Callidus - A market leader in a non-category
CallidusCloud (NASDAQ:CALD), as the company is now known, is a company without a country. No I don't mean that it isn't domiciled in the US. What I do mean is what is the market for this company's solutions? The company and others self describe the solutions that it supplies as Sales Performance Management. But the core of the company's overall set of competencies is in supplying solutions that are used to calculate complex commission and incentive payments for employees and to provide an audit trail that the commissions are paid for the right sales. But another market consultant says the SPM is really some form of advanced Customer Relationship Management (that's CRM the solution and not the company). Why should an investor care - very simply putting the prospects for a company in a real space in which it is a leader is far different than the prospects for a company exploiting a niche or even worse for a company competing in a jungle where the predators of the CRM world roam unchecked.
Callidus really is a market leader in the Sales Performance Management space or at least says leading market intelligence firm Gartner. But that rating begs the question - is Sales Performance Management a space or is it a nice to have feature, or set of features that ought to be part of a much broader solution? I come down on the latter side of that question and hence think that the shares of Callidus ought to be avoided. Not because I'm making a call on a specific quarter. I don't have that kind of information, and if I did, this would hardly be the forum in which to reveal it. But as I will lay out in this article, I think for many reasons this company is, as the saying goes, an accident waiting to happen and there could be a great number of causes for the potential accident. And accidents for smaller companies that have elevated valuations, while not necessarily fatal to the company, can put a big hole in one's portfolio.
It has long been contended by some observers that Callidus would get bought and this would be the exit strategy for investors. No one ought ever to say never regarding acquisitions. Companies spend loads of money and buy things that many outsiders think to be irresponsible. One has only to look at the Microsoft (NASDAQ:MSFT) acquisition of the Nokia (NYSE:NOK) phone business to see a high profile example of that.
I personally do not see Callidus being acquired by any of the logical acquirers. As Gartner says, a lot of the high-profile stack vendors including IBM (NYSE:IBM), MSFT, Oracle (NYSE:ORCL), Salesforce.com (NYSE:CRM) (CRM - this time the company) and SAP (NYSE:SAP) are already there. And most of them are there because they have already bought companies in the space. Buying Callidus would be an admission its partner at the ball wasn't right for it, something few companies seem to be able to do. Callidus is a relative small company and could readily be acquired at a significant premium - but why? If Sales Performance Management is really CRM, all of the potential acquirers have strong entries in that space and compete bitterly in the market.
Callidus started its life as a company that was focused on paying commissions and other incentive compensation, primarily to field sales forces. That is still the core of the company's business although it has expanded beyond that functionality into the entire SPM space. Since s010, the company has acquired 12 other companies on the way to transforming itself into a company that's based on a strategy that they call "Lead to Money." Really! The strategy is based on optimizing the overall sales process including hiring the right sales people, follow the best sales leads, pricing and configuring the product properly, keeping track of the process of sales contracts, ensuring that the sales people assigned are in the right territory with the right quota and finally paying the people who sold the product at the right commission.
I must confess that I have not paid much attention to this space for a long time. For many people familiar with the Customer Relationship Management (CRM - the space and not the company) solutions, almost all of them have included functionality that's almost exactly the same as that which Callidus sells. Over the years, I have heard more complaints about the Siebel sales management process than I care to recall. As CRM solutions have gotten more and more complex over the years, they have tended to aggrandize adjacent areas of functionality. And yet here I found Gartner projecting that this space that I didn't know existed in isolation being forecast to do $6 billion in business by 2020.
