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JUNE 18, 2001
Warning: Software Gloom Won't Lift Soon
By Mark Veverka
Every year at this time, a marine fog socks in some of California's most beautiful surfing beaches, from Santa Cruz to San Diego. The hazy gray skies tend to linger from dawn until early afternoon, whereupon the leaden layer usually burns off, and the sun again is allowed to glisten off the waves until dusk.
This annual condition has come to be called "June Gloom." And if you listen to Goldman Sachs software analyst Rick Sherlund, there's little but gloom for software stocks right now. At an informal dinner for technology scribes last week near Palo Alto, the highly credible Sherlund pulled no punches. Fresh from an exclusive software CEO summit at Pebble Beach on Tuesday, Sherlund warned that things could get worse before they get better.
"The preponderance of the news is negative. [Software] stocks will give back 10%-20% of their recent gains," says Sherlund, who has covered Microsoft since Goldman Sachs took the company public in 1986.
As one software executive told him, "The snake has swallowed the pig, and it's a much longer snake than we expected." When those chief executives attending the powwow were asked to predict when they thought software sales would begin to pick up, "nobody said the third quarter," recalls Sherlund.
Earlier this year, software was being touted as a more resilient technology sector, relative to the rest of tech, and it was expected to help lead the bloodied industry out of its rut. There was, and still is, some logic to the thinking behind that theory. While companies are curtailing spending on hardware, they will still make strategic purchases of certain software -- such as customer relationship-management and Internet-integration products -- that would make their enterprise systems run more efficiently. In other words, they would at least buy what they need to ensure that their hefty technology spending of the past few years begins to produce some returns.
Consequently, software executives had been slightly more optimistic about their fortunes for the second quarter, with many once predicting that signs of a rebound could manifest itself during the quarter.
That was then. "The consensus is changing. It's all pre-game talk until you get into the last month of the quarter," Sherlund proclaims. And now that we're here? "I've heard a decidedly different tone," he says. "They're showing more concern."
Many CEOs indicated that they now expect results to be weaker than the first quarter's, meaning momentum is going in the wrong direction. With that in mind, Sherlund says, "I would be pleased if the software companies we cover meet our estimates for the June quarter. We suspect that estimates may need to come down for the second half and perhaps 2002 as well."
Did someone say downgrades? The second half of this year was supposed to be when the big rebound began. Of course, we now know that much of that rosy talk was arbitrary wishful thinking proffered in the vacuum of a downward spiral.
The exercise of predicting software sales is a particularly thorny one, explains Sherlund, because of the industry's back-loaded business model. About 60% of the sales during a given quarter get booked during the final four to six weeks of the quarter. The industry needs a new business model with revenue recognition spread over 12 months, he proposes.
But that is a problem to be fixed another day. The problem at hand is that corporate customers are not pulling the trigger on software purchases that legions of salesmen thought would be in the bag by now. "The big deals aren't closing," Sherlund says.
Why not?
A couple of reasons, neither of which are necessarily new, though they seem as valid as ever. Corporations are coming off a tech binge unlike any before. The double incentive of Y2K preparation and the fear of getting "Amazoned" by a dot.com rival drove information technology spending to a new stratosphere. In hindsight, Y2K spending was overkill and the dot.com threat is now nearly benign.
Companies are bloated with information technology software and gear, and they are supposed to buy more? For what reason?
Then there's the not-so-small matter of corporate profits. If bottom lines are shrinking, why should corporations buy more software? The bucks are stopping in the executive suite. "The CEOs said [they're] not signing any purchase orders right now," Sherlund says.
A reversal in pathetic corporate profits is imperative for tech spending in general, and software spending in particular, to recover, but predicting when corporate profits might begin to stabilize is out of Sherlund's bailiwick. But Goldman Sachs' bellwether market strategist is pointing toward the end of the year. Says Sherlund: "I think Abby Cohen would say by the fourth quarter we should start to [see profits] get into positive territory."
But that doesn't help investors much in the short term, which is looking dicey. Sherland recommends Microsoft as a "relative safe harbor" because most of the bad news should be behind the company. He also finds some solace in Siebel Systems because customer relations-management software registers high on information technology executives' shopping lists. "If any company should make its numbers, it's Siebel. And yet [CEO] Tom Siebel was apprehensive himself," Sherland says.
The June gloom doesn't stop there. Contributing to the dreariness could be Oracle, which is slated to report earnings for its fiscal fourth quarter (ended May 31) on Monday, June 18. And Sherlund is not optimistic that Larry Ellison & Co. will meet their already-reduced consensus estimate of 14 cents a share. Indeed, he says, Oracle's silence has been deafening. The lack of a pre-announcement by Oracle has done little to calm Sherlund's fear of an earnings whiff. "I think they will have fallen short," he says. And that would not be sunny news. Says Sherlund: "As Oracle goes, so will go software stocks."
Slap the cuffs on. The congressional hearings on the efficacy, or lack thereof, of Wall Street analysts are long overdue. But it seems some of the lawmakers and experts who are testifying are overlooking a key point: We do not need new legislation or more rules. We simply need the government, the exchanges and the professional organizations to enforce the rules that already exist. There is more than sufficient regulation, on paper at least, governing the practices and conduct of brokerage analysts.
Both the Association for Investment Management & Research and the National Association of Securities Dealers are very clear about how analysts are supposed to practice their profession. For starters, they are to establish reasonable bases for their recommendations; their analyses need to be full, fair and accurate; and they are required not to intentionally omit material facts. The issue is not about an analyst's right to be wrong, it is about his or her obligation to be ethical and within the law.
What's a venture capitalist? AOL Time Warner's Fortune magazine held its annual "Cool Companies" bash last week at a San Francisco night club near the Castro district. The event was understandably understated, given the lean times for magazine ad sales. AOL Time Warner used the event to herald the recently closed acquisition of the Bay Area's Business 2.0 magazine by eCompanyNow, a technology monthly launched by Fortune only last year. ECompany will assume the better established Business 2.0 name, but is not expected to keep many, or any, of its staff.
Times have definitely changed. It was only a year ago that Time Warner leased Pacific Bell Park and flew in Warner's Barenaked Ladies pop band to entertain an intimate crowd of hundreds of then-employed dot.commers. At least this soirée had an open bar.
Another post-bubble phenomenon is that it is no longer cool to admit that you are a venture capitalist. To wit: One guest at the affair introduced himself as "an early-stage private equity investor."
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