Hortonworks: Has Someone Stolen Their Porridge?

| About: Hortonworks (HDP)

Summary

Hortonworks reported their Q2 results on 8/4 and the response of investors was to send the shares down by almost 30%.

3 brokerages out of the 10 who follow the name cut their rating and almost everyone lowered their price targets.

Objectively viewed, the results while no doubt disappointing for a hyper-growth company, were really far less disappointing than the share price reaction might suggest.

The miss in bookings, the most objective sales metric for this kind of company was 0.5% and the company did not reduce its bookings forecast.

The company made some progress, although less perhaps than might have been hoped for, in terms of reducing cash burn and in better managing expenses.

Has Something wicked this way come?

That is from Macbeth when the witches are talking about welcoming him to their cave. It is also the name of a movie, I have come to find out but I think Shakespeare will do as a reference point. I don't really have to guess as to how Shakespeare might have chosen to describe the quarter that was just reported by Hortonworks (NASDAQ:HDP). Hyper-growth companies are supposed to produce hyper-growth and upside revenue surprises. That obviously didn't happen here.

The headline numbers for Hortonworks results for Q2-2016 were total revenues of $43.6 million, 46% year on year growth but a miss compared to prior expectations of about $1.6 million or 3.5%. The miss was more in terms of consulting than in terms of product, but it is still a miss. And the EPS (well the loss) was $.72 compared to guidance and expectations of $.68, i.e. $.04 worse.

Bookings for the quarter were essentially in line at around $62 million although a reserve was established that muddied the bookings comparison a bit. Overall, the company missed its bookings target that it had articulated on the call in the prior quarter by $300k or 0.5%.

But many observers who follow these kinds of names including this writer expect upsides to bookings and clearly bookings missed management expectations. The CEO was candid enough to suggest that he recognized that the bookings would disappoint most investors. I think it is fair to assume that the sales performance was the primary factor involved in the company deciding to part ways with its COO Herb Caunitz; no one outside the company really knows if he was the scapegoat or the impediment to better sales performance.

Obviously the issue of demand and revenue generation demands a deeper dive which I will attempt to illuminate in the following section. For now, I will just leave it by saying that the CEO has assumed direct responsibility for revenues, a role he has held in the past. He has taken action to change the go-to market profile of the company by laying off about 5% of the company's employees and replacing them with direct sales people. He believes that sales coverage has been so thin that it led to a focus on large deals -- and the evidence supports that contention to an extent with $6 million transactions being closed in the quarter. He believes that the coverage in EMEA was close to non-existent.

Despite the changes that have been made in the sales force, the company management lowered its revenue guidance for the balance of the year which is prudent given the time it is likely to take for new hires to become productive. On the other hand, left its booking forecast unchanged to slightly higher. At an estimated $265 million, bookings are expected to exceed reported revenues by 50%. In Q2 bookings exceeded revenues by 43% which probably suggests the level of caution in the company's guidance. Overall, the bookings growth in the quarter was 49% year to year. The problem for this observer and others is despite the guidance heretofore, bookings growth had been 91%. Bookings of $62 million in the quarter compared to $53.7 million in Q1, which is sequential growth of 15%, not an inconsequential attainment, I believe but less than most observers were anticipating and that is the primary component of the extreme share price sell-off seen this day.

At some point in terms of valuation, investors ought to focus on bookings and not on much else when it comes to evaluating sales performance. The problem is, that when investors focus on percentage bookings growth it is almost inevitable that see the progression from 91% to 49% as a disappointment regardless of whether the results were consistent or not with company guidance. I know that was my reaction, and I imagine that it was the reaction of many other investors or potential investors as well.