As things go, $6 billion of revenue these days is a small space, but then again CALD is a small company. It has forecast revenues of $208 million this year followed by $250 million in 2017. That seems pretty reasonable since market analysts think the space itself is going to grow at a bit more than 17% through the end of this decade. I might have decided to leave the name alone. It has a nominal valuation that seems about right for a pure SaaS company in a 17%-plus growth market. It isn't quite profitable, and the scourge of stock-based compensation is in evidence with that metric up no less than 58% last year and up by 33% in the first quarter of this year. The epidemic with that metric has reached opioid-like proportions. (Besides the basic dishonesty of saying that stock-based comp is an unusual item that can't be predicted, using the metric as a piggy bank to regulate earnings is just beyond what I countenance without a comment). The company says that it is obtaining a modest level of leverage in its operating margin performance. The CFO forecast on the call that margins will rise from about 7% this year to 8% and will continue to grow at 100 bps/year into the future. Of course that is tantamount to saying that I could run a four-minute mile if you put me near the finish line of the track and asked me to walk across. I have yet to understand the logic of a company saying it beat its earnings guidance and then on reading further find that it beat the guidance solely by increasing stock-based comp.
Gartner ranks CALD in its Leaders Quadrant. But it is not alone to be sure, and it has to compete with Salesforce. Competing with CRM these days is more or less akin to having horse cavalry charge tanks as was done by the Poles at the start of WW II. Again, if you believe the market research statistics, CALD has less than a 10% market share even though it is in the Leaders Quadrant. Sometimes that might be all right, and I have written articles on companies in the Leaders Quadrant, or even elsewhere, that I believed would be market share gainers. I just have a very hard time figuring out how a company that specializes in one space and one space only and which has a 10% or less market share can survive in a market segment where IBM and Oracle are neighbors with CALD in the Leaders Quadrant and where Salesforce is said to have comparable product but less execution capability. Guess the Gartner analysts haven't looked at CRM's latest quarterly reports or paid much attention to the AI functionality that CRM is building into its sales cloud.
One thing to note before readers go much further. This is a small-cap name. Revenues this year are forecast to be $208 million, and the company has a market cap of just $971 million. Those readers who do not like dealing with small-cap names ought not to read much further other than for informational purposes.
The company is non-GAAP profitable and has been for some time now, but non-GAAP operating margins were just 7% last year. Stock-based comp is running at just over 10% of revenues and the metric rose by 58% last year. I will go through some other significant financial metrics below, but I think there's a plague of small software companies which generate cash and are non-GAAP profitable and seemingly maneuver their costs to produce decent headline numbers by increasing their reliance on stock-based comp. It is the unheralded opioid plague of the IT investment world at the moment.
The company has 10 analysts who write research on the firm and they have a mean target price of about $22. The consensus recommendation among the 10 analysts is between buy and strong buy. Indeed, one analyst who recently attended the CallidusCloud C3 customer conference went so far as to comment that management delivered a confident and upbeat presentation. Was the man expecting that the company CEO would deliver a downbeat and shaky presentation? If that is the state of analysis on the company, well that's a good thing if you are considering taking a short position. (By the way this is a reputable analyst from a large multi-national IB. He has been doing this a long enough time to know better).
So, I think that some of the elements that are needed for a viable short thesis are present here. A company in a space that it doesn't dominate facing much larger companies, some of which are marketing machines in a "category" that doesn't really make sense. A legacy product which basically is software that pays commissions, something that needs to be done, but which is certainly a relatively narrow niche. A company that's modestly profitable non-GAAP but which has used stock-based comp at an increasing rate to improve headline numbers. A company with which analysts still appear to be having a love affair.
For the most part I like to write positive things about small software companies. I like to discover new names that are doing neat innovative things. This just doesn't happen to be one of those times.
What is Sales Performance Management and how is it used?
Sales performance management (SPM) has been around in some form since the farmers in ancient Babylon sent their sons into Ur to sell their wheat crops or their chickens. The farmers wanted to know who was selling how much at what price and they wanted to figure out if they could make some big deals with big buyers, maybe from Egypt. Anyone who has a company that sells things has been figuring out how effective the process is since there have been salesmen and customers.
That's both a good thing and a bad thing. It is good in that most businesses will want to automate the process and it is bad in that acquiring a new SPM solution is inevitably a "nice to have" rather than "a need to have" solution. After all, enterprises are obviously getting by with some SPM alternatives and have been doing so for a long time.
