Our Computer Software & Services Industry includes a broad range of companies, offering a wide range of products and services, spanning personal computer operating systems and office productivity suites to network security applications to payroll processing services to information technology consulting and outsourcing services. The group's end markets are also wide ranging, with nearly every facet of the global economy being targeted.

General Characteristics

Broadly speaking, this industry can be broken into two, though somewhat overlapping, segments-one in which the primary product is a suite of software and services offered via a perpetual license agreement (the customer purchases the software), and one in which a combination of software and services is offered as a tailored solution to a vertical market's recurring need (customers usually contract for services). A classic example of the first segment would be a software developer selling database management systems; a typical instance of the second would be a company selling transaction-processing solutions to financial institutions.

Competition is a common theme in this industry, with rivalries between some companies being particularly keen. Well-known computer hardware vendors also operate large-and very profitable-software and services operations, underscoring the competition in this arena. Entry into this industry is not uncommon, but its competitive nature requires the newcomer to be able to sustain a technological and product marketing edge over its larger rivals. If successful, the new entrant can grow very quickly. However, in the end, it may find itself an acquisition target if it is unable to reach large enough scale.

As a general rule, sales and marketing expenses, which are often scaled back when business is difficult, are a large part of the industry's cost structure. Expenditures on research and development vary across the industry, though they figure prominently in a software developer's cost structure. In addition, many of the companies that populate our industry have global operations, exposing them to the vagaries of foreign exchange. Nonetheless, on average, the group's margins are wide, and the good returns on invested capital suggest effective use of funds.

The rapid increases in data processing speeds have provided the foundation on which suites of complex software applications and interfaces could be developed and deployed, bringing the potential for greater efficiency and productivity to nearly every kind of business. Indeed, even the smallest business depends on the combination of a personal computer, an array of software and services, and high-speed Internet access. Accordingly, the demand for computer software and services can be characterized as being robust. That is not to say that the group is immune to the business cycle. Rather, information technology, of which software and services is an integral part, has become inseparable from a business's daily operations, cushioning the effect of the downside of the business cycle.

Balance of Market Power

In any industry there is a balance of power between the producer of goods and services and its end markets. In the case of Computer Software & Services, one could argue that the advantage has historically rested with the providers. Indeed, from the birth of the mainframe computer through the disruptive influence of the Internet, this group has provided an important means by which customers could use information technology to their benefit. Moreover, many of this industry's players have been quite effective in their sales efforts, in point of fact becoming integrated into their customer's operations. Accordingly, purchases of new products and services, upgrades, and add-ons were more determined by the industry's development cycle than a customer's specific need. That is not to say that the Computer Software & Services industry did not provide significant value. Rather, the group's customers were in the long process of adoption, which supported its heady growth and underpinned its fundamental advantage over its end markets.

One could posit that this industry will never truly mature, given the inexorable advance of high technology. Nonetheless, it has taken on some of the classic signs of doing so. Specifically, there seems to have been a shift in the balance of market power from the industry to its end markets. On point, this group's end markets are experiencing increasing competition and, thus, pressure on profitability. Moreover, many systems are not used to their fullest, with much unused capacity left idle. Consequently, this industry's customers are looking for ways to use their systems more efficiently, rather than just continuing to expand what they have. One of the industry's responses has been the concept of virtual servers or virtual computing, which, in a simple sense, provides more effective use of system capacity by allocating computing resources, including software and services, broadly across an enterprise. Another industry response is the move to so-called cloud computing, wherein computing resources are not directly owned and software and services are purchased-by contract or metered usage-and made available via Internet technology.

Investment Choices

For those interested in taking a position in high technology, there is a wide range of stocks to choose from in the Computer Software & Services industry. Growth prospects vary, as does risk.