ServiceSource: An Attractive Way To Invest In The Cloud


Renew OnDemand is in hyper growth phase.

Trades at a significant discount to pure play cloud stocks.

CEO has been buying over the past year.

Last week, I attended the Northland Growth Conference in NYC. It was an exciting day spent with some of the fastest growing SaaS (software as a service) companies in America. One of the intriguing meetings was when I sat down with ServiceSource International's (NASDAQ:SREV) CEO Mike Smerklo and CFO Ashley Johnson. In the past two years, ServiceSource has unbundled its service offering and essentially built its own startup SaaS company on the fly. It has been no easy task from a business perspective but it was the best decision for its long-term growth prospects.

IPO and Transition

When the company went public in 2011, it was a managed services provider in service revenue management, providing solutions that drive increased renewals of maintenance, support and subscription agreements. Customers would outsource the renewals of contracts to ServiceSource. This was a bundled service that included software and associated services, and the company was paid based on performance. In less than 10 years, Smerklo went from startup to a $200 million-plus revenue business. This legacy business is consistently profitable but also people intensive.

The technology space is changing at breakneck speed. Cloud adoption has been widely accepted and businesses have been shifting to recurring revenue models. This plays right into the strengths of ServiceSource that has over 12 years of leadership and experience. In recent years, clients began asking for an unbundled software solution. Smerklo made the tough decision to offer a cloud-based product called Renew OnDemand. In the short term, investment into this new startup offering has hurt margins and ServiceSource is expected to post a loss of 7 cents in 2014 as per street estimates. This would be its first loss since going public.

ServiceSource currently manages $14.5 billion in recurring revenue for the world's largest and most respected technology and B2B companies. This is just the tip of the iceberg. The company views the total addressable market as a $310 billion market opportunity and $115 billion within the installed base. Recent deals with Aria and Accenture should help bolster the sales efforts of ServiceSource.

Insider Buying

While insider activity doesn't always tell the whole story, it is encouraging to see CEO Mike Smerklo investing more of his own money in SREV stock over the past year. In 2013, Smerklo purchased over 88,000 shares at an average cost of 7.34.

shares price cost
2/11/2013 21,500 6.9 148,350
2/25/2013 22,900 6.44 147,476
5/14/2013 14,285 6.8 97,138
6/10/2013 12,255 8.51 104,290
12/3/2013 17,400 8.68 151,032
total 88,340 7.34 $648,286
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Complicated Valuation

Because ServiceSource is still largely a managed services play with a cloud startup, investors may be confused at how to value this entity. So far the stock market has taken a wait and see approach on its transition to a cloud company. The stock price has largely followed its revenue growth as it decelerated in 2012 and bottomed out in the first quarter of 2013. As revenue growth has accelerated, the stock has bounced off the lows. Revenues should continue to accelerate in 2014.

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While it will take time for the cloud sales to scale for ServiceSource, they are growing at a very fast rate. JMP Securities analyst Patrick Walravens forecasts $12 million in sales for 2013, $38 million in 2014 and $74 million in 2015. A slide from last year's analyst day shows the potential positive impact of Renew OnDemand on sales growth and margin expansion.

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The stock is currently covered by 6 sell side analysts: 2 strong buys, 3 buys and 1 hold. The mean price target is $12.88 or 53% upside from today's price of $8.40. Pure play SaaS providers are trading at lofty multiples. Workday (NYSE:WDAY), a ServiceSource customer, trades at 18x price to sales. Cornerstone OnDemand (NASDAQ:CSOD) trades at 16x. Concur (NASDAQ:CNQR) trades at 10x. Using the JMP estimate for 2015, ServiceSource is trading at 9x price to SaaS sales which means you are getting the profitable managed service business for free. There is a lot of room to unlock value over time with ServiceSource. Eventually, management may need to spin out the fast growing SaaS business, not only to get proper value for the asset but also to keep their top talent in place. If they do not take this step, private equity may look at SREV as an attractive buyout candidate. This is an interesting Kerchunker growth company to watch over the next few quarters to see how its Renew OnDemand efforts are progressing. I believe it worth accumulating positions at current levels.

Disclosure: I am long SREV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.