But let's drill down a little more. The solutions that Callidus sells are relatively cheap. I don't mean they are cheap in being a good value as I don't know that. But they are cheap overall. For $50/month, a user gets the basic package, which consists of Marketing Automation, LeadRocket and Enablement. A user has to buy a minimum of 25 seats to get the minimum package. If you want it all, the cost is $150/month. The company does charge for additional storage/usage above some minimum level, and it appears that some users are unhappy with that pricing formulation. This package which is felicitously labeled "Lead to Money" essentially has all of the functionality this company has developed, but I think it is more intended for sales managers and not sales people.
Now for $150/month, a user gets many things including Marketing Automation, Territory and Quota management, a tool that allows a salesman to configure, price and quote, another tool that allows either a salesman or a manager to obtain insights into what is called contract lifecycle management and other categories including My Sales Game and commission calculations. But think how many seats are required to generate $200 million of sales. Given the spread between the basic package and the more enabled packages, I chose to use the package called Sales Execution, which costs $70/month with a minimum of 50 users. That turns out to be 250,000 salesmen. And these can't be any old salesmen since the company focuses on a few verticals such as such as Producer-Pro for the insurance carriers and Dealer-Pro for telco dealers and Multi-Level which is said to be a solution for the whole marketing space.
I would be hard pressed to find a space with more and larger competitors than one that encompassed multi-level marketing. Last I heard it is what the CRM Sales Cloud actually does.
If I sound a bit cynical about this kind of functionality it is because I am. It has been 25 years since I last worked for an enterprise software vendor and yet every function I mentioned was being done all though years ago. No one, even then, would try to calculate commissions by hand and then present the results to a horde of ravening salesmen. At least I didn't. No sales manager alive would not have a tool that allowed him to look at territories and quotas. And I think without fear of contradiction that every sales manager I ever knew had a tool that allowed him to look at the status of contracts and that presented some kind of year-to-date sales performance management tool. In those years, most of the functionality was contained in purpose built Excel spread sheets or if the VP of Sales was ambitious, he would get some kind of homegrown integrated tool built by the internal IT function. Maybe the software sales space was more advanced than some other areas of the world but honestly, it has been 25 years.
So, I guess the first conclusion that I have to draw is that what CALD does has been done before in many ways and there's nothing particularly unique about the functionality that the company is offering. People write about predictive analytics or AI or Virtual Reality because these are new spaces in there have never been commercial solutions. That is exactly the opposite here. Whether you like Tesla (NASDAQ:TSLA) or detest the company, what they are doing is new and potentially revolutionary. What Callidus is doing is packaging very old wine in shiny new bottles. My conclusion is that the space that Gartner calls Sales Performance Management is no space at all, but simply a subset of categories generally called CRM at most software vendors.
So maybe there is no real SPM space. But that doesn't mean that CALD can't be successful selling what it does to companies that employ lots of sales people within its target verticals.
If CALD had a unique set of functionality, or if it could be proven that its tools resulted in improved... well outcomes than the other tools in the market or if the company had some kind of credible competitive moat, I might agree with the proposition. Although management was consistently upbeat during the last conference call and seemed pleased with Q1 performance, I think it recognizes the limited differentiation it enjoys outside of the commission payment area. In one answer to a question during the conference call, the CEO, Leslie Stretch, talked about the integration of IoT with other Callidus solutions would create significant differentiation. I would surely need to see and understand a far more concrete example before I accepted the assertion of Mr. Stretch.
Let me start by including a paragraph from what's called the world's largest market research store:
"The emergence of sales performance management solutions has also opened new business potentials for the main stakeholders present in the ecosystem. These solutions (I believe the author means companies) have expanded their offering portfolios and have also been influential in expanding their revenue aspects to different markets. From the inception of sales performance management in 2005, these solutions and services have extensively evolved their functionalities with ongoing technological enhancements and have proved to be the advanced version of Customer Relationship Management."
