Tech Industry Analysis

Chordiant Software, Inc. - Margin Pressure Continues

May 14th 2008

Chordiant Software, Inc. (NASDAQ:CHRD) faces strong headwinds for the remainder of 2008, and does not appear to have any plans to alter its trajectory. License revenues that grew 33% in fiscal September 2007, have fallen off sharply down 48% year to year for the first six months of 2008.  March quarter results were very, very disappointing with license revenues for the quarter of $4.8MM down 75% year to year and down 46% quarter to quarter. With over 50% of revenues coming from financial services sector,  Chordiant will likely be under top line pressure throughout FY08. 

Chordiant's MGI Index scores, - key metrics of corporate business model efficiency have all either declined or collapsed from December 2007 to March of 2008. Although management has implemented a significant expense reduction program, the collapsing MGI metrics combined with current license revenues trends indicate that Chordiant will need a much more dramatic reduction in its cost structure in order to return to break-even.

The dramatic miss is being attributable to the difficult macro-economic environment, in particular in the financial services sector.  While management continues to be encouraged by the growing pipeline of opportunities, the poor results underscore the elongation of the sales cycle and the prospect that business could remain disappointing for some time to come.

Given the negative MGI Index scores, the high percentage of revenues derived from a handful of customers in the financial services industry, and the large amount of lower-margin services revenues, 2008 looks to be a very challenging year for Chordiant Software.

Note: This is an excerpt from an MGI Research Note published on May 13th, 2008

Enterprise Software – Thoughts on Q1; Will Increasing Pipelines Offset Lower Close Rates?

May 14th, 2008

With the Q1 earnings reporting season rapidly coming to an end, the outlook for the rest of the year is coming into focus for enterprise software firms.

The overall tenor of software company earnings was uninspiring.  While there weren’t any huge negative surprises, the positive surprises were few and far between. None of that should be new news given the growing evidence of a recession in the US economy, the volatility in capital markets and the trauma in financial services and retail. Results for the largest software companies (Microsoft, Oracle, and SAP) were modestly disappointing to investors even though our own preliminary analysis of MGI Index (MGI-X) efficiency scores indicates that many companies have at the very least maintained their business model efficiency.   Among the many smaller and mid-sized companies there is nothing to contradict the sense that business momentum is slowing.  In our view, the remainder of 2008 will likely be tougher than management is publicly admitting – and we re-iterate our view that in inflation adjusted terms, the overall IT spending could be flat to negative in 2008.

Oracle Q3 2008 Post-Mortem

UPDATED 26 March 2008

Overall Q3 results for Oracle (MGI: 2,210) have been viewed as somewhat disappointing. Given the substantial number of acquisitions the company has done over the past several years, not to mention Oracle’s broad international exposure, many investors have come to think the company is fully insulated from the risks of an economic slowdown. Obviously this was a flawed assumption.

We believe looking at Oracle’s MGI Index performance helps put the results into better perspective. As we have written on previous occasions Oracle has one of the highest MGI X index scores for applications software vendors (“ASVs”). Oracle’s score currently stands at 2,210 as of the February quarter, and Oracle’s rank was #2 out of the 65 ASVs we track. While Oracle has an excellent score, the Change Vector (which we believe performs as something of an intermediate leading indicator of future results) was modestly negative in the August and November quarters (see chart below). The February quarter, although disappointing to investors, did show a return to a positive Change Vector reading which we believe bodes well for the May quarter performance.

Given that Oracle was closing the quarter during a period of extraordinary volatility in the financial markets, coupled with an extremely challenging year-ago comparison, we would not read too much into the numbers relative to where Q4 results will be. Likewise, our checks during the quarter suggested that there could be some delays in closing the business, particularly in key verticals like retail and financial services. The most pronounced area of weakness in the quarter was the modest applications’ license growth. This should not be terribly surprising given the extraordinary year-earlier growth as well as the fact that applications deals tend to be bigger and carry more associated expenses of deployment. We had also heard that Oracle had taken steps to incrementally tighten spending on travel and discretionary expenses.

We view the strong earnings growth that was in large part driven by continued significant improvements in operating profitability as evidence of both the leverage of Oracle’s increasing scale as well as the effectiveness of the company’s internal reporting systems. Perhaps as important, management’s comments regarding the strong sequential growth in its pipeline (not quantified) indicates the future remains bright. Management on balance is quite confident and it appears to us that Q4 could very well upside estimates.

[Due to a typographical error, this post has the updated and correct MGI X score for Oracle - 2,210.]

Oracle Acquires BEA Systems – Realism Prevails

January 16^th, 2008

As MGI Research predicted in research notes on October 12^th 2007 and October 26^th 2007, realism prevailed as Oracle today announced a friendly acquisition of BEA Systems, Inc. for $19.375 per share.

