Earlier this week Descartes Systems (DSG-TSX) announced that it has launched an electronic service for the new Importer Security Filing (ISF)10+2 customs filings regulations for the United States.
The 10+2 customs filing rule (10 data elements and 2 messages) is designed to help identify actual cargo movements and improve the accuracy of cargo descriptions. Expanded ISF descriptions are part of Department of Homeland Security’s (DHS) strategy to better assess and identify high-risk shipments to prevent terrorist weapons and materials from entering the United States. As well, the new descriptions help regulators trace product inputs to root manufacturers for product safety recalls (remember lead paint and toys?). The 10 data elements are:
Manufacturer (or supplier) name and address
Seller (or owner) name and address
Buyer (or owner) name and address
Ship-to name and address
Container stuffing location
Consolidator (stuffer) name and address
Importer of record number/foreign trade zone applicant identification number
Consignee number(s)
Country of origin, and
Commodity Harmonized Tariff Schedule number
Initially, the service is expected to be rolled-out to Descartes' current 4000 customers, and then bundled with current electronic services for new potential customers. Currently only 5% of documentation worldwide is handled electronically. As more Governments layer more regulation on the movement of goods, and as margins compress with a declining world economy, more shippers will be forced to switch from manual customs filing processes to electronic processes. As complexity increases, so do the costs of manual input. Increased regulation such as the 10+2 becomes increasingly positive for electronic messaging vendors such as Descartes Systems, especially in a weakened economy. Although 10+2 is a fairly major regulation, there are dozens more to be enacted over the next two years including EU harmonization. At one point soon, it may become impossible to manage shipping documentation manually.
As adoption of the service increases by its client base throughout the year, DSG revenue should increase by between $1.5 million and $2.5 million for FY2010 (C2010) and $0.01 incremental EPS or a 5% positive impact on forecasted earnings of between $0.20 and $0.23 EPS. By FY2011, the EPS impact should double to 10%.
However, the more interesting possibilities for Descartes Systems lie in bundling. As Descartes layers more electronic documentation services onto its distributed platform, it can offer compelling service bundling options for potential new clients that are difficult to compete with on pricing and scope . The bundling options would be similar to how cable companies bundle channel packages, internet access, and phone services to consumers.
In North America, the launch of the electronic 10+2 customs filing service could be a tipping point for Descartes Systems because it establishes a base for aggressive service bundling. If management executes effectively, then bundling strategies could have substantially more significant impact on performance than $0.01 EPS improvement in FY2010. Investors should be aware of this potential.
There is still a lot of gross margin leverage with this SaaS Company. Descartes Systems is well positioned to take advantage of some of the utility/cloud computing opportunities that are emerging, which should have a positive impact on network costs. Similarly, with a highly evolved and expansive normalized data taxonomy, it is well positioned to federate data flows with like-minded partners and extend its reach throughout the supply chain from point of procurement to point of sale. Such data integration could result in transaction based revenue sharing with gross margins nearing 100%.
Investor should take note of the launch of DSG's 10+2 custom filing service, because three years from now, it may be looked back upon as a key service launch in the evolution of the Company.
I do not own shares in Descartes Systems.
1/23/09
Tech Earnings This Week: Google Beat As Expected
After the outstanding earnings report from IBM (IBM-NYSE) earlier this week, I suggested that Google (GOOG-Q) would also beat analyst expectations. It did.
Revenues of $5.70 billion were 18% higher than the same quarter of 2007, and a 3% sequential improvement over Q3 2008. Adjusted earnings for the quarter were reported at $5.10 per share versus expectations of $4.95.
Looking deeper into the performance metrics reported, indeed Google seems to be benefiting from the flight to safety by marketing budgets, along with its increasingly international footprint.
Revenues of $5.70 billion were 18% higher than the same quarter of 2007, and a 3% sequential improvement over Q3 2008. Adjusted earnings for the quarter were reported at $5.10 per share versus expectations of $4.95.
Looking deeper into the performance metrics reported, indeed Google seems to be benefiting from the flight to safety by marketing budgets, along with its increasingly international footprint.
Aggregate paid clicks increased 18% over Q4 2007, and 10% sequentially. Revenue from Google owned sites, essentially search, increased by 22% over Q4 2007. AdSense revenues grew by 4%. Revenues from international sources increased as percentage of total sales to 50% from 48%.
Google management chose to take some impairment charges in the quarter, which impacted negatively on reported earnings. However, operationally, it could be inferred that Google performed ahead of expectations. As I expected.
Investors should marvel at the margins of this Company which was reported at 33% in the 4th quarter, which is a 10% improvement sequentially over Q3. It should be interesting to see what happens during Q1 2009, which is typically the weakest quarter for media spending. Notwithstanding, Google should continue to benefit from the "flight to safety" for at least two more quarters.
