information technology sector report 1392

8/2/2019 Information Technology Sector Report 1392

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Information Technology

Sector Report

John OShaughnessy & Maggie McRae

Applied Portfolio Management

Spring 2010


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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 analysisInternet Software and Services........8Phase of Life Cycle......8Business Cycle Classification....10External Factors.11Porters Five Forces...16SWOT Analysis.20

Business analysisSoftwarePhase of Life Cycle............31Business Cycle Classification.......32

External Factors34Porters Five Forces.......38SWOT Analysis......43

Financial Analysis Internet Software and ServicesSales Growth...21Earnings Growth..22

Margin Analysis....24DuPont Analysis.......27Cash Flow Analysis.....28

Financial Analysis SoftwareSales Growth...44Earnings Growth..45Margin Analysis....47DuPont Analysis...49Cash Flow Analysis.51

Works Cited.52


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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.


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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 20042008 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 20042008 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


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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%.


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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).


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Information Technology Sector

Industry Group Industry Company Market

Capitalization

Software and Services Application Software Microsoft Corporation(MSFT)

$252.3 B

Internet Software and

Services

Google (GOOG) $171.95 B

IT Services Computer Sciences CP(CSC)

$8.0 B

Technology &Hardware

Computers andPeripherals

IBM $163.6B

Hewlett-PackardCompany

$113.1 B

CommunicationEquipment

Nokia $52.0 B

DirecTV $30.1 B

Corning Inc. $28.2 B

Semiconductors andSemiconductor

equipment

Semiconductors andsemiconductor

equipment

Intel Corporation $108.3 B

Texas Instrument Inc. $28.6 B

Source: Yahoo! Finance


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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 Ticker Industry/Sub industry Market Cap

GOOGLE INC GOOG Internet Software & Services 170.17B

EBAY INC EBAY Internet Software & Services 28.67B

VERISIGN INC VRSN Internet Software & Services 4.28B

WEBMD HEALTH CORP WBMD Internet Software & Services 2.25B

EARTHLINK INC ELNK Internet Software & Services 870.06M

YAHOO INC YHOO Internet Software & Services 616.19M

REALNETWORKS INC RNWK Internet Software & Services 616.19M

THESTREET.COM TSCM Internet Software & Services 92.46M

Business analysisInternet 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 (Hook89).

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


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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 newBing 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.


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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 (Hook91). 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.


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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 Wide-

Web. (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. Internet-

capable 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 20002009:

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


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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 powerand 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 tokeep customers.

- Cyclical with economy.- Low switching costs- Consumers concern over lack of security- Over diversification

Opportunities

- Increasing popularity of Internet all overglobe.

- Virtually limitless possibilities of Internettechnology.

- Advancements in technology make Internetaccessible almost anywhere.

Threats

- Copyright issues abroad.- Problems with foreign governments


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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 Average Earnings Growth

S&P 1500 Super 8.12% -6.25%

Info Tech 9.91% 18.86%

Internet Software & Services 25.39% 49.63%

Google 74.12% 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 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 DuPontAnalysis

OperatingProfit Margin

Asset Turnover Leverage Interest Burden Tax Burden ROE

S&P 1500 11.06% 0.401 5.392 0.3523 0.4419 3.72%

Info Tech 12.98% 0.912 2.173 0.6829 0.6369 11.20%

IntSft. &Srv. 23.52% 0.594 1.299 0.8447 0.6580 10.08%

Google 30.43% 0.686 1.125 0.8826 0.7221 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 2005 2006 2007 2008

S&P 1500 1.9578 1.7644 0.0876 3.1221 4.7135

Info Tech 1.1337 2.1626 0.8157 4.463 -0.3267

Int. Sft. &Srv. 33.7812 88.6241 57.2816 120.007 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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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

Company Ticker Industry Sub-Industry Market Cap (in billions)

MICROSOFT CORP MSFT Software Systems Software $246.63

ORACLE CORP ORCL Software Systems Software $117.01

SAP AG SAP Software Application Software $51.12

SYMANTEC CORP SYMC Software Systems Software $13.94

INTUIT INC INTU Software Application Software $9.38

MCAFEE INC MFE Software Systems Software $5.98

ELECTRONIC ARTS INC ERTS Software Home Entertainment Software $5.25NOVELL INC NOVL Software Systems Software $1.65

QUEST SOFTWARE INC QSFT Software Application Software $1.45


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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.

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December 2003 - December 2009

MSFT

SAPORCL

S&P 500

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 worldwidephenomenon 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


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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


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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


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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

WEAKNESSES:

Growing popularity of doing business

onlineCyclical industry with the economy

OPPORTUNITIES:

As technological advances, companieshave the opportunity to also advance.

Numbers of computers sold aroundworld is increasing

THREATS:

Foreign technology from China andIndia

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 Softwareindustry, the S&P 1500 and Microsoft.

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

-20%

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2004 2005 2006 2007 2008

Sales Growth- Software

InfoTech

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S&P 1500

Microsoft


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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 Softwareindustry, the S&P 1500 and 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

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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

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

0%

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2003 2004 2005 2006 2007 2008

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InfoTech

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Microsoft
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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 20.49%

2004 21.12%

2005 15.32%

2006 14.87%

2007 11.79%

2008 15.97%

Margin Analysis: Net Profit Margin

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.

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2003 2004 2005 2006 2007 2008

Net Profit Margin- Software

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S&P 1500

Microsoft


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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

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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2003 2004 2005 2006 2007 2008

Operating Margin

InfoTech

Software

S&P 1500

Microsoft


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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


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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

Du Pont

Analysis

Operating

Margin Asset Turnover Leverage Interest Burden Tax Burden ROE

S&P 1500 0.111 0.401 5.392 0.352 0.442 3.72%

Info Tech 0.130 0.912 2.173 0.683 0.637 11.20%

Software 0.270 0.701 1.958 0.684 0.598 15.16%

MSFT 0.436 0.702 2.006 1.069 0.742 48.73%


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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

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.

Cash Flow Analysis: Software2004 2005 2006 2007 2008

S&P 1500 1.9578 1.7644 0.0876 3.1221 4.7135Info Tech 1.1337 2.1626 0.8157 4.463 -0.3267Software 2.6413 2.2216 4.4335 3.03 2.4508


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information technology sector report 1392

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