Analysts on software: "Digest," then invest

"Right now, we're just in a year of digestion," said Chris Galvin, infrastructure software analyst for the investment bank. "Digestion of all the technologies that companies really overbought."

Galvin was among four software analysts on the "Software: 2001 Outlook" panel Monday at J.P. Morgan H&Q's annual technology conference here. The near-term future for software will be rocky, the quartet agreed.

That assessment shouldn't be a surprise considering the recent profit warnings from the likes of Oracle, i2 Technologies, Ariba and Commerce One.

Companies still can't say for sure how their sales will look for the next couple of quarters because corporate buyers are no longer sure how much they have to spend, analysts said. "To a certain extent, the end customers don't know," said Ian Morton, an e-business infrastructure analyst.

The software industry can take years to unwind after a major surge, panel moderator Cristina Morgan said. For example, after a burst of software-related initial public offerings in 1996, the next two years saw declines in software IPOs.

"We're not out of the woods yet," said Morgan, co-director of J.P. Morgan H&Q's global technology research.

In such an uncertain market, many Wall Street watchers believe investors should play it safe. Although the tech-heavy Nasdaq composite index may have bottomed in recent weeks, technology companies still haven't seen definite signs of a turnaround in their sales, analysts said.

Established sector leaders provide the best protection in a weak market, analysts said. "I think it's a great time for the strong ones to get stronger," Galvin said. "I think it's a really good time for the category leaders to clean house...I'm looking for safe havens rather than the next big theme you can grab onto."

J.P. Morgan H&Q isn't alone in those sentiments. In a research note released Monday, Goldman Sachs urged investors to look for "safer" companies.

"We believe in these uncertain times, customers like to work with familiar and profitable companies that are financially healthy," the Goldman Sachs research team wrote. "These criteria favor larger, more established companies because of long operating histories, size, brand name and third-party support."

However, investors shouldn't be surprised to see the software industry spawn companies in these times that will turn out to be long-term successes, analysts said, citing companies such as Siebel Systems, founded in 1993 during a relatively weak environment for technology investing.

"There is a tremendous amount of technology innovation still to come," J.P. Morgan H&Q enterprise software analyst Jim Pickrel said.

In fact, successful companies often use economic downturns to lower investor expectations for future quarters. Security software analyst Sterling Auty believes that although the companies he follows are rightfully cutting forecasts because of the economic slowdown, much of the cuts in their projections stem from caution rather than actual signs of weakness.

"In several cases, we did get half of it (from) gamesmanship," Auty said. "I would say it's a 50/50 mix" between companies "sandbagging" on earnings estimates and a making true reflection of demand.

Morgan wondered if the economic downturn has software vendors rethinking an industrywide shift toward subscription-based businesses and other sales models designed to make revenue more predictable. Wall Street's nervousness may increase the appeal of the old model of selling traditional licenses, paid for entirely up front, rather than subscriptions that stretch revenue over a period of time, Morton said.

But analysts generally agreed that regardless of the short-term pressure to get as much money as possible immediately, software companies believe they are better off with a steadier, ongoing source of revenue. "I think the range of (revenue) models will only increase," Pickrel said.

Regardless of how a corporation records its revenue--an issue on investors' minds Monday after Computer Associates disputed a New York Times article suggesting that the company uses accounting tricks to mask slowing business--a company's health can be measured by looking at changes in the business, Galvin said. "There's no right model," he said.

And even though no one knows when the software industry's downturn will end, now is the time to buy healthy companies because prices are low, Morgan said.

"What has really happened here is we've hit the reset button on investors' expectations," she said.