We re-iterate that we see this transaction as 12-month accretive to Oracle’s earnings as numerous opportunities for economic rationalization and synergistic revenue generation are available to Oracle and BEA. Both companies are headquartered in Silicon Valley and both have numerous offices and sales forces in overlapping geographies. Oracle’s recent MGI Index scores confirm their execution capability as an efficient acquirer and integrator of enterprise software businesses. We expect Oracle to leverage the complementary sales opportunities that will be driven by the troika of business applications, database servers and now also applications servers. At the same time, the concern we expressed about the prospects for Oracle’s Fusion initiative have been reinforced by this acquisition.

Doubtless, the current turbulent equity market environment for tech stocks played a key role in accelerating a successful transaction. Carl Icahn’s advocacy for a pragmatic exit, together with BEA’s board realization that in the prevailing uncertain economic and market conditions, a combination with Oracle for cash is a smart business decision, were the other key factors in driving this deal. For BEA, the risk of staying independent has begun to outweigh the opportunity that a standalone company can harvest. As we mentioned in our analysis in October of 2007, Oracle did come back to the table with a price that was incrementally better than the initial $17 per share offer, yet below the $21/share “Maginot Line” established by BEA. Realism prevailed in this instance. In spite of a tightening credit, we expect to see a pick up in tech merger activity as cash-laden industry players step in to buy undermanaged, low MGI-Index companies that happen to have premiere products in their markets.

Callidus Software: A Harbinger of an Industry Trend?

Excerpt of MGI Research Note from December 2007

On November 27th, 2007 Callidus Software (MGI-X: 387; NASDAQ: CALD) announced a re-structuring that included a cost reduction plan, the appointment of a new head of sales, and a $10 million share repurchase program.  An event of this type for a company with modest visibility like Callidus would typically not invite a lot of commentary. Yet, if one was to take a closer look at the applications software sector, a question would naturally arise: Why is Callidus the only company that has recently announced plans to improve efficiency and profitability? Why aren't more software companies taking concrete steps to reinforce their business models? This is not to pick on Callidus, €“ at least the new CEO - Leslie Stretch is taking steps in the right direction.

Oracle: No Stretch Marks

December 18^th 2007

Oracle (NASDAQ:ORCL, MGI-X 1885) will report November Q2 earnings on Wednesday, December 19^th. In our discussions with various industry contacts, we see no reason not to expect Oracle to post another powerful quarter. The distinct impression one gets from evaluating the field data is that Oracle has not had to stretch very hard to make the numbers this quarter. 

We believe that in spite of the growing concerns over the broader US economy and the impact of the subprime meltdown on the financial services sector, Oracle’s business continues to be very much on track. The breadth of the company business mix across numerous verticals is at this point working to Oracle’s advantage as it buffers the company, for now, against sector specific negative economic trends. While Oracle will feel the negative economic impact in financial services and retail, the company retains a strong market position in telecommunications, energy, and health care, among others.

On the cautionary side, Oracle August quarter MGI Index results, - although seasonally  lower, were also below previous results with MGI-X at 1885 vs. MGI-X of 1976 for the May 2007 quarter and MGI-CV (MGI Change Vector) a negative reading of -44% vs. +49% for May 2007 period.

The broader scenario for Oracle remains largely favorable. Overcoming the initial investor and customer skepticism over its market consolidation strategy, Oracle has marched through its latest series of acquisitions while improving or at least maintaining its operating efficiency and keeping most of the customers. Maintenance renewal rates remain extremely high and while there are rumblings that Oracle’s pricing is expensive, users recognize that staying the course is considerably less expensive than ripping everything out and starting over.

We believe that Oracle continues to do an increasing number of large and very large transactions.  In particular we heard of one deal with a major computer hardware company that approached nine figures. We have not had any inputs regarding international business, but the general weakness of the dollar and the company's broad exposure overseas is a plus for Oracle. More importantly, as already noted earlier, we did not get the sense that there was any notable pressure to close business at the end of the quarter.

The intense competition between Oracle and SAP in the applications software space will continue to resemble a trench war of attrition, and like in WWI, the battle lines will move in both directions as neither company has a clear market advantage yet.

As for the financial services vertical, while there has been a significant changing of the guard at the CEO level, and a growing number of headcount reductions in the main lines of business, to date there has yet to be a visible factual retrenchment with respect to IT investment. The real test is whether there are going to be meaningful cutbacks in IT spending initiatives post Q4 results. 

Are SaaS (Software-as-a-Service) companies vulnerable in a recession?

December 4^th 2007

MGI Research: Are SaaS (Software-as-a-Service) vendors vulnerable in a recession?

