InformationWeek

August 30, 1999

Taking Stock:
New Era For IT Services

Y2K issues will be resolved; investors should start looking for software and IT services companies in which to invest

By William Schaff

William Schaff hough it has helped to be heavily invested in technology in this equity market, not all technology sectors have fared equally.

For instance, if you have invested heavily in software and IT services, you haven't done nearly as well this year as those who own semiconductor and semiconductor equipment stocks. Between Jan. 1 and Aug. 23, the Goldman Sachs technology segment indexes have generated the following returns: GS Semiconductors, 58.7%; GS Networking, 46.9%; GS Hardware, 26.5%; GS Internet, 24.8%; GS Software, 18.3%; and GS Services, 2.4%.

Since the InformationWeek 100 index is focused heavily on software and services, it hasn't been the leading technology index. That honor goes to the semiconductor index and the Nasdaq 100, which is up by 30%, compared with 17.6% for the InformationWeek index.

But I expect the fortunes of software and services stocks--and the InformationWeek 100--to change once Y2K issues are resolved after the first quarter of next year. Also, some of the newer software companies may find a more receptive investment audience once short-term concerns fade.

My advice: Start looking for software and IT services companies in which to invest. Filter through some of the laggards with strong product lines--for example, BMC Software (BMCS-Nasdaq) in systems management software, Compuware (CPWR-Nasdaq) in applications and software tools, and J.D. Edwards (JDEC-Nasdaq) in enterprise resource planning and consulting.

New Era of Networks Inc. (NEON-Nasdaq) is another company that belongs in this "fallen angel" category. It recently missed its second-quarter earnings and had a revenue shortfall--and was punished quickly: Its stock price declined from $78 to a recent low of $12; its price at press time was about $16.

But there's a lot on the positive side of the ledger for New Era. It develops and markets a suite of enterprise application integration software and is a direct beneficiary of the need for IT services to address the expansion into E-commerce and Web applications. Though revenue from licenses and services grew 48% and 52%, respectively, in the second quarter, weakness in revenue from its IBM channel resulted in disappointing revenue growth. The relationship with IBM is strong, but New Era is dependent on IBM's sales force. IBM represented one-third of the 120 deals New Era closed during the quarter.

In addition, royalties from IBM were below expectations, coming in below 30%, the low end of the royalty range. New Era receives between 20% and 40% of IBM indirect sales for MQSeries Integrator.

In the near term, the recent Sun Microsystems-Forté Software deal may help New Era. Forté has an enterprise application integration suite that also must use New Era's MQSeries Integrator as the underlying integration engine.

But let's face facts. With revenue growing this quickly, New Era is bound to have lots of competition. The company faces the same issues as many other software and services companies: Buying-decision timetables continue to expand, and Y2K is affecting corporate IT purchase decisions.

New Era is also greatly dependent upon IBM, causing greater risk to revenue predictability. It doesn't help that the company has made quite a few acquisitions.

New Era had revenue of $65.8 million in 1998, generating earnings per share of 23 cents. Operating margin went negative this quarter as operating expenses exceeded revenue of $26.1 million by $500,000. In the prior year, operating margins were at 8.5% and had increased to 11.8% in the first quarter of fiscal 2000. Revenue projections are for roughly $120 million in 1999 and $170 million in 2000. Earnings-per-share projections for 1999 and 2000 are minus-27 cents and plus-21 cents, respectively.

I wouldn't be surprised to see New Era's stock glowing again in 2000.

William Schaff is chief investment officer at Bay Isle Financial Corp. in San Francisco, which manages the InformationWeek 100 Stock Index. You can reach him at bschaff@bayisle.com

Go to InformationWeek Financials