Enterprise Software – Who Would Have Thought it would be Boring?

Enterprise software stocks continue to be generally listless despite significant growth in cash flow and modest gains in revenues, not to mention the sharp increase in the pace of industry consolidation. During the past 20 plus years that we have followed the industry much of that time has been characterized by significant volatility with many individual stocks moving 50% or more in a single year and with the group broadly moving up or down together. Today the majority of software stocks seem to be stuck in trading ranges of 15% to 25% in terms of 52 week high/lows. Put another way it has been a challenging “stock picker’s” market in software for the past couple of years, with the vast majority of stocks being comparatively uninteresting…..or boring.

Our demand checks for enterprise software spending have for the most part been quite positive. Discussions with systems integrators, consultants, field sales managers, and market research sources generally indicate that demand continues to gradually improve.

• Industry analysts who handle deal inquiries relating to licensing terms and conditions have been very, very busy (while some of this may reflect changing pricing models, much of it is indicative of increasing spending).

• Systems integrators are aggressively adding capacity and we continue to hear reports that government and financial services sectors remain very active.

• Field managers appear to be hitting numbers.

The only problem area continues to be the mature mainframe sector. (Here we see ongoing efforts to restructure the businesses as seen by the buyout of Serena Software and BMC’s plans to organize into two business units, one for its mainframe business, one for everything else.)

We would point to results from a wide range of major companies such as SAP and Oracle (recently reported May Q4 results were very impressive), to a significant number of smaller companies as evidence of the underlying health of the industry. Microsoft’s tools business is also doing very well.

Independently of industry fundamentals there have been a number of instances of substantial setbacks owing to execution issues (Microsoft’s ongoing delay of Vista, CA’s recent sales management issues) as well the growing number of companies wrestling with questions as to the timing of option grants (Quest Software among others), that have resulted in sharp stock price corrections. These steep sell-offs are indicative of negative surprises, but who is really that surprised by the ongoing delay of Vista? Or the continuing challenges CA faces? Accounting issues continue to be wild card factors that are extremely difficult to predict and represent an ongoing risk despite Sarbanes-Oxley.

While the majority of our field checks are quite positive with respect to demand prospects, we have also heard reports of increased anxiety as the Fed’s efforts to contain emerging inflation and slow the economy are expected to take hold later in the year. (Most of these concerns regarding the risk of a slowing economy are emanating from hardware manufacturers rather than software companies.)

The anemic performance and steadiness of enterprise software stocks is in sharp contrast to many other sectors in the market and signs that market’s volatility is on the rise.

What gives?

As the divergence between fundamental performance and valuations continues to increase, we believe the principal reason behind investors’ lack of interest is simply that the sector is no longer exciting and investors are uncertain what to make of this new wave of consolidation.

The high growth period of the ‘80s and ‘90s is clearly past. The current recovery is largely a function of the share consolidation of IT spending by users seeking to rationalize their IT infrastructure and vendors as they seek to capture market share and broaden their product offerings. The substantial ongoing consolidation among companies as evidenced in part by Oracle’s string of large deals over the past 18 months or so has added to the sense of uncertainty, despite Oracle’s strong revenue and earnings gains. Arguably the scale of improvement is gradual and not dramatic. Another way to look at it, is that the software market has become so broad and diverse that it no longer makes sense to discuss it generally but rather more specifically in terms of “pockets” such as software on-demand which continues to do relatively well, or the mainframe space which hasn’t.

However, this is not going to be the case forever. Technology is not static and to that end there are numerous powerful forces that are gathering that will serve to unleash big changes in the not too distant future. Open source, on-demand, and services oriented architectures are a potent brew that we believe will contribute to the emergence of new services and new demand. Furthermore we continue to believe that the forces driving industry consolidation are still a very big factor that will take the weaker players out of the market.

Hence our advice to investors is to continue to be patient, the sector will not be boring for much longer. In the not too distant future (probably 2007) we will see increasing stresses brought on by the growth of open-source, on demand and services oriented architectures, which will lead to greater volatility and more excitement. However, while the volatility will increase, from an investing point of view it will continue to be a stock picker’s market, but the stakes will be significantly larger than they have been of late.

Legal Disclaimer
Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.

Blue Atlas Management, LLC is our official business entity for consulting related work. In addition, we also have a website for those of you who are interested in learning more a little more about our services http://www.blueatlasmanagement.com. Please feel free to contact us at jmendelson@blueatlasmanagement.com, with any comments or questions.

The Recovery in ERP Software

The ongoing consolidation of enterprise software companies continues at a pretty active pace, with the recent announcements of RedHat’s pending purchase of JBOSS as well as Oracle’s deal to acquire Portal Software and most recently JDA’s pending acquisition of Manugistics.