Part of the wound regarding investor perceptions of the company was self-inflicted. The conference call was poorly managed and not well thought through. It seems likely that this company does a far better job selling large deals than it does in staging conference calls-based on the two to which I have listened. If that weren't the case I would apply for a TDY assignment and have little difficulty in improving sales results. (LOL-I am not that presumptuous.) But the fact is that the conference call had no prepared remarks either articulated at the start of the session or published which many observers including this writer prefer. The definitions of certain captions were changed more or less without explanation and the change in executive leadership seems to have been a last minute action-even the 15% sequential growth in bookings was not called out either in the press release or on the call. Hiding one's light under a bushel basket is not a great idea for a management of a hyper-growth company and especially for a company whose results were bound to be disappointing.

I am of two minds in writing too much about bookings. At the end of the day, bookings are what sales people are paid and how they are measured relative to their quotas and just how efficient they are in terms of productivity. Bookings, at a miss of 0.5% compared to prior guidance were not really a disaster on any objective standard. 49% year on year growth in bookings was not some "annus horribilis" attainment.

But the sales performance was below the levels expected by this writer and others. The CEO acknowledged, that with the company's win/loss reports indicating low to mid 90s win results, it is clear that the company simply doesn't know about opportunities in which it should be competing. Basically he was saying that no company in a competitive space will win over 90% of the time and that the only way that win/reports get to such levels is when the business is not competing for enough opportunities. The old saying, "never up, never in" is certainly true in IT sales as in many other areas of life.

The deferred revenue balance in aggregate rose by 25% since the start of the year although most of the increase was in the long-term deferred bucket. Long-term deferred revenues grew by more than 100%, to 26% of the total deferred revenue balance. The company is signing more multi-year engagements of size rather than short, transactional acquisition arrangements and that is the biggest factor in terms of reported revenue growth being suppressed but is not the explanation behind the slowdown in bookings growth.

The company made progress in terms of its operating cash burn but it has a very long way to go. Overall the GAAP loss shrunk sequentially last quarter as did stock based comp., but both numbers are far too high. Stock based comp was 50% of revenues last quarter which may be necessary for a company at this stage of its development-I understand developers and sales people who join smaller companies do so in order to get paid for the potential success of their employer, but very high potential dilution is likely to impact valuation until there is a clear path to its control and ultimate decline as a proportion of revenues.

Regardless of how it happened, overall operating cash flow losses dropped by 36% sequentially and by 60% year-on-year. The CEO re-articulated his goal of reaching EBITDA break-even by the end of the year and some visible progress was made in reaching that objective.

At this point the company has a cash balance of almost $130 million. Given the sharp reduction in operating cash burn, and the company forecast that capex will be down to $2.0 million-$2.5 million/quarter, the issue that had been on the minds of investors after last quarter, i.e. the potential requirement for another secondary offering would seem to be off the table. The company's A/R balance remains at elevated levels in the opinion of this writer and it ought to be a source of funds over the coming months. I remain a bit concerned that management has not seen fit to address this issue and concerned as well that none of the analysts on the call saw fit to address the subject. DSO of well over 100 days is simply not an acceptable level to carry.

Are elephants still in style?

As some readers may recollect, the symbol for HDP and for Hadoop is that of the elephant. The product was named for a little yellow plush toy of an elephant and the name has stuck for more than a decade. Of course things with the elephant for a symbol are having a difficult time of it this summer. Those of us who are fond of elephants need to do something to keep them from extinction, but this company ought to be able to take care of itself.

In the wake of the results presented last evening, the skeptics are out in full cry and there have been 3 or 4 analyst downgrades and a host of price-target decreases. The price target decreases make sense the way analysts construct price targets; the downgrades-well not so much.

The basic arguments regarding demand and the risks to the long-term forecasts relate to three inter-related elements. One of these is that the market for Hadoop solutions will never reach the immense size that is forecast and hence the TAMs that are forecast in the $50 billion range will never be realized. The second issues is that Horton Works' strategy of being pure open source will never produce viable financial results. As a corollary, one issue for investors is the potential competition from MapR and from Cloudera. And finally there is the issue relating to the competition potential and real from the cloud vendors such as Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN) and even Google (NASDAQ:GOOG).

