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.