Information Technology Sector Report

John OShaughnessy & Maggie McRae Applied Portfolio Management Spring 2010

Table of Contents Recommendation.....3 Info Tech Sector Overview, size and composition......5 Industry Overview: Internet Software and Services........8 Industry Overview: Software.................................30 Business analysis Internet Software and Services........8 Phase of Life Cycle......8 Business Cycle Classification....10 External Factors.11 Porters Five Forces...16 SWOT Analysis.20 Business analysis Software Phase of Life Cycle............31 Business Cycle Classification.......32 External Factors34 Porters Five Forces.......38 SWOT Analysis......43 Financial Analysis Internet Software and Services Sales Growth...21 Earnings Growth..22 Margin Analysis....24 DuPont Analysis.......27 Cash Flow Analysis.....28 Financial Analysis Software Sales Growth...44 Earnings Growth..45 Margin Analysis....47 DuPont Analysis...49 Cash Flow Analysis.51 Works Cited.52

Recommendation We recommend increasing the APM portfolios present weight in the Info Tech sector by 2% from 15.9% to 17.9%, which is slightly below the S&P 500s weight of 19.90%. The Info Tech Sector tends to be cyclical and follows the S&P 500. The sector however generally outperforms the overall market, even when it is down. The sector does show potential for positive earnings growth, even in a recessionary time. Companies in this industry have lower fixed cost structures and generally maintain lower amounts of leverage than the overall S&P. It would be difficult to lower the beta of the sector lower than 1.0, as no industries within the sector have a beta lower than .9. We recommend that the additional 2% be allocated in the Internet Software and Services industry. The Software industry is experiencing lower net profit margins and decreased ROE in 2008 compared to prior years. Sales and earnings growth has also been decreasing since 2007. We believe that in the coming years there will be a shift for businesses to do business online instead of having to update and change software frequently to keep up with technology. This change would lower the current beta in this sector slightly, and would also lower the APM portfolio beta marginally. The overall risk of the portfolio would remain relatively constant. We believe that this would generate positive returns for the portfolio due to the Internet Software and Services industries ability to outperform the overall S&P and even their own sector, in recessionary times. The current betas of the Info Tech and Software sectors are 1.1 and Internet Software and Services is 1.0; allocating a small portion to Internet Software and Services of the portfolio would lower the overall beta slightly.

Most companies in the Internet Software and Services operate with higher margins than the overall S&P; this demonstrates their ability to generate more profit from every dollar invested. Over the period from 2004 2008 the operating profit margins of the Internet Software and Services industry have been steadily increasing. The higher margins within this industry show companies ability to be more flexible in converting their revenues and are more able to manage costs as sales fluctuate with the economy. Companies in this sector seem to foresee the recession continuing, and they are willing to give up earnings and decrease leverage and lower their overall risk. From 2004 2008 the industry has also shown an ability to be a net generator of cash flow, with the Internet Software and Services sector being a rather significant generator. Global usage rates for the internet are rapidly increasing. The internet has revolutionized the way that mankind conducts business and everyday life. Many companies like Google have shown steady declines in sales growth over past years, but it is hardly possible for companies to grow at over 50% for any lengthy period of time. The growth potential in the Info Tech sector and the Internet Software and Services industry is large, and based on our research it should continue well into the future. We believe this change will be a quality addition to the APM class portfolio. More recently the Info Tech sector has had a good year, since last years fallout on March 9, 2009. Looking at the characteristics of the industry in 2008, one can see that it still grew despite the recession. Increasing the weight slightly in this sector would be a good choice given the chance that the road ahead is still rocky and risky economically and inflation-wise. The leading companies are under-levered, growing, and the government will be a major player, as it

expands its influence into the private sector; there will always be customers and demand for products in this industry. Overview: Info Tech Sector, Size and Composition The Information Technology Association of America defines Information Technology as the study, design, development, implementation, support or management of computer-based information systems, particularly software applications and computer hardware. Information Technology is currently the largest of the ten sectors in the S&P 500 with a sector weight of 19.91%. As of December 31, 2009, the S&P 500 Index total market capitalization was $9,929.45 billion (S&P 500 fact sheet). The market capitalization of the Information Technology sector is $1,839 billion.

The Information Technology sector is segregated into three industry groups: Software and Services 39.14%; Technology Hardware and Equipment 44.9%; and Semiconductors and Semiconductor Equipment 12.79%.

The Global Industry Classification Standard (GICS) code for Information Technology is 45. This sector is broken down into three industry groups: Software and Services (4510), Technology Hardware and Equipment (4520), and lastly Semiconductors and Semiconductor Equipment (4530). These three industry groups are broken down further into industries. The first industry group, software and services, is broken down into three industries: Internet and software services (451010), IT services (451020), and Software (451030). Technology Hardware and Equipment (4520) is broken down into three industries: Communications Equipment (452010), Computers and Peripherals (452020), and Electronic Equipment, Industrials and Components (452030), and finally Office Electronics (452040). Semiconductors and Semiconductor Equipment (4530) consists of only one industry, Semiconductors and Semiconductor Equipment (453010).

Industry Group Software and Services

Information Technology Sector Industry Company Application Software Internet Software and Services IT Services Microsoft Corporation (MSFT) Google (GOOG) Computer Sciences CP (CSC) IBM Hewlett-Packard Company Nokia DirecTV Corning Inc. Intel Corporation

Market Capitalization $252.3 B $171.95 B $8.0 B $163.6B $113.1 B $52.0 B $30.1 B $28.2 B $108.3 B

Technology & Hardware

Computers and Peripherals

Communication Equipment

Semiconductors and Semiconductor equipment Source: Yahoo! Finance

Semiconductors and semiconductor equipment

Texas Instrument Inc.