Whether a real recession hits the US and spreads to the global economy or the US economy simply slows down in 2008, all software companies - enterprise-license oriented and software-as-a-service (SaaS) on-demand vendors alike will see a meaningful impact in terms of license revenue growth and maintenance renewals.

SaaS on-demand companies' revenue models are typically based on a number of user seats, so in an expanding economy with growth in hiring, SaaS companies are able to grow within their installed base and capture revenues as their clients expand with the economy. In a declining economy, SaaS companies may take a triple hit as they will see their initial transaction sizes trimmed, upsell opportunities reduced or eliminated, and then there is a possibility that users will aim to reduce the number of subscribed seats.

In practice, it may be difficult for users to instantly dial down the number of subscribed seats, as most contracts are for 12-24 month intervals and there is the pesky issue of SaaS vendors holding the user data making migrations painful. History suggests that if the downturn/recession lasts longer than nine months, we will likely witness a meaningful negative impact on SaaS companies. This is not to say that vendors oriented towards traditional enterprise licensing models will do much better in a recession, but just to point out that SaaS vendors are far from immune to an economic decline.

When it comes to software company performance in a recession, the results will stem from management experience and economic efficiency of the business model. Some of the early SaaS companies were “christened by fire” in the technology meltdown of 2000-2002. The few of these early SaaS adopters that are still run by the original management team are likely to do well if the economy takes a dip. On the other hand, the bulk of the pure-play SaaS vendors were funded between 2004 and 2007, and their management teams will have a steep learning curve when it comes to adjusting their business model to deal effectively with an economic downturn. This is in part due to pure psychological conditioning as industry press and many analysts and investors have already designated the SaaS business model as “superior”.

In reality, “execution is everything” – regardless of the business model. And so far, the economic efficiency of SaaS companies has clearly lagged behind the rest of the applications software industry. In a recent benchmark of applications software companies, the business model efficiency (as measured by the MGI Index benchmark score - the MGI-X) of SaaS application providers has trailed behind the traditional enterprise software licensing oriented suppliers and the sector averages. For example, Salesforce.com (MGI: 1334; NYSE: CRM) placed only 11th out of 65 applications software vendors benchmarked in the study - behind "traditional" enterprise license & delivery model vendors such as Oracle (MGI: 1976; Nasdaq: ORCL), Microsoft (MGI: 1773; Nasdaq: MSFT) and Amdocs (MGI: 1461: NYSE: DOX). Less well known, but a much better example of a well-managed software company with a SaaS/On-demand model is Vocus (MGI: 1878; Nasdaq: VOCS). Of the sixty five application software vendors we benchmarked, only four out of thirteen pure-play SaaS vendors rank above the sector median.

Some of the reasons why SaaS vendors are not as efficient as their "traditional model" competitors have to do with how revenue is booked on a deferred basis, but in part the inefficiency stems from heavier support and infrastructure burdens that many SaaS vendors have been privately complaining about. In an enterprise model, the user provides the first level of support, but in the SaaS model, most - if not all - support is the domain of the SaaS vendor. SaaS vendors have to run an operations center that hosts the system (or manage a third-party hosting provider). In discussions we have held with some SaaS CEOs, many have expressed a desire for a hybrid business model, a notion that is often at loggerheads with what they are being told by their VCs.

Bottom Line: In the event of an economic downturn, SaaS vendors will be sharing the pain with their enterprise model brethren. With the exception of one SaaS company, MGI Index benchmarks for most SaaS application providers reveal mediocre efficiency scores that are well behind the overall economics of the applications software sector.

i2 Technologies - Trapped in No Man's Land

30 November 2007

The one-time darling of supply chain management (“SCM”) software, i2 Technologies (MGI: 981, NASDAQ:ITWO) announced on Nov. 1, 2007 its Q3CY2007 financial results and the formation of a “strategic review committee”. The company also disclosed that JPMorgan has been retained since early this year to assist with a “strategic review” of the business. We believe i2 could be an attractive and, under certain conditions, an accretive acquisition target for companies such as Infor or JDA Software. Alternatively, the company could survive as an independent player and command a higher valuation assuming it implements a major restructuring plan. At present, the company is caught in no man’s land – appearing to be too expensive and a poor fit for most buyers, and lacking a coherent management plan to drive the business as a stand-alone entity. [This post is an excerpt from an MGI Research Note published Nov. 19, 2007.]

Bottomline -- i2 has come a long way, and has plenty of room for further progress. In its current state, the company is stuck in neutral – unattractive to most buyers in the market, and seemingly unwilling to sell at the current or a (future) lower valuation. Without an aggressive management team driving the business forward, the company, customers, and employees will likely drift. Revenues will continue to slide, morale will suffer, and customers will tighten their purse strings until the future becomes more certain.

