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Goldman Sees Choppy Seas Ahead For Software Stocks

With warning signs pointing to significant weakness in demand from the U.S. enterprise market, Goldman Sachs last week downgraded the vast majority of the software companies it tracks from "attractive" to "neutral" last week.

The move was prompted at least partially by research that showed IT managers at Fortune 1000 companies slowing the growth of their IT spending next year.

"A more mature IT industry is more closely correlated with the overall macro backdrop than ever, implying likely deceleration in IT spending growth next year as economic headwinds mount," said the report, authored by Sara Friar, vice president of Goldman Sachs' technology group, and three other analysts from the company's investment research arm. "Our latest survey of Fortune 1000 IT executives implies decelerating tech capital spending looking forward, consistent with this view."

Goldman Sachs also slightly reduced earnings-per-share estimates for 20 software companies by an average of one percent across the board.

"Concurrent with our change in coverage view, we are reducing the estimates of most of our covered companies, focusing on pure-plays that could be harmed as customers seek to purchase 'good enough' substitutes from larger vendors, as well as vendors who sell 'big ticket' items that could be delayed in a slower spending environment," Goldman Sachs analysts wrote in the report.

The move by Goldman Sachs comes as concerns mount about the impact various economic issues will have on the technology sector, including the continuing ripples from the collapse of the subprime mortgage industry.

"I think the biggest concern is the financial sector," said Robert Johnson, associate director of technology coverage at independent market research firm Morningstar. "With banks and mortgage companies under a bit of pressure, so to speak, I think there is some concern about what's going to happen with their IT spending."

Similar concerns caused stocks from all industries to pull back in early November after Cisco announced softening sales in the U.S. enterprise market. Cisco CEO John Chambers told analysts during a November 8 teleconference that Cisco had seen a "dramatic" decline in sales to portions of its enterprise market in the U.S. in the last quarter, and that Cisco saw the enterprise market continuing to be "lumpy."

But Johnson says the financial market problems will probably not have a huge impact on the software business as a whole.

"We aren't as concerned as some might be because it is 20 percent [of the U.S. software market] and not 50 or 60 percent of the total, and a lot of software spending is just maintenance spending. It's not like they have to make a new decision to buy this or buy that. I think that spending is going to continue."

There are some sectors of the software industry that are certainly less at risk, said Morningstar's Johnson.

"Within software, we're bullish on people who manage security and people who manage storage," he said. "But we're certainly more aggressive in the software services arena where we have a number of five-star rated companies—EDS, Cognizant, Infosys and Wipro. They're probably among our favorites in the software sector."

Goldman Sachs also seems to favor the software-as-a-service (Saas) trend.

"The ability to quickly and easily turn on new applications with a significantly lower initial cost of ownership makes SaaS an attractive offering for small- and mid-sized businesses," Friar and her team wrote, "significantly expanding the market for software applications. More broadly, and including enterprises, these benefits are likely to be key in a slower economic environment where purchasers of software may be increasingly skeptical of significant upfront investments which we anticipate to characterize 2008."

Potentially softening the blow for more established software companies is increasing sales to international markets, particularly into developing economies in China, India and Eastern Europe.

"For BMC, CA, Oracle, and other large conventional software companies, 40 percent to 50 percent of their business comes from overseas," said Morningstar's Johnson. "So certainly as those markets hold up better relative to the U.S. business, that should be a positive."

"Our checks through the broader software channel outside the United States continue to indicate a considerably more robust outlook for software spending in 2008 than domestically, and particularly in the emerging economies as well as in EMEA and Asia (particularly outside of Japan)," wrote the Goldman Sachs analysts.

It's also likely that consolidation will continue in the software market.

"I think one of the things that's been very supportive over the last year, even in the license-based model is that there's been so much consolidation in the field," Johnson said. "With Oracle picking up so many players, and HP and IBM for that matter, that's had a buoyant effect on software company stock." He noted that consolidation has essentially eliminated almost all the independent software companies in the business intelligence sector.

"We expect no slowdown in M&A activity from software consolidators such as Microsoft, Oracle, Symantec and CA, and larger IT incumbents anxious to add to their high-margin and higher growth software portfolios, including IBM, HP, EMC, Cisco, and potentially Sun," the Goldman Sachs report said. The company retains favorable ratings on Microsoft and Oracle because of their potential ability to "consolidate spending."