$28.6 B

Industry Overview: Internet Software and Services The Internet Software and Services sector comprises 5.78% of the Information Technology sector. Some of the major companies are well known names such as Google, Yahoo, EBay, VeriSign inc., WebMD, and others. These companies are listed with their market caps and industry classification in the table below.
Company GOOGLE INC EBAY INC VERISIGN INC WEBMD HEALTH CORP EARTHLINK INC YAHOO INC REALNETWORKS INC THESTREET.COM Ticker GOOG EBAY VRSN WBMD ELNK YHOO RNWK TSCM Industry/Sub industry Internet Software & Services Internet Software & Services Internet Software & Services Internet Software & Services Internet Software & Services Internet Software & Services Internet Software & Services Internet Software & Services Market Cap 170.17B 28.67B 4.28B 2.25B 870.06M 616.19M 616.19M 92.46M

Business analysis Internet Software and Services Phase of life cycle: Internet Software and Services The Internet Software and Services industry is currently in the growth phase of the industry life cycle. Hook defines the growth stage as Product acceptance is established. Rollout begins and growth accelerates in sales and earnings. Proper execution of strategy remains an issue (Hook 89). There are many parts to this industry, but a major facet is online search engines. Established search engines such as Google are looking for more ways to expand further into the

Internet Software and Services industry including expanding into new categories such as social networking and even cellular phone technology. With the advent of smartphones, many providers are looking to develop their own cell phone software. This may hurt companies such as Google; they may stray away from their core business and lose market share to competitors such as Microsofts new Bing search engine. As one can see from the chart below, online search engines have been growing rather steadily since 2006.

The general outlook is that these companies will continue to grow through 2010 and beyond (IBISworld). Other companies such as WebMD are continually dedicated to improving their interface to the user, providing many with easier ways to help diagnose illnesses and direct them to necessary medical assistance. VeriSign Inc. provides security for digital transactions. They are currently working on a dramatic expansion and protection of the internet, they have invested over $500 million dollars into Project Titan. This major project will not only increase the security of the internet, but also increase its speed and reliability.

Classification by business cycle: Internet Software and Services The Internet Software and Services industrys behavior over the last several years would characterize it as cyclical industry according to Hooks classification system. According to Hook, a cyclical industry is defined as Profitability tracks the business cycle, often in an exaggerated manner (Hook 91). As you can see from the chart below for the past several years the top three performing companies in the Internet Software and Services industry follow the S&P 500 very closely. Google appears to have much larger swings, but still tracks the market somewhat closely.

According to the National Bureau of Economic Research and CNNMoney.com, the current recession in the United States began in December 2007. One can clearly see from the graph above that all of the major players in the Internet Software and Services sector track the markets up and down swings. Some firms such as Google track the overall cycle of the market, just in a more exaggerated manner. We do believe that the results of the graph make sense; most people generally do not seek out the latest and greatest technology when the economy is in a recession. So it would seem logical that these companies would track the market as they do. 10

External Factors: Internet Software and Services The Internet Software and Services industry is affected by many external factors. These factors have a significant impact on the profitability, sales, and survival of many companies within the industry. In Hook Ch.6 there are five main external factors, which affect sales and profitability. These offer a big picture of the industry, and are absolutely necessary to perform a top down analysis of any industry (Hook 94). These five factors are technology, government, social changes, demographics, and foreign influences. Technology Technology is likely to be the most important external factor for the Internet Software and Services industry. This sector is constantly changing and improving on itself, due to its fiercely competitive nature. In order for a company such as Google to stay on top, it must constantly innovate and come up with revolutionary ideas and products. Other companies will eventually (and currently are) producing search engines that are as good if not better than Google. Microsofts Bing.com search engine is one significant attempt by another company to replace Google as the number one search engine and it has the potential to put a significant dent in Googles profit margins. Google along with the other companies in the sector must heavily invest in research and development in order to stay at the top of their industry. Computers and internet technology have revolutionized the way that everything in todays world operates. As such, there is virtually no concern that the industry will become obsolete at any time in the near future. More recently there has been a trend toward internet based applications and software. The Internet Software

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and Services industry will expand considerably in the future, due to the virtually unlimited potential of computers and the internet. Government The government affects the Internet Software and Services industry in a variety of ways. The first is through regulations. Some believe that government regulation of various forms of communication on the internet could greatly impact the industry. If the government could see and or track what people are doing on the internet, this would cause hesitancy among internet users. According to the American Association for the Advancement of Science, Such regulations could prevent people from seeking counseling, expressing political opinions, or engaging in commerce, and could impede the development of e-commerce and the World WideWeb. (USAToday.com) In countries such as China, it is apparent how government regulation affects the industry via censorship. Chinas government does not allow its citizens to access certain social networking websites, such as Facebook, Twitter, and others. China also requires companies such as Google to censor certain websites and searches. The Chinese government does not allow access to over 18,000 websites. (www.wikipedia.com). This regulation drastically reduces the usefulness of the internet in China and other countries with such comprehensive legislation. The US government does not regulate the internet nearly as much as China, which could be a key factor for the success of software and service companies in the US. Government spending also has a significant effect on the industry. The United States government is projected to spend $500 billion on IT from 2010 - 2015. The government will spend some of this money making their online databases easier to access, and securing our

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infrastructure against outside threats. The government will surely contract many companies to help them develop these new resources, making them a major player in the internet software and services sector.The government can also assist companies who have first mover advantage, by issuing patents. This helps protect individuals and companies property rights. If the government did not provide this security the industry would most surely suffer. Social Changes Cell phone technology is progressing at an extremely rapid rate. An increasing number of people have smart cell phones today. Many of these phones can do everything from finding the best pizza in town to running a business, all from the palm of ones hand. The recent trend towards smart phones, is due in large part to the price of them coming down as more and more companies are offering them. This means that more and more people are using the Internet and websites such as Google, to look up just about anything. Many large companies have recognized this trend and have already jumped on board. Google is currently working on a second generation Google phone. Even companies such as Bank of America, have developed various apps for phones allowing their customers to check account balances, pay bills, and even make mortgage payments all from their cell phone. Companies in this industry are beginning to offer more mobile phone friendly versions of their websites. This makes it even easier for customers to use these websites on their phones. EBay now allows customers to search for and make bids on items from cell phones. Internetcapable smart phones were a technology that only a few years ago many people would have agreed that they could live without. After owning a smart phone, most would agree that they

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could not imagine life without one. As technology improves in the coming years, more people will have faster and cheaper access to the internet. Many use the internet as a tool to find just about anything they have questions about. The future of the Internet Software and Services industry from the social perspective looks very bright.

