Tech Industry Analysis

SugarCRM CEO Departs - Open Source SaaS Not Immune to Recession

May 11, 2009  (c) 2009 MGI RESEARCH, LLC

On May 7th 2009, SugarCRM (MGI-X:NR; pvt.), a highly visible open source CRM software company announced that its CEO John Roberts was leaving the business effective immediately. Board member and founder of VA Linux, Larry Augustin is assuming the role of CEO.  It is unclear if a search for a permanent replacement CEO is underway.  As MGI Research discussed in a note published on January 7, 2009, titled, "2009 Outlook for Open Source: Do or Die Time", the halcyon days of easy capital and low near-term profitability expectations for VC-backed open source companies are likely to come to an end this year.  MGI Research estimates that SugarCRM's revenues are close to the amount of total capital raised, i.e., $45 million, and it's probable that the company is encountering the same headwinds as others in the SaaS/enterprise software market - lower renewal rates, downward pressure on pricing, and drop in the deferred to realized revenue ratio, a key indicator of soft demand.  

The competitive impact of this specific event is minimal - SugarCRM has struggled to compete effectively against Netsuite, Oracle, RightNow, Salesforce.com and SAP.  But from an industry perspective, this event highlights the challenges even well capitalized open source software (OSS) vendors like SugarCRM face in building durable businesses, and how OSS companies by and large have failed to be universally disruptive.  The success of OSS (and indeed it has been successful in a few niche markts) should be measured company by company and market by market.  Ultimately, management execution and not the degree of open source conformance will determine success or failure in specific OSS companies.

Two core business assumptions regarding the OSS business will now come into focus and face a reality test:  1) that the recession will benefit open source companies, and 2) downloads are more important than bottomline profits.  CEOs of OSS companies should take note of this event - it could be the first of many replacements this year.  Investors should note that the success of Linux, and namely RedHat (MGI-X:840; NYSE:RHT) is not transitive - there are plenty of lackluster OSS results, and the OSS business model has not proven to be more efficient or even as profitable, as evidenced by RHT's and Novell's mediocre MGI-X scores.

SAP-Teradata Announcement Reflects Pressure on SAP vs. Oracle

April 28, 2009  (c) 2009 MGI RESEARCH, LLC

The recent SAP-Teradata announcement that SAP's BW (Business Warehouse) will be ported to Teradata (NYSE: TDC; MGI: NR) comes only one week after Oracle's public bid to acquire Sun Microsystems. The press release was light on details - e.g., shipment dates, channel issues, scant mention on either company's website, and in the short term was of greater benefit to Teradata, which extended its ability to re-sell the SAP/Business Objects BI products.  Given the tactical nature of the announcement, and the practical reality that it will be at least 6-9 months before customer beta testing of the SAP/Teradata combo, MGI Research sees minimal short term benefit of the announcement to SAP, and minor impact to IBM or Oracle.  In the bigger picture, the event highlights the tectonic shift that will occur if Oracle (Nasdaq: ORCL; MGI-X:2,314) closes the Sun (Nasdaq: JAVA; MGI-X:656) transaction. We re-iterate our view that HPQ or IBM are likely bidders for SAP within the next 24-36 months.   

Absent from the announcement was any reference to a deal around demand forecasting - a known weakness for SAP, particularly in retail and in spite of its Khimetrics acquisition, and a relative strength for Teradata.  The lack of any news means the expected Teradata/SAS (private; MGI-X: NR) partnership may still go forward. 

The deal underscores the emerging reality that Oracle will effectively distance itself from SAP, and now compete head to head with HP (NYSE: HPQ; MGI-X:1,822) and IBM (NYSE:IBM; MGI-X:1,769) if it finalizes the acquisition of Sun.  HP's relationship with Oracle will cool, and the HP/Oracle Teradata-killer product ("HP/Oracle Database Machine") is likely relegated to the junk heap of joint development projects. Oracle's strong MGI scores through 30+ acquisitions large and small points to its ability to innovate through acquisitive growth combined with operational efficiency.

For a company that historically possessed tremendous strategic vision and world-class execution, SAP increasingly looks tactical and lacking a coherent strategy.  SAP abandoned Cognos as the two companies were working joint go-to-market efforts when SAP launched its bid for Business Objects, pushing Cognos into the hands of IBM.  Global 2000 CIOs are eager to reduce their supplier base, and without a broader product set or a clear edge in innovation, SAP is at risk of losing its seat at the table of industry leaders inside the enterprise.

MGI Research believes IBM is an innocent bystander in this announcement - neither benefiting significantly from it, nor feeling any pain from SAP/Teradata announcement-ware.

Bottomline: The SAP-Teradata announcement does little to alter the rapidly changing industry dynamics in which Oracle is emerging stronger than ever, with impressive MGI-X scores, and SAP is playing a reactionary game in which it is unclear if it can or will compete via acquisition or internal development.  If Oracle is successful in integrating Sun (and it maintains ownership of the hardware assets), IBM and HP will be under pressure to make a run for SAP - a logical combination for both companies. Teradata may be a tuck-in acquisition for a larger player, or more likely, simply an industry orphan with a robust installed base and maintenance revenues.

OSBC Open Source Conference Highlights

April 1, 2009 (c) 2009 MGI RESEARCH, LLC

We recently attended InfoWorld’s 6^th annual OSBC event in San Francisco – where the open source community convenes in a business setting.  The major theme was the attraction of open source products' low cost during a period of IT budget contractions.  Our major interest was to measure the relative success of open source companies in reaching the enterprise market and their ability to threaten the established vendors.  The short conclusion is that open source projects continue to make inroads into Silicon Valley development efforts, but as a business, open source companies have yet to prove their long-term viability with a business model capable of delivering attractive returns to investors. 

