E-finance: corporate knowledge services recovery is delayed - Brief Article

T+D, August, 2002 by Peter L. Martin

Recent channel checks and industry barometers (earnings, research studies, and so forth) indicate that the difficult environment has persisted and, in some cases, worsened. Based on our research, we're adjusting our estimate for the timing of a corporate spending recovery. Our revised corporate IT spending outlook for 2Q02 assumes a continuation of instability in the marketplace, with sequentially flat to declining corporate spending relative to 1Q02. For the remainder of corporate year 2002, we expect to see a flat 3Q and modest improvement in 4Q--versus prior expectations of a spending recovery in the back half of the year. We regard the first quarter of 2003 as a possible inflection point due to pent-up demand for software and services and the advent of new budget cycles. We expect 1QFY03 to be a positive year- over-year comparison for most software companies. That should entice investors, based on positive momentum going forward.

Currently, we don't see any catalyst for the software group throughout the summer or 3Q02. We expect negative economic and corporate news to continue to weigh on the stocks, limiting any upside.

Although we don't believe the industry's stock performance is poised to move upward, there are some catalysts to look for, including a corporate spending recovery mergers and acquisitions, and valuation metrics. Based on our due diligence, however, we believe an IT spending recovery before FY03 is unlikely. We don't expect corporate earnings to improve enough near term to increase IT budgets in the back half of the year. Investors may look to front run the recovery by buying stock at the end of 3Q02, but that could prove dangerous if the spending increase doesn't materialize.

We view M&As as a possible catalyst, but not until sellers lower valuation expectations. However, sellers--due to pride, ego, and invested capital--haven't adjusted valuation expectations downward to reflect the current market environment. Activity could pick up in late Q3 or Q4 as cash balances decline and reality sets in, pushing deals over the hump unless hampered by dilution, burn rates, and low stock prices. Valuation is the most likely catalyst for the group.

As analysts and investors shift their perspectives and valuation metrics to 2003, stocks in the group should look considerably more interesting on the basis of valuation due to the expected improvement built into current 2003 estimates. In that valuation scenario, investors could be prompted to buy these stocks based on a long-term investment horizon. First call estimate means are rich, and we recommend that investors discount FY03 estimates by 10 to 15 percent to ensure a more conservative valuation basis. We believe value investors will be safe initiating purchases in 4Q02, or once investors have confidence that the market has bottomed and created a reliable floor for 2003 earnings estimates.

June performance for the overall corporate knowledge services sector was ugly--down 18 percent for the month as the market continued to free fall on worries about accounting and the economy. The S&P 500 fell 7.9 percent; NASDAQ fell 11.4 percent. Corporate segments heaviest hit by the sell-off were content management (down 28.3 percent); infrastructure software (down 21.2 percent); and business intelligence (down 20.7 percent). We believe the sell-off is justified as second-quarter earnings will be poor and as the economy continues to affect the sales cycle and signing of purchase orders.

The best-performing sector was instructor-led training, down just 2.1 percent. ILT's out-performance is due to bad news on the segment having already been reflected in the stock price. Two of the best-performing stocks were in the staffing segment--AMN Healthcare Services and Medical Staffing Network. Both companies are benefiting from the positive supply-and-demand characteristics of the health-care market, One of the worst-performing stocks was SkillSoft-down almost 60 percent following the announcement of its proposed merger with SmartForce. Due to miscommunication and perceptions regarding valuation, investors voiced their view of the merger by selling stock big.

Peter L. Martin, CFA, is managing director with Jefferies & Co., San Francisco. He follows various segments within the knowledge services industry, which are broadly categorized under e-learning and traditional education and training.