Now one conclusion I might draw is that if this company ever fails in selling its market research it can readily go into business selling buzzword compliant sentences. But to me, the heart of my short thesis is that SPM is really the advanced version of CRM. And so I believe it to be. Any vendor that has to compete in the advanced CRM space against CRM, the company, IBM, Oracle, Microsoft, SAP and many others is offering its current investor a very risky proposition to say the least. All of those vendors have highly integrated, but modular tools that can do everything that CALD sells. All of those companies have the CRM space as a prime business focus. Oracle bought what was once the leader in CRM at the time - Siebel. If Siebel didn't do something, that was almost exactly the functionality described in the above write-up - well I must not have understood what I used to hear every quarter.
I will turn now to competitive assessments made by Gartner, something that it is well acknowledged to be good at. Gartner says that Callidus Cloud is a leader in SPM product innovation. It is also cited as being able to conduct complex incentive compensation calculations and it has a new feature called Research View that offers visibility into every user edit action and the ability to trace payout amounts back to the original transaction. But Gartner has a number of significant cautions. One of those, which might deter a lot of users, is that what is described as a hidden kink in the pricing model. Like most SaaS companies, pricing is basically per month per product, but apparently Callidus applies monthly fees for data storage overruns. Other cautions included reference customers identifying issues with accessing consulting experts and these customers gave the company below-average scores for customer satisfaction and product quality. Most potential buyers of SPM are going to read that last one and shudder. There may be an answer - but if there is I haven't seen it. Why would I want to invest in a company that is judged to have below average scores for customer satisfaction and product quality in a market with many, many alternatives?
Let's look at what Gartner says about IBM. As some users know, IBM is not my favorite company, but that doesn't mean that it can't be a real competitor. Gartner says that IBM has improved its position on the strength of its customer experience, improved product quality and new functionality. IBM got into a part of this business by buying a company called Kenexa, which was at the time a leading provider of cloud-based talent management solutions. Many users want to tie talent management and SPM together for obvious reasons. You can do that with IBM and you can't do that with Callidus. The major caution cited by Gartner is the technical architecture that IBM offers since it is not based on a native cloud platform.
I will just do one more of these - but I do not think that readers will make better investment decisions by reading through a long synopsis of what Gartner provides. Gartner ranks CRM as a visionary. That is not as good as a leader, but it is probably good enough. Here are some strengths cited by Garner. Gartner says that CRM has advanced sales action capabilities such as the ability to track closing deals and achieving product certifications. I date back to the GANT chart era, but it is far more useful for all of the players and senior management to have a unified view of everything going on in their sales force and how that relates to annual quotas. That is what the CRM tool is designed to achieve. Gartner also says that CRM's reference customers were quite pleased with the company's new Work module. On the other hand, Work, being a new product for CRM, it has not yet been enabled with the new user interface platform that's one of CRM's real growth drivers.
I do not propose to try to summarize the rest of the report. What it says, more or less, is that there are plenty of companies in the space and they all have some positive attributes and areas of concern. There is nothing that suggests that the CALD offering is particularly unique or differentiated when compared to the offerings of most of its competitors. And it is also suggested that many users want to buy more than just advanced CRM capabilities. They really want suites to accomplish the resolution many different pain points deliver.
CallidusCloud has two strong features which are apparently not yet offered by competitors, which are its Research View feature and its capabilities in the area of complex incentive compensation. Both of these are real selling features but not at the expense of customer satisfaction and product quality. And like many other feature/function advantages, in a crowded market as this is, it will not be long before some other vendor has a better set of commission calculation functionality and I imagine every vendor is going to want to offer something such as Research View.
Putting it all together - Callidus has no real competitive moat, it has limited product differentiation and users are not all that thrilled about the product quality of what they have bought. There are loads of competitors, some of whom have integrated their SPM products with other functionality which seems a reasonable thing to do. You would have to provide a typical investor with a huge value discount to overcome some of these negatives in terms of evaluating Callidus. So let's go there.
