Drip Portfolio Software Companies Aren't Drips

Check Point, Siebel, Wind River, Adobe, and Red Hat are promising investments. However, software businesses change so quickly that it is nearly impossible to know what a particular segment -- whether Internet security or embedded software -- will look like in 3 years, let alone 17. A leading company today could be dislodged tomorrow by new technology. Due to this, most software companies are not suitable for a 17-year steady investor.

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By Mike Trigg (TMF Tonto)
March 1, 2001

We continue the Drip Port high-growth study today, looking at the remaining software companies on our list of prospective finalists below:

                      5-Year Estimated
Company, Ticker            Growth Rate
Red Hat (Nasdaq: RHAT)             50%
Cree (Nasdaq: CREE)                47%
Check Point Software (Nasdaq: CHKP)40%
Siebel Systems (Nasdaq: SEBL)      38%
Palm Inc. (Nasdaq: PALM)           37%
Wind River Systems (Nasdaq: WIND)  37%
Trex Company (NYSE: TWP)           35%
Concord EFS (Nasdaq: CEFT)         34%
Gemstar-TV Guide (Nasdaq: GMST)    33%
Jabil Circuit (NYSE: JBL)          31%
Solectron (NYSE: SLR)              29%
ADC Telelcomunn. (Nasdaq: ADCT)    28%
Panera Bread Co. (Nasdaq: PNRA)    28%
Starbucks (Nasdaq: SBUX)           26%
Adobe Systems (Nasdaq: ADBE)       25%
Krispy Kreme (Nasdaq: KREM)        25%
Nasdaq 100 (AMEX: QQQ)             NA

Last week, John Del Vecchio eliminated Internet Relationship Management (IRM) software vendor BroadVision (Nasdaq: BVSN). He concluded that despite the company's overwhelming growth potential, the competitive advantage periods in its software segment are too short for long-term Drip investors.

With BroadVision's departure, the remaining software companies on our list are Check Point Software, Siebel Systems, Wind River Systems, Adobe Systems, and Red Hat. There are plenty of financial and business model advantages -- including excellent profit margins, working capital management, and low capital expenditures -- that make these companies ideal investments. Let's take a peek at each business and determine if any of them shine to the extent that we should overlook the volatility in the software industry. Here, then, are the contenders for our Finalist List.

Check Point Software
Check Point is the leading vendor of software-based firewalls, which keep unauthorized users from accessing a company's website, applications, or sensitive corporate information. Check Point is also top dog in the virtual private network (VPN) software market. A VPN is a secure connection to a company network by way of the Internet. The company leads both the firewall and VPN segments with 41% and 52% market share, respectively.

As businesses continue to move operations online, mission-critical information is more readily available to employees, customers, and partners, but also open to potential harm. Companies are unwilling to leave the safety of this information to chance, creating explosive demand for Check Point's products. The company's lead should grow as it leverages its competitive advantage: the ability to bundle firewall and VPN software. Bundling the software is an obvious synergy because once data is unprotected by a firewall, it's exposed to potential harm.

Siebel Systems
Siebel is the leading vendor of customer relationship management (CRM) software. CRM focuses on front-end (external) business practices. Examples include customer service, sales, and marketing. Company websites have become a major investment vehicle by fulfilling every customer need anytime, anyplace. The Internet has improved the flow and quality of information, thereby allowing employees to make critical decisions that improve relationships with customers and suppliers.

The Rule Maker Portfolio showed last month that CRM is a repeat-purchase business, which makes future income more predictable (something I always look for in a potential Drip). As Siebel's customers experience cost savings, improved customer retention, and lower customer acquisition costs, they often add more software. Further, companies that use Siebel's applications generate a return on investment in only 10 months along with a 15% increase in sales growth, a 21% improvement in customer satisfaction, and 20% gains in employee productivity. Thus, it is not surprising that Siebel derives more than half of its revenue from existing customers.

Wind River Systems
Wind River's operating system (OS) powers devices like laser printers, network routers, and digital cameras. In fact, it can be found in over 150 million individual products. Its anonymity persists, however, because it's embedded and invisible to users. Wind River leads the embedded market with a market share of 35%. Excluding companies that develop embedded systems in-house, its market share rises to more than 60%.

Embedded OSs traditionally powered things like robots, car engines, and radar systems. But as computing resources expand past the PC to newer appliances -- such as handheld computers, cellular phones, and kitchen appliances -- significant opportunities arise. International Data Corporation estimates that the information appliance market will grow from $2.4 billion in 1999 to $17.8 billion in 2004. The real magic behind Wind River's products, however, is its royalty-based revenue model, dictating that it receives payment on each device that gets shipped with its software.

Adobe Systems
Adobe's flagship product Adobe Acrobat is the de facto standard for document management. It converts written information into portable document format (PDF) files, which saves businesses money by reducing paper flow and improving business communication. Adobe Photoshop is also the leading photo editing product, with 89% of Web designers using it to design Web pages. Photoshop has a similar market share for photo editing in the print publishing market, according to Zeke Ashton's Rule Maker examination of Adobe last year.