More surprising this week was the strong earnings report from Apple (AAPL-Q). Although iPhone sales were weak as expected, strong performance from the laptop line of business was a big surprise. As a premium priced product in a declining market, one could predict that this business would crater during the quarter, but instead it powered earnings. International sales again helped push iPod performance ahead of forecasts. Essentially, Apple's diversified product base was critical to its surprise performance.
On the other hand, Nokia (NOK-NYSE) showed a deep decline in performance due to weak handset replacement activities worldwide. As I have stated in an earlier post, people find their mobile subscriptions to be essential, but are choosing to hold off on fancier phone upgrades. On top of that, for consumers actually looking for new bling, they are choosing the iPhone over Nokia products in Europe.
Because Research In Motion (RIMM-Q) looks more like Nokia than Apple from a product perspective, there is probably a greater chance than not that RIM could miss analyst expectations when it reports. However, it was reported during the fall of 2007 that shipments of Storm were better than expected. Unlike Nokia, RIM has been launching new devices throughout 2008, which should benefit performance. However, with iPhone being Apple's weakest product line, and Nokia reporting significant declines in sales, it doesn't bode well for RIM's quarter.
Because Yahoo! (YHOO-Q) has a greater exposure to the U.S market than Google, and because it relies more on impression-based display ad revenue than Google, it could report earnings next week that miss expectations. Management instability, and the erosion of brand equity by incessant takeover speculation do not help, either. Marketers probably do not feel as safe allocating budgets to Yahoo! as compared to Google. Social media players like Facebook and MySpace are a direct susbstitutes for Yahoo!'s portal business, and are nipping at the edges of Yahoo!'s traffic while gaining more mindshare with marketers, which also does not help. If the dominant online media player is showing 18% growth in sales in a market where total growth is forecasted to be around 10%, the performance gaps need to occur somewhere.
I do not own any share in the Companies discussed above.
1/20/09
Route1 (ROI.V): Has it finally found its way?
I must admit that when I first ran into Route1, I was not too impressed with the story. It was early 2005 and a really expensive, clunky pseudo-notebook "dumb terminal" passed by my desk. Excitement was brewing on Bay Street because some banks were sniffing around the concept. I thought "wishful thinking, weak idea, dead company". A year later, I saw for the first time the much more elegant Mobikey concept, and although a bit rough around the edges, I could see some potential for virtual desktops. But it was a hard contrarian sell to a world of broadband connectivity, and the customer base remained pretty skinny. I thought "solid idea...too bad about the Company" and forgot about it. In the meantime, Management continued to convince investors that there was promise while burning through loads of cash and raising more equity capital at increasingly diluted share prices.
Three years, several million dollars in deep R&D, and a few hundred million shares later, the Company has found itself positioned at the nexus of three major themes of the Obama administration: digital infrastructure, the environment and energy policy, (more on these later). The promise of the now technically perfected Mobikey is starting the be fulfilled by no less than the U.S. Federal Government itself. With real orders.
I actually joined the Route1 fanclub last fall after one of its shareholders convinced me to take another look at the Company and its technology. Soon after, I became a proud Mobikey owner and an avid user (the Mobikey hangs on my keychain). Here is why I believe that Route1 is in a special Company-making spot:
> What it does: The technology allows employees of organizations to securely use applications and manipulate data remotely without any of it ever leaving the organization's server room (virtual or otherwise). With the Mobikey, employees can access and manipulate the data from any PC-based device in the world with an addressible IP connection without compromising the data. Unparalleled employee mobility combined with unparalleled data security.
Why does the U.S. Federal Government care?
> In 2004, the U.S Congress enacted an appropriations bill legislating that all Federal employees must be able to telecommute twice every two weeks. The objective of the legislation is to reduce the carbon footprint of the U.S. Government, and to improve employee morale in the Washington area where the average commuting time has grown to 49 minutes. Data security made implementing this legislation very difficult and, by the beginning of 2007, only a small portion of government employees ever telecommuted at all (4.2%), let alone with the frequency described by the law. The level of physical and network security made it prohibitively expensive to outfit and support any but a few telecommuters with the gear required to make a secure connection. The Mobikey solution reduces the setup and support costs to a fraction of what it would be otherwise. Not only that, with this technology the Government Services Administration (GSA) could soon encourage employees to use their own home computers to telecommute.
