Shares digital

Despite an unsurprising tumble with the rest of the market, there is still plenty of value in the software sector. Russ Mould uncovers the software surprises

Fat backlogs, merger and acquisition activity, and healthy cash flows all sounds like an appealing mix as the credit crunch grinds on, despite the US Federal Reserve’s increasingly frantic attempts to keep debt markets liquid. Yet, after a promising run in January and February, when the sector handily outperformed the FTSE All-Share, Software and Computer Services has joined its Technology Hardware cousin in the market’s doghouse (Shares, 13 March ‘08) after a dismal showing in March. A fall of 8.1% over the past month compares to a 3% slide by the All-Share and leaves the sector ranked 30th out of the 36 listed in the sector performance table (opposite).

At first sight this seems baffling. Many stocks are now trading on single digit prospective Price/Earnings (PE) ratios. Such lowly ratings have already seen bidders successfully swoop for Vega (VEG), Xansa (XAN) and Chelford (CHR). ClinPhone (CNP) rejected an unsolicited approach in February, Horizon Technology (HOR) received one just last week.

‘Valuations are low and there is the prospect of consolidation, after KKR’s bid for Northgate Information Solutions (NIS). Civica (CIV) is thought to be open to talk if a deal finds a backer and private equity is circling like a vulture,’ says Jonathan Imlah of Altium Securities. ‘Of course none of this is news as such, but it really is a matter of who goes first,’ the analyst continues.

Earnings estimates have held up well, suggested stocks have been derated massively, even if they have done nothing wrong. SDL (SDL), FDM Group (FMDG:AIM) and SQS Software Quality Systems (SQS:AIM) have produced good numbers and stated they have yet to see any impact from the crisis which has engulfed the debt markets and taken many banking groups’ earnings with it. Trading statements from Detica (DCA), Anite (AIE), Vero (VERO:AIM), Kewill Systems (KWL) and Micro Focus (MCRO) have also reassured.

Unstructured data management expert Autonomy (AU.) has even positioned itself as a potential beneficiary of the credit crunch. A recent multi-year $70 million order from an unnamed global bank suggests demand for the Cambridge firm’s compliance archiving solution could go through the roof. Banks will increasingly have to ensure they have information ready to meet regulatory requirements and possibly lawsuits from disgruntled shareholders and sub-prime mortgage holders alike

Yet still the sector has slumped.

Profit warnings from NetDimensions (NETD:AIM), Maxima (MXM:AIM), Silanis (SNS:AIM) and games software developer SCI Entertainment (SEG), which also had to admit a bid for the firm had collapsed, warns of the dangers involved in the sector. Many software and IT services players have exposure to the financial services or retail sectors. The prospect of more credit problems and an economic slowdown could easily filter into cuts in IT spending later this year, and turn this spring’s encouraging trading statements into summer or autumn profit alerts. Some stocks may therefore prove cheap as they first seem, should earnings estimates start to fall.

A selective approach is therefore clearly the key.

‘Longer term, you should be focusing on high visibility outsourcing businesses rather than consultancy businesses, unless they are very specialised such as SQS,’ asserts Altium’s Imlah. ‘And you should not play in the general IT services areas, especially those firms which are sub-scale.’

Shares says:

BUY Anite, Civica, SQS Software Quality Systems, SDL