Q4 Postmortem: Bing, Boom, Bah – Outlook Still Healthy

Disappointing results at Oracle, Symantec and SAP have raised questions as to whether the disappointments reflect a slowdown in spending, the maturation of the industry or the impact of “disruptive technology” as represented by “start ups” offering on-demand, software as a service.

We understand investors being nervous, but we think it is a big mistake to place too much importance on a single quarter and to read as much into the quarter as people seem to be doing.

Obviously after more than twenty five years, the enterprise software industry is a maturing industry. However, this is a not a new concern and the performance over the past couple of years with growth rates well above GDP underscore that the sector has recovered from binge years of the late ‘90s.

Our discussions with industry contacts do not lead us to believe that the growth in IT spending for 2007 will be less than it was in 2006. In fact we continue to believe that it will be modestly better like it has been in each of the past several years. The reason for our confidence is that enterprise tech spending has become a cyclical industry. The last big boom cycle was driven by the fear of a Y2K disaster and the Internet Bubble, which was followed by a period of massive consolidation of spending and resources. The net result is that companies have largely gotten their houses in order and that with a generally healthy economy are now faced with the need to incrementally invest in their IT infrastructure.

As for the impact of “disruptive technology,” there is no debate that for investors looking for growth rates of 20% or better these smaller companies are the place to be, whether they are “software as a service” or companies addressing newly emerging functional requirements.

While the longer term picture for 2007 and 2008 may very well be healthy, the near-term outlook is more clouded. Although there is evidence to suggest that the seasonality of the industry is diminishing, the first quarter of a new year has traditionally been problematic. On the heels of seasonally strong Q4 results, the early part of Q1 is usually pretty good. However, by the time Q1 draws to a close the angst has set in and investors fret about whether estimates for the full year are too optimistic. Expectations moderate and stock prices wilt, until there comes a point where investors once again are drawn to the sector and the whole cycle repeats itself. When 2007 is over we would be surprised if the overall enterprise software sector didn't do pretty well.

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.

SAP’s Miss – Market Slowdown or Market Shift?

SAP’s disappointing Q4 results raise the critical question as to what do they mean. Is it a company specific issue, or is it a reflection of a broader weakening of demand for enterprise software. We’re not going to go through the specific numbers since there are plenty of sell-side analysts who do just that, but with indicated Q4 revenues up only 7% that’s a sharp slowdown vs. year to year comparisons throughout the rest of the year.

We’ve checked in with a number of our industry contacts (systems integrators, market research analysts, as well as independent consultants and field sales) to get the benefit of their perception of market conditions.

Is it an indication of a slowing demand for applications software? It is a bit early to say for sure, given that Oracle’s November quarter results were a bit disappointing on the applications side as well, but our checks to date do not suggest a deterioration in the market. Furthermore a recently published survey by a leading brokerage house of 500 corporate IT buyers suggests the prospects for IT spending continue to be pretty healthy.

Is it an execution problem at SAP? SAP has generally been very effective in managing its sales execution during the past several years. We have no reason to think SAP sales force is any less effective than they have been in the past apart from the increased challenge of no longer being able to benefit from angst over Oracle’s acquisitions. If anything SAP's strategy to largely steer clear of acquisitions would suggest a greater degree of stability.

Is it a product problem? While some observers are busy critiquing SAP’s SOA capabilities and lack of an on-demand solution as a reason for the slowdown in their business, we do not see this as a significant issue for SAP from a competitive perspective, since we can make comparable criticisms of virtually any competitor in the market.

Or is it a reflection of changing competitive dynamics with rival Oracle? We resisted making this declaration six months ago or so when Oracle had its first big blow out quarter and SAP came up a bit light. However, at this juncture despite the fact that Oracle’s apps business was not as strong as expected in the November quarter and our view that SAP remains the powerhouse in applications, we now believe that Oracle’s success to date in its major acquisitions is costing SAP a significant amount of business. Another way to put it is that SAP is no longer enjoying easy wins owing to uncertainty and concerns over Oracle’s acquisitions and how they would support those products. In addition we think this is particularly relevant in the all important small and medium business market, which by all accounts represents the biggest growth opportunity.

One bit of good news for SAP is that Henning Kagermann will continue at least one more year as CEO, forestalling a much anticipated horse race between leading executive board members Shai Agassi and Leo Apotheker and the risks that one of these key executives will leave.

With many software companies reporting December quarter results in the next few weeks there will be a wealth of additional data points and qualitative commentary to help investors handicap the outlook. However, our view is that demand remains healthy and that while there are a variety of factors that impacted SAP’s results ranging from the effects of a weaker dollar, to inevitable execution issues, as well as an overly optimistic forecast, we think the evidence of the past year points to a visible shift in the competitive landscape.

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.

2007 Outlook – Looks Pretty Good the Hangover from Y2K and the Internet Bubble are Finished

Will spending growth for enterprise software continue to improve in 2007?
Based on our informal, qualitative discussions with a pretty wide variety of industry contacts (software sales executives, implementation consultants, industry analysts, as well as users), our sense is that the ongoing gradual recovery in software spending growth will continue in 2007. The improving demand is being driven by a number of factors ranging from customers finally having digested the huge amount of technology investments made in the late ‘90s, a prolonged period of deferred IT investment, to the ongoing challenges of meeting Sarbanes-Oxley regulation, and the benefit of a healthy economic climate. We also believe that the growth rate in software spending will modestly outpace GDP growth in 2007. No one we know is complaining about the spending environment anymore and in our various conversations we see more and more evidence that business is quite healthy.