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Demographics The internet is widely used by all generations. The graph below (www.pewreaserch.org) illustrates the increase in the usage of the internet across all categories from 2000 2009:

The trend especially among younger people is towards smaller more portable devices, to access the internet. Many adults have now become a part of social networking websites, such as Twitter, Facebook, and MySpace. These companies have all responded to this increase in mobile demand and as such they all offer their services, on handheld devices such as smart phones.The only hurdle for Internet Software and Services companies is bringing the price of their goods and services down. This is especially true in times of recession, when many people are losing their jobs. As time passes, and more companies enter the smart phone and internet software and services industry, the products will get better and prices will surely fall. Without the internet and other software systems, many businesses would not be able to function in

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todays rapidly changing environment. Large growth in this sector is possible and will continue for the foreseeable future. Foreign Influences Recently there has been a significant increase in demand for internet software and services. Countries such as Asia, Europe, and others all rely on the internet and computers to conduct business. Social networking is also just as popular abroad as it is in the United States. This steady increase in demand has been to the benefit of many internet software and services companies in America. There have been some issues such as Googles censorship issues with China. In the early part of the decade these censorship issues cost Google much of its market share to other Chinese search engines. Foreign governments with different laws and restrictions have always posed issues for international business, and the internet software and services industry is no exception. Porters Five Forces: Internet Software and Services Internal Industry Rivalry The five forces model is one of the simplest tools to analyze external threats from other companies. According to English, the first parts of the SWOT analysis to consider are: internal industry rivalry, threat of new entrants, threat of substitute products, bargaining power of suppliers, and the bargaining power of customers. These factors are each analyzed below.

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Internal Industry Rivalry: High The rivalry between firms in the internet software and services industry is very intense. An example would be between the most popular search engines, Yahoo! Google, and Microsofts new Bing. Early on, Google and Yahoo began offering email services with limited amounts of storage space, however due to intense competition both websites now have so much storage space that the average consumer is not likely to ever come near filling it up. In most cases, the switching costs between software providers in this industry are relatively non-existent. Currently most of the internet services are free to the user, so switching from one search engine to another is as easy as clicking a mouse. These companies must direct their focus heavily on research and development. The high level of competition ensures that companies must stay at the technological forefront in order to keep customers using their services. Threat of New Entrants:Low The threat of new entrants in the Internet Software and Services industry is relatively low for several reasons. Several very large firms dominate the industry. Anytime a new competitor begins to rise up with a newer and better product or service they are usually bought out by one of the existing large firms in the industry, before they pose any real threat. In 2006, online video sharing became very popular and showed strong future growth potential. Google quickly recognized this and instead of trying to create a competing online video sharing website, they bought YouTube for $1.65 Billion. Companies such as VeriSign Inc. operate a wide range of network infrastructure. This includes two of the internets thirteen root name servers. VeriSign also runs the .com and .net 17

internet domains. It would be virtually impossible for a new competitor to come to the market with a new product and take this business away from VeriSign, as the switching costs to do so would be astronomical. This makes the threat of new entrants to this sector rather unlikely. There are simply too many large established firms, which would be difficult to compete with. Many of these large established firms could simply buy new entrants out at the first sign of a threat. Threat of Substitute Products:Moderate The Internet Software and Services industry is not really threatened by new products. At this time, there is no substitute for the internet. There is, however threats to software and service providers in the sense that other companies may develop better software and service products rendering current ones obsolete. The increase in the use of newer devices has created a threat for software providers in the sense that they must make their software compatible with these new platforms. This is especially true when websites like WebMD develop apps which allow users more direct access to their services. Most apps are only compatible with certain devices and must be constantly updated and changed so that consumers can use them with newer devices. Bargaining power of suppliers:Moderate The suppliers in the internet software and services industry do have a good amount of bargaining power; however, the main driver of this industry is the development of new technology and product innovation. There is really no substitute for the products in this industry, there is currently no other internet but the suppliers must stay focused on improvement to keep their customers. Another major limiting factor for these companies, due to the massive increase in the use of the internet, is that the current internet infrastructure needs to be upgraded to handle

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the increase in demand. If this does not happen the internet itself may become slow and inconvenient and this could drive consumers elsewhere. It is also relatively difficult and expensive for businesses to change their online software and service packages. Thus, suppliers do have a good amount of bargaining power in this respect. Bargaining power of customers: Low to Moderate In parts of this industry, customers have a fair amount of bargaining power, whereas in other parts, they have less. WebMD is not the only medical information site; there are many others. So for most customers, they can express their bargaining power by just using other websites if suppliers do not provide them with what they want. Businesses that contract to use the services of various internet software providers have less bargaining power due to high switching costs. It would be very costly for EBay to cease their use of VeriSigns transactional security services. EBay and other internet shopping websites must heavily secure their online transactions, with ID theft being such a large problem. There are not many security companies like VeriSign to design such a comprehensive security programs. This considerably reduces the consumers bargaining power and their choice of products. Most websites and online service companies usually set a price for their product or service. If one wants to use this service or product, they must pay what the company sets as the price. Due to its competitive nature, this industry must constantly innovate and offer its customers with the best products at the best value. The industry itself will push out companies that are inefficient and do not offer good products. This provides customers with a little bit of bargaining power, and definitely plays in their favor.

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SWOT Analysis: Internet Software and Services

Strengths - Ability to innovate. - Convenience of services, keep customers coming back. - Popularity of social networking. Weaknesses - Must have latest technology and features to keep customers. - Cyclical with economy. - Low switching costs - Consumers concern over lack of security - Over diversification Threats - Copyright issues abroad. - Problems with foreign governments

Opportunities - Increasing popularity of Internet all over globe. - Virtually limitless possibilities of Internet technology. - Advancements in technology make Internet accessible almost anywhere.

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Financial Analysis: Internet Software and Services. In this section the annual sales and earnings growth rates of the Internet Software and Services Industry are compared to the Information Technology Sector, the S&P 1500 Super Composite, and Google, Inc., the largest company in the Internet Software and Services Industry. 1. Sales Growth: Internet Software and Services and Components

The chart indicates some very apparent trends in sales growth. The rate of growth in sales appears to be on the decline in the Internet Software and Services Industry. In spite of this decline in the rate of growth, in 2008, a challenging year for business, the growth rate was still 16.5%, which, measured by any other industry, is significant growth. In addition, the Internet Software and Services Industry have outperformed the Information Technology Sector as a whole in every year except for 2006. The same can also be said when comparing the Internet Software and Service Industry with the S&P 1500 Super Composite, and when comparing the Information Technology Sector with the S&P 1500 Super Composite.

