Spend Management - A brief walk down memory lane!
There is the old saying that talks about those who ignore history are doomed to repeat it. It can be and has been used many times and in many ways. When I noticed the Coupa Software (NASDAQ:COUP) IPO, my mind was immediately taken back to Ariba, which developed the granddaddy of all spend management software and was an early poster child of the internet stock bubble. Ariba was formed in 1996 and from its first genesis it was one of the shooting stars of the last tech bubble and was going to change the way everyone purchased everything. Dare I suggest that it was almost impossible to hold a reasonable discussion about the shares with many holders who felt that the company was developing the Holy Grail and making it available to the public. The company and its share price history wound up creating a score or more of young multi-millionaires in the valley and taking a decent size bite out of loads of pension funds, mutual funds and the portfolios of individual investors. Lots of greed and almost no prudence.
Ariba wound up not quite changing the world and it ultimately got acquired by SAP (NYSE:SAP) for $4.3 billion in 2012. The valuation was no less than 10X revenues and perhaps that has put stars into the eyes of many entrepreneurs who want to develop a spend platform that allows them to spend their ownership earnings as have the founders of Ariba. It happens that Coupa Software, the subject of this article, sells for a similarly extended valuation - more than 10X EV/S - without much in the way of visible justification. I have a predilection against trashing newer companies, especially brand new ones where enthusiasm runs high and the management is trying to build a successful business. But sometimes there is just nothing to do but trash away when the valuation has nothing much to do with the reality. This is one of those times.
I would love to say that I was there at the end when Ariba was finally sold, although the premium paid when it was acquired wasn't all that great, as I was certainly there at multiple times from the start but sadly that was not the case. But it was a fun name to follow and I knew one of the founders reasonably well and got to ride in the fastest and one of the more elaborate cars I have ever set foot in. Unfortunately, without gullwing doors, my exit from the vehicle was far more difficult than my entrance and no doubt was a source of amusement to diners that evening at the Lark Creek Inn (sadly no more). And under the circumstances, I enjoyed about the most expensive bottle or two of California Cab in which I have ever indulged. As the famous song from the movie Gigi goes, "Ah yes, I remember it well." But that is another story and has no relevance to the subject of this article.
Spend Management - Is it a category or a feature?
Features usually do not wind up making long-lived profitable companies. My basic inclination is to describe spend management as a feature even though Gartner makes it a category and has it with its own Magic Quadrant. If I could answer that question in a straightforward fashion it would shorten the balance of this article to the vanishing point. Obviously, businesses have to buy things and they want to buy things economically. Duh! And it's self-evident that there is a value in connecting prospective buyers with aspiring sellers. And with the coming of the cloud, it has been possible to devise software to allow for these interconnections in a cost effective and efficient fashion with modern GUI that is very easy for the most casual of users to operate.
Over the past couple of decades, there have been more far-fetched iterations of the concept that had potential users bidding for things like pencils and copiers as well as industrial raw materials in a form of Dutch auction, but in general, Ariba delivered a service that was valuable to some and not so useful for many.
Just about every ERP vendor, including Oracle (NASDAQ:ORCL) and Workday (NYSE:WDAY), has spend management functionality and most of them have many modules to facilitate the process. NetSuite (NYSE:N) currently uses the Coupa solution as a part of its spend management platform. It really is better for most users to buy tightly integrated spend management solutions if they are on offer. The largest vendor in this space is SAP which has acquired several leading properties that are as yet un-integrated but still are leaders.
The question is very straightforward, although the answer is anything but straightforward. Does the world need a purpose built, best of breed spend management solution when so many comparable platforms exist and are tightly integrated into the respective ERP vendors? My predisposition in writing this is to conclude that Coupa, while having interesting, advanced and purpose built cloud technology with all that is implied in those words, does not justify enough unique value to be sold on its own to most users. Needless to say, my experiences, both positive and negative with Ariba, lead me to want to take a far more exhaustive look before just discarding Coupa in the waste bin. But sadly, after having taken a good look at both the financials and what I could glean of the product and the technology, investors at any rate do not need another one of these best of breed cloud vendors attempting to enter a market that is best served by tight integration with ERP and SCM solutions. The valuation and the rapid slowing of sequential growth lead me to believe that this is one IPO that should be avoided, and at these levels, the shares can be shorted. Coupa is apparently to be the last tech IPO of the year, and perhaps it will have some scarcity value, but there is no way, based on what numbers are presented in the prospectus to find a way to justify the valuation.
As will be seen below, it might be that Coupa was put together with the thought of being acquired. There have been many acquisitions in this space. But lately we have seen a couple of instances regarding Twitter (NYSE:TWTR) and perhaps Impreva (NYSE:IMPV) where the reality of acquisition was far less than the hope. Coupa appears to be overvalued and hoping to be bailed out by expecting the company to be bought would seem to me to be a highly risky strategy for an investor.
