs and GEs. They can afford to buy software, and they're buying from established names, even in terms of the newer e-business kind of software. If they're buying it, they're buying it from established players like Microsoft."

    Dissenting viewpoint
    Of course, as with everything in technology, not everyone is so bullish. Skeptics say the enterprise software sector is no better off than the rest of the technology companies, which are still in a wait-and-see period.

    "I completely disagree with this notion that there are some areas that will not get adversely impacted," said Sanjiv Hingorani, an analyst with Dresdner Kleinwort Benson.

    Like Osborne, Hingorani cited Microsoft in his projections--but to make a very different point. In its last quarterly report, he noted, Microsoft projected earnings of 42 cents to 43 cents a share for the fiscal fourth quarter, less than its second-quarter reduced earnings of 47 cents.

    Some analysts have said software companies have a leg up because their contracts stipulate the purchase of future upgrades. But Hingorani argues that often the revenue from long-term deals is recognized up front, making the future sales under that contract less vital.

    The solution? "They have to keep selling," Hingorani said.

    Taking stock
    Still, investors seem to be optimistic. Since the start of the year, the stock price of several of these companies has gained as much as 50 percent, compared with a 20 percent rise in the Nasdaq.

    Shares of PeopleSoft, which makes customer relationship management software, have risen nearly 60 percent. Stock gains of at least 40 percent have been posted by Siebel Systems, which makes CRM products and e-business software; Rational Software, which makes e-commerce and e-business programs.

    A recent report by Giga analyst Erin Kinikin shows strong revenue growth by enterprise software companies stretching into the third quarter of 2000. The report showed that Siebel's revenue grew 135 percent, PeopleSoft by 100 percent, i2 Technologies by 85 percent, and SAP by 53 percent.

    These companies have one major advantage over their hardware counterparts: Software costs less to make than computers. Operating more like a publisher than like a manufacturer, software companies have the advantage of a lower cost of sales than hardware companies.

    Cost of sales for IBM, for example, averaged about 63 percent in 2000. By contrast, Microsoft's cost of revenue totaled 14.8 percent for its most recently reported quarter.

    "Companies tell me this is one of the sectors that has not seen a decreasing in budget for the coming year, for 2001," said Eric Brethnoux, analyst at investment bank Lazard Freres.

    On the contrary side, Hingorani will believe it when he sees it. "When times get soft, expenditures on everything get curtailed," he said.

    Staff writer Mary Jo Foley contributed to this report.