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Google has seen a steady decline in its rate of sales growth over the past four years. This is understandable, however, as it is not realistically possible for a Google to grow at rates of 50%. It is remarkable that Google sales grew in 2008, a challenging year, at nearly 31%. In the past year (2009), Google has lost some market share to Microsofts new Bing search engine. In the 4th quarter of 2009, Google posted a 17.9% increase in sales from the previous year (NYtimes.com). 2. Earnings Growth: Internet Software and Services

In the 2004 to 2008 period, the percentage growth in earnings in the Internet Software and Services Industry underwent a sharp reversal. In 2006 especially, the momentum of the industry reversed, possibly from unsustainable rates of growth in 2004 and 2005. In 2007 and 2008, it is best to describe earnings growth as flat, with the Industry reverting to earnings growth once again in 2008. In 2007, the Information Technology Sector did outperform the Internet Software and Service Industry. Google has also experienced a sharp decrease in earnings growth in 2007

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and 2008. In 2008 Googles earnings growth rate was only less than 1%, as no one was immune to the economic collapse. According to the above tables, it is evident that the severe recession economy has had a significant impact on the demand for new technology as well as the profitability of delivering this technology. 2008, was a year marked by panic and fear where many industries were paralyzed by the financial and market crisis. In spite of this, Internet Software and Services demand increased although at a declining rate. This declining rate of sales did severely impact the profitability of an industry that operates in a high research and development mode. Both the Information Technology Sector and Internet Software and Services Industry did outperform the market as measured by the S & P 1500 Super Index over the 2004 to 2008 period. Both this Sector and industry have the potential to outperform the overall market in the future as well. The average sales and earnings growth for the period for the four categories in the above graph are listed below.

Average Sales Growth S&P 1500 Super Info Tech Internet Software & Services Google 8.12% 9.91% 25.39% 74.12%

Average Earnings Growth -6.25% 18.86% 49.63% 138.42%

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3. Margin Analysis: Internet Software and Services

The above graph of data from 2004 to 2008 displays the higher gross margins that the Internet Software and Services industry enjoy versus the overall Information Technology sector. It also shows that Google has been able to improve its gross margins over time, even in a severe recessionary economy. Companies in the S&P 1500 Super Composite operated with considerably smaller margins the Information Technology sector, and even smaller margins than companies in the Internet Software and Services and their margins were impacted in 2008 by the recession. The higher margins of the Information Technology sector and the Software and Services industry demonstrate that companies in this industry do generate a lot of profit from products and services that cost relatively little to produce. Due to the ease of outsourcing such tasks as customer service and the little amount of physical production of goods, the industry is able to operate very efficiently and keep fixed costs down in the production process.

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The above graph compares the operating margins for the Internet Services and Software industry with the Information Technology sector, the S&P 1500 Index, and Google from 2004 to 2008. During this period, the S&P 1500 Index had an average operating profit margin of 14.7%, better than the Information Technology sector by 1.7%. The Internet Software and Services industry achieved an operating profit margin 6.9% better than the S&P 1500 Index. The operating margin of the Internet Software and Service industry has been increasing somewhat steadily over this period, meaning that it is earning more per dollar of sales than both the Information Technology sector as a whole and the S&P 1500.

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The graph above shows that the Internet Software and Service Industry and the Information Technology sector have higher profit margins than the S&P 1500 Index. Google obviously shows great net profits compared to other companies in the industry and sector. Companies in the Information Technology sector generally operate with larger profit margins and are less capital intensive. This reduces the risk that if revenue falls, the companies within the sector will show a net loss. The higher net profit margins of both the Software and Services industry and the Information Technology sector demonstrate that the companies within this industry and sector have more operating flexibility in converting their revenues into actual profit and are more able to manage their costs as sales fluctuate. The profit margins of the S&P 1500 Index companies appear to be crippled by the effects of the severe recession as well. Generally the profit margin of tech companies is maintained at a higher level than most other industries, this is mostly due to their lower costs of production, and overall higher efficiency.

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4. ROE Decomposition: Internet Software and Services Industry

Over the period (2004-2008), the Information Technology sector and the Software and Services industry had a higher ROE than the S&P 1500 Index in most years. This may be due to the lower financial leverage of the Information Technology Sector and the Software and Services industry when compared to the S&P 1500 Index companies, and the higher operating profit margins on average over the period.

2008 DuPont Analysis S&P 1500 Info Tech IntSft. &Srv. Google

Operating Profit Margin 11.06% 12.98% 23.52% 30.43%

Asset Turnover

Leverage

Interest Burden

Tax Burden

ROE

0.401 0.912 0.594 0.686

5.392 2.173 1.299 1.125

0.3523 0.6829 0.8447 0.8826

0.4419 0.6369 0.6580 0.7221

3.72% 11.20% 10.08% 14.97%

The above table shows the ROE breakdown with the most current available data (from 2008). Googles ROE is considerably greater than the S&P 1500, companies such as Google typically require minimal leverage because they generate significant profitability. Due to

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the current recession many companies in S&P 1500 are feeling the downside effects of leverage. Leverage magnifies losses; this is may be why the S&P 1500s profit margin is nearly three times smaller than Googles. As a response to the financial crisis, especially the severe credit crisis which occurred at the end of 2008, companies are seeking to decrease leverage, despite low interest rates. These companies are likely forecasting a significant rise in interest rates as massive government deficits and a forecasted decline of the dollar will leave the FED with no choice but to raise interest rates in the near future. It seems as if companies in the Information Technology sector, and the Internet Software and Services industry are following this trend. The economic recovery, if there is one, is likely to be anemic. The companies in this industry seem to recognize this and are willing to give up earnings to decrease leverage, and reduce their overall risk. 5. Cash Flow Analysis: Internet Software and Services Industry
Net increase (decrease) in cash and cash equivalents 2004 S&P 1500 Info Tech Int. Sft. &Srv. 1.9578 1.1337 33.7812 2005 1.7644 2.1626 88.6241 2006 0.0876 0.8157 57.2816 2007 3.1221 4.463 120.007 2008 4.7135 -0.3267 35.7465

The table above is the results of the indirect method of preparing a statement of cash flows for the S&P 1500, the Information Technology sector, and the Internet Software and Service industry. The net increase (decrease) in cash and cash equivalents is calculated by summing the net cash flow from operating activities, investing activities, and financing activities.The results show that overall the Information Technology sector is a net generator of

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free cash flow, with the exception of 2008. The Internet Software and Service industry has also been a significant generator of free cash flow over the five-year period. The industry has been expanding as the Internet has increased in universal usage. The reduction in financial leverage also improves cash flow, especially important in times of economic slowdown.