Conference Highlights

Open Source = Cheaper Alternative to Established Vendor Offerings

A key theme from most open source companies was “our product is the low-cost alternative to the expensive ‘proprietary’ solution from major vendor X”.  Interestingly, only Ingres was able to produce numbers remotely close to a true TCO analysis comparing the cost of adopting Ingres versus the competition.  Most open source vendors have not made the marketing transition from targeting their developer communities to delivering durable marketing messages to the enterprise buyer. 

Show Me The Money!

Linux has clearly established itself in the datacenter, and is increasingly gaining traction on a certain percentage of netbook shipments.  Multiple data points, examples and anecdotes were provided, and this is corroborated by what we are hearing elsewhere in the industry.  Nonetheless, as a venture capitalist heavily invested in open source highlighted during a keynote panel, even RedHat, which is viewed as the poster child of open source success with its Linux products, has only managed to win less than 5% market share.  In the database sector, we estimate mySQL’s revenues to be in the $80 million range, and when combined with the revenues of Ingres (FY’08 revs of $68 million, profitable), they are insignificant to a $15 billion+ database market.  Our takeaway from this is that open source companies are impacting the margins of established companies, but have not gained sufficient credibility within the enterprise to cause long-term damage to the core business model of companies like Microsoft, Oracle, SAP, Salesforce.com, and others. As previous MGI Research has detailed (see Research Note - "2009 Outlook for Open Source - Do or Die Time?"), the total revenues of companies like Alfresco, Jaspersoft, SugarCRM, Talend, and others are not nearly as impressive as the venture dollars these companies have attracted, and most of the leading venture-backed open source companies are on their Series C, D, or even E rounds of capital. Surely the pressure is on them to start delivering profits in advance of a desired investor exit.

Will Recession Push Corporate Buyers to Consider Open Source Products?

It’s unclear if the pressure on IT budgets will drive CIOs to replace installed products with open source alternatives.  One of the major hurdles to enterprise adoption of open source was the lack of internal skills necessary to implement and manage an open source product.  Headcount is typically the largest cost line-item in an IT budget, and an obvious target for savings.  It’s unlikely that CIOs can manage a headcount reduction (and the loss of skills), and then expect to adopt an open source product that demands a new set of skills the remaining IT department employees are unlikely to have. 

Database Market Update

In the database world, Ingres may do better than mySQL, given its legacy as a proven enterprise-class product and the $30 million of R&D investment pumped into improving the product over the last three years.  In addition, even Sun folks mentioned the impact of losing mySQL founder Martin Mickos, who leaves Sun at the end of this week.  Mickos was treated like a rock star at this event, and there are rumors that he is planning on buying mySQL back from IBM, in the event that IBM is able to acquire Sun.  It’s clear that mySQL market momentum suffered just after it was bought by Sun, and Oracle’s strategic move of buying InnoDB, the leading transaction storage engine of mySQL, also slowed the growth of mySQL.  Microsoft appears to be a beneficiary of the cost pressures on database spending, as SQLServer is perceived as a lower-cost, low risk alternative to Oracle and IBM.  The core Sybase database business appears to be under pressure, as mySQL and Ingres both make inroads into the installed base that is growing tired of paying maintenance and perceives Sybase to be an absentee owner of the product.

Overall Conference Mood

Not surprisingly, conference attendance was off – organizers claimed 600 registrations, but the kick-off keynote session had about 200 in a ballroom that was reduced in size by one-third.  Our non-empirical estimate is 60-70% of attendees were vendors, 20-30% were industry service providers (lawyers, VCs, press), and 10-20% were user organizations.  A noticeable difference from other recent events was the energy emanating from the open source community.  It was ever so faintly reminiscent of the buzz of years past in the tech industry.

Conference Notes: Pacific Crest Emerging Technologies Summit

February 27th, 2009

(c) 2009 MGI RESEARCH, LLC

We attended a three day tech conference sponsored by Pacific Crest Securities, a technology focused investment bank.  Day 1 was dedicated to Data Center and Cloud computing, Day 2 was focused on On-demand/SaaS software, and Day 3 targeted Clean Tech. The event was well-organized, well-attended, and offered a bevy of market and company insights. Unsurprisingly, the overall tone of conference presentations was muted, downbeat and cautious. The following themes dominated:

Timing is Uncertain

Most companies expressed a great deal of uncertainty about the timing of the current recession. There is no clear sense that the economy will recover during the second half of 2009 and several CEOs have expressed a great deal of anxiety over the length of the current recession.

Unclear Economic Drivers

No product or sector jumped out as a “must-have” product or technology in 2009.  IT buyers are under no pressure to buy anything – or even pay their maintenance bills – in 2009. 

Stimulus Money Out of the Picture

Largely absent in the prepared remarks and the Q&A of nearly every presentation of Day 1 and Day 2 was mention of how the government stimulus money would impact a given sector or company.  Even on Day 3, clean tech companies provided minimal information on the topic.

Demand Visibility is Zero

No surprise, nearly every CEO/CFO lamented the lack of pipeline visibility.  Of deals that slipped out of Q4, 15-25% may be completely lost, with another 25-30% that may or may not happen in the first half of 2009.

