The Software Industry is changing and bringing new opportunities for investors. Salesforce.com, a likely IPO in Q1 2004, is the first profitable software company of its size which is basically renting out applications. It’s proving a model for Software as services.

According to IDC companies spent more than $2.3 billion last year for software delivered as a service, up from $1.8 billion the year before. The research firm predicts that the market will reach $8 billion by 2007.
That's far less than the $22 billion that Gartner predicted the ASP market would reach in a forecast it issued at the height of the frenzy in 1999.

SAGE, the last technology FTSE 100 company, earns 47% of its revenue from services. Accenture’s PE has always been greater than that of Microsoft.

The deep trends shaping the future of all software can be summarized by three-C's: software is becoming a commodity, it is being customized by users, and we are seeing network-enabled collaboration.

What this means is that your code is less important than ever. So one can take advantage of cost-optimised locations such as India, or the open-source LINUX development community.

What Software companies must ship is an understanding of the customer demands, not code.

IT systems and architectures have been measured by Speed and Functionalities such as robustness, scalability and extensibility. Increasingly they will be measured by how secure and interoperable they are. Almost any discussion of software today touches on the number bugs and worms infiltrating Microsoft’s platform.

The areas to invest in are as a result in the applications which sit at the pinnacle of interoperability: P2P applications such as Social Networking or Navio, which makes on-line rights tradable; or Business Intelligence software, specifically the subsector of business analytics. Security and Business Continuity remain hot areas. Indeed, major established suppliers such as Computer Associates, Cisco Systems, Network Associates, and Symantec have been actively buying security startups as a way to flesh out their own product lines.

As far as interoperability goes, Web Services which enables disparate IT systems to communicate with each other in real time with specific business goals in mind at the enterprise level has filled the gap. Previously this was called EAI [Enterprise Application Integration] but that generally occurred between two parties. Legacy systems companies like Relativity Technologies or Soamai fall into an adjacent category. Web Services gets at the one to many, or spoked aspect of modern day software networks. Companies such as Systinet, Warburg Pincus backed, develop tool kits for creating software based on webservices protocols [SOAP and UDDI].

When investors talk about Enterprise Software as a dud category, it’s because they are not accepting the reality that there are good ideas and there are bad ones. Within great new ideas in the Software space, I would note Gresham Computing who are revolutionising the time it takes for large global banks to complete Nostro transactions. The impact of this is trillions of dollars a day no longer needed to be put up as collateral on money transfers between banks, dramatically improving the liquidity of the world banking market. The share price is still unreflective of its inherent value to the financial world.

The problem we have now is a lack of a consistent method of measuring the value of software companies. Proper caution makes the investor more worried about how she will get her return and therefore they correctly focus more on the ability to deliver profit than before. The problem is that too little profit today can result in lack of investment and growth but equally too much profit today, leading to investment in market share, can lead to either much more profit in the future or none – depending on competition. Equally valuations can be heavily skewed by consolidation and acquisition. All in all an incredibly difficult task – not what people want to hear.

So the bottom line is that software companies are undervalued today because of the very fact that investors don’t know how to value them. They don’t know which ones are most undervalued so they undervalue them all. What the companies have to do is to build their own valuation models based on real facts and realism. When investors see companies delivering plausible arguments for managed growth in both revenue and profit and then meeting these goals they will trust them and value them properly. Until that time caution will be the watchword.

Julie Meyer is CEO of Ariadne Capital; she can be reached at: julie@ariadnecapital.com

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