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Industry Overview: Software The software industry comprises 22.96% of the Information Technology sector. The software industry is divided into three sub-industries: Application Software, Systems Software and Home Entertainment Software. Systems Software comprises the majority of the Industry at 86.61%, followed by Home Entertainment Software at 9.33% and Application Software at 4.05% (Industry Sector Scorecard). Some of the major players in the industry include: Microsoft, Oracle, SAP and Symantec. These companies had some of the largest market caps in the industry; Intuit at $9.36 billion to Microsofts whopping $246.63 billion. Most of the companies mentioned above operate in the systems software sub-industry: Microsoft, Oracle, Symantec, McAfee and Novell. SAP, Intuit and Quest are some of the largest companies in the Application Software sub-industry, and Electronic Arts is a major company in the Home Entertainment sub-industry. Below is a table that outlines these 9 major companies and their classification in the industry. Some of these companies, however, have major competitors in other industries. For example, Microsofts major competitors are Apple and IBM, which operate in the Computers and Peripherals industry.

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Company MICROSOFT CORP ORACLE CORP SAP AG SYMANTEC CORP INTUIT INC MCAFEE INC ELECTRONIC ARTS INC NOVELL INC QUEST SOFTWARE INC

Ticker MSFT ORCL SAP SYMC INTU MFE ERTS NOVL QSFT

Industry Software Software Software Software Software Software Software Software Software

Sub-Industry Systems Software Systems Software Application Software Systems Software Application Software Systems Software Home Entertainment Software Systems Software Application Software

Market Cap (in billions) $246.63 $117.01 $51.12 $13.94 $9.38 $5.98 $5.25 $1.65 $1.45

Phase of the Life Cycle: Software The software industry currently operates in the growth phase of the industrial life cycle. Hooke explains the growth cycle: The practitioners acknowledge the industrys product acceptance and have a brief historical framework for estimating future demand. Growth companies also prosper independent of the business cycle and enjoy fat profit margins (Hooke 89). Industries in this stage of the cycle also are able to sustain revenue growth and profits over longer periods of time. Using the S&P 1500 Software Index, we have found that sales growth has been positive since 2002. Companies are always updating their software, streamlining the new and more effective ways to do business. New technology and innovative ideas keep the industry growing at a steady pace. IBISWorld, an industry expert, states: Industry revenue is forecasted to grow at an average annualized real rate of 3.0% in the five years through 2014. New innovations, along with falling prices for hardware, software and data communications, will tend to promote growth in the software industry. Industry activity is expected to pick up when the U.S. and global economies strengthen in 2011 through 2014 (IBISWorld). We believe that the software industry will continue to grow in the next 5 years; companies are eager to expand by improving their existing products and creating new products with easy and friendly user-interfaces. Microsoft has recently released Windows 7, implementing features to create a faster, simpler and more reliable experience for the consumer. Also, earlier this year, Oracle finalized an agreement

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to acquire Sun Microsystems. We believe that this merger will result in a well-integrated company that will deliver a superior level of performance, reliability and innovation in their products and services from this point forward. Customers will benefit as this company seeks to grow through its applications and services. Phase in the Business Life Cycle: Software The Software industry currently operates in the cyclical category of the business life cycle. According to Hooke, cyclical industries are those whose earnings track the cycle. Their profits benefit from economic upturns, but suffer in a downturn. The earnings movement is exaggerated. Boom times are followed by bust times. (Hooke 90). The graph on the next page shows the stock prices of Microsoft, SAP and Oracle compared with the S&P 500 from December 2003 to December 2009. From December 2003 until around December 2007, prices from Microsoft, Oracle and SAP have steady upward-sloping prices similar to those of the S&P 500.

Historical Snapshot: Stock Prices from December 2003 - December 2009

$60.00 $50.00 Stock Prices $40.00 $30.00 $20.00 $10.00 $0.00
Nov-09 Sep-09 Jul-09 May-09 Mar-09 Jan-09 Nov-08 Sep-08 Jul-08 May-08 Mar-08 Jan-08 Nov-07 Sep-07 Jul-07 May-07 Mar-07 Jan-07 Nov-06 Sep-06 Jul-06 May-06 Mar-06 Jan-06 Nov-05 Sep-05 Jul-05 May-05 Mar-05 Jan-05 Nov-04 Sep-04 Jul-04 May-04 Mar-04 Dec-03 Economic Recession: December07

$1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 MSFT SAP ORCL S&P 500

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From December 2007 to about May 2009, Microsoft and SAP have shown a significant decrease in stock price, following the trend with the S&P 500. Oracle has a slight dip in price but then stabilizes. All of these stocks see an upswing in February in 2009, showing that these companies respond closely to changes in the S&P 500. We believe that the software industry is cyclical, meaning that its earnings track both the ups and downs of the business cycle. Their profits benefit from economic upturns but suffer in a downturn. It is clearly shown that when the market was yielding steady returns, Microsoft, SAP and Oracle also had a steady growth. As soon as the late 2007 recession occurred, prices in these companies dipped until February 2009. The software industry seems to follow the market closely. In times of a recession, companies may not have the extra cash to update their current software. Large companies will focus their spending on operating activities and they will not necessarily update their software. A lack of disposable income in households will also affect sales of computers that affect software sales.