Coupa just went public on October 6, 2016. As a result, many of the metrics that I like to look at aren't available at this point. There is, however, plenty of data with regards to spend management since the category is so old and it is offered by so many vendors. I think there is enough information to reach some reasonable conclusions for readers and investors.
Does Coupa have a special sauce?
Best of breed competitors in a market that is chock full of competitors whose solutions are tightly integrated must have special sauces of various kinds and flavors if they intend to grow. It is almost inevitable that Coupa's initial costs are going to be higher for its solution than will be the case if a user simply bought a module from a vendor offering an entire stack of ERP capabilities. Sometimes, the vendor will simply "throw in" the spend module to seal a deal or to get a user to agree to some other term or purchase. Coupa, as it currently is, can't do that.
What Coupa can and has done is to develop a platform that has been purpose built to use the cloud. The company says that what it does would otherwise require a user to buy multiple disparate point applications. Can that assertion be supported?
Coupa has talked about network effects in its S-1. I am bound to imagine that this will be the heart of most of the analyst reports that will appear in November. The concept is straightforward and needs a bit more exploration because it is one of the ways the company and the stock will work. It was supposed to be the special sauce for both Ariba and its cousin in the business, Covisint (NASDAQ:COVS). Neither of those vendors was really able to monetize the network effects and the record of Covisint since it became independent a couple of years ago is anything but enviable. (Of course, its record when it was owned by Compuware really wasn't much better - another one of those "ah yes, I remember it well" moments.)
Coupa has achieved a CAGR of 122% in its "expense under management" and an 80% CAGR in the number of transactions on its platform over the past three years. Those seem like impressive numbers - but of course, the base from which they are calculated is very low and the charts do not reflect the reality of the company's markedly slowing revenue growth.
But to be fair, here is the case the company makes for the network effect.
"We benefit from powerful network effects As more businesses subscribe to our platform the collective spend under management on our platform grows. Greater aggregate spend under management on our platform attracts more suppliers which in turn attracts more businesses that want to take advantage of the goods and services available through our platform thereby creating powerful network effects. In addition, as more businesses and employees use our platform, the amount of spend under management continues to increase. This leads to more value and savings for (our) customers and improves our ability to attract more business... The resulting increase in sales enables us to further invest in our platform and to improve our functionality and user interface…"
The S1 says that the attributes offered by this company's solutions when compared to those available elsewhere include a unified product architecture, ease of use, ease of deployment, ease of configurability and rapid supplier adoption. Some of those claims are a bit economical with the truth. I don't propose to analyze each of them specifically, but they present a picture of the competitive landscape that is not currently borne out by results.
SAP is the largest company in the space mainly due to a series of acquisitions. For the most part, SAP's massive customer base uses SAP's spend management software if they have purchased anything in the space. All of SAP's products are cloud based. The company started in the space by buying a company called Commerce One which was Ariba's competitor of note back in the bubble days. The purchase of C1 is an interesting story in that the company was pretty close to going to the wall when SAP appeared as a guardian angel but it isn't relevant to the current analysis.
Overall, the C1 acquisition didn't go so well and the money might better have been spent buying lottery tickets.
But the Ariba that SAP bought in 2012 is another matter entirely. The fact is that Ariba was an independent company through 2012 and had a reasonably broad community of suppliers and of course being hitched to SAP means it has a huge number of potential buyers.
SAP has also bought Concur at the end of 2014. Concur, at the time, was probably the most popular expense management platform used by many enterprises to automate the processing of expense reports and travel and entertainment analysis and control. SAP paid over $8 billion to buy Concur which was 15X trailing revenues at the time. There is a saying that someone has not gotten what they paid for but has certainly paid for what they got.
Again, even large companies use emotional criteria in making decisions. SAP wanted to be the undisputed leader in the category and now it is. The Concur product is really popular and it is easy to use even for dummies like this writer. But it was one of those transactions that I could never quite figure out either back then or now.
But regardless of how it got there, and regardless of disregarding sunk costs as an adage, SAP is the gorilla in the space and anyone who aspires to market leadership is simply going to have to come through a company that has made the category a focus. It would be and is a formidable task.
The spend management module offered by Workday was built with the rest of the company's offerings. Users buy it along with the other WDAY solutions. Other than the fact that none of the so called comparative reviews that allegedly compare the two products actually do so, WDAY appears to have enjoyed substantial success in selling the product as part of its overall solution. Interestingly, in one survey, Coupa was described as the "hottest" product of 2015, dethroning Workday which won that honor the prior year. Sic transit gloria mundi, as the saying goes.
