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Rational gains despite downgrades

The maker of software development tools says business will improve in the second half of its fiscal year, but that's apparently too far away for analysts.

    After its profit warning Tuesday, Rational Software said business will improve in the second half of its fiscal year, but that's too far away for analysts, who downgraded the stock Wednesday.

    Investors, however, didn't let the downgrade bother them. They pushed Rational shares up 69 cents to $14.63 Wednesday morning.

    After Tuesday's closing bell, the maker of software development tools cut 10 percent of its work force and lowered financial targets for its fiscal fourth quarter ended March 31.

    The company said it sees revenue of between $240 million and $245 million and pro forma earnings in the range of 20 cents to 22 cents a share. First Call had expected revenue of $252.67 million and earnings of 22 cents a share.

    However, the company said it expects a rebound in the second half of its next fiscal year, which will close March 31, 2002. That makes the rebound due sometime in October. For fiscal 2002, revenue is expected to be between $900 million and $950 million, and pro forma earnings are estimated to be in the range of 50 cents to 60 cents a share.

    Rational, which provides the tools that help developers design, code and test software, has seen its stock fall 80 percent from its high for the year amid the market meltdown.

    In its warning, management indicated that the slump is hitting the high-growth telecommunications, finance and technology sectors--key segments for Rational that make up a large chunk of its customer base.

    "We have reduced our rating, as we do not expect a great deal of near-term momentum for the stock," said Goldman Sachs analyst Anne M. Meisner, who removed the company from her "recommended list" and lowered it to "market outperform." Meisner said the long-term prospects for Rational are bright.

    "Upside catalysts (are) too far out to justify purchase," said Prudential Securities analyst John McPeake, who downgraded Rational to "hold" from "strong buy" and slashed his price target to $15 from $50.

    Though the company "continues to be a well-positioned market leader, near-term upside for the stock is unlikely," he added.

    Red flags
    Analysts also noted that the company is having some problems integrating Catapulse, a software maker it acquired in November. Meisner noted that sales of Catapulse products seem to be trailing behind expectations, but that the company has managed to hide the fact by emphasizing that combined sales of Catapulse's products with its own Content Studio line are doing well.

    McPeake also saw red flags raised by Rational's plans to buy back 20 million shares. McPeake suggested that could be a move to pay management for the company's purchase of Catapulse without running expenses directly through the income statement.

    McPeake noted that some investors "were already concerned about the highly scrutinized Catapulse buy-in" and could get more troubled by this move, which will limit dilution of the Catapulse share grants and boost executive compensation.

    Emphasizing the positive
    J.P. Morgan Chase analyst Chris Galvin and SG Cowen Securities analyst Rehan Syed were more impressed with the company's projections for a rebound. Both maintained their ratings on the stock.

    Galvin called the company's 2002 profit warning "more substantial than expected," but maintained his "long-term buy" rating while slashing estimates.

    Syed maintained a "buy" rating, calling the company's miss of 2 percent to 4 percent "slight."

    Both analysts believe the company is seeing strength in its large deals. Rational posted a record 30 transactions in excess of $1 million in the quarter and saw strong demand from large systems integrators such as IBM Global Services, Cap Gemini and EDS. It also has a strong balance sheet, with more than $1 billion in cash.

    Some analysts also observed that the economic downturn is working in Rational's favor. They said there seems to be a "flight to quality" as customers consolidate vendors and stick to market leaders.

    Many are afraid that less-established companies may become insolvent, Prudential's McPeake observed. "This allowed Rational to sell larger deals into some customers," he wrote.

    Added Goldman's Meisner: "Rational is one of the best-managed and best-positioned companies within the infrastructure software segment. We continue to believe that the stock will be one of the first to bounce back when the economy begins to improve."