Economic Recession: December07

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The graph above includes three additional stocks: Symantec, Intuit and Electronic Arts. These stocks also follow along the S&P 500 index. Intuit, Oracle and Symantec display earnings that also resemble a cyclical cycle. External Factors Technology Technology plays a very critical role in the software industry. In order for a company to survive in this industry, superior technology and competitive advantages are driving factors that help to keep businesses afloat. According to IBISWorld, The software industry is a highly competitive industry characterized by rapid technological change, evolving industry standards, changes in customer requirements and frequent new product introductions and enhancements. As a result, software companies tend to spend significant amounts on research and development. Technology is constantly changing and companies are striving to find new ways to expand their software and services for businesses and the individual. For example, two Silicon Valley companies, Apple and Google, have become prominent in the mobile phone industry through the development of sleek operating systems as well new applications and software for cell phones. Their products have become must haves and have captured the attention of competing software companies. Intel and Microsoft are rolling out products such as MeeGo and Windows Phone 7 Series to compete directly with Apple and Googles technology. Also, according to Niraj Sheth from the Wall Street Journal, Intel has been stepping up investments in mobile-device software to help take its so-called x86 chip technology into new markets beyond computing. As companies continue to tweak and update their current software, they are also bringing their technology to new markets.

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It is also important that companies in this industry protect their technology. Since there are many open source options (free software) on the web, some companies may want to save money and simply depend on open source technology. This is a keen threat for the big software companies such as Microsoft, Oracle and SAP since open source software offers their products basic components. Software companies protect their proprietary information through the use of patents, copyrights, trademarks, trade secret laws, confidentiality procedures and contractual provisions. The future success of many software companies is highly dependent upon their technology; it is necessary for these companies to protect their source codes. Failure to protect such technology could lead to a loss of valuable assets and competitive advantage. Government: Software There are several federal regulations and laws put in place by the U.S. government for software companies. U.S. copyright laws protect owners of copyright from the distribution, display and reproduction of such works. More specifically, the Digital Millennium Copyright Act (DMCA) of 1998 criminalized some cases of copyright infringement and prohibits the manufacture and distribution of services designed for the sole purpose of undermining technology used to protect copyrighted works (IBISWorld). Therefore, it is increasingly important for software companies to file requests for patents and copyright to prevent infringement. The governments main impact on the software industry is keeping a watchful eye for anti-trust and issues with monopolies within the software industry. Microsoft has been at the brunt of many competition lawsuits and it has been under scrutiny that they are running a monopoly. Microsofts Office, Internet Explorer, and Windows operating system are

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prepackaged onto most new computers such as Dell, Gateway, Acer, Toshiba and Lenovo (Microsoft.com). Complaints from other companies about the lack of competition sprouted concerns. This has caused the government to intervene, resulting in a lawsuit against Microsoft. In 1998, Microsoft was sued by the U.S. Department of Justice and the Attorney Generals of 20 U.S. states for illegally thwarting competition. In 2001, the Department of Justice reached a settlement, requiring Microsoft to share its application programming interfaces with third-party companies and appoint a panel of three people who will have full access to Microsoft's systems, records, and source code for five years in order to ensure compliance (IBISWorld). Overall, the government plays an active role to institute antitrust laws to ensure that everyone is provided with fair prices, the best quality and unbiased competition amongst businesses. Social: Software Computers and software have become an increasing part of everyday life for businesses, government and individuals. Businesses, as well as the government, which make up 90% of software users, rely on software for budgeting, spreadsheets and scheduling, security, human resources, legal documentation, data research, and for performing other various tasks. Individuals and households depend on software primarily for word processing, games, spreadsheet software, educational purposes, etc.

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The use of mobile phones has also played an important role in the software industry. The rising popularity of applications, the prominence of smartphones and increased use of text messaging provide great opportunities for the software industry. As people strive to become more connected via computers and cell phones, the use for software will continue to persist. Software helps to keep people connected, improves efficiency and helps streamline data making information more accessible. Demographics: Software Computers have been a worldwide phenomenon since the mid 1990s; the number of PC users has skyrocketed in the past fifteen years. According to the Economist Intelligence Unit, North America will have the most personal computers per person in 2010. With nearly one computer per person, PC ownership in the United States will exceed that in the rest of the world. Although the computer is gaining popularity worldwide, ownership in Asia and Australia is lagging. Less than one-fifth of the population in these continents owns a computer. Overall, global IT spending fell in 2009, but is forecast to be back on track in 2010. Aided by demand for sleeker netbooks and laptops, PC sales will increase by 8% (The Economist). Increased computer sales in the United States paves the way for software companies. Since more people are buying computers for their personal and

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professional use, they will need software to satisfy these needs. Software companies can step in and offer a variety of products and services to meet the needs of these consumers. Software companies also tend to target younger generations with educational software, mobile applications and social networking. The younger generations have grown up with technology. They understand how things work and they utilize technology in their everyday lives. To them, computers have become a necessity for communication. These are the customers that software companies strive to satisfy. It is probably the most difficult to sell software to low-income families and older populations that do not have the money or the desire to purchase computers. Foreign: Software Although companies in the United States lead the information technology industry, they are dependent on a complex network of suppliers, subcontractors and integrators around the world to make their products. The industry is highly competitive and companies strive to cut costs through low cost suppliers and customer service employees from foreign countries. Countries such as China and India have been working to develop a skilled work force, making them prime competition for the United States companies selling software. Cheap labor and materials will make the products less expensive, attracting budget conscious clients. A huge issue with foreign software is security. Any foreign intelligence group can infiltrate a business or the government with malicious and hostile codes that could create catastrophe. Porters Five Forces: Software

Porters five forces are the basic tool of analyzing the competitive threats and essential for SWOT analysis. The logic of the Porter system flows directly from industry structure to competitive positioning to company product and market strategy. These five forces determine 38

the average profitability for the industry (English 63). The five forces consist of: internal industry rivalry, threat of new entrants, threat of substitute products, and bargaining power of suppliers and bargaining power of customers. Internal Industry Rivalry: MODERATE

The rivalry within the software industry is moderate. Companies are spending massive amounts of money on research and development in order to keep up with competition and the newest technologies. In order for a company to keep a large share of the market and remain profitable, it is absolutely necessary to employ the newest and most efficient technologies in their products. Also, the software industry is very specialized and not all companies compete directly with each other since they offer differentiated products. For example, in the graph below, these nine companies listed have the highest market capitalizations in the software industry. Not all of these companies, however, compete directly with each other because they specialize in different products.