Software Maintenance Revenue Risks

There is now a more clear sense among market participants that maintenance revenues and SaaS renewals are in play. Even companies with considerable maintenance revenue streams (e.g., Symantec, MGI-X: 1,361 NASDAQ: SYMC) lacked conviction in their presentations.  As MGI Research predicted earlier in 2008 (Software Maintenance Revenue – Sacred Cow or Hamburger Meat?), maintenance revenues are now under pressure thus highlighting the need for companies to optimize their execution and business models for survival in 2009.

Current Economy Testing Management Teams

The current investor psychology bias is clearly in favor of those management teams with defensive plans and that have the leverage to adjust their business models and generate cash. In our view, companies with MGI Index scores below 1,000 are going to be struggling and those with scores below 500 are at risk.

Lack of ROI Proof is Hurting Tech

Many CEOs mentioned the 9-16 month maximum timeline for Return on Investment (ROI) that customers are now demanding. With a few exceptions, most conference presenters did a below average job at articulating their core value and ROI either through direct savings or through new revenue generation. Despite a common refrain that “customers are taking longer to buy, and demanding shorter pay-back periods, very few companies produced or even mentioned a credible ROI or TCO model or a case study.  

VDI is DOA, Long Live the Cloud

While VMWare core server-based products continue to win market share, VMware’s efforts to bring virtualization to the desktop, via its VDI (virtual desktop infrastructure) initiative appears to be falling short of expectations in the marketplace.  In defense of VMW, Citrix  was surprisingly quiet about its Xen success at the desktop, and Desktone, a DaaS (desktop as a service) company was equally unexciting.  Even though VMWare may not be winning at desktop virtualization but no one else is either. It is not clear if the VDI market will reach maturity and if it is worth dominating. At the same time, in many sessions and panels, presenters sang praises to various forms of public and private cloud computing. There seems to be a consensus emerging on some sort of a federated, public/private cloud computing model and corresponding desktop and server tool set needed to support access and security for this paradigm.

Deluge of M&A in 2H09?

A well-run panel on SaaS/On-demand sector M&A was standing room only.  Corporate development representatives from Microsoft, Netsuite and Concur sat on a panel, along with Ed Booth, the former CEO of IDeaS (acquired by SAS).  Tellingly, two-thirds of the people in the room were VCs, and one-third of the panel attendees were executives.  The panelists agreed that private company valuations have yet to re-set as deeply as public company valuations.  A panelist from Microsoft has re-iterated his company’s view that there should not be a premium to valuation of SaaS companies even if one takes deferred revenues into account and correctly pointed out that enterprise software companies have plenty of deferred revenue items themselves. While it may be self-serving for Microsoft to state that, it is also factual as many mature enterprise software firms boast ratios of deferred to reported revenues that are similar to those from established SaaS companies like Salesforce.com.  Conversations with various conference participants and attendees furthers our view that in spite of challenges, the second half of 2009 and early 2010 will see a deluge of M&A as many private companies seek the shelter of larger, more profitable public and private companies or merge with equals in the hopes of fusing a larger, more stable business platform.

Clean Tech - Dead Money for 2009

Day 3 of the conference was devoted to clean tech companies, and over 30 companies presented, from Applied Materials  to Xjet Solar.  The recession is clearly having a major impact on clean tech, as depressed energy prices are altering the economics of many clean tech projects, frozen debt markets have locked up major infrastructure projects (e.g., large scale solar and wind projects that require debt financing), and green initiatives have been slammed into the back seat as survival con-cerns top the corporate agenda.  Given the confluence of dynamics, most public clean tech companies appear to be stuck in neutral, at best, and at risk if the recession worsens or extends far into 2010.

Tech Industry Layoffs Quietly Begin

© 2009 MGI RESEARCH, LLC

January 9, 2009

Recent checks of our networks indicate that the belt-tightening at technology vendors has begun.  As we communicated to clients in Q4, the headcount reductions being discussed among tech sector CFOs was in the 10-20% range.  Marketing budgets appear to be under the greatest pressure, but even sales forces are being culled. Some of the cuts appear to be pre-emptive, while others strike us as indications that management teams are planning public announcements of 2009 cost containment measures during their Q4 earnings calls.  We look forward to updating the MGI benchmarks of companies as they report their Q4 numbers.

Industry Analyst Firms - An Indication of Marketing Cutbacks

Most of the industry analyst firms like Gartner (MGI: not rated; NYSE: IT), Forrester (MGI: not rated; Nasdaq: FORR), and AMR Research (private) have already begun cutting staff, or have active plans to trim headcount. As their revenue mix has become more dependent upon vendors (and less user-oriented), Gartner, Forrester and AMR are all at risk due to a) vendors slashing their marketing spend, b) a significant decline in conference sponsorship and attendance, and c) the impending consolidation of tech vendors.  User (i.e., Fortune 500 and SMB companies) appetite for IT industry information from the likes of Gartner, et al is also diminished.  As IT budgets dry up, there is less need for supporting documentation of new hardware and software purchases.  As an example, the financial services sales team led Gartner's sales force production in 2007.  Given the turmoil on Wall Street, it's hard to see this repeated in their current results.  Further consolidation among the analyst firms is likely, although the much-discussed Forrester acquisition of AMR Research may fail to materialize due to falling revenues and an inability to bridge the gap on valuation. On the bright side, with highly predictable revenue streams the analyst firms are able to easily adjust expenses to match expected revenue bookings.

