Enterprise Software: More Room For Downside Surprises

With the Q1 earnings reporting season rapidly coming to an end, the outlook for the rest of the year is coming into focus for enterprise software firms.

The overall tenor of software company earnings was uninspiring. While there weren’t any huge negative surprises, the positive surprises were few and far between. None of that should be new news given the growing evidence of a recession in the US economy, the volatility in capital markets and the trauma in financial services and retail. Results for the largest software companies (Microsoft, Oracle, and SAP) were modestly disappointing to investors even though our own preliminary analysis of MGI Index (MGI-X) efficiency scores indicates that many companies have at the very least maintained their business model efficiency.

Among the many smaller and mid-sized companies there is nothing to contradict the sense that business momentum is slowing. In our view, the remainder of 2008 will likely be tougher than management is publicly admitting – and we re-iterate our view that in inflation adjusted terms, the overall IT spending could be flat to negative in 2008.

At the same time, although Q1 was lackluster, it was by no means terrible especially given all of the economic flux. Longtime observers of the software space would recall that Q1 is seasonally a slow quarter for the industry (excepting those companies whose fiscal year ends in March), and Q1 is a quarter when changes to strategies, sales territories, quotas, etc. are often implemented.

So what could investors learn from the results of the first quarter of 2008?

Many software CEOs have been re-iterating that their pipelines have continued to grow and that they are optimistic regarding the overall outlook for 2008. This is somewhat at odds with our field research with customers and industry executives. That said, a common theme voiced by many industry practitioners is that the sales cycles are lengthening. The ability to close a deal in 2008 requires a higher level of approval than in 2007 or 2006. In addition, the underlying sense of urgency by users to move forward has gone. It is clear that software buyers are broadly more cautious, even as they recognize the importance of their investment.

The weaker close rates are attributed to the macro-economic weakness and usually to some execution related problems as companies kick-off their new year.

Consequently, most companies have seen their outstanding pipelines expand vs. their expected sales – contributing to the sense of optimism regarding the year. So called “coverage ratios” are clearly up. Unfortunately for outside observers, there is no way to look at these statements in a quantitative rather than qualitative context. Nevertheless, close rates have deteriorated making the critical question for Q2: Will the expansion of the pipeline more than offset the weaker close rates?

Most software companies appear to have left their guidance for the full year and Q2 intact. Looking at guidance commentary for a perspective, it appears that most companies believe that the expansion of their pipelines will offset the lower close rates.

From our vantage point at MGI Research, the calculus software investors will engage in is as follows:

1. Assess relative valuations (are the stocks cheap?);

2. Assess individual company positions

a. Is the product a need to have, or a nice to have offering?

b. Is the company the competitive leader?

c. Is the company executing efficiently? What are the MGI-X and MGI-CV scores?

3. Make a determination on the near-term/intermediate term prospects for the broader economy.

We are not in a position to answer this third, final question; but we do believe that a combined assessment of relative valuations and competitive positions can help investors at least avoid the investment bear traps. A large portion of the analysis of the short- to mid-term software industry trajectory will be a function of recessionary impact on specific user sectors and which will be impacted more or less negatively: e.g. retail, government, education, durable goods, et al; and c) which sectors may hold up better – e.g., health care, energy, et al?

Bottom Line: While management remains optimistic, and software pipelines are growing, we do not believe that this will automatically convert into top line revenue growth. There appears to be more room for downside surprises as government and corporate buyers tighten their belts and push out their IT expenditures into 2009.

Comments

[User 49180:]

This article seems to be a series of vague conclusions.Is there a point?

2008 May 15 07:10 AM

[p. smith:]

For ERP software vendors like ORCL and SAP... yes.

For best breed software and consulting vendors such as supply chain management leader i2 technologies and SaaS vendors sepecially in HR and ACCOUNTING, 2008-2012 is the rapid growth period.

SAP and ORCL are not growing anymore, their decline will become obvious by end of this year...

2008 May 15 10:49 AM

[kingofcary:]

The comment wrt large s/w companies struggling i.e. MS, Oracle, SAP is misleading. Of course some campanies struggle as is always the case. However, I see no mention of IBM one of the largest and certainly a bellweather. 4q07, 1q08 ... record revenue, profit, margin, EPS etc and by all measures and exceptional balance sheet. To not include this positive point indicates lack of crediility in the article.

2008 May 15 11:31 AM