2006 was a record year for consolidation among enterprise software companies with a myriad of deals large and small, how will 2007 look in comparison? While we’re not sure 2006 was a record year in terms of total value of software M&A value, we’re pretty sure it was a record year in terms of total numbers of transactions. Some of the notable transactions in 2006 are as follows: EMC’s deal to buy RSA, HP’s deal to buy Mercury, and Perigrine Software, Oracle’s continuing spate of smaller acquisitions, infor’s acquisition of SSA Global (itself a conglomeration of many smaller software companies), along with further consolidation being done by private equity firms such as Silver Lake’s $1.2 billion acquisition of Serena Software or the aborted buyout of Embarcadero. While the past couple of years have been very busy for M&A in the enterprise software industry, we believe the forces driving consolidation remain very strong and we expect that 2007 will be another active year. We would not be surprised to see some potentially very large deals given IBM’s continuing desire to be seen as a software company, not to mention HP’s improving focus and Oracle’s success to date in digesting its large acquisitions.

Software stocks after a slow start had a strong finish. What’s the prognosis for 2007? How do valuations look? Since we are no longer in the business of making specific stock recommendations we are limiting our comments to broad brush strokes. We’re quite optimistic that 2007 will be overall another good year for the enterprise software sector in terms of industry fundamentals. We also believe that stock valuations are not unreasonable given the growth characteristics, but that as usual stock performance will be quite mixed.

What will be the hot areas, on-demand hosted applications, business intelligence, ERP applications, analytics, and business service management? During the past several years, on-demand hosted applications providers have done extremely well, benefiting from favorable up-front economics and rapid implementation. While we believe on-demand will continue to do very well going forward particularly with small and medium sized businesses, we think the market is beginning to mature. Large enterprises will embrace on-demand for non-strategic applications and in those instances where concerns over data security on less. ERP applications have enjoyed a recovery which we expect to be continued through 2007. Analytics has been very hot benefiting from companies looking to leverage their existing applications and from what intuitively is a high return on investment. We also see from our work that “e-Service” applications are gaining significant strength in the market as more and more companies recognize that as products are increasingly commoditized, that their service capabilities represent a critical basis for competitive success. Finally, we believe that business service management, long talked about by companies like BMC and others, is in fact gaining real traction in the market.

2006 was a year where the momentum among the major software vendors continues to shift. SAP’s license growth decelerated, while Oracle’s accelerated. Microsoft is finally rolling out Vista. The net of all this is that SAP’s stock has become stuck in a trading range, Oracle’s has broken out of a longstanding trading range, and Microsoft’s following a violent downdraft around the middle of the year appears to be recovering.

Options backdating took the gas out of many, many software stocks. We don’t expect this issue to be as corrosive in 2007.

What’s on tap for the big guys in 2007? We believe SAP will continue to be stuck in the current trading range as it license revenue growth continues to be comparatively sluggish vs. the high rates seen in 2004 and 2005, and the valuation is still rich. SAP registered approximately a 4% price gain in 2005 and a 3% gain in 2006, or 17% for the past two years. We expect SAP to have another year where the shares will be lackluster. While Oracle shares were down 6% in 2005, they’ve roared back in 2006. Although we don’t expect a repeat of the 43% price gain so far in 2006, we do believe that Oracle will continue to outperform the peer group in 2007. Over the past two years, Oracle shares are up 34%. Finally, with respect to Microsoft shares, which were down 2% in 2005 and up 12% (following a sharp downdraft in the middle of the year), we think the shares will have a pretty good year in 2007 and could be a positive surprise.

What does IBM’s recent pronouncement that it is now a software company first and foremost really mean? IBM despite its position as one of the largest software vendors in the world, a spate of significant acquisitions in 2006 (Micromuse and FileNet), as well as the sale of its pc business, is still thought of as primarily a hardware and services company. The declaration that IBM is a software company reflects a frustration with the stock’s valuation and perhaps indicative that the company’s appetite for software acquisitions is not yet satiated.

Will CA recover? While investors have obviously been very disappointed this past year in the pace of CA’s recovery (one step forward, two steps backward), there is little doubt in our mind that CA will recover. The problems to date, in our view, illustrate the tremendous complexity of the business in terms of evolving from older license models to the new subscription based model, as well as struggling with the challenging of defining a rationale pricing model. However there is no question, in our mind, that CA given their breadth of products and deep penetration in the marketplace that the company will recover its balance and resume growth in the 5% to 10% range.

Can BMC continue its turnaround? BMC has enjoyed a terrific year in terms of their stock price. The gains have been driven by 6 quarters where the company has beaten its guidance. Perhaps more importantly bookings growth has turned positive for the past couple of quarters. In our work during the past year we’ve attended a number of BMC events, most notably its user conference earlier in the year. There is little doubt that business service management is gaining traction in the marketplace and that BMC is the clear leader, benefiting in large part through the strength of their CMDB (change management database) offering. Our sense is that BMC’s healthy progress will continue.

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.