Success Factors: Going for Break-Even Rather than Revenue Growth?

by: Naveen Selvaraj

Success Factors, Inc (NYSE:SFSF), a SAAS (Software as a Service) provider of workforce performance management solutions is discovering that cloud services can also lose steam in a weak economic environment. While on the face of it, a 30% revenue growth rate is impressive, investors will not be pleased with another quarter of operating losses.

Revenue Growth Is Slowing Down Pushing Operating Break-Even Further Down The Road

Source: Gridstone Research

SFSF has delivered revenues of $38.7 M and operating losses of $(2.1) M in Sep09 quarter.and guided for revenues of $39.5 M (mid-point) in the Dec09 quarter

A Comparison of SFSF with CRM's early days

One way to judge SFSF's top-line growth is to see how growth has decelerated vis-a-vis the biggest SAAS player, (NYSE:CRM). The chart below shows that SFSF's revenue growth has decelerated faster than CRM despite CRM being ~10X times larger than SFSF in terms of revenue in the previous quarter (Jul09). CRM was a $30-40M quarterly run-rate company way back in 2004. Though the macro environment would have been much better then, CRM was a category innovator and had to sell the concept and then the 'service'. Despite this CRM managed a ~80% YOY revenue growth rate in those periods. In fact CRM's growth rate dipped to sub-50% only in Jul07 when it was already a $170 M a quarter company.

CRM Vs SFSF: A Comparison Of Revenue Growth Rates (% YOY)

Source: Gridstone Research

Revenue growth and achieving a certain base of revenue is extremely important for SAAS providers since selling costs are very high (~50% of revenues) and therefore break-even can be achieved only if the company reaches a certain scale which helps it absorb such high selling costs and fixed costs to generate an operating profit.

Going back to CRM, it was quite profitable even in 2004-05 when it was the same size of SFSF. However operating profits turned to losses after the stock-based compensation accounting norms (SFAS123) kicked in and non-cash charges ate into profits. However, cash flow generation was positive despite increasing capex spends for CRM even in that period.

CRM Broke Even At $40 M A Quarter Revenues...

Source: Gridstone Research

Post stock-compensation expenses being factored in, CRM returned to profits in Apr07 quarter when it reached a quarterly revenue of $144 M. Contrast this with where SFSF stands today at ~38 M in quarterly revenues.

...Non-Cash Charges Pushed The Break-Even To ~$150 M A Quarter Revenues

Source: Gridstone Research

SFSF could break-even at probably $50M of revenues (assuming gross margins remain intact) but this has come at the cost of impacting revenue growth. As the chart below shows, SFSF has reduced sales and marketing spends in absolute $ terms and as a % of revenues. So the close to break-even income statement of 3Q09 does mislead one into thinking that SFSF can reach a steady-state of robust growth and sustainable profits in the next quarter or so.

Will Reduced S&M Spend Backfire In The Long-Term For SFSF?

Source: Gridstone Research

In the Jun09 quarter earnings call, Success Factors CEO Lars Dalgaard mentions that operating break-even (on a Non-GAAP basis) has been achieve in Jun09 quarter, three quarters earlier than promised during the IPO in Nov07.

Excerpt from Jun09 Earnings Call Transcript CEO comments:

...SuccessFactors revenue grew 44% and true to the model and our promises, we drove strong margin expansion. First, gross margins expanded to 79%, up from 53% at the IPO. Cash flow positive continued and finally, SuccessFactors improved operate margin from negative 109% at IPO to breakeven. That’s operating margin profitable three quarters earlier than we promised...

Lars has continually being saying the Performance & Talent Management is a $16 B market opportunity and so there is immense scope for growth. He mentions this in the Mar08 quarter earnings call and again in the Mar09 earnings presentation. Below is a slide taken from than presentation.

Much-Touted Market Opportunity?

At around $120 M in annual revenues, SFSF has a minuscule share (<1%) in this 'apparently' huge market opportunity. Investors who bought into the IPO of SFSF in Nov07 were probably expecting growth rates of >50% for the initial two years at least considering this market opportunity and the ability of SAAS services to penetrate the SMB market for these applications.. Clearly the downturn would have made them scale down the expectations. But considering its size and the apparently huge market opportunity, SFSF's decision to scale down sales and marketing spends is perplexing at best.

Scaling Back On S&M Seems A Wrong Move

Clearly at the first signs of market stability and customer IT budgets getting spent, SFSF should have focused on top-line growth rather than boasting about achieving operating break-even earlier than planned. As the CRM ( success story indicates, SAAS providers need to first reach a sizeable customer and revenue base before they think of consolidation and improving profit margins. Another sore point in SFSF's growth story is that it largely been US market driven.

Concentration Risk Still Remains For SFSF

In 2008, SFSF got almost ~89% revenues from the Americas (largely US). Europe and APAC revenue contributions were still in single-digit $M. There is huge scope for improvement in this aspect when compared to CRM itself. SAAS providers are less constrained by geo constraints for product delivery while S&M expenses will naturally be heavy in every new geography that they plan to enter.

Geographic Diversification In Revenue Is Urgently Needed For SFSF...

Source: Gridstone Research

..Again CRM Shows The Way

Source: Gridstone Research

The lack of geo diversification is another reason for SFSF to increased marketing spends rather than curtailing them. SFSF revenue streams are highly concentrated in terms of both geo diversity (US) and product/service portfolio (Performance management) and there is urgent need to reduce concentration risk by diversifying in at least one if not both.

Not Many Positives for SFSF Stock And Follow-On Stock Offering Will Reduce Investor Returns

With revenue growth slowing down, there is hardly any positives for SFSF in the Sep09 quarter results. Increasingly, it looks like SAAS providers will have a tougher and long winding road to sustainable profits and continuous top-line growth. Besides these worries, the long-term success of a such 'focused' SAAS providers like SFSF seems questionable.

SFSF had a successful follow-on public stock offering of 12 M shares at $15.5 per share last week, with the underwriters (Goldman Sachs, Morgan Stanley and Deutsche Bank, no less!!!) even exercising their green-shoe option for an additional 1.8 M shares. Goldman and Morgan Stanley had also under-written SFSF's IPO in Nov,2007 which was priced at $10 per share. With a current share base of ~57.3 M shares, the dilutive effect of the additional shares is nearly 25%. While SFSF probably had no other option than raising additional equity(it had a negative book value of equity as of Sep09 quarter), clearly this only makes the stock less attractive to long-term investors. Even if investors had invested in the IPO at $10 and were currently in the money with gains of ~50%, it is unlikely that the gains are sustainable after the follow-on offering. To conclude, in all aspects, SFSF stock seems avoidable at the current price and its current fundamentals.

Disclosure: No Positions.

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