Technology Giants Looking to Cut -- Saas, Midsize Firms Slower to Act

Larger companies, such as Oracle (MGI:2,023; Nasdaq: ORCL) are constantly managing their expenses, and we expect Oracle to continue managing headcount through its fiscal year (May 31).  In contrast to Oracle, SAP (MGI:1,160; NYSE: SAP) has been increasing its global headcount, which is reflected by its lower MGI scores.  Ironically, the vendors who could benefit from more disciplined cost controls are least likely to take action.  For example the high majority of application software vendors do not have margins (35%++) anywhere close to Oracle's, and over 50 of the ASV's that MGI covers have MGI benchmark scores below 1,000 - an indicator of inefficient operations.  SaaS vendors will need to prove they can generate more revenue per dollar of sales and marketing expense, as their high sales and marketing budgets will be forced to shrink. SaaS vendors typically have less margin to cut in their R&D budgets, relative to their on-premise competition.  We expect most of these companies to announce cuts in the 3-7% range, if at all. Investors and users concerned about their vendors' viability should be pushing for cuts in the 15%+ range.  

Bottomline:  News will begin to leak of technology vendors making headcount reductions.  The industry publishing firms like Gartner, Forrester, et al are planning or actively executing employee layoffs.  As earning season approaches, we expect more announcements of cost control efforts.  Those midsize companies not making significant cuts will likely face further cost challenges (and earnings disappointments) later in the year.

Top Ten Tech Surprises in 2009

© 2009 MGI RESEARCH, LLC

January 9, 2009

In the tradition of Byron Wien’s Top Ten Surprises, here is the MGI Research Top Ten Tech Surprises for 2009.  To make our list, the surprise must have a probability of 10% or less of occurring – a “low probability, high consequence” event. If conventional wisdom is thinking about it, then by definition we strike it from consideration. We look for seismic events that would rock the entire IT industry, forcing most, if not all participants to re-think their strategic planning assumptions. 

Huge Recovery in Tech

Buoyed by a massive injection of government spending in healthcare, infrastructure, and energy, and a surprise second half rebound in the financial services sector, the IT industry exits 2009 in remarkably good shape.  Despite dire analyst projections after miserable Q4 2008 earnings, tech sector results exceeds expectations and ’09 earnings grow at double-digit rates after significant cost reduction efforts taken in Q1 followed by strong second half sales.  Companies delivering upside surprises include Oracle (which derives additional growth from its midyear acquisition of Cerner), IBM, Autodesk, Intel, and Applied Materials, among others.

Intel Goes Private

CEO Paul Otellini organizes a management-led buyout of the chip giant after the shares of INTC briefly dip below $10.  Unable to invigorate public market interest in the stock, Otellini joins forces with private equity firms Silver Lake Partners, Francisco Partners, and a club of super high net worth individuals in Silicon Valley and takes the company private.  Two months after the deal closes, Intel announces the Clean Energy and HealthCare divisions – and commits to material amounts of investment in both sectors.

Steve Ballmer is Ousted as CEO of Microsoft

Faced with a corporate bureaucracy that looks more like IBM circa 1990 than Google 2005, Steve Ballmer proves unable to motivate the troops in 2009.  CTO Ray Ozzie proves to be long on vision, but woefully incapable of producing a shipped product in either shrink-wrap or cloud-ready format.  The blame falls on CEO Ballmer who is also held accountable for the missteps surrounding Microsoft Vista.  Corporate IT budgets shrink dramatically, and 15% of Microsoft customers elect to not renew their enterprise license agreements – the first sign of a slow, long-term decline in corporate use of Microsoft products.  Frustrated by board chairman Bill Gates’ meddling in the business, Steve Ballmer accedes to institutional pressure to increase the dividend and transitions out of Microsoft by the end of the year.

Google Experiences Severe Setbacks

Amidst great expectations relative to its competition heading into 2009, Google faces a series of surprising setbacks throughout the year.  CEO Eric Schmidt, considered a shoo-in for national “technology czar” barely gets the job, and then is confronted with an administration consumed with domestic economic issues.  Privacy concerns are splashed across the front pages, and Google, with more than 75% market share in search, bears the brunt of the criticism.  Internally, Google faces employee unrest – original Googlers are rested and vested, and largely calling it in.  Google employees from the past four years are under water on their options, and increasingly disgruntled with the cutbacks in company perks.  Billionaire founders Brin and Page find the scope and size of the management effort to be challenging, particularly without the full-time involvement of CEO Schmidt to shield them from the day-to-day minutiae of operations. 

Amazon’s Kindle Book Reader Becomes Platform Device – Enters the Enterprise

Amazon CEO Jeff Bezos announces an array of new capabilities and services associated with the Amazon Kindle.  Leveraging the existing strengths of Amazon’s one-click payment system, its user friendly web site, and the open APIs of the Kindle device, Amazon transforms the Kindle into a multi-use platform for music, content, and books.  An industrial “hardened” version of the Kindle is launched mid-year, and developers flock to the open source platform.  Combined with the surge in usage of Amazon’s Elastic Compute Cloud (EC2), Wall Street re-evaluates Amazon in light of its growing technology driven products and services.

Sun Fails to Find a Buyer

Stymied by its private equity owners KKR, Sun Microsystems fails to find a buyer in 2009.  A sale to IBM falls through at the last minute, and then Google fails in an attempt to buy Java and select open-source assets (MySQL among others) and place them into a trust associated with the Mozilla Foundation in an effort to keep them out of the hands of Microsoft.  Revenues fall below $12 billion, the company endures three rounds of layoffs, and CEO Schwartz is forced to cut the R&D budget by thirty percent.  Another reverse split of the stock is contemplated.