> The gas crisis of 2007 and 2008 added fuel (so to speak) to the legislation. Agencies in the Washington area were beginning to lose employees who were choosing to find alternative employment closer to home in the suburbs. In the fall of 2007, the Director of the GSA set a goal that by 2010, 50% of its employee base would telecommute. In 2007, only 10% of GSA employees commuted, and only 4.2% of all federal workers did. Although the recession has burst the fuel bubble for now, it is a stated policy by the Obama administration to reduce energy dependence on foreign sources without increasing domestic exploration in environmentally sensitive areas. With the amount of collaborative technology available, one can expect that telecommuting could be a cornerstone initiative for fuel conservation, and the Obama administration will want to lead by example. As many as 33% of all Americans could telecommute regularly, although only 7% (Lister, Harnish 2008) do so now.
Through its Government procurement partner, Qwest (Q-NYSE), Route1 has finally secured a major reference account with U.S Federal Agencies. Although the Company does not disclose its total number of deployments to date, I estimate that the first order of approximately 30,000 units through Qwest is probably close to 5 times larger than total current deployments. And this is to fulfill an order from one section within one Department in Washington which is ordering 95,000 devices over the next three years. There are already other Departments lining up as the emphasis in Washington moves towards those themes. Apparently, employees of some Departments in Washington are personally buying Mobikeys ahead of departmental purchases.
Is Route1 out of the woods? It is very close, and Management can see daylight. There is still some cash burn to go in 2009, with little left in the tank. However, there is a clear path to earnings likely in H2 2009. And I think that there is a greater than 50% chance of some surprise upside catalysts arising out of its Qwest relationship later in 2009. The capital structure of the Company has been weakened, and Management understands that it needs to be fixed before too long.
Management is scarred and toughened by its past challenges. It has had fits and starts in sales and marketing and has changed courses many times with limited success. In the end, the U.S. Government found Route1 through a Google search, not due to intrepid sales capabilities by Route1. However, going forward, the Company has designed a really solid recurring revenue stream model based on monthly subscriptions, and has leveraged its relationship with Qwest to maximize margins. Recurring gross margins could be as high as 90%.
The Company has been busy forming reseller relationships with others, and has had some success with other foreign governments. It is likely that Management will try to repeat the Qwest model within the European Union.
Underlying the Company's positive outlook is its unique technology. Notwithstanding the Mobikey form, the fundamentals of the technology are software driven. This opens up the possibilities for many new forms including mobile devices, home routers, and wireless routers. With Mobikey technology, bandwidth utilization could be made multiples more efficient. Content producers could truly control distribution. And, even more interesting, combined with server virtualization, Route1's desktop virtualization could help to revolutionize the efficiency and security of cloud computing. The underlying Mobikey and Mobinet software could be a very important technology as network infrastructure evolves. The early investors in this Company could find themselves rewarded for patience as the technology takes off over the next 3 to 5 years.
I do not own shares in Route1 nor do I receive compensation in any way from the Company, although I do own a Mobikey.
Three years, several million dollars in deep R&D, and a few hundred million shares later, the Company has found itself positioned at the nexus of three major themes of the Obama administration: digital infrastructure, the environment and energy policy, (more on these later). The promise of the now technically perfected Mobikey is starting the be fulfilled by no less than the U.S. Federal Government itself. With real orders.
I actually joined the Route1 fanclub last fall after one of its shareholders convinced me to take another look at the Company and its technology. Soon after, I became a proud Mobikey owner and an avid user (the Mobikey hangs on my keychain). Here is why I believe that Route1 is in a special Company-making spot:
> What it does: The technology allows employees of organizations to securely use applications and manipulate data remotely without any of it ever leaving the organization's server room (virtual or otherwise). With the Mobikey, employees can access and manipulate the data from any PC-based device in the world with an addressible IP connection without compromising the data. Unparalleled employee mobility combined with unparalleled data security.
Why does the U.S. Federal Government care?
> In 2004, the U.S Congress enacted an appropriations bill legislating that all Federal employees must be able to telecommute twice every two weeks. The objective of the legislation is to reduce the carbon footprint of the U.S. Government, and to improve employee morale in the Washington area where the average commuting time has grown to 49 minutes. Data security made implementing this legislation very difficult and, by the beginning of 2007, only a small portion of government employees ever telecommuted at all (4.2%), let alone with the frequency described by the law. The level of physical and network security made it prohibitively expensive to outfit and support any but a few telecommuters with the gear required to make a secure connection. The Mobikey solution reduces the setup and support costs to a fraction of what it would be otherwise. Not only that, with this technology the Government Services Administration (GSA) could soon encourage employees to use their own home computers to telecommute.
