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« Back to Part 1: Storage and Security Software
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TMF Max: Does that make an investment in video game software riskier?
TMF Braden: It can mean a good bit of risk for the investor, especially since with the exception of Electronic Arts (Nasdaq: ERTS), most of the companies are fairly small -- in the $300 million to $500 million range in terms of market cap. Investors need to look for companies that have shown creativity and innovation -- and that have been able to create "franchise" titles with loyal audiences that will buy an updated version each year. Examples are "Mortal Kombat" and Acclaim (Nasdaq: AKLM) in the 1990s, or the sports titles Electronic Arts, which I own, has now.
TMF Max: In reading your report, of course you mention Sony's (NYSE: SNE) PlayStation 2 quite a bit. But I was also reminded by your report of Microsoft's (Nasdaq: MSFT) upcoming Xbox system. How big a shadow does Microsoft cast here? This is software, after all, so it's pretty much always appropriate to ask what effect Microsoft is going to have once it really gets in the game.
TMF Braden: That's a huge question. We're undoubtedly at the beginning of a new hardware cycle now with PlayStation 2 and Sega's Dreamcast out there. Nintendo will have a new machine next winter and so will Microsoft. Many in the industry believe Xbox will become the leading console out there by the end of this hardware cycle, which will probably last three to five years.
In terms of hardware power, Xbox will be the most impressive out there: We're talking about 733 MHz and an eight-gigabyte hard drive, really almost laughable figures for a machine that will probably cost around $250 and plug into your TV. The real question will be how good the games are, but since nearly every major developer has signed on with Microsoft that's a safe bet.
TMF Tonto: Can we talk more about this notion of the "hardware cycle?" What should investors consider with regard to it?
TMF Braden: Investors should keep in mind that software sales will always be a function of the number of consoles out there on which you can play the games. If you're developing games for PlayStation 2 and Sony only sells a few of them -- of course, that isn't going to happen in the real world -- obviously you're not going to recoup your development and marketing costs on the games sold. I believe PlayStation 2 is in a strong position right now, so investors looking at the next three to five years should definitely look for companies developing strong offerings for Sony. Does that answer the question?
TMF Tonto: Yeah, that helps a lot.
TMF Max: Define "strong offerings." You say it's more like Hollywood: How do you spot the blockbuster that hasn't made it to the market yet? Or do you not try to play that game?
TMF Braden: It can be hard to tell from behind a desk. I play a few games myself, but I also look at online reviews and ask folks I know who play more than I do... There are also companies like NPD and PCData that track sales on a weekly basis.
TMF Max: So your analysis is less based on looking at the financials in this sector? You're looking more at the creativity within the company, and less on the proven pipeline?
TMF Braden: Obviously you can't ignore the financials, but doing a backward-looking comparative analysis of the companies in this sector -- trailing P/Es and stuff like that -- isn't worth much except, perhaps, as a starting point. A proven pipeline is a good place to start when you're looking at franchise games, but remember it's a new ballgame in many ways with all the new consoles coming out. And it will be reinvented again in a few years when online gaming really hits the mainstream.
TMF Max: Yes, I've certainly seem some get burned by looking at trailing P/Es in this sector.
TMF Tonto: It's pretty obvious that the Street has already recognized the tremendous potential in these other software spaces and their respective leaders. However, I think it's important for our readers to understand that they haven't missed the boat.
TMF Fuz: Well, like I said, I think the forecasts for storage are still understated. The value of information is increasing exponentially, so there is tremendous demand to store and manage this data effectively. And the Internet changes every year, which means in the future there will be richer applications that we can't even begin to comprehend today.
TMF Max: John, you sound like you've really found religion on this one. But there are some pretty serious risks here, too. I mean, "the Internet changes everything" didn't make every dot-com worth buying.
TMF Fuz: Right, but the infrastructure is crucial. The leading companies have real business models, strong cash flow, and we're seeing traditional firms like General Electric (NYSE: GE) embrace the Internet in a big way. GE is not going out of business. If anything, such companies will increase the proliferation of the Internet as a business medium.
TMF Max: So you're saying that the value in pursuing storage software is that "real companies" -- with real money -- are the ones that are going to be buying these products and services?
TMF Fuz: Well, in part yes. Amazon will be around too, in my opinion. Every company needs storage infrastructure today because information is a company's most valuable asset and it creates competitive advantage.
TMF Max: Okay, let's draw to a close. Quickly, what about Web-testing software, which is the other industry you focused on, John? I notice that Mercury Interactive (Nasdaq: MERQ) was added to the Nasdaq-100 yesterday. Is that any surprise? Does it have any meaning?
TMF Fuz: Well, testing, like storage is crucial. Websites must function properly. This is called functional testing. They must also handle the traffic, called load-testing, if a site goes down, it means lost revenue, pissed off customers and the destruction of shareholder value just look at eBay (Nasdaq: EBAY) when their site went down the stock lost 20%.
Mercury Interactive is profitable, has strong cash flow, and the outlook I feel is brighter than what the Street thinks. A key driver is international adoption of the Web, which has lagged the U.S.
TMF Tonto: What about companies that help manage the entire software development process... build, test, and manage. Is a company like Rational Software (Nasdaq: RATL) ahead of the game or do they partner with Mercury?
TMF Fuz: Yes, Rational is a leader here. But, as far as testing goes, Mercury is clearly the leader. They have the best mind share and market share. So, we get back to increasing returns.
TMF Max: Thanks, guys.
For more on increasing returns in the software industry, check out "Q & A on Siebel Systems."
For more information on Industry Focus 2001, click here.
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