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The Great Software Sell-Off Of 2014

A healthy first-quarter earnings report sent shares of Vasco Data Security International (VDSI) up more than 40% in April.

The surge made Vasco one of the few software companies to have sidestepped a massive sector sell-off that caught some of the biggest, hottest names in the industry. Those included FireEye (FEYE), ServiceNow (NOW), Splunk (SPLK) and Tableau Software (DATA).

In mid-February, before the wave of selling started, four software groups ranked in the top 20 among 197 industries tracked by IBD — a solid showing. On the IBD 50 list, Tableau, NQ Mobile (NQ), Manhattan Associates (MANH) and NetEase (NTES) were all riding high.

As of Friday, the security software group was 18% off its early March high. The database software group was 17% off its peak. Enterprise software had tumbled 20% and medical software developers, as a group, were 24% off their high.

In the past week, none of IBD's 10 software groups ranked in the top 50 industries. Six of the 10 groups ranked weaker than 150. On an individual basis, NQ Mobile is 71% off its February high. FireEye, a market favorite early in the year, on Friday traded 68% below its high from early March. The tumbles stand in sharp contrast to the tech-heavy Nasdaq, which corrected nearly 10% in March and April, but has since recovered to new highs.

Part of the reason for the software sell-off was valuation, according to Frederick Ziegel, an analyst for Topeka Capital Markets.

Though not considered a high growth company, Vasco's consistent profits and smaller but growing year-over-year quarterly revenue provides some insight into how investors are evaluating software companies, he says.

In addition, Ziegel says, attitudes toward investing in the sector also changed.

"Earlier this year investors took the attitude that you spend money as fast as you can to build the business and then all of a sudden they reversed course," Ziegel said. Suddenly, "spending money like you were going to be dead tomorrow" fell out of fashion, he said.

Another, more simple factor in the year's massive software sell-off: skittish investors, says Tom Vandeventer, manager of the Tocqueville Opportunity Fund.

"The way the market works these days is if there is something going on and people don't understand it, it feels like everybody just jumps to the sidelines," he told IBD. "The control of volume is really in the hands of the traders and not the investors.

Survival Of The Fittest

Beyond Vasco, other software developers that have remained in investors' favor include Palo Alto Networks (PANW), OpenText (OTEX) and Synchronoss Technologies (SNCR).

Palo Alto is a leading provider of security firewall systems. OpenText makes content management software to help companies manage unstructured data from Web pages, websites and Microsoft (MSFT) Word documents.

Synchronoss has emerged as a leading provider of the activation process for smartphones, tablets and cellphones for service providers. It also dragged investors through a harrowing double-dip correction, diving 36% between October and February and scooping out another 27% divot from March to May. The stock has since recovered sharply, and was trading up 41% year-to-date on Friday.

All four companies, including Vasco, are growing and posted recent quarters with earnings and revenue ahead of expectations. The common denominator: All are chasing segments of growing markets. By 2016, global sales of security software and hardware systems are expected to reach $84.5 billion, up 37% from 2012, says market tracker Gartner.

Sales of enterprise content management software are expected to reach $9.32 billion in 2017, up 82.3% from last year, says The Radicati Group. By 2015, sales of global public cloud services will reach $184.5 billion, up 64.5% from 2012, Gartner says.

Chinking The Firewall

Just in the past couple of weeks, cyberattacks on JPMorgan (JPM), Home Depot (HD) and celebrity users of Apple (AAPL) iPhones have dominated headlines. The increasing number of such threats continues to drive demand for some but not all security software developers.

Vasco's primary customers are financial institutions, Ziegel says.

"The overwhelmingly largest percentage of their business is with banks that use the Vasco authentication products for their consumer online banking customers," he said.

Palo Alto is building out its role in firewall systems through recent acquisitions. Those included Cyvera, a security software company focused on deciphering hacking techniques, for $200 million earlier this year.

Investors also applauded Palo Alto's agreement to pay $175 million to Juniper Networks (JNPR) to end a patent infringement tussle with the network gear maker, says Daniel Ives, an analyst for FBR Capital Markets & Co.

The Juniper lawsuit was a huge overhang that has been removed, Ives said, and Palo Alto has "expanded their market opportunity all around this next gen firewall market, which is really the golden jewel in cyber security.

OpenText's reaccelerating revenue growth is the result of a change in strategy about two years ago involving several recent acquisitions.

The integration plan helped boost organic revenue growth by offering customers more than one product in one easy-to-use system, says Mark Schappel, an analyst for The Benchmark Co.

Formerly, OpenText salespeople that sold software for managing Word documents would have to go back and try to sell software for managing Web pages and websites separately.