To this writer, the crucial issue remains the likely size of the market for Hadoop technology. If the market is as large as it is forecast, then there will be room for a variety of competitors selling different versions of similar technologies. Indeed, should the market reach the size forecast most of the other concerns will be as "dust in a windy street." As might be expected for a market this nascent, the number of forecasts is more or less limited by the number of electrons willing to traverse networks. One set of numbers says that currently Hadoop revenues are about $6 billion out of $27 billion spent on a variety of big data solutions. Other numbers are different but more or less comparable in their relationships.

Services makes up a big piece which is basically the segment in which HDP competes. The author looked at several different market research services that estimate Hadoop revenues over future periods. Of course they were all different but most of them had common estimates that suggested Hadoop would have a CAGR of greater than 50% over the next 5 years and would reach total revenues of either at or in excess of $50 billion.

I do not think any but a futurist can claim to have the credentials or the prescience to be able to unequivocally forecast that these kinds of growth metrics will be achieved. It isn't as though I or anyone else that I know of is back from the future with specific knowledge of how the market for Hadoop and Big Data will actually develop. I would certainly like one of those little books that Biff (the villain in Back to the Future) secured in order to build his fortune by knowing winners and losers of various sporting events long before the matches were played. Sadly, such publications do not seem to be currently available. All that one can objectively say is that a 50% CAGR and a $50 billion TAM ought to ensure that HDP snaps back significantly from this bump in the road.

As I wrote earlier there are more than a few doubters as to the future success that HDP is likely to have in the competitive environment going forward. Here is one such Q&A marked on the Q2 conference call marked by far more heat than light, "Maybe a follow-up on Greg's question around what's happening in the landscape and I want to hit on the competitive environment and more so around what the cloud guys are doing…" And the answer, 'So from a cloud perspective…where basically the major players were either on stage and/or demonstrating solutions in that space, We've got partnering relations from a business and/or technical perspective that sort of matter in that space. From a business perspective, it extends our enterprise customers' architectures and it extends our coverage model frankly with additional workloads both ephemeral as well as long running…" And then the response from the questioner, "So no comment about them competitively? They have some of their tools that they offer, but you don't see that changing." The questioner here is a well-known analyst from a well-known firm.

I think the point of including a significant discussion is to suggest that even well experienced and respected analysts are not using their disciplines to elicit information but want to make writing points. HDP has a very tight integration with Azure and really the HDP "product" powers the Azure offering in this space. Are the other significant independent cloud vendors going to occupy all of the market for Hadoop tools? Then again, are the independent cloud vendors going to destroy the overall database market? In a very large market, success doesn't mean that one company or the other can't co-exist with many others.

When questioners ask the equivalent of "wife beating" queries as this was, they aren't looking for information but they are trying to make a point to their clients as to their toughness. I really do not imagine that anyone quite imagines that a question addressed to the VP of strategies at Hadoop is going to elicit an answer that competition is hurting hard and that the company is being hurt by the large cloud vendors who offer their flavor of Hadoop. And I imagine that the questioner well knew that Horton Works is the Hadoop engine that powers runs the Microsoft HDInsight Hadoop offering.

I looked extensively to see if there were any significant updates to the competition on-going between MapR, Cloudera and HDP. The study I liked the best was that by Forrester Wave, which said that a user needs to get "great consulting help because the competition was so vibrant." No words about who to choose or who is winning or losing-but just come and pay us $10,000s of dollars and we will help you make a choice. This writer found nothing even mildly dispositive or interpretive with regards to who is winning or losing the competitive battle amongst the 3 major vendors in the space.

At the end of the day, the case for investing in HDP is that it has now become very, very cheap and that the market for Hadoop solutions represents one of the best growth opportunities for several years to come in the IT space. The odds seem high that either Horton Works will get its share of the market in the years to come or that a better or larger operator will consolidate the company and sell its technology more successfully.

