As many of you know, my partner and I recently moved offices and are now sharing space with Insight Venture Partners. Insight is one of the largest and most well-established venture capital firms in New York and the team has always maintained a keen eye on the world of enterprise software.
I've just recently had the chance to meet Peter Sobiloff, who coincidentally this week penned a timely post at Sandhill.com on what software companies must do to survive an economic downturn.
Ready for a Downturn? by Peter Sobiloff
Software companies with a plan for bad times will not just survive a downturn–
they will emerge stronger than before.
I encourage everyone to read Peter's post in its entirety as I think he hits on many of the issues facing software companies of all sizes in the coming year or two. With that said, I'd like to highlight a few of his points specifically and react to them from the perspective of a public-equity investor in the space.
Point 1: A Downturn is Likely
Peter cites a confluence of factors for his cautious outlook:
- Weakening credit conditions
- Consumer confidence
- Rising gas prices
- Housing market woes
- Weakening dollar
- The upcoming Presidential election
I wholeheartedly agree with all of Peter's points, but would add two more to the equation:
- Employment trends -- The third leg of the U.S. consumer fallout relates to employment. Thus far, employment trends have been surprisingly resilient, but this week's rumor of massive layoffs at Citigroup is, in my view, a harbinger of things to come.
- Beijing Olympics -- I'm a believer in the BRICS phenomenon as a long-term secular growth driver; but given the valuations being afforded the Chinese equity market (and other emerging markets); it would be foolish to think that the MARGINAL rate of economic growth isn't vitally important for global IT spending trends. With the Beijing Olympics coming next year, there is a very real catalyst for China to slow down its torrid growth (with little thought of inflation) in the second half of next year.
Point 2: This Downturn will be Different from the 2001 Bubble
...It is impossible to talk about a downturn without comparing it to the dotcom
crash of 2001 and the subsequent recession. But if a downturn comes next year,
the drop will be different and not nearly as steep. Here’s why.
The
dotcom boom was characterized by immature and unproven business models which
exposed tech companies across the board. A startup that wasn’t making money
would buy Cisco equipment and Viant’s consulting services. That cycle of
economic activity based on immature models was bound to fail.
Today’s
software companies are much more mature. All tech companies have learned a lot
of lessons which set them on much more sound footing than during the dotcom era
and will help them during a future downturn...
There is no question that the technology markets (and the U.S. equity markets on the whole) are far better positioned than we were in 2000; when "irrational exuberance" was a stark reality. Software valuations are in-line with historical levels. That is to say, publicly-traded software companies are neither particularly expensive nor cheap based on historical comparison (both relative to the market indices as well as measured against absolute earnings, cash flow and revenue growth multiples).
That said, I do worry a bit about Peter's second analogy; i.e., the issue of immature bubble companies spending money on Cisco hardware and Viant services. Although we don't have that to worry about this time, we do have a tremendous amount of spending coming from the emerging economies. All of those companies in China, India, Indonesia, Brazil, Russia, etc...have been building with extremely cheap access to capital. That certainly argues for a lot of froth (and poorly managed enterprises) that could very quickly close off their spending spigots. That's a risk that is also impossible to quantify, because we have very little reliable data on the true econometrics driving many of those countries.
Point 3: Downturns can be an Opportunity
...Economic cycles – both up and down – are always an opportunity. Like anything
else, the more prepared a company is, the better it will ride out either cycle.
Executives must communicate with management about a potential downturn,
have a specific action plan, have “buy in” for the plan at all levels, and build
the business in a “componentized” way that enables progress during tough times.
Savvy companies can use an economic trough to execute strategic M&A deals
and gain ground against their competitors.
The software companies that
operate strategically during a downturn will emerge as stronger businesses for
the long term.
Peter is spot on here. The software industry has matured considerably since the late 90s. Growth rates, in aggregate, have slowed but that's as much a function of the industry gaining scale and importance (it now figures in at about 25% of IT spending). Well-run software businesses are attractive in good and bad times. With unbelievably high gross margins; software companies that are pragmatic can effectively control their spending and protect margins in downturns (i.e.,slow down hiring, pare back poor-performing sales reps, consolidate G&A through M&A and outsourcing). In addition, while license revenues can fluctuate considerably, maintenance revenues remain predictable and sticky. Subscription revenues (an emerging line item as SaaS gains popularity) are, as well. Many software companies are sitting on boatloads of cash.
Software companies with a plan in place; and a pragmatic, forward-thinking executive team will come out of this downturn better off.
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'Tis the season and that means giving as well as getting; and so I'm sure Marc Benioff, a former Oracle acolyte, would like to say thanks today, too. You see, the lofty valuation afforded NetSuite today had a halo effect on shares of salesforce.com (CRM); as investors no doubt looked upon the relative size, profitability and cash flow generation of CRM and bid the shares up in sympathy. CRM finished the day at $65 (up 8%) at a new 52-week high.