March quarter earnings were generally okay and did not contradict our longstanding view that the spending environment continues to gradually improve. Independently of the ongoing macro-economic concerns regarding the risks of inflation and the challenge for the Fed to slow but not tank the economy, the underlying trends driving the recovery in IT spending are very much intact. The picture, as always, is complicated by the challenge of handicapping of investor expectations vs. reality. Likewise deciphering the critical elements of individual company reports with respect to execution, strategic position, competitive dynamics and demand, will also be debated by market pundits.

The Recovery in ERP Software

While one wouldn’t know it based on the stock performance of ERP companies, the ERP market, long thought to be mature is showing very healthy growth of late.

SAP has been demonstrating impressive growth for the past several years and has significantly increased its market share. However, Oracle for all the controversy surrounding its acquisition strategy, is in fact a considerably larger applications vendor, than it was several years ago, and we believe its organic growth rate is healthier than recognized. (We expect Oracle's May Q4 results to provide further confirmation of healthy applications growth.) Growth hasn’t been limited to the largest vendors a number of other vendors are seeing good growth as well. Among smaller, but nonetheless sizeable companies, such as Epicor, Lawson (which has recently acquired Intentia) and SSA Global (itself a particularly active acquirer) have shown healthy growth in their most recent quarters. In addition there are a number of private companies of notable size that are also doing quite well, one that comes to mind that is not particularly well known is Deltek. While most companies are posting healthy growth, there are always some exceptions the most visible among these would be QAD and Manhattan Associates.


What’s behind the recovery in ERP software? How long will it last? Who are the prime beneficiaries?

Our discussions with various industry contacts ranging from systems integrators, field sources within the larger applications vendors, industry analysts and consultants indicate that there has been a significant up tick in ERP activity.

The boom in our opinion is being driven by the confluence of a number of trends.

• First, the accelerating consolidation of the enterprise software industry and in particular, Oracle’s applications acquisition binge is leading companies to actively re-evaluate their strategies toward applications vendors in general. (While Oracle has been by far the most aggressive, there has been a visible increase in consolidation among the other vendors as well and if our sources are correct, there are many, many more to come.)
• Second, the emergence of On-Demand services as a compelling alternative to traditional options such as building the software, buying a packaged application or outsourcing. Users increasingly recognize the benefits of retaining control of the software but without the headaches of managing the software itself.
• Third, the influence of Sarbanes-Oxley, which is forcing companies to re-examine their business processes with an eye to ensuring better controls through increased automation and integration of transaction processing coupled with ongoing investments in data warehousing and business intelligence.
• Fourth, the emergence of service oriented architecture which will enable new applications functionality and new found flexibility and is also contributing to the ERP boom, as ERP vendors work to introduce SOA versions of their existing products along with new functionality that wasn’t possible before.
• Finally, ongoing improvement in IT budgets driven by a combination of accumulated benefits of more efficient spending and the continuing strength of the economy.

These trends are driving demand across all segments of the market from very large to very small companies. The vendors meeting the demand vary according to the needs of the respective segments within the market. Put another way, we see SAP, Oracle as well as a handful of other vendors like SSA Global, Lawson, Epicor and QAD working with larger and mid-sized companies. On the other end of the spectrum we see on-demand, ASP companies such as salesforce.com, Rightnow, along with others enjoying good momentum among smaller to mid-sized companies. Microsoft which has made a number of acquisitions with the intent of becoming a major force in the business applications market has had mixed success.

Under the radar are a number of privately held companies that are also enjoying healthy growth such as Deltek and Authoria.

The improving demand is also evident across the many functional segments of enterprise applications such as GL, HR, performance management, training, analytics, budgeting/planning, and so on. Finally, our checks with respect to spending trends by vertical industry segments also suggest ongoing recovery. In particular we believe that the financial services, government, energy, retail, manufacturing and healthcare sectors are all doing pretty well.

So if the business is broadly doing better, why aren’t financial results even stronger and why haven’t the stocks performed?

• Growth rates for revenues and earnings while improving are still well below the boom period of the late ‘90s.
• Ongoing consolidation has created greater complexity and uncertainty in assessing results with respect to underlying “organic” growth as well as concerns over integration of acquired companies.
• Impact of FAS 123R is a factor in that as companies adopt the new standard for recording options expense reported earnings inevitably take a hit. In addition, while the impact on cash flow is comparatively modest, FAS 123 R does make near-term comparability of results more complex and difficult.
• SOA while clearly an opportunity is also clearly a risk, much as was the case with the emergence of the client/server model. Investors are challenged to determine which applications companies will get it right vs. not, as well as how much of the broad vendor claim for SOA capabilities are real or not.

Legal Disclaimer
Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.

Blue Atlas Management, LLC is our official business entity for consulting related work. In addition, we now have a website www.blueatlasmanagement.com for those of you who are interested in learning more a little more about our services. Please feel free to contact us at jmendelson@blueatlasmanagement.com, with any comments or questions.