> The gas crisis of 2007 and 2008 added fuel (so to speak) to the legislation. Agencies in the Washington area were beginning to lose employees who were choosing to find alternative employment closer to home in the suburbs. In the fall of 2007, the Director of the GSA set a goal that by 2010, 50% of its employee base would telecommute. In 2007, only 10% of GSA employees commuted, and only 4.2% of all federal workers did. Although the recession has burst the fuel bubble for now, it is a stated policy by the Obama administration to reduce energy dependence on foreign sources without increasing domestic exploration in environmentally sensitive areas. With the amount of collaborative technology available, one can expect that telecommuting could be a cornerstone initiative for fuel conservation, and the Obama administration will want to lead by example. As many as 33% of all Americans could telecommute regularly, although only 7% (Lister, Harnish 2008) do so now.
Through its Government procurement partner, Qwest (Q-NYSE), Route1 has finally secured a major reference account with U.S Federal Agencies. Although the Company does not disclose its total number of deployments to date, I estimate that the first order of approximately 30,000 units through Qwest is probably close to 5 times larger than total current deployments. And this is to fulfill an order from one section within one Department in Washington which is ordering 95,000 devices over the next three years. There are already other Departments lining up as the emphasis in Washington moves towards those themes. Apparently, employees of some Departments in Washington are personally buying Mobikeys ahead of departmental purchases.
Is Route1 out of the woods? It is very close, and Management can see daylight. There is still some cash burn to go in 2009, with little left in the tank. However, there is a clear path to earnings likely in H2 2009. And I think that there is a greater than 50% chance of some surprise upside catalysts arising out of its Qwest relationship later in 2009. The capital structure of the Company has been weakened, and Management understands that it needs to be fixed before too long.
Management is scarred and toughened by its past challenges. It has had fits and starts in sales and marketing and has changed courses many times with limited success. In the end, the U.S. Government found Route1 through a Google search, not due to intrepid sales capabilities by Route1. However, going forward, the Company has designed a really solid recurring revenue stream model based on monthly subscriptions, and has leveraged its relationship with Qwest to maximize margins. Recurring gross margins could be as high as 90%.
The Company has been busy forming reseller relationships with others, and has had some success with other foreign governments. It is likely that Management will try to repeat the Qwest model within the European Union.
Underlying the Company's positive outlook is its unique technology. Notwithstanding the Mobikey form, the fundamentals of the technology are software driven. This opens up the possibilities for many new forms including mobile devices, home routers, and wireless routers. With Mobikey technology, bandwidth utilization could be made multiples more efficient. Content producers could truly control distribution. And, even more interesting, combined with server virtualization, Route1's desktop virtualization could help to revolutionize the efficiency and security of cloud computing. The underlying Mobikey and Mobinet software could be a very important technology as network infrastructure evolves. The early investors in this Company could find themselves rewarded for patience as the technology takes off over the next 3 to 5 years.
I do not own shares in Route1 nor do I receive compensation in any way from the Company, although I do own a Mobikey.
IBM Beats Analysts Expectations...yet again.
Today, IBM reported Q4 2008 earnings of $3.28 per fully diluted share, 17% ahead of Q4 2007 and generally ahead of analysts expectations. On a currency adjusted basis, the Company reported $27.0 billion in sales, a 1% decline from Q4 2007. Software sales grew by 9% on a currency adjusted basis, technology services up 3% and and business services were reported as flat.
For the full year, IBM reported record sales of $103.6 billion, record pre-tax income of $16.7 billion and free cashflow of $14.3 billion (excluding Global Financing receivables). Earnings were reported at $8.93 per share for the full year.
Not a bad year.
The Company is guiding for a minimum of $9.20 in EPS for 2009, which is a 3% forecasted increase. With its expansive international footprint and the potential to benefit from President Obama's "digital infrastructure" stimulus package, one could anticipate that IBM could potentially beat that minimum. This should be considered a rosy outlook considering the world economic situation for 2009. With $12.9 billion in cash, it has the ability to continue to make strategic acquisitions in software and infrastructure during 2009 while the shares of strategic targets may be depressed.
IBM has been transforming itself for over a decade now into the preeminent technology services company in the world. With little fanfare. While Google (GOOG-Q), Microsoft (MSFT-Q) capture the imaginations and mindshare of the public, IBM has been performing.
With respect to performance, there is greater chance than not that Google could beat analysts expectations when it reports later this week. During economic recessions, marketers look for measureability for their reduced budgets. Google's CPC model and its dominance are likely to attract more dollars than expected because budgets tend to flow to "safety" during bad economic periods. Google is generally perceived to be a safe spot for marketers because of the reach and measureability of its offerings.
I do not own any shares of the Companies discussed above.
For the full year, IBM reported record sales of $103.6 billion, record pre-tax income of $16.7 billion and free cashflow of $14.3 billion (excluding Global Financing receivables). Earnings were reported at $8.93 per share for the full year.
Not a bad year.
