ServiceSource IPO: Large Market, Powerful Value Proposition

ServiceSource (NASDAQ:SERV) was launched by a group of former Cisco (NASDAQ:CSCO) employees in 2000. This specialized outsourcer manages service agreement renewals for blue-chip tech firms such as Adobe (NASDAQ:ADBE), VMware (NYSE:VMW) and NetApp (NASDAQ:NTAP). ServiceSource collects commissions based on the value of contract renewals it generates, allowing its customers to focus efforts on developing and selling new products. ServiceSource plans to raise $99 million by selling 11.9 million shares at a range of $7.50-$9.00. Existing shareholders are selling 3.9 million shares, representing 33% of expected deal proceeds. Morgan Stanley (NYSE:MS) and Deutsche Bank (NYSE:DB) are the lead underwriters on the deal, which is on the IPO calendar for the week of March 21.


ServiceSource manages the renewals of maintenance, support and subscription agreements for leading tech companies. Its dedicated sales teams are aided by the company's extensive data warehouse and growing portfolio of cloud based applications. In total, its service sales organization numbers 1,323 employees, operating from six sales centers around the globe and selling in 30 languages. The company has more than 55 customers across major IT segments: software (Adobe, VMware), hardware (Hitachi, NetApp), networking (Avaya, Juniper (NYSE:JNPR)), resellers (NEC (OTC:NELTY), Qwest (NYSE:Q)) and technology-enabled healthcare (Abbott (NYSE:ABT), Agilent (NYSE:A)). ServiceSource typically enters into three-year, commission-based contracts with tech companies and bills monthly based on the value of renewal sales it closes on its customers' behalf. In recent customer engagements, ServiceSource claims to have boosted average renewal rates by 15 percentage points, and in 2011, it expects to manage contract renewals representing a potential $5 billion in service revenue streams (+35% y/y). In fiscal 2010, the company generated $153 million in sales and $15 million in EBITDA. Though revenue rose 38% from the prior year, EBITDA margins declined to 10% (from 20%) as it invested aggressively in growth.

Key Issues

ServiceSource has a concentrated customer base; its top 10 customers represent more than 50% of sales. Its largest customer, Sun Microsystems (JAVA) (13% of 2010 sales), terminated its engagements in the 3Q10 following its acquisition by Oracle (NASDAQ:ORCL). On the profitability front, EBITDA margin fell by 10 percentage points in 2010 and the company expects continued margin pressure in the near-term due to growth in service sales teams and general overhead. The company typically bills monthly in arrears and generally incurs commissions and implementation costs 1-3 months before generating revenue from new accounts, meaning that cash flows tend to lag new customer engagements. Finally, the industry migration to SaaS delivery model threatens to cut into traditional hardware/software maintenance streams; to date, SaaS subscription renewals have constituted a relatively small portion of ServiceSource's revenue.


ServiceSource has a large addressable market and offers a powerful value proposition to major IT vendors, whose service and support contracts represent a high-margin revenue stream. Further, the company has notable growth equity backers in General Atlantic and Benchmark Capital, and it is lined up to be the 13th venture-backed IPO of 2011. As a group, this year's batch of venture IPOs has posted a 10% average return from offer price, outperforming the 3% average return of their non-venture counterparts. Nonetheless, investments in growth have taken a heavy toll on margins, and the industry's ongoing shift toward cloud computing raises questions about ServiceSource's long-term market opportunity, as on-demand software and support are typically sold as a combined package. All told, ServiceSource lacks a close comparable as a niche provider of service revenue management, and the success of the deal will likely hinge on the way investors frame their relative valuation analysis. At 3.6x trailing sales, ServiceSource is valued at a premium to a basket of managed services/outsourcing peers (3x average), but looks like a bargain relative to the lofty multiples of the SaaS sector (5x-12x). As a technology-enabled sales outsourcer, however, we believe investors will be hesitant to place ServiceSource in the latter category.