Cautions for the Software Sector - Goldman

by: Eric Savitz

Expressing caution on the software sector heading into second quarter earnings report, Goldman Sachs software analysts Sarah Friar, Sasa Zorovic, Derek Bingham and Frederick Grieb this morning chopped estimates on a host of software companies. They also cut their ratings on both Intuit (NASDAQ:INTU) and Digital River (NASDAQ:DRIV) to Sell from Neutral.

“A difficult U.S. macro environment and its slow spillover internationally create problems for the group,” the Goldman analysts wrote in an extensive software industry research note this morning. “These are seen in longer sales cycles, price discounting, and the need for multiple signatures for deal closings, and hence sales slippages. All this is somewhat offset by currency benefits, ongoing strength in emerging markets and trough valuations.” They also note that short interest in the group is at a three-year high and could provide some support for the shares.

Goldman cautions that while P/E multiples have compressed for software stocks this year, they see “downside risk to Street estimates for the whole group.”

On the downgrades, Goldman says that neither call is focused on the current quarter - July for Intuit, June for Digital River - but that they do consider Street estimates to be too high. “We expect the outlook over the next couple of quarters and into 2009 to increasingly weigh on the estimates and hence the stocks given exposure to consumer and [small- and medium-sized business] sales.”

For Intuit, Goldman cut their target price to $25 from $31, and added the stock to the firm’s Conviction Sell List. They note that small business spending - which accounts for close to 40% of the company’s revenue - is likely to slow. Goldman asserts that “the combination of deteriorating macro environment with weak end-demand, tight lending environment, etc, are likely to compel small businesses to slow down spending - including on Intuit’s key products in this market.” They also expect consumer spending to deteriorate in FY 2009 from 2008. Goldman also notes that Intuit generates just 5% of revenues internationally. Goldman cut its EPS estimate for the July 2009 fiscal year to $1.50 from $1.55; for 2010 they go to $1.70, from $1.76.

For Digital River, which provides e-commerce software, Goldman’s target price drops to $33 from $38. Goldman asserts that U.S. consumers are in a “sorry state,” with job creation, real hourly wages, home prices, equity prices and willingness to lend to consumers ” all near the bottom of the ranges posted since World War II. “We believe consumer spending is likely to slow - and we are lowering our growth estimates as a result,” Goldman writes. For 2009, Goldman cuts its pro forma EPS estimate to $2.07 from $2.17; for 2010, they go to $2.31, from $2.45.

The Goldman software analysts also recommend two pair trades heading into earnings season: They advise going long Symantec (NASDAQ:SYMC) and short Check Point (NASDAQ:CHKP); among other things they note that CHKP trades at a premium to SYMC on a price/cash flow basis. They also suggest going long CA (NASDAQ:CA) and short  BMC Software (NASDAQ:BMC); they note that CA’s valuation is lower, with conservative expectations, while BMC’s FY 2009 targets “offer little room for upside and could potentially require lowering due to a more sluggish macro environment and likely waning currency benefits.

The Goldman analysts also trimmed estimates for Adobe (NASDAQ:ADBE), Autodesk (NASDAQ:ADSK), BMC, Citrix (NASDAQ:CTXS), Kenexa (KNXA) and Parametric (PMTC).