Oracle has focused on supply chain management for a very long time now. Anyone who sells ERP more or less has to offer some kind of supply chain functionality. And Oracle offers products that it has built for the cloud that include order management and order promising. And most supply chain functionality again more or less must include some kind of spend management functionality. Oracle's spend management functionality is part of the company's e-business suite. Oracle also focuses less on the functionality of offering connections across a network and more focused on purchasing analytics and optimizing the purchasing function based on different criteria.
Gartner has several different reports encompassing the procurement space. Sometimes it includes SCM software as part of the category and other times it doesn't. Its P2P MQ report, which as the name suggests is focused exclusively on procurement, is only on its second annual release.
Gartner's consolidated report probably does a disservice to Coupa (as well as some other vendors) in that it lumps together many different solution sets in the same MQ. The solution set is a different approach than the functionality offered by Coupa. I think it is more representative of the functionality that many users want to buy and thus it has value on that basis.
But I think that when investors look at TAMs and look at Coupa's sustainable growth rate, at least they might want to consider the various elements that make up the market and which present different ways of accomplishing similar objectives. As shown below, there are disturbing signs that this unicorn is already showing slowing growth, far earlier than might be anticipated for a company like this.
Gartner says that the market it defines was worth $11 billion last year, but pure spend management is just a tiny fraction of the total. In an analysis done by a firm with the less than felicitous title of "Apps run the world", it pegs the procurement market to be worth $5 billion and to have a CAGR of 1.6% through 2020. The 3 leading vendors in the space are SAP with a 22% share, Oracle with a 12% share and IBM (NYSE:IBM) with a 10% share. Coupa along with 6 other vendors are each said to have a 1% market share with Infor having a 2% share. I think that without knowing much more than that, it would suggest that there are loads of risks in forecasting that a tiny company in a crowded space that has a low growth rate is going to find a way to maintain a high level of growth for an extended period. But as I said at the outset to this article, that was my predilection and I do not want to be guilty of writing an article mainly based on my not so thrilling experiences with the e-procurement space as it used to be called. Needless to say, the estimates for the CAGR of the space are hardly dispositive.
There are other surveys that give Coupa a better position when the market is more narrowly defined. The latest Forrester Wave analysis puts Coupa in the leadership position ahead of Ariba and Oracle, although it lists Oracle twice and SAP twice in its analysis which is now 2 years old. The Garner report, which is just a couple of months old, says that Coupa is in the leader quadrant just a few steps behind SAP. However, this report doesn't include Oracle at all.
Gartner estimates that the specific market for what it calls P2P (Procure 2 Pay) is running at a $4 billion rate with a CAGR of almost 12%. Gartner says that 19% of its end-user inquiries came from users trying to get assistance in the procurement and deployment of P2P solutions. That was the greatest area of interest in any particular MQ space that Gartner tracks. I think that overall, Gartner's numbers make the most sense in evaluating the potential outlook for Coupa.
Gartner says that Coupa is #1 in the market for ease of use and has a high customer satisfaction score. It got a high score for security, recovery and availability. Of all the independent vendors in the space, and there are many, it is clear that Coupa is the strongest and the most likely to succeed.
The company has a large backlog but the growth rate of that metric and the growth of the company's deferred revenue balance showed significant slowdowns in growth in the first half of the current fiscal year. The company's growth in derived bookings, had it been calculated by the company, would have shown a visible slowdown as well because of the 12.5% growth in the deferred revenue balance so far in the fiscal year. I assume that the company will give a derived bookings metric and comment on its growth or lack thereof when it initially reports its earnings.
The company's sequential growth has shown a significant slowdown in the past several quarters that has apparently gone unrecognized. Or if it has been recognized, it must be that some investors don't care about it that much. In the last sequential quarter, revenue growth was 6.6%. The prior quarter, sequential revenue growth had been 10.7% and the quarter before that revenue growth had been 15.6% which in turn was down from 22% in the prior quarter. I think that looking at an annualized growth rate in total revenues that has fallen from over 100% to about 30% in the past year is cause for concern.
Personally, almost regardless of any other single factor, the rather significant decline in sequential revenue growth seen in the past few quarter coupled with the sharp slowdown in the growth of both the backlog and the deferred revenue balance would leave me suggesting that the shares are not valued consistently with current revenue growth prospects.
In the nature of things, I assume that the quarter that is to end later this month will show some kind of rebound from the 6.6% sequential growth. If nothing else, I would be reasonably certain that the underwriters, including Morgan Stanley and JPMorgan, would have reasonably insisted on that kind of assurance. But for a company of this scale to have gone from being described as the hottest company of 2015 to a much compressed growth rate will simply not support current valuations.
What are the potential pitfalls or speed bumps that have declared similar companies in the past and which might derail expectations for this vendor?
