Enterprise Software 2006 Outlook -- More of the Same
The enterprise software industry has seen modest growth during the past several years. The benefits of a gradual recovery in IT spending to software vendors, being diluted by ongoing pricing pressures from the increasing use of open source alternatives, consolidation of products, the emergence of third party maintenance providers, as well as growing competition from hosted application providers. We expect 2006 will in many ways be similar to 2004 and 2005, meaning further significant consolidation of vendors, and valuations constrained by uncertainty as to profitability and growth prospects.
The enterprise software industry has shown negligible growth during the past five years or so. Following a sharp decline in the years immediately following 2000, 2004 and 2005 did see a resumption of modest growth.
In contrast to the latter portion of the ‘90s when small software companies dominated the landscape, the power has again shifted back to the largest software franchises, such as Microsoft, Oracle, SAP, Computer Associates and others. However, investors remain concerned about a number of risks to these franchises that has limited the performance of these stocks.
The bubble period of the late ‘90s was a unique and crazy time. Demand for software was feverish, driven by the fear of widespread system failure with Y2K and the greed associated with the opportunities represented by the internet to turn the old “bricks and mortar” world upside down.
In the aftermath of the bubble, the reality that IT spending was out of control struck home. Companies suddenly realized that they had overbought capacity and that their bid to address the opportunities and challenges of the internet was haphazard and not well thought out. A period of severe retrenchment ensued.
The period of retrenchment generally benefited the largest software vendors as large corporations looked to rationalize and standardize their technology infrastructure. The primary goals of these initiatives were to significantly reduce the amount of IT headcount needed, and to be able to utilize less-expensive offshore IT labor.
While IT spending has finally begun to recovery over the past couple of years or so, the reins remain very tight.
Though the prospects for broader IT spending continue to gradually improve, a lengthy list of challenges for software vendors remain. Put in the broadest possible terms, the longstanding business model for enterprise software companies is under assault.
Pricing pressures continue to build.
• Open source alternatives, such as Linux, or other elements of the “technology stack,” is an ongoing threat to major franchises such as Microsoft Windows, or major database products such as Oracle or IBM’s DB2, and application servers as well.
• Third party maintenance providers are another challenge to leading software franchises that threatens to undermine their highly profitable maintenance revenue streams.
• Hosted applications companies like Salesforce.com or RightNow, as well as many others, is another threat to the traditional business model of upfront license revenues complemented by ongoing maintenance and support revenue streams.
As investors readily appreciate, it is extremely difficult to handicap or predict with any accuracy how these various threats to the enterprise software business model plays out in terms of impact on revenue, earnings growth or overall profitability.
If the risks to the business model weren’t enough, the enterprise software industry is at the cusp of a major change in technology architecture. The industry is moving toward web services. We’re not going to try to put forth a substantive definition of what, how and why, but simply note that the move to web services or services oriented architecture will ultimately open the door for smaller software companies to compete again.
Each of these trends has been widely discussed and is arguably well discounted in equity valuations. Nonetheless the associated uncertainty as to the degree of impact, limit the prospective recovery in valuations.
Perhaps the biggest question facing investors as 2006 gets underway is whether the momentum behind any of the aforementioned trends picks up enough speed to create a tipping point in the near-term so as to present a highly disruptive influence to the current industry equilibrium. Our best guess is that this is unlikely to happen within the next twelve months.
Overall, we expect that 2006 will look much like 2005. Meaning, that while IT spending continues to gradually improve, there will be no evidence of a major positive breakout in growth for the larger software companies as any improvement is offset by ongoing pricing challenges.
We do believe that the prospects for smaller software companies will on the margin improve, since much of the consolidation efforts on the part of corporate IT spending have been completed.
Likewise we expect that merger and acquisition activity in the software sector will continue at a rapid pace.
For investors these trends suggest that valuations relative to the broader market averages are not likely to change radically. We also believe that software stocks which generally underperformed the major averages are not likely to be very exciting in 2006. It will continue to be a challenging market environment, where winning stocks may not necessarily be represented by the best companies.
Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.
The enterprise software industry has shown negligible growth during the past five years or so. Following a sharp decline in the years immediately following 2000, 2004 and 2005 did see a resumption of modest growth.
In contrast to the latter portion of the ‘90s when small software companies dominated the landscape, the power has again shifted back to the largest software franchises, such as Microsoft, Oracle, SAP, Computer Associates and others. However, investors remain concerned about a number of risks to these franchises that has limited the performance of these stocks.
The bubble period of the late ‘90s was a unique and crazy time. Demand for software was feverish, driven by the fear of widespread system failure with Y2K and the greed associated with the opportunities represented by the internet to turn the old “bricks and mortar” world upside down.
In the aftermath of the bubble, the reality that IT spending was out of control struck home. Companies suddenly realized that they had overbought capacity and that their bid to address the opportunities and challenges of the internet was haphazard and not well thought out. A period of severe retrenchment ensued.
The period of retrenchment generally benefited the largest software vendors as large corporations looked to rationalize and standardize their technology infrastructure. The primary goals of these initiatives were to significantly reduce the amount of IT headcount needed, and to be able to utilize less-expensive offshore IT labor.
While IT spending has finally begun to recovery over the past couple of years or so, the reins remain very tight.
Though the prospects for broader IT spending continue to gradually improve, a lengthy list of challenges for software vendors remain. Put in the broadest possible terms, the longstanding business model for enterprise software companies is under assault.
Pricing pressures continue to build.
• Open source alternatives, such as Linux, or other elements of the “technology stack,” is an ongoing threat to major franchises such as Microsoft Windows, or major database products such as Oracle or IBM’s DB2, and application servers as well.
• Third party maintenance providers are another challenge to leading software franchises that threatens to undermine their highly profitable maintenance revenue streams.
• Hosted applications companies like Salesforce.com or RightNow, as well as many others, is another threat to the traditional business model of upfront license revenues complemented by ongoing maintenance and support revenue streams.
As investors readily appreciate, it is extremely difficult to handicap or predict with any accuracy how these various threats to the enterprise software business model plays out in terms of impact on revenue, earnings growth or overall profitability.
If the risks to the business model weren’t enough, the enterprise software industry is at the cusp of a major change in technology architecture. The industry is moving toward web services. We’re not going to try to put forth a substantive definition of what, how and why, but simply note that the move to web services or services oriented architecture will ultimately open the door for smaller software companies to compete again.
Each of these trends has been widely discussed and is arguably well discounted in equity valuations. Nonetheless the associated uncertainty as to the degree of impact, limit the prospective recovery in valuations.
Perhaps the biggest question facing investors as 2006 gets underway is whether the momentum behind any of the aforementioned trends picks up enough speed to create a tipping point in the near-term so as to present a highly disruptive influence to the current industry equilibrium. Our best guess is that this is unlikely to happen within the next twelve months.
Overall, we expect that 2006 will look much like 2005. Meaning, that while IT spending continues to gradually improve, there will be no evidence of a major positive breakout in growth for the larger software companies as any improvement is offset by ongoing pricing challenges.
We do believe that the prospects for smaller software companies will on the margin improve, since much of the consolidation efforts on the part of corporate IT spending have been completed.
Likewise we expect that merger and acquisition activity in the software sector will continue at a rapid pace.
For investors these trends suggest that valuations relative to the broader market averages are not likely to change radically. We also believe that software stocks which generally underperformed the major averages are not likely to be very exciting in 2006. It will continue to be a challenging market environment, where winning stocks may not necessarily be represented by the best companies.
Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.
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