John O‟Shaughnessy & Maggie McRae
Applied Portfolio Management
Table of Contents
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
Porter‟s Five Forces……………………………………………………………………...16
Business analysis – Software
Phase of Life Cycle………………………………………………………………............31
Business Cycle Classification……………………………………………………….......32
Porter’s Five Forces…………………………………………………………………………………....…...…38
Financial Analysis – Internet Software and Services
Cash Flow Analysis………………………………………………………………………………………….....28
Financial Analysis – Software
Cash Flow Analysis………………………………………………………………………………….…………51
We recommend increasing the APM portfolio‟s present weight in the Info Tech sector by
2% from 15.9% to 17.9%, which is slightly below the S&P 500‟s 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
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
More recently the Info Tech sector has had a good year, since last year‟s 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).
Information Technology Sector
Industry Group Industry Company Market
Software and Services Application Software Microsoft Corporation $252.3 B
Internet Software and Google (GOOG) $171.95 B
IT Services Computer Sciences CP $8.0 B
Technology & Computers and IBM $163.6B
Hewlett-Packard $113.1 B
Communication Nokia $52.0 B
DirecTV $30.1 B
Corning Inc. $28.2 B
Semiconductors and Semiconductors and Intel Corporation $108.3 B
Texas Instrument Inc. $28.6 B
Source: Yahoo! Finance
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 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 Microsoft‟s 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 industry‟s behavior over the last several years would
characterize it as “cyclical” industry according to Hook‟s 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
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
market‟s 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.
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 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.
Microsoft‟s “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
Google‟s 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 today‟s 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
and Services industry will expand considerably in the future, due to the virtually unlimited
potential of computers and the internet.
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-
In countries such as China, it is apparent how government regulation affects the industry
via censorship. China‟s 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
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.
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 one‟s 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
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.
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
today‟s rapidly changing environment. Large growth in this sector is possible and will continue
for the foreseeable future.
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 Google‟s 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.
Porter’s 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.
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
Microsoft‟s 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
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 internet‟s thirteen root name servers. VeriSign also runs the .com and .net
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 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
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 VeriSign‟s 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
consumer‟s 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.
SWOT Analysis: Internet Software and Services
- Ability to innovate. - Must have latest technology and features to
- Convenience of services, keep customers keep customers.
coming back. - Cyclical with economy.
- Popularity of social networking. - Low switching costs
- Consumers‟ concern over lack of security
- Over diversification
- Increasing popularity of Internet all over - Copyright issues abroad.
globe. - Problems with foreign governments
- Virtually limitless possibilities of Internet
- Advancements in technology make Internet
accessible almost anywhere.
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.
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 Microsoft‟s new Bing search engine. In the
4th quarter of 2009, Google posted a 17.9% increase in sales from the previous year
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
and 2008. In 2008 Google‟s 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%
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.
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.
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.
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 Operating
Asset Turnover Leverage Interest Burden Tax Burden ROE
Analysis Profit Margin
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). Google‟s ROE is considerably greater than the S&P 1500, companies such as
Google typically require minimal leverage because they generate significant profitability. Due to
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 1500‟s profit margin is nearly three
times smaller than Google‟s.
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
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.
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 Microsoft‟s
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, Microsoft‟s
major competitors are Apple and IBM, which operate in the Computers and Peripherals industry.
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 $5.25
NOVELL INC NOVL Software Systems Software $1.65
QUEST SOFTWARE INC QSFT Software Application Software $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 industry‟s 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
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
Historical Snapshot: Stock Prices from
December 2003 - December 2009
$60.00 Economic Recession: December‘07 $1,800
$20.00 $600 ORCL
$400 S&P 500
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: December‘07
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.
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 Google‟s 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.
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 product‟s
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.
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
The government‟s 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. Microsoft‟s Office, Internet Explorer, and Windows operating system are
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.
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.
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.
Computers have been a worldwide phenomenon since the mid 1990‟s; 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
Increased computer sales
in the United States paves the
way for software companies.
Since more people are buying
computers for their personal and
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.
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.
Porter’s Five Forces: Software
Porter‟s 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
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.
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 Microsoft‟s products. It would be difficult for another company
to score a deal with computer manufacturers as well as develop a product as efficient as
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
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 Microsoft‟s market share as it
becomes more popular. Internet software is also a big threat to software companies. There is a
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 don‟t 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.
SWOT Analysis: Software
Ability to innovate Growing popularity of doing business
Convenient and efficient for businesses online
Cyclical industry with the economy
As technological advances, companies Foreign technology from China and
have the opportunity to also advance. India
Numbers of computers sold around Government regulation
world is increasing
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.
Sales Growth- Software
0% S&P 1500
2004 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
Software industry is a cyclical industry meaning that it tracks the market and doesn‟t 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
-20% S&P 1500
2004 2005 2006 2007 2008
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
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 Microsoft‟s 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
30% S&P 1500
2003 2004 2005 2006 2007 2008
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 Microsoft‟s research and development as
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%.
Margin Analysis: Net Profit Margin
Net Profit Margin- Software
15% S&P 1500
2003 2004 2005 2006 2007 2008
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.
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
20% S&P 1500
2003 2004 2005 2006 2007 2008
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
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 Microsoft‟s operating margin increased by 14% from 2007. This is
impressive especially during the economic recession.
Du Pont Analysis: ROE Decomposition
The ROE measures a corporation‟s 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
Du Pont Operating
Analysis 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%
and the Software industry. This may be because Microsoft‟s 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 company‟s 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
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 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
Software 2.6413 2.2216 4.4335 3.03 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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