According to Gartner and Forrester, e-Procurement is finally going mainstream. But I find the contention a bit hard to square with the Gartner comment that 50% of North American and 35% of Western European organizations with more than $2 billion in annual revenue have invested in at least one of the main modules of someone's P2P suite. If half the organizations in this country already have P2P, just what kind of growth rate is possible mathematically. It is smaller organizations that present the most opportunity and inevitably their procurements are far smaller and simply haven't the potential to scale up. If Coupa's future is going to be centered on addressing the SMB market, just how profitable will it ever be.
The biggest speed bumps that this company is going to face are competitive in nature. It is going to have to beat SAP primarily and Oracle and WDAY as well in winning large deals and to do so on a consistent basis. That is simply not an easy thing to do. Most of the company's sales are coming through partners that provide it with far more credibility than it would otherwise be able to muster.
I suspect that this company will enjoy a typically high renewal rate comparable to other categories of enterprise software. Once users start down the path with this vendor they are going to be loath to eliminate automated spend management procedures and very unwilling to switch vendors. I don't think as a practical matter that the company will have a hard time in sustaining its renewal rates at levels that other mainstream cloud software vendors enjoy well above 90%.
On the other hand, I think that the cohort analysis presented in the S1 is not particularly encouraging. I am glad to see it done and it is worth the time necessary to look at it. This is a young company and I am not too sure that all of its statistics have enough points from which to draw conclusions. But I would have anticipated that the fiscal 2013 cohort of customers would have seen far more growth than has thus far proved to be the case in the most recent years. From a financial point of view, the most profitable kinds of sales for this company are to sell its users additional seats and additional modules. This is not apparently happening at this point, at least looking at the flat revenue trends shown in the cohort analysis on pg. 53 of the S1.
A larger risk is that the company's reliance on network effects. In the end, one of the things that wound up crippling the business growth for both Ariba and for Covisint related to the far weaker network effects than had been anticipated. Both of them, at their peak, developed large networks of suppliers who made products available on their service, but neither was really able to monetize the networks into the kind of sustained growth that had been anticipated. At this point, Covisint is close to extinction while SAP's stable of spend management solutions which include Ariba, Fieldglass and Concur appear to be doing reasonably well and benefiting from SAP's large eco-system. As mentioned earlier, the failure of the 2013 customer cohort to show growth suggests that the network effect that the company is looking for has not yet showed up.
A deeper dive into the company's financial model
I suppose no one can have a reasonable expectation that a tech IPO might make money. A few do generate positive cash but that is not a hallmark of this breed of company either.
The company is reporting GAAP gross margins in the low 60% range and has done so for the past two years now. There should be some leverage as revenues rise and it is typical for cloud subscription revenue models to yield GAAP gross margin of 70%-75% or a little higher.
The company has been spending about 25% of its revenues on research and development, although it went down some last quarter. I do not think there is a material trend to see in GAAP research and development expense.
Another hallmark of this crop of companies is the extraordinary level of sales and marketing expense. Last quarter this company had a sales and marketing expense ratio of 62%, up from 54% the prior quarter. The increase was said to be the result of the company's annual sales conference. The lower number the prior quarter was a product of reduced advertising spend. For the most part, sales and marketing expense has held in the low- to mid-60% range. It is clear that no company will ever make money with a gross margin in the low 60% range and sales and marketing cost higher than that even if only marginally.
General and administrative costs did show a bit of control last quarter and were 15% of revenues, down from 19% the prior quarter. But general and administrative expense has been running in the mid-teens except for one outlier quarter for the past two year. There were statements in the S1 regarding some of the specifics in terms of quarterly expenses. What was not seen in the S1 was anything relating to a plan to show significant operating leverage let alone achieve operating profitability. There is simply nothing to demonstrate that this company can or will achieve leverage in its markets at anywhere near its current scale.
The company's cash flow from operations (CFFO) is running at an annual burn rate of about $15 million and has shown no signs of becoming positive in the near future. While stock based comp fell by more than 50% to just 5% of revenues, the other metrics in cash flow remained more or less consistent. It would take a significant improvement in either the company's net losses or a marked improvement in balance sheet metrics before the company can achieve positive cash flow.
Investors buy IPOs with the expectation of either hyper-growth that may even be accelerating or a clear path to profitability or some positive cash flow anomalies. There is nothing of that here. The company has a market capitalization of just less than $1.4 billion, even after the shares have retreated from their initial highs. The net proceeds of the offering were used to wipe out the convertible preferred shares and so the company's cash balance probably remains at less than $100 million - enough but not particularly an outlier.
The company appears on track to achieve $125 million in revenues this year. That is an EV/S of well over 10X, a level that can only be justified for companies with the highest growth, the most unique products and an outstanding competitive position. There is nothing that I see in either the technology, the space, the business environment profitability or cash flow that might make Coupa shares worth buying at present prices. Those fortunate enough to have gotten shares at the IPO would do well to take profits before the company has to explain falling growth rates and the absence of any clearly defined path to profitability.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.