Adobe Illustrator is the leading graphics software on the market as well, controlling roughly 60% of the market, despite stiff competition from Macromedia's (Nasdaq: MACR) Freehand product. Adobe's leadership in the photo editing market enables it to leverage existing customers to purchase Illustrator. The company has a strong presence in other areas -- like animation and film production -- but Adobe's secret sauce is the mind share of its products. The graphics gurus that use Photoshop, for example, can't imagine life without it and are more than willing to buck up for the additional features during every upgrade cycle.

Red Hat
Red Hat sells software, tools, and support based on the Linux OS. Linux was originally designed to offer personal computer users a low-cost or free OS, compared to traditionally more expensive Unix systems. Demand continues to grow for Linux-based solutions, as businesses seek out ways to reduce their cost of ownership. But with only 4% of desktop computers Linux-based, compared to 87% running Microsoft (Nasdaq: MSFT) software, commercial acceptance is an uphill battle, particularly among Fortune 1000 companies.

Consequently, Red Hat has built its business around server-based applications and the embedded software market. There's been renewed interest in the company recently, after IBM (NYSE: IBM) announced it would spend $1 billion on the open-source system in 2001. Despite Red Hat's overwhelming opportunities, there are other Linux companies vying for a piece of the open-source pie and it's trying to sell something that can be downloaded for free. Plus, no Linux-based company has posted a profit and the OS is still something that appeals mostly to techies.

Bon Voyage Software Companies!
Check Point, Siebel, Wind River, Adobe, and Red Hat are all promising investments, but the lack of visibility into their businesses makes it nearly impossible to know what a particular segment -- whether Internet security or embedded software -- will look like in 3 years, let alone 15. Meaning, a company sitting atop its industry today could quickly be dislodged, given the rapid pace of technology change. Do the names Lotus, Netscape, or Corel ring a bell?  

Even after taking a good look at each company, it's difficult to know for sure whether any have a sustainable advantage over the competition and potential innovation. Innovation is particularly important in the software industry and occurs when a solution to a problem is found. Solutions for a company include everything from better management of relationships with customers to improvements in running an organization's supply chain.

By focusing on solutions to problems, a company is forced to constantly reinvent its own products to meet changes in market demand. It's possible that many of these current leading companies will be able to consistently reinvent products that correspond with market demand, but it's extremely difficult to do so in the software industry, leaving long-term drip investors with less risky places to put their money.

If you feel any of the above companies have a very likely 17-year period of significant growth (remember: the company, not the industry) make your case on the Drip message board and we'll consider putting them on our Finalist List. Two software companies -- Ariba (Nasdaq: ARBA) and Mercury Interactive (Nasdaq: MERQ) -- have made our Finalist List already, but I'd venture to say both will be cut rather quickly for the same reasons listed above. 

Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity"-- information. To see his holdings, view his profile. The Motley Fool is investors writing for investors.

Drip Portfolio


3/1/01 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
CPBCAMPBELL SOUP0.822.74%30.75
INTCINTEL CORP0.561.97%29.13
JNJJOHNSON & JOHNSON1.751.80%99.08
MELMELLON FINANCIAL CORP0.190.41%46.50
PEPPEPSICO INC(0.27)(0.59%)45.81

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(7/28/1997)
Drip1.28%0.60%1.28%(4.92%)18.71%
Comparable S&P 500n/an/an/an/a6.39%
S&P 5000.10%(0.37%)0.10%(5.99%)32.22%
S&P 500 (DA)0.10%(0.36%)0.10%(5.88%)34.84%
NASDAQ1.47%(3.50%)1.47%(11.62%)39.11%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (7/28/1997)
Drip8.61%
vs. S&P 5003.17%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
10/7/9837.6586MEL34.8946.5037.11%
11/14/9716.818JNJ80.6299.0825.43%
9/8/9752.2886INTC24.8929.1317.54%
7/28/008.2253PEP47.5245.81(3.38%)
4/13/988.52CPB53.6930.75(38.75%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
10/7/9837.6586MEL$1,313.89$1,751.12$487.56
11/14/9716.818JNJ$1,355.88$1,666.33$344.86
9/8/9752.2886INTC$1,301.42$1,522.91$228.20
7/28/008.2253PEP$390.86$376.80($13.20)
4/13/988.52CPB$457.40$261.99($177.26)
 
Cash: 
Total: 
$0.02
$5,579.17
 


Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.

Note
Drip Port launched with $500 on July 28, 1997, adds $100 to invest every month, and the goal is to own $150,000 in stock by August of the year 2017. Due to the slow nature of dollar-cost-averaging and our relatively significant starting costs, we do not expect to seriously challenge the S&P 500 for the first three to five years as we build an investment base. The long-term advantages of dollar-cost-averaging still overcome the short-term disadvantages, however. Final note: our investment in Campbell Soup is frozen due to fees instituted in its investment plan. Click here for a history of all Drip Port transactions.