Panning for Gold Amidst the Tech Rubble: Finding Quality and Avoiding Risk

by: MGI Research

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, (NASDAQ:DELL) Sun Microsystems (JAVA), and Motorola (MOT) 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. CEOs who consistently improve their MGI scores during boom times typically outperform 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 JDA Software (NASDAQ:JDAS) (pending acquisition of i2), Epicor (NASDAQ:EPIC)(recent acquisition NSB Retail in the U.K.), Yahoo! (NASDAQ:YHOO) (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 retrench 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 outperform 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.

Disclosure: None