The Company is guiding for a minimum of $9.20 in EPS for 2009, which is a 3% forecasted increase. With its expansive international footprint and the potential to benefit from President Obama's "digital infrastructure" stimulus package, one could anticipate that IBM could potentially beat that minimum. This should be considered a rosy outlook considering the world economic situation for 2009. With $12.9 billion in cash, it has the ability to continue to make strategic acquisitions in software and infrastructure during 2009 while the shares of strategic targets may be depressed.
IBM has been transforming itself for over a decade now into the preeminent technology services company in the world. With little fanfare. While Google (GOOG-Q), Microsoft (MSFT-Q) capture the imaginations and mindshare of the public, IBM has been performing.
With respect to performance, there is greater chance than not that Google could beat analysts expectations when it reports later this week. During economic recessions, marketers look for measureability for their reduced budgets. Google's CPC model and its dominance are likely to attract more dollars than expected because budgets tend to flow to "safety" during bad economic periods. Google is generally perceived to be a safe spot for marketers because of the reach and measureability of its offerings.
I do not own any shares of the Companies discussed above.
1/12/09
The Recurring Technology Services Model Comes Home to Roost (Kinda)
For a little over a decade now, software companies have been attempting to transition away from the feast or famine quarterly grind of perpetual licensing sales designed in the 1980s and perfected during the client/server decade of the 1990s. The first Application Service Provider (ASP) models at the turn of this century were ahead of the provisioning capabilities at the time, but were the start of a revolution that just may help shareholders not only survive but even thrive during this increasingly nasty worldwide recession. Or so we hope. Like all things evolving, there are variances and nuances to the recurring services software model that, for technology investors, may mean the difference between solid performance and "what just happened?" cratering.
There is a reason why, in recent years, analysts have fallen in love with the recurring services software model. At scale, a well designed model offers predictable revenue streams and cashflow, scaling leverage, and resiliency against the impact of economic slowdowns. More importantly, on-demand software is increasingly the way many customers can afford to pay for reliable technology.
The challenge of this model is that it is expensive to scale to a positive earnings inflection point where free cashflow gets generated. In other words, a lot of capital gets burned on the way to success. One of the pioneers of the model, and arguably one of the most successful perveyors of the Software as a Service (SaaS) is CRM on-demand software maven Salesforce.com (CRM-NYSE). The Company is legendary for taking on and pummeling CRM perpetual licensing heavyweights Peoplesoft and Seibel, which are both now divisions of Oracle (ORCL-Q). Considering that Salesforce.com is trading at 104x TTM P/E, investors still love the stock (even with a recent 40 minute service outage). Regardless of the economic conditions investors believe that, for the most part, Saleforce.com clients will pay a modest monthly fee and follow it into the cloud as the Company extends services through its app server infrastructure. In a final irony, Oracle is now stating that it is ready to take on Saleforce.com head-to-head with its own hosted services. See what Larry Ellison thinks. To get to its profitability tipping point, Salesforce.com burned through a lot of capital. NetSuite (N-NYSE), another on-demand pioneer still is - over $6 million last quarter. From 2003 to 2007, it was ok to burn through vast amounts of capital to scale. Is the capital still available to assist on-demand growth, and if not, can vendors leverage the model and adjust towards less lofty scale but greater profits?
Most software and media companies (there is not much difference anymore) claim to have launched, or are about to launch some type of recurring software service. As nearly the entire sector (Even Larry Ellison) transitions to the recurring revenue model, it begins to lose its purity. Once diluted, the model begins to morph and also lose some of its famous revenue attributes such as predictability, leverageability, and scalability.
After reviewing hundreds of these types of Companies, here are some points to ponder when yet another on-demand (insert service here) investment thesis is presented.
1. Renewal Risk. Although the recurring services model is fairly immune to the quarterly life-or-death struggle of the perpetual license unit sales, there remains some pretty significant revenue risk associated with multi-year contract renewals common to the model. I am aware of several SaaS vendors already beginning to negotiate major client renewals that are due in 2010. Earlier stage vendors with customer concentration risk could suffer devastating consequences if key clients switch or abandon. Clients are aware of this and are eager to leverage this risk into better renewal terms.
2. "Devil is in the Detail" Risk. Not all recurring revenue is created equally. Variance in the granularity, scope, and input costs associated with the recurring revenue streams create variability in risk. As well, key terms such as length, minimum guarantees, automatic renewals, and capital equipment commitments impact the marginal value of of recurring service revenue to investors.
> Granularity: monthly revenue can be charged at the server level, on per seat or subscription basis, or at a transaction level. At the highest level (server level), a multi-year SaaS contract would be less sensitive to economic cycles, including short-term economic downturns. Typically, transaction models are consumer facing and more economically sensitive, and are likely to vary with demand elasticity. The more transaction-oriented the license, the greater the potential risk may be to earnings as activity declines. However, there is a contrarian perspective...
