Currently, the Application Software Industry is overvalued by $2.73, on average. Numerous respected mid and large cap companies reside in this sector, but do not offer great value. Small and micro cap application software companies provide the greatest investment value.
Investors should expect consolidation of these smaller niche firms as the more established platform companies, such as Microsoft, Oracle, SAP, and Computer Associates, try to better define their brands. The smaller niche firms offer specialties, which will allow the platform companies to better define their specialties and create strong branding and product protection.
The Application Software Industry is truly a tale of two cities: companies which provide financial accounting platforms and those who provide reporting and ad hoc analysis capabilities. We see Oracle and SAP as the two major players in this industry, as well as Computer Associates to a lesser extent. Each firm provides basic financial accounting software for numerous Fortune 500 companies. Nearly every other company in this industry provides add on software which complements the major players identified above.
Some of the following items help explain our view of Application Software:
1.) Oracle’s acquisition of Hyperion Solutions: this acquisition suggests that the smaller niche companies are ripe for consolidation. Platform providers will seek to purchase their smaller cousins as they attempt to add value to their current platforms. These niche reporting applications.
Hyperion and Oracle Announce Acquisition
2.) Large Industrial Companies Will Seek To Leverage Accounting Platforms: As business software, especially financial accounting software, becomes more sophisticated, expect firms to migrate to these platforms.
3.) Niche Micro, Small and Mid Cap Players Provide Essential Add On Functionality: The smaller players in this industry should continue to be successful. The best of these corporations offer efficient solutions to the numerous gaps in the platform software discussed above. Many of these companies are successful because they seek to provide a specialty capability, otherwise not offered.
4.) Analytics Technology: Apart from large accounting platforms, analytics technology provides the hottest opportunity. As accounting systems become more efficient, firms will seek to find more efficient analysis tools. Corporations will seek applications that help minimize the non-value add work performed by analysts.
Here are the metrics for the Application Software Industry:
Table 1: Industry Metrics – Application Software
While the industry offers promise, the statistics do not bode well for investors. The industry has a modest weighted average cost of capital, but suffers from a lackluster capitalization rate. According to the Fed Model, Application Software is considerably over valued, since the earnings yield is considerably lower than the current risk free rate (10-yr Treasuries).
Table 2: Per Share Industry Values – Application Software
Industry per share values confirms the problems identified in Table 1. Application Software companies are overvalued by roughly 12.5%. The low earnings power value is quite troubling, since investors should expect these companies to be more profitable due to economic moats.
We have chosen to analyze nine companies in this industry:
1.) Advent Software – ADVS
2.) Sybase Inc. – SY
3.) SPSS Inc. – SPSS
4.) SAP – SAP
5.) Intuit Inc. – INTU
6.) BMC Software – BMC
7.) Compuware – CPWR
8.) QAD Inc. – QADI
9.) American Software Inc. – AMSWA
Table 3: Altman Z Score of Selected Application Software Companies
These lackluster scores further support our analysis that the Application Software Industry has few compelling investment opportunities.
* This article is for informational purposes. The author cannot be held responsible for monies gained or lost on trades based on this research.
