Software showing signs of positive momentum

Technology is one of the two sectors of the Dow Jones Euro Stoxx index that have posted gains since the start of the year.

The sector has grown 1.36% in sterling terms from 31 December 2002 to 27 March 2003, compared to -6.18% on the index as a whole.

Software companies are seeing positive earnings and price momentum, the first technology industry to begin showing positive momentum, says SchroderSalomonSmithBarney strategist Stewart Breed.

Over the past four months, telecoms and technology stocks have taken over from defensive stocks as the dominant momentum plays, although media stocks still appear reluctant to join the upswing.

Breed says software had a rollercoaster ride in 2002, its price relative to the Pan-European DJ Stoxx index falling by 50% between the start of the year and September 2002. Since then the sector has outperformed by 50%, but it remains nearly 30% lower relative to the index than at the start of 2002.

Over the same period, software stocks have suffered downgrades as demand for new products fell 30%-40%, maintenance contracts were consolidated and margins were squeezed, he says.

'Relative to the rest of the market, from the start of 2002 to September 2002, forward earnings fell by 16%. Since then, and coinciding with the sector's outperformance, relative earnings have risen 10%,' Breed says.

SAP is the largest UK software stock, accounting for 70% of the sector by capitalisation. It suffered during 2002 as earnings estimates were cut but has stabilised since the sector's low in September. Over February, the stock has risen on the back of better-than-expected results for the fourth quarter 2002, driven by increased operating margins.

Breed says while mid-cap Sage, the second-largest stock in the UK software sector, has yet to see an upgrade in consensus earnings forecasts, these are expected to improve over the next 12 months due to its dominant market position.

Breed says software earnings could be further boosted over the next 12 months by continued margin improvement helped by ongoing cost cutting, while the sector also stands to benefit from a large installed base of customers where there is the potential to cross-sell additional products and upgrades.

While Framlington Net Net fund manager Nick Evans says a long-awaited increase in capital expenditure would be a plus for software companies, hardware companies are unlikely to match the performance of their sector colleagues.

'Consensus expectations are for a 4% top and bottom line growth this year for software companies. This estimate looks realistic but we believe it might even be too pessimistic if companies start to increase capital expenditure during the year,' he says. 'However, estimates for the hardware sector, which are coming in at around 9%, are too optimistic given the amount of oversupply that still exists in many areas.'

Overall, Evans believes valuations of technology companies remain expensive compared to the rest of the market and this suggests further declines are necessary. However, he concedes there is room for individual stocks to perform, with difficult markets benefiting those strong enough to remain standing.

Blair Speedy

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