Lehman analyst: There is hope for some software convertibles

By Ronda Fears

Nashville, Tenn., July 31 - While software converts have suffered alongside the broader market, Lehman Brothers convertible analysts find hope in the group and recommend eight for buying opportunity.

"While at a macro level we recommend an underweight stance in the technology sector, we also believe that select opportunities do exist in the software space," Venu Krishna, head of convertible research at Lehman, said in a report Wednesday.

"Also, within the software sector, there are subsectors that are relatively better-positioned than others, allowing convertible investors a decent entry point. In other words, an underweight stance does not imply a zero weight."

Krishna's top four picks are the Veritas 1.856% due 2006, Citrix 0% due 2019, BEA Systems 4% due 2006 and Mercury Interactive 4.75% due 2007.

His next four picks are the Symantec 3% due 2006, Network Associates 0% due 2018, HNC Software 5.25% due 2008 and Siebel Systems 5.5% due 2006.

"In the past few months the convertible secondary market has experienced one of its most trying times. There has been a marked slowdown in primary new issuance as well, which makes the task of finding secondary market opportunities paramount," Krishna said in the report.

"We focused on the software sector given its sharp pullback in recent weeks and given the reasonably large number of software converts outstanding."

There are 17 software converts issued by 15 companies with a face value of $6.3 billion. Year to date, he said, these converts have lost 21% of face value but have held up well relative to their underlying stocks.

"The hefty premium of over 418% suggests that software converts have generally held up well relative to the steep declines in their underlying common stocks. On a nonweighted basis, software converts are down 18.1%, participating in just 30% of their underlying common stocks' decline of 60%," Krishna said.

"It is also interesting to note that of the 17 software convertibles, four have actually outperformed their common stock on a total return basis-an exceptional relative performance and reason for investors to dig deep to identify selective opportunities in this subsector."

Given the relative lack of hard assets at software companies, continued weakness in demand and the busted nature of the converts, he said he approached the sector from a credit and liquidity perspective. A scoring methodology was created using six basic sigma concepts based on the relative importance of eight parameters representing the fundamental appeal of each company from a convertible investment perspective.

Four yardsticks were then used in combination to make the software convertible picks - a company's scoring on the ranking scale, Lehman's outlook on a particular software subsector, company-specific factors and the convertible characteristics.

"The near-term outlook for software companies remains challenging as corporate IT spending remains weak with no visible signs of a pick-up. Software vendors, in particular, are faced with an interesting dilemma - while some are seeing a decent pipeline of business, closings are not materializing," Krishna said.

This has left a gaping hole between interest and actual new business and revenues.

More generally, he added, in the face of weak software demand, sales cycles appear to be lengthening, deal sizes are shrinking, and customers are buying "as needed." The lack of urgency to buy new software on the part of IT managers is also driven by a fair inventory buildup during the heydays, as a combination of price discounts and data usage growth fueled purchases.

"Despite these challenges, the longer-term outlook for the software sector remains fairly sound, largely due to the productivity and efficiency benefits they bring," Krishna said.

"However, while on one hand the severity of the pullback in the technology sector is only matched by its astounding rise in the 1990s, there is a case to be made that technology stock valuations in general, and software stocks in particular, are perhaps still not cheap compared to the broader markets.

"This brings the convertible investment consideration to the forefront as a potential alternative investment vehicle."

Krishna said his approach "is premised on a relatively short-term investment horizon of up to two years, given the busted nature of the converts in this spectrum. Also, more broadly, we are of the opinion that a high single-digit to a mid double-digit return with potential for some upside should be considered adequate in the current environment, especially in the context of a diversified portfolio."

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