Why The IT Sector Has Outperformed the General Market YTD 2009: Licensing.

As of September 18th, the TSX Information Technology Index has increased year-to-date by 69.8% and has been the best performing sector in the market.(Global Equity Weekly - BMO). As a corollary to this, in the case that skeptics believe it to be a RIM-only measurement, the information technology sector of the S&P 500 has been the top performing sector with a 44.9% year-to-date improvement (Global Equity Weekly - BMO). From the March 6th market lows, the performance has been even better.

The RES Free Thinking Top 5 Small Cap Tech Picks performed better than the IT Sector as a whole. The aggregate stock price performance of TSX:DSG, TSX:CX, TSX:BWC, TSX:RKN, and TSXV:GXI is 196% since March 6th, and 185% YTD since January 1st. As well, during that time CX and DSG were able to raise $17 m, and $40 m in new equity respectively.



The common themes among the RES Free Thinking Top Picks are as follows:

• Unique solutions that solve problems within the respective market niches
• High growth
  
• Generating cash flow
• Expanding Gross Margins
  
• Recurring revenue licensing models
• Strong cash balances (to a lesser extent)
  

The two most important themes has been the presence of recurring revenue licensing models, and solutions that solve current problems. In January, as the economy continued to dive, I posted this note extolling the virtues and possible risks of recurring revenue software licensing models during the then deepening recession. Now ten months later, it appears that the IT Sector is leading the world economy out of recession and the recurring licensing model may be one of the main reasons why.


Review of the Root Cause of the Recession

It is well understood that the root cause of this recession was excessive leverage among consumers and within the financial services sector. Credit dried up and people were unable to buy things that required a capital commitment (cars, homes, furniture, etc...).Frozen credit markets impeded capital investments by business.


 Current Behavior

Consumers and businesses have been actively de-leveraging and preserving balance sheets. This means that both consumers and businesses are reducing capital spending and expenses to pay down debt, preserve cash balances and to increase cash flow. For business, this means cutting capital spending initiatives, reducing headcount and minimizing discretionary expenses while concurrently maximizing the productivity output of remaining resources. If your software solves a strategic problem, and you operate with a recurring revenue licensing model, this is a "perfect storm" earnings scenario.

Why is the IT Sector Benefiting?

Since the Tech Bubble burst in 2001, software vendors have been actively transferring software licensing from the balance sheets to the income statements of their customers. As a result, many leading IT vendors were unaffected by the recent cuts in capital spending. Instead of buying multi-million dollar perpetual licenses, many IT buyers pay monthly subscriptions or transaction fees that are more aligned and accountable to the income statement. Increasingly, clients can measure earnings against IT expenditure, which makes software license expenses on the income statement essential to cash flows and, thus non-discretionary - protecting these licenses from expense cuts.

Increased granularity of licensing makes recurring licensing susceptible to expense reductions as headcount is reduced. Logically, less headcount correlates to less software and less license revenue. However, because businesses are attempting to maximize cash flows, and the productivity of remaining resources, there is a tendency to acquire more IT services to improve the potential for cash flow, offsetting the impact of expense reductions for IT vendors. And because balance sheets are less likely to be impacted by an investment in software, businesses are more likely to acquire more information technology licenses in the short-term.

Software licenses acquired during the  two (and even three) years prior to the recession are typically contracted with three and even five year terms, essentially insulating many IT companies from the downturn of the past two years.

So there it is, the evolution of licensing from perpetual to recurring licenses since the end of the Tech Bubble has positioned a significant component of the IT Sector to be insulated from balance sheet de-leveraging while concurrently benefiting from increased investment in productivity and cash flows. These are some of the primary reasons why the IT Sector has outperformed the rest of the market YTD 2009.

Will InfoTech Continue to Outperform the Market in the Short-term? Mid-term?


In the short-term, the IT sector should continue to show strong performance, although it may be overtaken by a couple of other industry groups such as Materials during Q4.

There are four positive conditions that could help to sustain IT earnings growth, and share prices for Q4 2009:

• The IT Sector is beginning to benefit from infrastructure spending programs that have begun to trickle into the market
  
• As the economy shows some signs of recovery, delayed spending may be resuscitated during Q4 - there may be more surprise upside contract announcements as a result.
  
• As consumer confidence continues to edge ahead, Holiday spending may be less austere than in 2008- which bodes well for mobility, games, media, and consumer devices. 
• Q4 is historically the strongest quarter for IT Sector cash flows, and stock prices, so if the world economy improves as predicted by economists, there is a chance that earnings for the IT Sector could continue to outperform the market until the end of the year.  

There is one negative condition for Q4 for new money to the sector:

• Because the IT Sector has delivered one of the highest returns since the market bottomed, there is likely to be a lot of profit taking if there is a sustained correction over the next month or so. This means that it is a stock pickers market, and it is not necessarily the current high flyers of 2009 that offer the best returns for Q4. Caution is recommended.
  

The mid-term outlook for the IT Sector is a little less assured. Persistent unemployment could ultimately undermine future growth in the sector as most IT is aligned to either workers or consumers. The impact could show up as compressed margins as long-term contracts are renewed, or as declining revenue growth if job losses continue to mount during 2010. Returns from invested capital should normalize in the sector beyond 2009 as stocks become more fairly valued on earnings multiples.

However, the IT Sector is generally very healthy with strong balance sheets, and good cash flow so it probably should remain an area of emphasis for money managers. Portfolio Managers that bought into the sector in the spring may begin profit-taking as bonus season kicks in during Q4.

Disclosure: I own shares of CX.