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After four years of misery, life is returning to the software sector. Spending is increasing, shareprices are rising and deals are flowing. To make money, however, you'll need to follow fundamentals – not the crowd. Elliott Davis reports

Hell hath no fury like a stock market scorned. At the turn of the millennium investors were consumed by tech fervour, pushing IT and software company valuations up to ludicrously unsustainable levels. But then the fallout hit.

Four years ago London's techMARK index stood at 4000 points, today it resides just below the 1100 mark. Back then five software and computer services companies were encamped in the FTSE 100. These days only one, accountancy software supplier Sage, remains.

In February 2000, the software and computer services sector was the fourth most actively traded sector on the market. As of December 2003, it had slipped to 22 in the pecking order.

Needless to say, the corporate casualties were many. Infobank's journey from £1.7 billion procurement-software business to financially challenged market deserter in three and half years may have been among the most spectacular collapses, yet from Cedar to Orchestream and from Recognition Systems to Quality Software Products, London's legion of software stocks was decimated.

A software revival in 2004?

After almost four years of misery, however, rumour has it that life is returning to the embattled sector. Respected research group Gartner forecasts a 5.4 per cent increase in IT spending for 2004 and share prices are heading north once more.

The only problem is that valuations remain high, relative to profitability. Corporate Synergy analyst Luke Ahern warns that it is essential for private investors to 'buy for the right reasons, i.e. on account of sound fundamentals and not just because everyone else is buying.'

Take one-time FTSE 100 member Autonomy. The knowledge management software specialist, which made a City celebrity of chief executive Dr Mike Lynch a few years back, may no longer be valued at £4 billion. Yet, can a firm reckoned to have generated a pre-tax profit of around £4.7 million in 2003 (rising to £7.2 million in 2004) seriously deserve a £333 million market cap and a p/e of nearly 100 times expected earnings?

Contrast Autonomy to plant engineering technology specialist Aveva. The latter justifies its £90.4 million market valuation (almost a record high) with a robust £5.6 million profit for the year to March 2003 on £36 million of revenue. Moreover, having recently received a €2.25 million order from the AREVA Siemens consortium, the company is expected to generate a £7.3 million profit this year. A prospective p/e of 18.1 is modest by comparison to much of the sector.

Business-process-management software supplier Staffware is another to have battled through with its reputation intact. A firm favourite of Arbuthnot analyst George O'Connor, and recommended by Growth Company Investor at 382.5p in March 2002, the shares recently passed the 600p level on the back of impressive results and a growing international presence.

Just two weeks ago management issued a trading statement confirming that full year results to December are likely to show a 25 per cent increase in EBITDA to a record £5 million on £43 million of revenue. Although a rating of 25.3 times earnings is fairly full, the shares remain worth picking up on signs of weakness.

AIM-listed CODASciSys, meanwhile, continues to exude quality, even though Baird analyst Ian Spence forecasts a reduced full year profit before tax, goodwill and exceptionals of £6.3 million (£7.5 million) on revenue increased four per cent to £69 million. The company itself has confirmed it expects to beat these estimates and says it finished 2003 with around £6 million in the bank. At current levels the accounting software and IT services business thus continues to represent fair value for investors.

Comeback kids

While CODASciSys has been growing solidly by organic means for some years, AIM's other software superpower has taken a different growth route.

Now valued at £132.9 million, followers of business software supplier Systems Union may remember the company's previous incarnation as Freecom.net, an ambitious yet loss-making e-commerce business with precious little turnover and a penchant for over-zealous acquisitions. Then new chief executive Paul Coleman decided to ditch the e-commerce arm and focus instead on the group's software interests – and Systems Union has not looked back.

Alhough yet to equal the £200 million valuation Freecom achieved at the height of its wheeler-dealing, Systems Union is now solidly profitable, rapidly expanding and is not overvalued at 16 times forecast earnings.

If Systems Union's resurrection was impressive, AIT's rebirth has been nothing short of remarkable.

Back in early 2002 the customer management software specialist was the toast of the market and then, less than a month after reassuring investors that full year expectations of a £6 million profit would be met, management dropped a bombshell, issuing a profit warning and revealing that cash was tight.

A deeply discounted placing, a £40.8 million loss and a drop to AIM soon followed. Yet AIT is now expected to return to profitability (to the tune of £1 million) this year. Much of the immediate upside has already been built into the price, of course, but the shares could reward punters prepared to hold for the long-term.

One other rebound stock rated by Corporate Synergy's Ahern – who estimates that a staggering 65 AIM companies, many of them software developers, are due to move from losses to profit this year – is Patsystems.

Indeed, Ahern believes that after a particularly tough four years even by software standards, much of the financial systems market is overdue a re-rating.

Take derivatives trading system developer First Derivatives. The County Down-based firm has generated a profit in excess of £400,000 and revenues exceeding £1.6 million for the past three years. Last year's figures were a touch disappointing, but with an established blue-chip client base and an absence of debt an improvement is now anticipated.

Asset-management performance software specialist StatPro (another Full List refugee), meanwhile, appears to be on the cusp of breakeven following a greatly improved set of interim numbers and the subsequent £280,000 acquisition of a 51 per cent stake in Italian risk management software developer Riskmap. If long-standing chief executive Justin Wheatley can build on this momentum, StatPro's current £10.3 million market cap could soon begin to look rather modest.

The enthusiasm for all things financial should not be over-generalised. Wealth Management Software's revival, for instance, appears to have recently stalled (although any existing holding is worth hanging on to), while the likes of Easyscreen and FFastFill have consistently disappointed and should be avoided.

Stars of the future

With the migration of AIT, Patsystems, StatPro and others from the Full List, AIM is increasingly being viewed as the guardian of real UK software potential, particularly among the small, niche players.

Like the earlier mentioned Aveva, both Delcam and Planit – the latter another recent Full List convert – produce software applications for the engineering and manufacturing sectors. Unlike Aveva, however, their courses have been less smooth and there is now ample reason to believe they are currently undervalued.

Despite Delcam's shares current two-year high, a recent trading statement proudly declared that 'the group achieved record sales in December', and now expects its trading performance for the year to 31 December, 'to be above market expectations'.

Even going on the past forecasts of a £1.1 million full year profit and 13.1p of earnings, the shares are valued at only 14.6 times earnings. With a £1.6 million profit and 19.8p of earnings expected in 2004 this rating drops to just 9.6 times the next year, though investors should also be aware that the company admits it will soon announce how it will handle a pension fund deficit.

Planit, meanwhile, which is presided over by Sage boss Michael Jackson, appears to have been oversold on the back of last year's swing from substantial profit to loss. With acquisition Radan bedding down well, December's interims showing a significant improvement over last year and a return to full year profits likely, it seems a good time to buy – providing you can stomach the company's £6.7 million debt pile.

Over in the leisure arena, acquisitive Clarity Commerce Solutions – which supplies electronic point of sale, ticketing and loyalty solutions to pubs, bars and healthclubs – is another decent prospect following a decent first half-trading recovery. Legal sector specialist Tikit is also expected to report vastly improved results for the year to December soon, even though its shares trade at a 25 per cent discount to their 12-month high.

Finally, broadcast software developer Pilat Media Global is yet another of those seemingly on the verge of moving from loss to profit in the coming months. A raft of deals have been signed, including a £10 million three-year contract with leading Canadian broadcaster CTV. House broker Shore Capital expects a £507,000 pre-tax profit from £9.1 million of revenue this year and though a 2004 prospective p/e of 38.7 is rather steep, this figure drops to 10.4 for next year.