Introduction -- Current State of the Business
I2 faces multiple challenges: Shareholders are agitating for a sale, a CEO search is underway, and results so far this year are lackluster. At the same time, the company’s MGI benchmark scores have been improving – an early indicator that the business has at least stabilized a bit, if not progressing modestly.

Former CEO Mike McGrath departed semi-abruptly in August, with the turnaround effort unfinished. He made strides in paring expenses and focusing the business along a handful of vertical industries (consumer goods, automotive, high technology and retail). The company today bears the imprint of his tenure, and herein lays the challenge for i2.

Oracle's Bid for BEA: A Mexican Standoff?

October 26, 2007

The events in the potential Oracle acquisition of BEA Systems seem to be following a B-movie script with tough talking characters angling to resolve their differences publicly while not losing face. It isn't a Mexican standoff just yet – the third opponent – another bidder or a white knight, is still missing and making it hard for BEA. Carl Icahn - a likely participant in this shoot-out - is sitting this one out for now.

In the course of the last week, Oracle put a Sunday, October 28^th deadline on their offer to buy BEA. In response, the BEA board put a price tag on the company - $21 per share a 23.52% or almost $1.5 billion premium to Oracle’s $17/share offer. Oracle promptly rejected BEA’s ASK as “an impossibly high price for Oracle or any other potential acquirer” - So far, so good. Not worthy of an Oscar but it has potential to get more interesting.

Short of BEA caving in to the $17/share offer, our view is that Oracle will probably let its offer lapse on Sunday and allow BEA stock price to settle down. We do not expect BEA shares to drop like a rock – no one seriously believes Oracle will just walk away to look at other options. There are other companies in middleware (Tibco, IONA, etc.) but none are on a scale that would be meaningful to Oracle. More likely, Oracle will initiate a tender at or about its original price some time after the $17/share offer expires at sundown on Sunday. A tender may come on Monday or even a week or two later. It would apply pressure on BEA and continue to fuel uncertainty around BEA's status - playing right into Oracle’s strategy.  BEA customers are not going anywhere, but new deals and contract renewals would be impacted by delays, additional terms and conditions, and that would impact BEA results on a go-forward basis. A proxy fight between Oracle and the BEA board is possible, could get nasty and may turn into a real Mexican standoff between BEA, Oracle and Carl Icahn. There is still a possibility that Oracle and BEA may in the mid-term strike a deal somewhere in the range between $17 and $21 per share but that would require a cameo appearance from Larry Ellison.

Bottom Line: We re-iterate our view (see our note from Oct 12^th, 2007 http://mgiresearch.typepad.com/tech_industry_analysis/2007/10/perfect-timing-.html ) that Oracle is likely to prevail in its bid for BEA Systems.

Perfect Timing - Oracle Bids for BEA

Oracle management picked a near perfect time to publicly announce its $6.68B bid for BEA Systems.
1. BEA is under pressure from Carl Icahn to sell the company
2. Few possibilities exist for a competing bid
3. SAP - a likely competitor for BEA - is distracted by its recent Business Objects acquisition
4. Others such as IBM, SUN and HP are unlikely to compete for BEA
5. Private equity firms are unlikely to pay the high EBITDA premium
6. BEA’s operating results continue to be uneven

The proposed transaction is hardly surprising for it has been long speculated. BEA has repeatedly declined interest in becoming a part of larger company in general and of ORCL in particular. BEA CEO and co-Founder Alfred Chuang has joked once that he “did not want to be cleaning barnacles off Larry Ellison's boat”.

While one would expect the BEA board to ask Oracle for more, Oracle’s proposed $6.68B price for BEA – at $17/share is a 25% premium to BEA’s previous closing price and values the business relatively fully. We expect Oracle to be rather firm on the valuation and only move the price up slightly, if at all. BEA has been struggling in many aspects of its business - operational, competitive and regulatory matters – so we strongly suspect that many shareholders will welcome Oracle’s bid.

Icahn’s increased ownership and advocacy for a deal creates pressure on the BEA board to respond to Oracle’s bid. However should the board and key shareholders push for a much higher price, this deal could become a long winter war akin to the Peoplesoft saga. If that happens, BEA’s board and shareholders may find themselves feeling very lonely as their sales pipeline shrivels. The only long-term winners would be Oracle and in part IBM which competes head-on with BEA.

Oracle President Charles Phillips declared ORCL’s desire for a friendly transaction. Interestingly enough, Larry Ellison is so far keeping a low profile in this deal. Phillips also underscored that ORCL’s previous acquisitions prove that ORCL lives up to its commitments regarding support of the acquired company’s products. Here we have to note that Oracle’s MGI Index (a metric of corporate efficiency or corporate body mass index) has been steadily improving over the last 3 years, despite having done a number of large and smaller acquisitions.