Deep Recession Drives Open Source, Linux

A severe decline in the US and European economy places extreme pressure on IT budgets.  IT spending for the year declines 5% compared to 2008, which was re-adjusted lower after disappointing Q4 results of the tech sector.  Open Source software is a surprise benefactor of the recession, as companies and government organizations shift to open source solutions in droves.  After several small, strategic acquisitions, Long-suffering Novell stages an epic comeback as the open source provider of choice across the entire technology stack.  Novell emerges as one of the hottest growth companies in tech.

HP and SAP Announce Merger

In a hastily convened conference call, HP CEO Mark Hurd and SAP CEO Henning Kagermann announce the merger of HP and SAP.  The new company unites two giants and HP hands SAP free reign to push forward its middleware (Netweaver) and SaaS midmarket (BusinessByDesign - BBD) initiatives.  SAP gives HP an enterprise applications and services business that finally crowns HP’s enterprise capabilities.  Mark Hurd remains CEO as SAP’s CEO Kagermann joins the HP board and co-CEO Leo Apotheker is named COO of HP.  The combined SAP-HP entity puts considerable margin pressure on IBM.  

AMD Declares Bankruptcy

After a string of bad to worse quarters and unable to find a buyer, AMD seeks Chapter 11 bankruptcy.  Global chip demand slumps beyond expectations, and Intel gains market share in a fierce price war/race to the bottom with AMD.  AMD is left in dire financial straits – Abu Dhabi-based Mubadala Investment Corp’s injection of $622 million fails to strengthen the rapidly weakening balance sheet of AMD.  The company loses more than two billion dollars in 2009.  Once-rival Motorola posts an equally dismal year, and both AMD and Motorola petition the Obama administration for anti-monopoly relief.  

Apple Buys Research in Motion

In a move completely out of character, the board of directors of Apple announce the acquisition of Research in Motion (RIMM) for just over $30 billion.  After tumbling below $35 per share, RIMM shares had stabilized while revenues remained flat for the first half of the year.  With the deal, Apple gets immediate entrée into the enterprise, while Research in Motion gains access to Apple’s innovative design team and network of retail stores.  An ailing Steve Jobs announces Apple’s intentions of aggressively pursuing corporate buyers. Dell shares fall 10% on the announcement.

Oracle - A Bellwether Prepares to Report

© 2008 MGI RESEARCH, LLC

DECEMBER 16th, 2008

Oracle – A Bellwether prepares to report

We believe there is a sense of trepidation in the air as investors, competitors, and even customers are awaiting Oracle’s announcement of its second quarter (FY2Q09) earnings on Thursday, December 18th.  With broad product and geographic exposure, Oracle (Nasdaq ORCL; MGI-X: 2,023; MGI-CV: -33 %,) is an industry bellwether. Given Oracle’s size, reach and maturity and the fact that Oracle’s Q2 results will include October and November of 2008, Oracle may be the proverbial “canary in the coal mine” for the economic health of the tech industry.  Beyond the FY2009Q2 results, the tone of the commentary from Oracle’s management could provide either a confirmation of the current trend or a re-evaluation of Wall Street earnings estimates for many IT vendors.  Oracle has been a steady performer in recent years, racking up respectable earnings gains, successfully executing acquisitions and consistently posting high MGI-X scores and positive MGI-CV readings. Yet in the August 2008 quarter Oracle’s MGI-CV was -33%, a negative reading indicating a general reduction in business model efficiency. That fact coupled with a number of qualitative factors gives us pause in assessing Oracle's short to mid-term momentum. 

Positives

In our view, Oracle continues to benefit from a number of positive factors, even in the current recessionary environment:

·       In benchmarks of leading applications software vendors conducted by MGI Research, Oracle has consistently ranked among the Top 3 most efficient applications software companies.  Most recently Oracle placed 2nd vs. 74 peers in MGI Research’s July 2008 ASV benchmark.

·       A highly effective sales organization – among the best at executing.

·       A proven track record in managing the bottom line and driving margin improvements.

·       The company is benefiting from a database upgrade cycle (movement to Oracle 11g).

·       Oracle continues to gain from price increases rolled out in Q1.

·       The sales force is getting its arms around the BEA product line.

·       Oracle completed its acquisition of the recognized leader in project management software, Primavera, during the quarter.

·       A relatively low exposure to SMB spending, which is likely to be most impacted by sharp demand changes.

·       Oracle has a substantial recurring revenue stream from maintenance with approximately half of its revenues tied to maintenance – which is highly profitable revenue (likely much more profitable than Oracle actually reports).

Negatives

At the same time, it would be foolish to assume that Oracle can somehow magically remain immune to industry headwinds.

·       During the Dot.com bubble burst, Oracle license revenues dropped over 25%.  While we believe that at present Oracle is not as aggressive in selling deals based on big increases in future capacity, there is every reason to believe that this recession will be as bad as or worse than the 2001-2002 tech nuclear winter.

·       The strengthening of the $USD will impact Oracle European revenue in Q2. This may also weigh on other US-based tech companies.

·       Though emerging markets have been helping in recent past, these markets are being impacted by the recession as well. All four BRIC (Brazil, Russia, India, and China) economies have shown signs of a slow down or outright recession.

·       Oracle has significant exposure to financial services, government, retail, consumer goods companies, among others.

Outlook: Oracle remains one of the best-managed companies in the software industry, with broad and deep distribution channels, as evidenced both by its high operating profitability, high absolute MGI-X score and relative placement within its peer group (e.g,. SAP, Salesforce, IBM, Microsoft).  The pipeline of deals going into Q2 was built on sales and marketing activities over the past 12 months.  While some deals may have slipped in the quarter, Oracle’s FYQ2 only covers the critical months of October and November – and thus has missed the month of December, which by most accounts is looking very bleak indeed.  Unlike competitors that are dependent on a strong October-December Q4 to make the fiscal year, e.g. SAP, Oracle’s Q2 is less vital to Oracle’s fiscal year. Most importantly, Oracle’s MGI-CV (MGI Change Vector) turned negative (-33%) in the August quarter – an indicator that tends to be highly sensitive to performance of large tech companies.  