"By integrating everything, there is some leverage they bring to the table, giving them new features and giving customers a reason to buy their stuff," Schappel told IBD.

Synchronoss derives more than half of its revenue from its mobile activation business for carriers. But its cloud business, which allows mobile users to store and access data over the Internet, is growing fast.

Cloud revenue jumped 74% to $46.7 million in the company's second quarter vs. the year-earlier period, setting the stage for the recent stock surge, Ives says.

"That has been the pizzazz part of the story," Ives said. "Investors are starting to see Synchronoss in a different light after what they have done in the mobile cloud piece.

Private Vs. Public Investors

VC software investments topped $10 billion in the first half of this year — the most since 2000, when software companies raised $13.6 billion in the same six-month window, say PricewaterhouseCoopers and the National Venture Capital Association.

The pace of investment stands in stark contrast to investors dumping shares of many publicly traded software companies.

But private investors differ from their public counterparts, says Mark McCaffrey, global software leader for PwC.

The private markets don't look at it from the standpoint that, in some of these disruptive markets, you may have a winner and you may have a loser, he says.

"They are betting on the fact that their (company) is going to be the winner, so they are giving it a healthy evaluation," he told IBD.

The Battle Vs. Rising Costs

Palo Alto, OpenText and Synchronoss continue to invest in R&D and sales and marketing at varying rates.

Vasco's Q2 sales and marketing costs rose 8%, but its R&D costs declined 2.6%.

Vasco is acquiring technology rather than developing it internally. In late May it agreed to acquire Risk IDS, a provider of authentication software to global banks for an undisclosed sum. A year ago, it paid $21.9 million to acquire Cronto, another maker of authentication software for online banking transactions.

In its third quarter, Palo Alto's sales and marketing costs rose 62.3% vs. the year-earlier period, while its R&D expenses jumped 79.6%.

But there is some difference between Palo Alto and other high-growth names, Ziegel says.

"They are being aggressive in expanding their R&D and sales and marketing, but they are profitable on a non-GAAP basis whereas some companies like FireEye are not," he said.

More spending could be coming. In late June, Palo Alto said it plans to raise $500 million from the sale of senior notes that could be used for working capital and acquisitions.

In its Q4 ending June 30, OpenText's sales and marketing costs increased 27.6%. R&D spending only climbed 12%.

OpenText has never been a big spender, which is a reason why their operating margin is around 30%, says Schappel.

"The company never poured an inordinate amount of money into those areas," he said. "They are not one of those 'grow at any price' companies.

Neither is Synchronoss. In Q2, the company's R&D spending grew by 5.7%, while sales and marketing expenses rose 14.7%.

In early August, it signed a deal with Time Warner Cable (TWC) to activate subscribers on that company's remote access home automation service. The company is also working with AT&T (T) to provide activation services for smart cars hooked to the Internet.

Synchronoss has also used acquisitions to build its cloud business. On Aug. 12 the company raised $230 million from the sale of senior notes, which it plans to use for internal investment or acquisitions.

Disruption Spells Opportunity

The growing number of disruption cases — situations in which new technologies or innovative companies change how companies either conduct or view business — has piqued the interest of private investors, says McCaffrey.

You have Big Data, security and storage, he said, "that is why the funding is so hot because all of these areas are impacting so many different markets and are becoming a megatrend around the world.

Synchronoss might be in the best position to capture a majority market share because they have no significant rivals in their fast-growing cloud business, says Tavis McCourt, an analyst for Raymond James & Associates.

"There is nobody that has scaled up a carrier-grade platform . .. with the kind of scale that Synchronoss has," he told IBD.

For Vasco, hackers continue to drive demand among banks, said Vasco President Jan Valcke during a Q2 conference call with analysts on July 24.

"The pipeline remains strong in banking, and I can say it's basically in all regions," he said.

The company's near-term outlook is largely determined by external factors, Ziegel says.

The biggest risk: Their business is very heavily international.

"So they are exposed to Europe's economic conditions and they are exposed to the banks, which can be kind of sporadic in the way they order product," he said.

Ziegel says Palo Alto is facing internal and external issues.

"You have competition but the bigger challenge is: Can they manage their growth and get to the profitability level they are targeting by the end of fiscal 2016?" he said.

OpenText's biggest challenge might be more near-term than a long-term issue. At issue is the company's $1.17 billion January acquisition of GXS, a cloud-based business-to-business integration services vendor.

Integration and growth are key issues, Schappel says.

"When they bought them (GXS) was a company that was not growing. When it came their way, they probably couldn't resist the price," he said. "They need to get it growing or GXS is going to weigh on their top line."

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