>Scope: During bad economic cycles, sometimes it is better to be under the radar. Data and application services that cover a broader scope of bundled functionality may be at greater risk of contract erosion through client unbundling. A primary example is financial data services. Stressed brokerage firms are cutting back budgets by actively unwinding premium bundled seat licenses from providers like Thomson Reuters (TRI-NYSE). In the meantime, low-cost individual data subscriptions are escaping the purge by being relatively unnoticed (at least for now). Ironically, the more entrenched a vendor, the more likely that it will be targeted for ad-hoc contract renegotiations while the unnoticed little app runs quietly in the background.
>Bundled capital risk: many recurring services require some type of specialized hardware or firmware for the service to work. In order to secure multi-year services contracts, vendors will often eat the equipment costs through financing, and pass on the expense through increased recurring licensing fees. In capital constrained times such as now, equipment bundling removes purchasing barriers, which is positive. On the other hand, this tactic reduces gross margin benefit, while increasing overall capital risk to the vendor. If the financing cannot be secured in reasonable timeframes, it increases contract and deployment risk.
>Term: longer-term contracts, such as 5 year and 3 year terms are typically lower risk that 12 or 24 month terms in a downmarket. The main risk related to long-term deals is clustering. Having multiple long-term contracts renewing during 2009 is probably not a good spot to be.
3. Stage of Development: This is an interesting variable for investors. A mature on-demand model can generate between 20% and 30% pre-tax margin. However, the greatest earnings lift comes from Companies who have hit the earnings inflection point within the previous 2 quarters, or are about to hit it within 1 quarter. Doubling, quadrupling EBITDA with similar increases in cashflow are common at this stage, even with modest growth. Earlier stage investments into rock solid solutions with the potential for market dominance could create the most long-term return if one has a 5 year investment time horizon and is patient. There is not much patient in these markets.
The recurring services revenue model, as it has evolved since 2000, has not been tested during a significant economic contraction such as the one that we are currently experiencing. One could expect that financially distressed clients could simply walk away from contracts, or force renegotiated terms. However, there is a lot of margin to play with. I am aware of some on-demand vendors already deciding to cut back on growth initiatives in order to maximize margins on forward contracts. Whereas topline sales are forecasted to grow by less than 10%, bottom line marginal contributions are forecasted to triple or even quadruple. If investors are looking for growing cashflows, then technology companies with strong recurring revenue streams may still be a good spot to look.
I do not own shares in any of the companies discussed in the post.
There is a reason why, in recent years, analysts have fallen in love with the recurring services software model. At scale, a well designed model offers predictable revenue streams and cashflow, scaling leverage, and resiliency against the impact of economic slowdowns. More importantly, on-demand software is increasingly the way many customers can afford to pay for reliable technology.
The challenge of this model is that it is expensive to scale to a positive earnings inflection point where free cashflow gets generated. In other words, a lot of capital gets burned on the way to success. One of the pioneers of the model, and arguably one of the most successful perveyors of the Software as a Service (SaaS) is CRM on-demand software maven Salesforce.com (CRM-NYSE). The Company is legendary for taking on and pummeling CRM perpetual licensing heavyweights Peoplesoft and Seibel, which are both now divisions of Oracle (ORCL-Q). Considering that Salesforce.com is trading at 104x TTM P/E, investors still love the stock (even with a recent 40 minute service outage). Regardless of the economic conditions investors believe that, for the most part, Saleforce.com clients will pay a modest monthly fee and follow it into the cloud as the Company extends services through its app server infrastructure. In a final irony, Oracle is now stating that it is ready to take on Saleforce.com head-to-head with its own hosted services. See what Larry Ellison thinks. To get to its profitability tipping point, Salesforce.com burned through a lot of capital. NetSuite (N-NYSE), another on-demand pioneer still is - over $6 million last quarter. From 2003 to 2007, it was ok to burn through vast amounts of capital to scale. Is the capital still available to assist on-demand growth, and if not, can vendors leverage the model and adjust towards less lofty scale but greater profits?
Most software and media companies (there is not much difference anymore) claim to have launched, or are about to launch some type of recurring software service. As nearly the entire sector (Even Larry Ellison) transitions to the recurring revenue model, it begins to lose its purity. Once diluted, the model begins to morph and also lose some of its famous revenue attributes such as predictability, leverageability, and scalability.
After reviewing hundreds of these types of Companies, here are some points to ponder when yet another on-demand (insert service here) investment thesis is presented.
1. Renewal Risk. Although the recurring services model is fairly immune to the quarterly life-or-death struggle of the perpetual license unit sales, there remains some pretty significant revenue risk associated with multi-year contract renewals common to the model. I am aware of several SaaS vendors already beginning to negotiate major client renewals that are due in 2010. Earlier stage vendors with customer concentration risk could suffer devastating consequences if key clients switch or abandon. Clients are aware of this and are eager to leverage this risk into better renewal terms.
