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The software industry is intensely competitive, but it has economics few industries can match. Although the up-front costs for creating software are huge, production costs are not largely because software can be burned on a compact disc or delivered over the Internet for almost nothing. When a company such as Microsoft hits a home run with a product like Windows, it can generate operating margins in excess of 40 percent.

Established software companies are cash cows, too. Working capital management is typically good because software can be stored and shipped electronically. This leads to low inventory and accounts receivable balances. And because little capital is required to build software, successful software com­panies generate tons of free cash flow.

Finally, software companies have excellent growth prospects. Companies will continue to buy technology that makes business run more smoothly. Software can automate tasks, such as accounting, and improve relationships with customers. High labor costs encourage the use of software because time-consuming tasks, such as budgeting, can be reduced and increase productivity. And when firms face tough times with falling revenues, soft­ware can help cut costs.

Segments of the Software Industry

There are many nooks and crannies in the software industry. But a common theme is that most are oligopolies, with only a few controlling the majority of sales. Because technology buyers are inherently conservative and loath to buy products from a vendor that might go out of business and leave them stranded for basic service, companies are increasingly buying only from industry leaders. Here are some of the bigger segments of the software industry.

Operating System

An operating system runs all the other programs on a computer. Tasks include sharing memory between applications and handling directions from external hardware such as printers. There are few opportunities in this market, with Microsoft's Windows operating system running more than 90 percent of the world's PCs. However, the Linux operating system has slowly become a respectable alternative for servers. (A server is a large computer running programs that serve an entire company rather than a single user.) However, Linux specialists such as Red Hat have struggled to make money because the soft­ware can be downloaded free over the Internet.

Database

Database software collects data so it can be easily accessed and updated. High switching costs make this market attractive because it's tough to move data from one database to another. But it's also mature, with growth unlikely to exceed the high single digits over the long haul because most firms already have databases in place. Oracle, IBM, and Microsoft dominate the market: Oracle tends to have superior technology, while IBM and Microsoft offer cheaper prices.

Enterprise Resource Planning (ERP)

Enterprise resource planning aims to improve back-office business tasks, such as accounting and human resources. For instance, an accounting application makes it easier to perform basic tasks such as budgeting and billing; human resources software can keep track of employee performance. Like database soft­ware, the ERP market Isn't growing very fast because most large companies al­ready have some type of ERP system installed. SAP, PeopleSoft, and Oracle are the big names in this segment.

Customer Relationship Management (CRM)

Customer relationship management software keeps track of client data, such as purchasing histories, so salespeople and customer service employees can tailor specific product offerings to customers. This creates selling opportunities and improves customer satisfaction. Unlike ERP, however, which can automate a finite number of back-office tasks, there's no necessary limit to how companies can interact more effectively with customers. Slebel Systems is the 800-pound gorilla in the industry, but traditional ERP vendors such as SAP and PeopleSoft have been catching up.

Security

With more products and services being sold online, sensitive data is more available to employees and customers, but also to harmful hackers. The damage caused by viruses and stolen credit card numbers alone has created tremendous demand. Growing products include firewalls, virtual private networks, antivirus, and intrusion detection. Check Point Software and Symantec have been two of the biggest benefactors thus far.

Video Game

This segment of the sector is dominated by Electronic Arts. It's costly to sup­port the numerous hardware platforms, such as Microsoft's Xbox and Sony's PlayStation, and the industry is also cyclical, with new platforms emerging every few years. Numerous platforms (e.g., Atari) are no longer viable. Last, low barriers to entry make it easy for an upstart with a popular game to achieve success.

Miscellaneous

Not all software companies compete in industries with several established players. For example, Intuit dominates tax preparation and small business software with very little competition. Likewise, Adobe dominates graphic design software; products such as Photoshop and Illustrator have near monopolies on their respective niches. Often, companies that dominate a smaller niche are more attractive investments than household names that serve larger markets.

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