Obviously this past quarter reported by HDP did nothing to prove the skeptics wrong. But it is my contention that it did little to prove either that the market growth for Hadoop was slowing or that HDP was losing share. It may have shown that like almost all smaller companies in competitive markets there can be bumps in the road and wrong turns as well. It may have shown that HDP had some issues in terms of sales execution and specific sales tactics. It may even suggest that more adult supervision is needed at the top of Horton Works. But if the market is growing at 50% CAGR and on its way to $50 billion of annual revenue, then there is both time and runway to fix the problems that were shown in relief by the disappointing quarterly revenue results.

Merger Mania and thinking about Horton Works?

I think it is difficult to ignore the environment for consolidation in the enterprise software space when looking at HDP shares. At the end of the day, it is the share price more than anything else that matters to readers. I could be wrong about everything else in terms of the size of the Hadoop market, the competitive position of Horton Works and the ability of its particular open source business model to succeed at scale but that isn't going to mean all that much if the company is bought for a significant premium. Earlier this week, Fleetmatics (NYSE:FLTX) was purchased for 6.3X EV/S. Its estimated growth rate is 20%. At the moment, RAX is said to be negotiating to finalize a deal with Apollo, which would see Apollo pay about 1.7X EV/S to acquire RAX. RAX has a growth rate of about 5% and is trying to transition its business away from selling public cloud usage to becoming an industry consultant. I had recommended both of these names in the recent past more because of their attraction as takeover targets than for any other single reason.

Of course there are differences between these companies and HDP in that both of the businesses make money and both generate positive cash flow. But HDP is growing several times faster than RAX and more than twice as fast as FLTX.

I recognize that the premium that would be necessary to acquire HDP is probably very large in the sense that management would almost certainly consider the current valuation as close to absurd. Before the share price debacle of today, the average share price target was little less than $18 and I doubt seriously that management would be prepared to take an offer than isn't within 20% of that kind of price. But the absolute dollars involved in a takeover are quite small -- a 70% share price premium would bring the cost of an acquisition to less than $1 billion and would still leave EV/S for the current year at 5X.

At this point, there have yet to be activists involved with the name-at least activists who have filed. That is reasonably likely to be a step to be soon seen if this company doesn't achieve consistent performance with regards to both growth and a path to profitability.

Disappointing quarter, certainly. Disappointing guidance, absolutely. But not certainly nowhere close to tragic bookings performance or cash flow and nothing that suggests that the company cannot be purchased on the basis of current transactions in the overall space for a very substantial premium. And the quarter, regardless of its disappointments, certainly suggested the dawn of some more rational cost discipline for the company coupled with some progress in terms of ending cash burn.

Summing Up

  1. Horton Works reported a disappointing quarter in regards to headline numbers and a quarter that was no better than in-line with regards to bookings.
  2. The bookings miss was actually 0/5% but most investors expected better performance than the 49% growth in that metric.
  3. The company is seeing more multi-year engagements which turn into revenue at far slower rates and that has led to a significant mis-match between bookings growth and revenue growth.
  4. The company chose to discharge its COO -- or so it seems -- as a partial scape-goat for the disappointing level of sales performance. The CEO will now run sales directly reprising a former role.
  5. The company's cost metrics showed some modest signs of improvement at least on a sequential basis but have a long way to go.
  6. The company's cash burn responded to higher revenues and lower costs by contracting quite sharply.
  7. The company continues to have an elevated DSO that has yet to be explained.
  8. The company, in the wake of today's share price shellacking, sells at levels of less than 2.2X earnings that totally belie its status of being a company in a rapid growth phase. That sets up a very realistic potential for an acquisition in this red hot acquisition market in terms of IT consolidation.

Overall, I think that while the HDP results have been deemed a grave disappointment and have engendered a huge markdown in share price, they have also led to significant opportunity for investors. If the Hadoop market is analyzed correctly by those with expertise in doing so, then HDP has one of the greatest potential alphas in the IT universe.

Disclosure: I am/we are long HDP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.