2. "Devil is in the Detail" Risk. Not all recurring revenue is created equally. Variance in the granularity, scope, and input costs associated with the recurring revenue streams create variability in risk. As well, key terms such as length, minimum guarantees, automatic renewals, and capital equipment commitments impact the marginal value of of recurring service revenue to investors.
> Granularity: monthly revenue can be charged at the server level, on per seat or subscription basis, or at a transaction level. At the highest level (server level), a multi-year SaaS contract would be less sensitive to economic cycles, including short-term economic downturns. Typically, transaction models are consumer facing and more economically sensitive, and are likely to vary with demand elasticity. The more transaction-oriented the license, the greater the potential risk may be to earnings as activity declines. However, there is a contrarian perspective...
>Scope: During bad economic cycles, sometimes it is better to be under the radar. Data and application services that cover a broader scope of bundled functionality may be at greater risk of contract erosion through client unbundling. A primary example is financial data services. Stressed brokerage firms are cutting back budgets by actively unwinding premium bundled seat licenses from providers like Thomson Reuters (TRI-NYSE). In the meantime, low-cost individual data subscriptions are escaping the purge by being relatively unnoticed (at least for now). Ironically, the more entrenched a vendor, the more likely that it will be targeted for ad-hoc contract renegotiations while the unnoticed little app runs quietly in the background.
>Bundled capital risk: many recurring services require some type of specialized hardware or firmware for the service to work. In order to secure multi-year services contracts, vendors will often eat the equipment costs through financing, and pass on the expense through increased recurring licensing fees. In capital constrained times such as now, equipment bundling removes purchasing barriers, which is positive. On the other hand, this tactic reduces gross margin benefit, while increasing overall capital risk to the vendor. If the financing cannot be secured in reasonable timeframes, it increases contract and deployment risk.
>Term: longer-term contracts, such as 5 year and 3 year terms are typically lower risk that 12 or 24 month terms in a downmarket. The main risk related to long-term deals is clustering. Having multiple long-term contracts renewing during 2009 is probably not a good spot to be.
3. Stage of Development: This is an interesting variable for investors. A mature on-demand model can generate between 20% and 30% pre-tax margin. However, the greatest earnings lift comes from Companies who have hit the earnings inflection point within the previous 2 quarters, or are about to hit it within 1 quarter. Doubling, quadrupling EBITDA with similar increases in cashflow are common at this stage, even with modest growth. Earlier stage investments into rock solid solutions with the potential for market dominance could create the most long-term return if one has a 5 year investment time horizon and is patient. There is not much patient in these markets.
The recurring services revenue model, as it has evolved since 2000, has not been tested during a significant economic contraction such as the one that we are currently experiencing. One could expect that financially distressed clients could simply walk away from contracts, or force renegotiated terms. However, there is a lot of margin to play with. I am aware of some on-demand vendors already deciding to cut back on growth initiatives in order to maximize margins on forward contracts. Whereas topline sales are forecasted to grow by less than 10%, bottom line marginal contributions are forecasted to triple or even quadruple. If investors are looking for growing cashflows, then technology companies with strong recurring revenue streams may still be a good spot to look.
I do not own shares in any of the companies discussed in the post.
1/9/09
Why The Tech Sector Is a Good Play in This Recession
Yesterday I was speaking to someone regarding the future of the information technology sector in the short-term and long-term. I believe that we can to the following conclusions:
1. Information technology is a horizontal sector, meaning that it pertains to consumer, government, services and industrial markets, and all niches from consulting to metal stamping, from coffee shops to open-pit mines. Information is infrastructure.
2. Information technology is no longer a speculative bubble as it was in 2000-2002, although there remain speculative niches within the broad sector. Overall, the sector generates reasonable cashflow and free cashflow growth.
3. Relative to some sectors, the cash to long-term debt ratios are positive.
The conclusion was that because information technology is such a broad sector, it should mirror not the US economy but the world economy. Worldwide stimulus initiatives by governments should create areas of opportunity within the sector. As President Obama (he's pretty much running the show now) puts the finishing touches on his massive stimulus package, the IT sector should benefit overall, however it is becoming clearer that some niches should benefit more than others:
- Companies that provide IT infrastructure including storage, bandwidth, switching, routing, virtualization, and security should benefit directly from the stimulus package.
