What are some of the factors investors should look for in the software business next year and beyond? In this discussion transcript, four Fools talk about the outlook for the video game, security, Web-testing, and storage sectors as they try to help market watchers identify the companies that will be tomorrow's leaders.
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TMF Max: Gentlemen, thanks for dropping by to discuss your work. In this year's Industry Focus, you each picked software companies and their sectors to analyze. John, starting with you, what did you look at, and what's particularly attractive about that industry?
TMF Fuz: I focused on two sectors: storage software and Web-testing software. The storage industry is on fire. It's the most important component of the information technology infrastructure today, with the Internet creating tremendous volumes of data. This is mission critical data about customers, for instance, that must be available 24/7.
Storage software helps reduce the complexity of managing a storage network, lowers the cost of ownership, and improves the functionality of the network. Storage spending is vastly outstripping spending for PCs and servers. Storage spending should grow 22% compounded annually by 2004 to nearly $80 billion, compared with 6% annual growth expected for servers. So the opportunity going forward is huge.
TMF Max: And in that space, you're looking at companies such as BMCS Software (Nasdaq: BMCS), Computer Associates (NYSE: CA), EMC Corp. (NYSE: EMC), Network Appliance (Nasdaq: NTAP), and Veritas Software (Nasdaq: VRTS). All of these are companies whose stocks have already appreciated quite a bit, yet you mentioned "the Internet" a moment ago. What is it that distinguishes this particular industry from some other generic "Internet industries" that, frankly, don't look very attractive as investments at the moment?
TMF Fuz: Well, the Internet is not going away. These companies provide a crucial component of the information technology infrastructure -- maybe the most important component. Storage is vital for companies like Amazon (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and Yahoo! (Nasdaq: YHOO). They continue to add capacity -- trillions of bytes -- at rapid rates. The difference here is that storage software companies have real business models, the leaders are profitable, and the long-term outlook is exceptional because the trends are likely understated right now.
TMF Max: You mentioned the "trends are likely understated." That reminds me of an article from a couple of years back by Roger McNamee. In it he wrote, "My rule of thumb is this: if a product is hot, Wall Street's earnings estimates will always be too low; if the product isn't hot, the estimates will prove to be too high." Do you agree with that, and does it apply to the storage software sector right now?
TMF Fuz: Well, he's right. Wall Street is still behind the curve on storage. Veritas (Nasdaq: VRTS) continues to blow away estimates and the Street has not caught up... yet.
TMF Tonto: At a $50 billion market cap?
TMF Fuz: I know, it's surprising. But the company manages earnings expectations very well. It continues to exceed those expectations, and furthermore it is capturing market share at a rapid rate which makes it difficult to model exactly what their revenue should be.
TMF Max: Well, it's true, I think, that the market does not estimate or value hypergrowth very well -- though that works both ways. The market can both dramatically overvalue and undervalue hypergrowth. Mike, you were looking at another relatively immature software industry that is still going through hypergrowth. What's the outlook for security software companies?
TMF Tonto: Well, the Internet continues to redefine the way business is conducted. Internal and external business processes are being Web-enabled and the increased efficiencies and cost savings afforded are mind-boggling. However, while a company's mission critical data moves online, it's also exposed to potential harm. That has created a ton of demand for a variety of security solutions. And that's what really struck me about this industry.
Within the security software sector there are a variety of markets with huge demand -- from firewalls to Virtual Private Network (VPN) to Public Key Infrastructure (PKI) to encryption, there are some very impressive growth drivers: Application Service Providers (ASPs), B2B, Wireless, and DSL and cable modems are all areas that will grow significantly and to be successful, each requires security measures.
TMF Max: So you were looking at Check Point Software (Nasdaq: CHKP), RSA Security Inc. (Nasdaq: RSAS), Symantec Corp. (Nasdaq: SYMC), and VeriSign Inc. (Nasdaq: VRSN) basically.
TMF Tonto: Yes, that's right.
TMF Max: What should an investor look at as far as determining the best of the competitors in the sector?
TMF Fuz: Market share is crucial in software, because of increasing returns; once a company gets a lead its lead often grows while competitors fall further behind. License revenue growth is important as an indicator of demand too.
TMF Tonto: That's right, John. CheckPoint Software has the dominant market share in two areas with huge demand -- firewalls and VPNs. Not only that, but the company bundles those two products together, which gives it a huge competitive advantage. Firewalls lay the foundation for network security -- everybody needs them. But people also need the ability to communicate securely over the Internet, and that's where VPNs come in to play.
TMF Max: "Increasing returns" is one of those elements that applies to lots of software sub-sectors, and I know its something that John and Mike focused on in their recent article, "What the Next Microsoft Will Look Like." But it doesn't really address what you were looking at, David, or am I wrong about that?
TMF Braden: Bill, you couldn't be more right. I looked at video game software, which is obviously geared more toward the consumer. So although you have many of the same attractive business dynamics of the software sector -- high margins, clean balance sheets -- you don't have things like recurring service revenues and things of that sort. It's a lot more like Hollywood than Silicon Valley. (That makes it a lot more fun, in my opinion.)
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