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First, Microsoft Corporation provides software and hardware products and solutions worldwide. SAP AG, together with its subsidiaries, develops, markets, and sells enterprise application software products for corporations, government agencies, and educational institutions. Intuit Inc. provides business and financial management solutions for small and medium sized businesses, consumers, accounting professionals, and financial institutions. Symantec Corporation provides security, storage, and systems management solutions to secure and manage information. Finally, Oracle Corporation, an enterprise software company, engages in the development, manufacture, distribution, servicing, and marketing of data base and application software (Yahoo! Finance). These companies all manufacture software but it is distributed to different consumers and meets different needs. Threat of new entrants: LOW

The threat of new entrants into the software industry is pretty low. It would be very difficult for a start-up software company to have large success and steal significant market share from software giants such as Microsoft. Most businesses that have purchased computers that come prepackaged with Microsoft Office and Windows operating system. This is a huge advantage to Microsoft since consumers who buy machines such as Dell, Toshiba, HP, Acer and Lenovo have a familiarity with Microsofts products. It would be difficult for another company to score a deal with computer manufacturers as well as develop a product as efficient as Microsoft Office. Another reason why there is a low threat of new entrants is the high start-up and R&D costs. Software architecture is expensive; you need many programmers, market researchers and other specialized talent to produce a widely circulated software product. Also, businesses and 40

households are brand loyal. They are unlikely to switch their software unless they are truly unhappy with it. Consumers want reliable and dependable software to meet their needs and they are less likely to try new products if their current solution is working well for them. Product differentiation also contributes to the low threat of new entrants. As mentioned above, the top nine companies in the software industry through market cap produce and distribute different products. A new entrant would have difficulty in developing a product that is not currently meeting consumer needs in a new market segment. Software is very specialized and these companies are very established; it would be difficult to steal significant market share from these companies. Threat of substitute products: HIGH There is a high threat of substitute products in the software industry. Some companies are looking for basic software with limited capabilities to meet their needs. These customers could potentially switch to cheaper options, especially as technology increases and becomes more advanced. Software companies are also threatened by the media through which its programs operate. As computers become more advanced, a new substitute for software may develop. People are also using their phones, such as PDAs and smartphones, to answer email and use the web. Companies such as Microsoft and Apple have responded to this growing trend by creating operating systems and applications for wireless phones. A big threat to software companies such as Microsoft and Oracle is internet software and open source software. Open source software, which some may call unreliable, consists of programs that perform basic functions such as word processing, spreadsheets and other applications. These services are usually free and could eat into Microsofts market share as it becomes more popular. Internet software is also a big threat to software companies. There is a 41

greater trend toward doing business online, especially with the growth of social networking websites. Increasingly more companies use the internet for their investments, banking services, data and access to the web. There is a threat that they could be switching to internet software as well. Google, who plays a major threat to companies such as Microsoft, are using the growing internet trends to develop products such as Google docs and the social networking feature Buzz. Bargaining power of suppliers: MODERATE-HIGH The bargaining power of suppliers is moderate to high. Software suppliers must stay ahead of the game as far as technology to keep their customers and develop high quality materials. Although there are limited substitute products in the industry, suppliers do have to keep improving on technology and innovation. Suppliers have do have moderate power with big technology companies through high switching costs; it would be costly for big companies such as Microsoft to find a new supplier and start from scratch. Bargaining power of customers: LOW-MODERATE The bargaining power of customers is low to moderate. Computers have become a necessity for businesses, governments as well as households. Software has helped business become more efficient and has created a standard for competition. Therefore, it is crucial in the business world for companies to invest in up-to-date computers and software. Compatibility also limits the power of buyers; the dominance of a few companies limits bargaining power if consumers are interested keeping consistency with its software use. Also, since there are limited options for a substitute for computer software, customers dont have a large bargaining power. Buyers do have the option however to choose between the specific products and make a decision to cater to their needs.

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SWOT Analysis: Software STRENGTHS: Ability to innovate Convenient and efficient for businesses OPPORTUNITIES: As technological advances, companies have the opportunity to also advance. Numbers of computers sold around world is increasing WEAKNESSES: Growing popularity of doing business online Cyclical industry with the economy THREATS: Foreign technology from China and India Government regulation

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Financial Analysis: Software In this section the report, the annual sales and earnings growth rates of the Software industry are compared to the Information Technology Sector, the S&P 1500 Super Composite, and Microsoft, the largest company in the Software industry. Sales Growth: Software This graph shows the earnings growth of the Information Technology sector, the Software industry, the S&P 1500 and Microsoft.

40% 30% 20% 10% 0% -10% -20% 2004

Sales Growth- Software

InfoTech Software S&P 1500 Microsoft

2005

2006

2007

2008

This chart indicates some apparent trends in sales growth, especially for Microsoft. In 2007 they had a huge spike in sales and then a heavy decline into 2008. A huge event for Microsoft occurs in 2007; Microsoft launches Windows Vista and the 2007 Microsoft Office System to consumers worldwide (Microsoft.com). This could account for the spike in sales growth in 2007. The Software industry and the Information Technology seem to follow the market closely. In 2007 and 2008 there is a decline in the information technology sector as well as the software industry, which could be attributed by the recent economic recession. The

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Software industry is a cyclical industry meaning that it tracks the market and doesnt drop marginally lower or perform higher than the market. The year 2008 was an unusual year in the financial world. The market, measured by the S&P 1500 also sees decline. Earnings Growth- Software This graph shows the earnings growth of the Information Technology sector, the Software industry, the S&P 1500 and Microsoft.