- Clearly healthcare technology providers should benefit, although there should be few winners and a lot of losers. There has been a lot of work done already on EMR in anticipation that the healthcare sector would adopt more IT solutions. To date, lack of political will has resulted in anemic uptake and a highly fragmented niche with a lot of minor vendors struggling to make money. There are likely to be few upstart winners, although most of the business should be earned by established healthcare technology providers like McKesson (MCK.NYSE). One could expect to see the usual suspects, led by Google (GOOG.Q), Microsoft (MSFT.Q), and IBM (IBM.NYSE) become more aggressive in gobbling up small and mid-sized specialists in the area.
- A vast majority of stimulus packages worldwide are focused on physical infrastructure such as roads, bridges, rail, and power. Although these initiatives are much smaller than the Obama package, there is likely to be benefit to engineering, production, and project management applications vendors.
- speaking of power, Obama's alternative energy plans will require significant IT support in hardware, firmware and software.
- Congressional hearings related to the financial meltdown are likely to result in more rigourous regulatory regimes, which could benefit IT vendors at a scale similar to the Sarbannes-Oxley accounting regulations resulting from the Enron scandal.
Public stimulus projects are only part of the story. Consumer spending habits and behaviors are already changing, and priorities should be much different this time around as compared to previous recessions. Here are some themes ( which have been touched on previously):
- Mobile subscription is a utility that is more important that cable TV, landline telephony, internet access, and in some parts of the world, electricity.
- According to published reports by the Mastercard Advisors, this Christmas online spending trends outperformed bricks and mortar. We may find an upsurge in online spending as consumers become more frugal and retailers move deals online. As retailers are forced to begin to consolidate the physical retail network, look for a new wave of investment in online security, payment systems, and logistics.
Information is the foundation of modern economies. The need for more efficiencies, reliability, and effectiveness should increase as the world economy recalibrates. Niche opportunities exist within the broader market that could have a 3 to 5 year time horizon.
I do not own any of the stocks mentioned in this post, nor do I receive any compensation from management.
1. Information technology is a horizontal sector, meaning that it pertains to consumer, government, services and industrial markets, and all niches from consulting to metal stamping, from coffee shops to open-pit mines. Information is infrastructure.
2. Information technology is no longer a speculative bubble as it was in 2000-2002, although there remain speculative niches within the broad sector. Overall, the sector generates reasonable cashflow and free cashflow growth.
3. Relative to some sectors, the cash to long-term debt ratios are positive.
The conclusion was that because information technology is such a broad sector, it should mirror not the US economy but the world economy. Worldwide stimulus initiatives by governments should create areas of opportunity within the sector. As President Obama (he's pretty much running the show now) puts the finishing touches on his massive stimulus package, the IT sector should benefit overall, however it is becoming clearer that some niches should benefit more than others:
- Companies that provide IT infrastructure including storage, bandwidth, switching, routing, virtualization, and security should benefit directly from the stimulus package.
- Clearly healthcare technology providers should benefit, although there should be few winners and a lot of losers. There has been a lot of work done already on EMR in anticipation that the healthcare sector would adopt more IT solutions. To date, lack of political will has resulted in anemic uptake and a highly fragmented niche with a lot of minor vendors struggling to make money. There are likely to be few upstart winners, although most of the business should be earned by established healthcare technology providers like McKesson (MCK.NYSE). One could expect to see the usual suspects, led by Google (GOOG.Q), Microsoft (MSFT.Q), and IBM (IBM.NYSE) become more aggressive in gobbling up small and mid-sized specialists in the area.
- A vast majority of stimulus packages worldwide are focused on physical infrastructure such as roads, bridges, rail, and power. Although these initiatives are much smaller than the Obama package, there is likely to be benefit to engineering, production, and project management applications vendors.
- speaking of power, Obama's alternative energy plans will require significant IT support in hardware, firmware and software.
- Congressional hearings related to the financial meltdown are likely to result in more rigourous regulatory regimes, which could benefit IT vendors at a scale similar to the Sarbannes-Oxley accounting regulations resulting from the Enron scandal.
Public stimulus projects are only part of the story. Consumer spending habits and behaviors are already changing, and priorities should be much different this time around as compared to previous recessions. Here are some themes ( which have been touched on previously):
- Mobile subscription is a utility that is more important that cable TV, landline telephony, internet access, and in some parts of the world, electricity.
- According to published reports by the Mastercard Advisors, this Christmas online spending trends outperformed bricks and mortar. We may find an upsurge in online spending as consumers become more frugal and retailers move deals online. As retailers are forced to begin to consolidate the physical retail network, look for a new wave of investment in online security, payment systems, and logistics.
Information is the foundation of modern economies. The need for more efficiencies, reliability, and effectiveness should increase as the world economy recalibrates. Niche opportunities exist within the broader market that could have a 3 to 5 year time horizon.
I do not own any of the stocks mentioned in this post, nor do I receive any compensation from management.
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