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.

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.  

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.

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

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.

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. 

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.