Bottom Line: Oracle’s earnings call may prove to be very important to the entire software and IT industry. Given the current environment, the company has little reason to provide an overly optimistic outlook and we expect management’s commentary to be muted, at best.  The company has scarce incentive to paint a rosy picture going forward with visibility on close rates being so limited.  While we have no reason to believe Oracle has blown the quarter, we see many reasons why the outlook will be painted grey and we expect the rest of the software sector valuations to suffer as a result.  

Software Maintenance Revenue - Sacred Cow or Hambuger Meat?

(c) 2008 MGI RESEARCH, LLC

The current downturn has given rise to numerous pieces of fundamentally good analysis on software company valuations that use software maintenance payments as a basis for valuing a business. Comments like “this company sells at only 2X or 3X its maintenance revenue stream” have popped up in numerous conversations with tech investors and sell side analysts. In fact, in better times, comments like these would send most investors to the trading desk. Software maintenance are the fees that software users pay to enterprise software providers to keep their products current, get enhancements, bug fixes and obtain all kinds of support. That is the theory. In the real world, the actual maintenance arrangements are typically a lot more complex and involve numerous terms and conditions, price increase clauses and caps, differentiation between renewable and perpetual contracts and many more highly-legalese terms designed in some cases to protect the users and in others to insure that the enterprise software vendors do not go out of business. Part of the reality is also that many software vendors treat maintenance as a right to collect 15-20% of the current list price of their product every year and in advance but in return forget to actually provide many enhancements or quality support, but in good economic times users tend not to bother with this issue too much. Thus, most investors tend to feel that the maintenance payments are a safe bet, - sort of a high-margin economic “sacred cow” in technology. 

Make no mistake, as analysts we are big fans of those fat recurring maintenance payments that users have little choice but to pay especially for software products that benefit from high degree of integration into customer environment and are very difficult to get rid of.

The experience of the 2001-2002 tech downturn has taught us many lessons, but one of the most important ones is that sacred cows like software maintenance can become hamburger meat if users feel enough of a budget pressure. We do feel that a similar scenario may unfold in the current economic cycle, especially if the recession lasts longer than the end of 2009. Thus, a valuation based on a multiple of software maintenance, especially during the times of low or no growth needs to take a more conservative view towards software maintenance renewal rates. We do not feel that we have yet entered an environment in which IT users are aggressively slashing budgets with a chain saw – so far it has mostly been a “freeze for now and use a scalpel later” environment. But again, the longer the recessionary mood, the more likely it is that maintenance payments will be slashed, re-negotiated, cancelled, re-negotiated again and otherwise reduced. Companies with perpetual software licensing models are particularly vulnerable to this risk factor. During 2002 we saw numerous examples of users calling vendor bluff on maintenance and dropping support – which they claim was not worth much anyway. Some of the companies affected by such aggressive user negotiating are no longer with us, e.g. Manugistics.  This can happen again and on a bigger scale, especially as it applies to smaller companies with low values MGI Index (MGI-X). SaaS companies are definitely less vulnerable to this specific risk factor for they tend to charge a monthly per seat fee. But they have their own issue: How do you grow the seat base when the client company is laying off 10% of its workforce. Reduced per seat pricing with advanced payment options covering 2-3 years was in the past often the solution of choice to this dilemma, but given the credit crunch it seems very unlikely as a way forward.

Bottom Line: there are no sacred cows in technology.

Soul of a Survivor - Attributes of Winning Tech Companies in a Recession

Using MGI Scores to Screen for Winners and Losers          October 21, 2008

(c) 2008 MGI RESEARCH, LLC

What are the implications of the recent financial meltdown for the technology sector?  Is the technology sector immune or a safe haven from an economic downturn?   An economic slump will in our view impact all technology vendors; however, we have long advocated that companies with higher MGI Index (MGI-X) scores are better positioned to withstand a slowdown in IT spending. At the same time companies with low MGI-X, low efficiency operating models are likely to be clobbered in the absence of proactive action by management. MGI Research has constructed an analytic framework to help our clients determine which tech companies may fare best, and which may suffer most in the current business environment. The approach presented here combines fundamental MGI-X operating efficiency data with qualitative indicators of a tech company performance such as a tech vendor’s ability to absorb a drop in customer spending. This is Part Two of a Two-part set of notes.

To further define the context of this note, we would re-iterate our expectation that the remainder of 2008 and most of 2009 are likely to provide little if any incremental growth IT expenditures. At the start of 2008 MGI Research forecast IT spending to grow in the range of 2-3%, – a projection that is now gaining widespread adoption. We expect to revise this projection for 2009 in December.

This two-part research note set provides a tool for sorting through the recent  carnage in tech equities - a market subjected to indiscriminant selling. This note attempts to help sort out the valuable nuggets (long term winners) from the worthless rocks (long-term losers). In the Part One Note, we defined “at risk” companies as those likely to lose market share and significantly disappoint their shareholders in terms of margins, revenue and earnings growth.  In this Part Two Note, we define “winners” as companies that maintain and grow their market share, retain profitability and margins, and are the first to take advantage of any upswing in demand or benefit from economic consolidations that are additive to earnings.