Earnings Growth- Software

100% 80% 60% 40% 20% 0% -20% -40% -60% -80% -100% 2004 2005 2006 2007 2008 InfoTech Software S&P 1500 Microsoft

This chart indicates the sales growth from 2004 to 2008 for the Software industry. In 2004 the Information Technology sector enjoyed an impressive 90% growth in sales. This was not sustainable, however, as earnings in 2008 were at -37%. The S&P 1500, the broad market index, also displays a negative earnings growth of about -72%. The Software industry and InfoTech sector did decline but not as steeply as the market in 2007 and 2008. The economic recession is a contributing factor but I also believe that prior to 2004 businesses and households 45

were still purchasing computers and software and that the InfoTech sector could not support a 90% growth for a long period of time. It is also important to notice that Microsofts earnings growth is positive in 2008 at 25% when the S&P, InfoTech and Software all have substantial decreases in earnings growth. Margin Analysis: Gross Margin

Gross Margin- Software

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2003 2004 2005 2006 2007 2008 InfoTech Software S&P 1500 Microsoft

The above graph shows that Microsoft and the Software industry have very high gross margins, meaning that Microsoft and companies in this industry are efficient at producing a profit on the cost of their sales, or cost of goods sold. Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing (Investopedia). This is likely true since Microsoft has spent a good amount of money on research and development in the past 5 years. Also, the software industry has a gross margin of around 90%, which is very high compared to the S&P 1500 at around 35%. As you move from the S&P 1500, which is a broad market index, to the software industry, the gross margins increase rapidly. The table below shows Microsofts research and development as

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a percentage of their sales. Notice that money spent on R&D is decreasing and their gross margin is decreasing from 2005 to 2008 from 82% to 77%. Microsoft R&D 2003 2004 2005 2006 2007 2008 20.49% 21.12% 15.32% 14.87% 11.79% 15.97%

Margin Analysis: Net Profit Margin

Net Profit Margin- Software

40% 35% 30% 25% 20% 15% 10% 5% 0% 2003 2004 2005 2006 2007 2008 InfoTech Software S&P 1500 Microsoft

The above graph shows the net profit margins of the S&P 1500, the Information Technology sector, the Software industry, and Microsoft. The S&P 1500 has had a decreasing net profit margin from 2006 to 2008: from 6.5% to 1.7%. Also, companies in the Information Technology sector generally operate with larger profit margins and are less capital intensive. 47

Their costs associate more with research and development rather than operating expenses. Then there is the software business. It has an exceedingly high gross margin of 90%, but a net profit margin of 27%. This shows that its marketing and administration costs are very high, while its cost of sales and operating costs are relatively low (Investopedia). Net profit margins are generated from the sales and net income of the business. It pretty much summarizes how effectively the business is run. Microsoft has a distinctly higher net profit margin in the year 2008 at 34% compared to their early net profit margins in 2003 at 23%. This is a good sign for Microsoft since they are still generating high profits in light of the economic recession. Companies with high profit margins usually have competitive advantages and are better suited during the hard times. Margin Analysis: Software

Operating Margin
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 2003 2004 2005 2006 2007 2008

InfoTech Software S&P 1500 Microsoft

The above chart displays the operating margin for the years 2003 to 2008. The operating margin typically explains how well a company generates net income from business operations. Companies with high operating margins can effectively control costs or have exponential sales

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growths that are increasing faster than the costs of operation (Investopedia). During the period from 2003 to 2008, the S&P 1500 and the Information Technology sector had steady operating profit margins. Although in 2008 the profit margin for the S&P 1500 did dip below the InfoTech sector. Software and Microsoft had higher operating profit margins; one could conclude that they are effectively controlling their cost or their sales growth is booming. I think it is important to point out that in 2008 Microsofts operating margin increased by 14% from 2007. This is impressive especially during the economic recession. Du Pont Analysis: ROE Decomposition

The ROE measures a corporations profitability by revealing how much profit a company generates with the money shareholders have invested (Investopedia). The Du Pont analysis that we conducted measured operating efficiency, asset usage and financial leverage into a final calculation of ROE. Over the period 2003 to 2008, the Information Technology sector and the Software industry had a higher ROE than the S&P 1500 Index in most years. Since 2005 Microsoft has also shown a substantially high ROE compared to the market, the InfoTech sector 49

Du Pont Analysis S&P 1500 Info Tech Software MSFT

Operating Margin 0.111 0.130 0.270 0.436

Asset Turnover 0.401 0.912 0.701 0.702

Leverage 5.392 2.173 1.958 2.006

Interest Burden 0.352 0.683 0.684 1.069

Tax Burden 0.442 0.637 0.598 0.742

ROE 3.72% 11.20% 15.16% 48.73%

and the Software industry. This may be because Microsofts operating margin for 2008 was 43% meaning that the company ran smoothly and efficiently. Microsoft also has high financial leverage, which will amplify the ROE. Corporate finance theory states that leverage magnifies ROE on the upside as well as the downside. Microsoft was able to return as significant amount to its equity investors by earning more than their cost of debt (Berk/Demarzo). The Information Technology sector, Software industry, and Microsoft each show higher ROE percentage than that of the S&P 1500. It is important to realize that the S&P 1500 has considerably high financial leverage compared to InfoTech and Software industry. The high leverage has a normally positive impact on ROE; the S&P 1500 has a leverage ratio of 5.392 but then a considerably lower ROE than the other groups analyzed. The problem with adding leverage to a companys equity to boost the ROE is that after a certain point the amount of debt realized becomes toxic; servicing the debt becomes too expensive especially if interest rates rise. Companies with high financial leverage should seek to Although there certainly are a number of cases where adding debt makes sense, it is not something that management wants to push as high as possible, unlike profit margins and asset turns. In fact, many perceive earnings generated from debt financing as higher risk than earnings generated from equity financing, particularly if the company is tied to the business cycle in any way, shape, or form. Whereas a company that is completely equity financed can normally ride

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out a downturn, a company with a large portion of debt financing is unfortunately not quite so well equipped (Motley Fool). Cash Flow Analysis: Software
Cash Flow Analysis: Software 2004 S&P 1500 1.9578 Info Tech 1.1337 Software 2.6413

2005 1.7644 2.1626 2.2216

2006 0.0876 0.8157 4.4335

2007 3.1221 4.463 3.03

2008 4.7135 -0.3267 2.4508

The table above shows the results of the cash flow from operating, financing and investing activities for the S&P 1500, Information Technology sector and the Software industry. The net increase (decrease) in cash flow for each year is shown by adding the three sources of cash flows. The Information Technology sector has negative flow of cash in 2008, which is not necessarily a bad sign for the sector. The sector may be investing more money into R&D or making large investments for new technology in the future. The Software industry does generate positive cash flow but does not match up with the market however. Their cash flows from financing activities have been consistently negative: from -34.8% in 2004 to -19.9% in 2008.

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