Callidus shares are cheaper than some SaaS vendors and the company both generates cash and is non-GAAP profitable. But no one could possibly confuse an investment in Callidus with an investment in a deep value name. The consensus estimates really don't support that Callidus is a GARP name either.
As mentioned earlier, the company has a market cap at the present time of $988 million and an enterprise value of $869 million. Intuitions currently own 86% of the shares while insider ownership is modest at 2%.
The consensus sales forecast for this year is $208 million and for next year estimated sales are $249 million. So that calculates to a sales forecast of about $240 million for the next 12 months. That calculates to a 12-month forward EV/S of 3.6X. Certainly no bargain, but about average for companies that are growing at 17%. The P/E on 12-month forward consensus EPS is 48X. Again, not at bargain levels, but also not incredibly high.
The company doesn't forecast cash flow or EBITDA, so estimating cash flow is really a fraught exercise. In Q1, operating cash flow decreased from $8 million in the 2015 quarter to $6.1 million and free cash flow dropped to $4.6 million. The company, for whatever reason, does not generate all that much deferred revenue, but as mentioned above, stock-based comp is rising significantly. The single largest factor in the Q1 cash flow decline is on the balance sheet in terms of the decline in accrued payroll expense. As that will not happen again this year, I think it reasonable to forecast that cash flow will have some meaningful relationship to reported earnings. Last year, the company generated a total of $26 million of cash flow and achieved free cash flow of $7 million.
Given the slow start to cash flow for the year and the muted expectations for quarterly increase in EPS, I think using a $10-12 million estimate for free cash flow seems reasonable. That is a free cash flow yield of 1.4%. No investor is going to think that a 1.4% free cash flow yield is adequate for the many risks in this investment.
But the real risk is simply that the competitive picture darkens or that IT spending falters and the company doesn't make its numbers. It isn't as though this company's shares aren't on the volatile side. The shares made a high of $21 before falling to $12 in February at the depth of the tech crash. In the prior year, the shares swooned from $17 to $12 in a five-month span. If the company misses expectations, it has shown that the shares can implode significantly. The shares reacted negatively to the recent earnings release because of the guidance cut, which reflected the company's decision to exit the selling of its solutions based on perpetual licenses.
Callidus is a leader in the space of Sales Performance Management software. Historically, its basic niche has been the payment of commissions and other kinds of incentive payments, and while it has products beyond that space, the company's commission product remains its core business and apparently is most highly evaluated by users. That being said, it has less than a 10% market share in the SPM space and the space is chocked full of vendors including CRM, IBM, Oracle, SAP and MSFT. SPM is really an adjunct to basic CRM functionality and has been around for a long time now.
The company announced several new products at its user conference that was held on May 11th. Management on the call had talked about some epochal new solutions that would dramatically increase the company's TAM. The company did announce an IoT solution although I think measuring the contribution of the new offering will be difficult, and I doubt if it will move the meter significantly over the next couple of years.
While this company's offerings reside in the Gartner Leaders Quadrant for SPM solutions, there's nothing visible that makes it offering particularly unique. There's no real competitive moat that will protect this company's market space from the encroachment of numerous, large and aggressive competitors.
The company's valuation, while far lower than other SaaS vendors that are forecast to grow faster, is no bargain either. Despite a significant rise in share-based compensation, free cash flow generation is minimal.
I can offer no catalyst in the form of a smoking gun with regards to a meaningful share price decline. Callidus could go along for some period of time and make its numbers. But it lives on the precipice and the precipice is high enough that a fall from its ledge will be painful for investors. I think that there's little positive alpha to be found on the long side and quite a bit of potential on the short side. Without second sight, which I do not have, I can't really forecast when an implosion of this company's business might take place. But I don't think the time is that far off when the shares, if not the company, are likely to be in a lower range than that at which they currently trade.
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.