Attributes of Winners – The Soul of a Survivor

High and Consistently Improving MGI Scores: Positive MGI CV

Companies with best-in-class MGI scores have historically done well during periods of slow economic growth.  For example, In the Application Software Vendors (ASV) segment, Quality Systems (MGI-X: 2809, Nasdaq: QSII) has not produced an unprofitable quarter since 2000.

Balance Sheet Strength

Companies with strong, unencumbered cash positions - particularly those that are not sitting on Auction Rate Securities (ARS – cash-like instruments that are currently frozen in the credit market squeeze), and free of debt (especially toxic converts that are used in the tech industry) will fare better during a recession. In the current economic cycle we have not yet seen any tech firms to be caught in a cash crunch or a violation of a debt coventant, but there are tech firms that have taken on meaningful amounts of debt in the last eight years.

High Recurring Revenues

Highly recurring maintenance revenues tied to long-term contracts are the hallmark of winners. Although maintenance revenues can decline (often more than a company expects), maintenance revenues are still high-margin, highly predictable revenue streams.  Companies like CA, BMC and Oracle are poster-children for predictable recurring revenues.

Ability to Withstand Margin Pressure

A high MGI-X score indicates that the company is very efficient, and is able to adjust quickly to deteriorating economic condtions while retaining profitability. High MGI companies tend to not only survive recessions but actually expand their footprint by acquiring competitors and customers.

No Major R&D Cycle/Stable, Proven Products

At the beginning of economic downturns, IT buyers favor reliability and stability – innovation and “beta” products get short shrift.  The majority of the product portfolio will be proven, mature products at the late stage of their lifecycle.  Conversely, vendors with revenue expectations contingent on delivering new products/early stage products will find themselves in a world of hurt – missing the top line, and spending heavily on R&D and likely disappointing on the bottomline.

Organizational Stability/Strong Culture of Success

An example of this is MGI Tech Giant Oracle (MGI-X:2023).  After more than 20 acquisitions and several business cycles, Oracle has consistently delivered strong MGI scores.  Companies with internal stability are able to withstand ferocious market winds and external pressures, while the weak are among the first to sink.

Proven Management That’s Still Hungry

Tough times test management’s mettle.  They also test the desire of management to work and create shareholder value.  Management teams that have delivered consistent (and hopefully gradually improving) MGI scores have a better grasp of the levers in their business – and tend to outperform during times of industry turmoil.

Broad Product Offerings That Easily Replace Competitor’s Point Solutions

By choice or by force, IT buyers often use times of tight budgets to pare their supplier list.  This ultimately benefits vendors with a broad portfolio of product offerings, even if buyers initially acquire only a small point solution component of an overall product lineup.  Slow demand typically benefits companies like Cisco, Oracle, and IBM, while punishing the one-trick ponies like Ariba and DemandTec.

Recognized Brand Name & Market Leader

IT buyers tend to be risk-averse. This is doubly so when companies are laying off employees. Companies that are recognized market leaders often (but not always) benefit from buyers unwilling to take risks.  The perceived “safe” choice often beats the competition, even though the safe choice may not be the most technologically advanced. Cisco, Google, Oracle, and IBM, among a couple of others are clearly recognized market leaders.

Finding Quality and Avoiding Risk in a Tech Recession

Using MGI Scores to Screen for Winners and Losers          October 21, 2008

© 2008 MGI RESEARCH, LLC

What are the implications of the recent financial meltdown for the technology sector?  Is the technology sector immune or a safe haven from an economic downturn?   An economic slump will in our view impact all technology vendors; however, we have long advocated that companies with higher MGI Index (MGI-X) scores are better positioned to withstand a slowdown in IT spending. At the same time companies with low MGI-X, low efficiency operating models are likely to be clobbered in the absence of proactive action by management. MGI Research has constructed an analytic framework to help our clients determine which tech companies may fare best, and which may suffer most in the current business environment. The approach presented here combines fundamental MGI-X operating efficiency data with qualitative indicators of a tech company performance such as a tech vendor’s ability to absorb a drop in customer spending. This is Part Two of a Two-part set of notes.

 To further define the context of this note, we would re-iterate our expectation that the remainder of 2008 and most of 2009 are likely to provide little if any incremental growth IT expenditures. At the start of 2008 MGI Research forecast IT spending to grow in the range of 2-3%, – a projection that is now gaining widespread adoption. We expect to revise this projection for 2009 in December.

This two-part research note set provides a tool for sorting through the rubble of a stock market subjected to indiscriminant selling and attempts to help sort the valuable nuggets (long term winners) from the worthless rocks (long-term losers). For purposes of this Part One Note, we define “at risk” companies as those likely to lose market share and significantly disappoint their shareholders in terms of margins, revenue and earnings growth.  In the Part Two Note, we define “winners” as companies that maintain and grow their market share, retain profitability and margins, and are the first to take advantage of any upswing in demand or benefit from economic consolidations that are additive to earnings.

Attributes of At-Risk Tech Companies

Low/Falling/Inconsistent MGI Index Scores; Negative MGI Change Vector Scores

The MGI Index (MGI-X) is a measure of how well the management team drives efficiency in the business.  Low MGI benchmark scores indicate a company that is undermanaged and typically underperforming relative to its peers. The MGI Change Vector (MGI-CV) is an indicator of the operating momentum of the company.  Typically a negative MGI-CV points to potentially poor business performance.

