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ERP stocks: Not out of the woods yet

An investment in major enterprise software application companies would have each returned an average of 617 percent between early 1995 and June 1998, but companies have seen their share prices fall significantly of late.

An investment in major enterprise software application companies like JD Edwards, Baan, Oracle, PeopleSoft, and SAP--nicknamed the "JBOPS"--would have each returned an average of 617 percent between early 1995 and June 1998.

That performance has handily outperformed all of the major market indices over the same period.

But since June, these Enterprise Resource Planning (ERP) back office software companies have seen their share prices fall significantly, far under-performing the broader market averages.

While tempting at current levels, investors need to be careful about jumping into these stocks today.

The stocks look cheap relative to recent history; but in fact, these vendors must deal with a number of fundamental changes in their markets over the next 18 to 36 months. And these changes are going to make earnings growth erratic throughout 1999.

Let's look at a few of the bigger issues that will cause this erratic performance.

First, the enterprise is changing its IT focus. After years of concentrating on projects that would cut costs and enhance efficiency (which benefited ERP vendors), the companies are now investing in projects designed to help grow revenue.

And revenue growth requires companies to focus on the customer. With that focus comes the need for more customized products at lower prices, a better understanding of customer needs, products designed and delivered to meet those needs, as well as improved customer support.

But the JBOPS bellwethers, as a general rule, do not yet provide the "front-office," or customer focused products, to effectively compete with independent vendors like Siebel Systems, Clarify, Manugistics and i2 Technologies.

Secondly, a shift has emerged among ERP software buyers. Historically, large, Fortune 1000 multinational companies have driven the growth in back-office ERP applications sales. These buyers, however, are beginning to reach saturation--and demand is slowing.

Many ERP vendors are now targeting the so-called "middle market" enterprise to maintain historical growth rates. These middle market corporations--businesses with annual revenue between $100 million and $1 billion--have not historically been big buyers of ERP software.

The middle market is also a much smaller overall market, which means there isn't enough business to allow all of the current ERP vendors to continue to grow at a healthy 50 percent per year. We are already in an extremely price competitive market, in which ERP vendors are heavily discounting products. This should lead to reduced profitability in 1999, and a major shakeout of the smaller ERP vendors.

Third, if the Gartner Group is correct with its prediction that almost 50 percent of IT budgets will be dedicated to solving the Year 2000 issue in 1999, precious few dollars will be left for modernizing the back office. With their limited IT staffs and budgets, middle market enterprises will not have the resources to undertake ERP installations, while at the same time deal with Year 2000 problems.

And lastly, if the United States enters a recession in 1999, ERP spending will decline. Unlike their Fortune 1,000 brethren, middle market customers are more willing to delay IT purchases in a recession.

What does all this mean? The overall market for ERP products will fall from the 50 percent annual growth rate to between a 25 to 35 percent in 1999.

Current valuations of the JBOPS do not yet reflect this reduced growth reality, or at best, are fairly valued at current levels. For example, while SAP is expected to grow its earnings per share by approximately 35 percent next year, the stock trades at a price-to-earnings ratio of 50-times 1999 estimated earnings per share. That's a clear indication of overvaluation. The other JBOPS either trade at a price-to-earnings ratio equal to or above their growth rates for 1999. In other words, don't expect further upside in the short-term.

Here's the bottom line: Unless you have a 24-month time horizon, think twice about jumping into the large ERP vendor stocks. ERP will not be a good place for your IRA dollars in 1999.