Exposure to Vertical Industries Vulnerable in the Current Recession

Certain verticals are more at-risk than others, and vertical industries experiencing a down-cycle historically have lowered then spend on IT. Financial services, retail, select consumer sectors, transportation, public sector, and housing/construction are all sectors that will likely lower their spending on IT.  Vendors reliant on those sectors will struggle to grow revenues. Companies like Blackboard (MGI-X: 1261; Nasdaq:BBBB) and Advent  (MGI-X:657; Nasdaq: ADVS) have considerable exposure to verticals that are likely to undergo a sharp drop in demand.

Technology-oriented Products Lacking Tangible ROI in 6 Months or Less

One of the lessons of the 2001-2002 IT industry nuclear winter was how important it is for a product/service to deliver rapid ROI and be marketed in business, not technology, terms.  Tech companies scrambled to re-write their marketing messages and focus their product offerings around essential business value that was quick to install and drive customer benefits.  During the past 2-3 years, many sales and marketing departments have lost the discipline of ROI-driven selling. 

Compete in Commodity Markets or Supply to a Commodity Market

Being inefficient in the high margin world of enterprise software is one thing. Inefficiency in a commodity market, or a supplier to a commodity market is another.  Commodity markets like flash memory, PC hardware, mobile handsets, and storage undergo bone-crushing margin compression during recessions.  Down cycles tend to wash out the marginal players.  Dell, Sun Microsystems, and Motorola are among those competing in a commodity market.

Unproven Leadership/Complacent Executives/Mediocre Management

Generals get tested during times of war, not peace.  Management teams and sectors that have not seen major combat are wild cards.  A more predictable indicator of management’s leadership is their efficiency during boom times.  CEO’s who consistently improve their MGI scores during boom times typically out-perform their competitors during periods of economic contraction.  Management that has cashed out recently and is otherwise complacent is also a warning sign of a business at-risk. 

Incomplete Mergers/Unfinished Restructuring Projects

Earthquakes stress the architectural integrity of a building.  Similarly, tough economic times strain an organization.  Companies in the midst of a merger are put to the test in a down market and the integration, or lack thereof, is exposed. Any material weakness in core business processes quickly becomes obvious – and customers and the competition exploit it. Companies like JDAS (pending acquisition of i2), Epicor (recent acquisition NSB Retail in the UK), Yahoo! (incomplete restructuring) fit this category of risk.

Product Transitions/Major Architectural Changes

Strategic transformations whether they are in the form of a major new product or a fundamental architectural change represent both opportunity and risk.  In some respects it is similar to the challenge of a major merger in that any material weakness in core business processes become exposed.  Hearing of critical new product or architectural changes, customers will often hold back their purchases until they are confident that the company has successfully executed its strategy.

Balance Sheet Weakness - High Debt Loads/Weak Cash Positions

When tech companies budget for growth and then suddenly re-trench due to lower IT spending, they burn cash.  Companies with high debt loads and weak cash flows usually suffer first during a recession.

Have an SMB Midmarket Focus

Tech companies that sell into Small and Medium size Businesses (“SMBs” defined as companies with less than $1 billion revenue, and often less than $500 million in revenues), particularly SaaS-oriented software vendors, were feted by the press and analysts in recent years.  However, SMBs are more dependent on access to credit for growth, and their orientation as (often) private companies drives management to put the brakes on IT spending faster during a contraction than large organizations.  Players like RightNow (MGI-X:587; Nasdaq: RNOW), Lawson (MGI-X: 833; Nasdaq LWSN), and QAD (MGI-X:690: Nasdaq:QADI) all carry considerable SMB exposure.

Narrow Geographic Coverage

Companies with limited geographic sales channels have underperformed relative to their globally oriented peers.  While its unclear which geographies will suffer the most/least during this downturn, having as many markets covered possible is likely a good thing.  Tech vendors with the broadest geographic coverage will out-perform competitors in need of capital to expand their market reach.

In Part Two of this two-note set, we'll peer into the Soul of a Survivor, what it takes for a tech company to survive an economic recession. 

IT Industry May Slump Until 2010

Oct 1st, 2008

(c) 2008 MGI RESEARCH, LLC

In the last few days we conducted an informal outlook poll of business executives from several leading financial services companies. The results of the poll provided us with some insight into what the business people at those companies are thinking about the time horizon for recovery from the current financial crisis, and what it means to IT spending and expectations. A majority of those with whom we spoke expressed a view that 2008 and 2009 will largely be write-offs for their core businesses, and at best a chance to pick up some good assets amid the current carnage. The prevalent point of view was that a sustainable recovery in the financial services sector should not be expected till 2010. Some also voiced concerns that consolidations and government intervention in the financial services sector while ultimately helpful, will not significantly alter the current downward trajectory for the economy as a whole. None of those we interviewed could offer any definitive view on what the direct immediate impact of the financial sector crisis is on tech spending, but did admit a great deal of uncetainty, mentioning that all spending, especially discretionary, is being put under review. Our analysis of this rather limited set of data points forces us to think that one should not expect a broad turnaround for business momentum for IT vendors till 2010 or even 2011, especially as it pertains to IT vendors focused uniquely on the financial services industry. It should be noted that the financial services sector represents over 20% of all enterprise IT spend.

In our research published in the July 2008 MGI benchmark of 75 applications software vendors, we highlighted a trend of stronger companies improving their MGI Index efficiency scores while the average application software companies saw their efficiency scores decline. We expect this trend to continue broadly amongst tech companies, as the companies with stronger management teams and business models "batten down the hatches" early to survive the current storm, while the companies with less efficient MGI Index scores tend to suffer from "deer in the headlights" over-optimism in their business planning. With Q3 now closed, we look forward to the quarterly confessional calls.