The Ponderings of Woodrow

Ellison's Early Xmas...

Quite the day for the world's second wealthiest software magnate. In what's been a turbulent U.S. equity market, Larry Ellison enjoyed not one, but two financial boons today:

• Oracle reported stellar Q2 financial results last night after the close; showing the world that, once again, his vision of consolidating the enterprise software industry is working. And those assailing the plan as a means of masking slowing organic growth are having to resort to the New Math in order to keep singing that song at this point. Database and middleware grew 30% in the Q; which is the best number I can recall from the company in at least 10 years [if anyone feels like confirming that as fact, I would greatly appreciate it].

• And then NetSuite, a company I've discussed quite a bit over the years, listed shares today at $26 per share, significantly above the thrice raised proposed offering range. As if that weren't enough, the stock rallied sharply late in the day to close the day at $35.50. In the process, that puts NetSuite's market capitalization at an astounding $2.1 BILLION.

Assuming the underwriter's exercised the over-allotment today, Ellison (and family + related parties) will beneficially own 65.4% of the outstanding shares; putting their one day paper gain at $1.38 BILLION.

'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.

As a shareholder of both CRM and ORCL, I too will raise a glass of eggnog tonight for the early holiday tidings.

Note: This is not a recommendation to buy or sell CRM, N, ORCL or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did not maintain a position (long or short) in N but did maintain long equity positions in both CRM and ORCL. As always, we reserve the right to alter our investment holdings at any time in the future. We also may, at times, carry derivative options on underlying positions as a hedge.

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NetManage acquired: Cheapest Nasdaq software stock no more...

As you might imagine, as technology investors, my partners and I maintain a variety of data sets that help us in our due diligence and screening processes. Two of the more basic measures used to value software companies are:

• Enterprise Value/Revenue
• Enterprise Value/Maintenance Revenue

Given the sticky nature of maintenance revenues, it's emerged as one of the main anchors for structuring software M&A over the last few years. Maturing software companies that have shown an inability to grow license revenues (or even suffered license revenue declines in many cases) have managed to maintain maintenance revenue renewals at a surprising rate (despite the best efforts of guys like Vinnie).

So what does this have to do with today's announced acquisition of NetManage (NETM) by privately held Rocket Software?

For whatever it's worth, NetManage was the cheapest (or least expensive) Nasdaq-listed software company that I knew of:

• Share price (12/11/07): $3.69
• Shares outstanding: 9.78mm
• Market cap (12/11/07): $36.1mm
• Cash and equivalents: $25.72mm
• Enterprise value: $10.38mm
• $33.79mm in TTM revenues
• $23.95mm in TTM maintenance and services revenues
  • Roughly $16mm in TTM maintenance (we use a percentage formula in our screens when maintenance isn't explicitly broken out)

For those playing at home, that implies NETM was trading at:

• 0.31x EV/Sales
• 0.65x EV/Estimated Maintenance

Today's takeout, by privately held Rocket Software, for $69mm in cash, represents a 95% premium to yesterday's closing price. Using the aforementioned financial metrics, that value the company at 1.32x EV/sales and roughly 2.8x EV/TTM (estimated) maintenance. Just to put a finer point on how "cheap" NetManage was, today's valuation would STILL put NETM at the 16th "cheapest" Nasdaq-listed software stock on a EV/revenues basis.

Don't misconstrue my comments to imply that "inexpensive multiples = good investments." In many cases, companies are "cheap" for a reason. In the case of NetManage, I don't profess to know much about the fundamentals of the business that couldn't be found in their SEC filings. But it's not everyday that you see the absolute cheapest company in one of your screens get taken out; even in this "Year of Software M&A."

Related:

• NetManage reports Q3 2007 financial results
• Q3-07 10Q Filing

Note: This is not a recommendation to buy or sell NETM or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did not maintain a position (long or short) in NETM. As always, we reserve the right to do so in the future. We also may, at times, carry derivative options on underlying positions as a hedge.

netmanage netm rocketsoftware investing m&a valuation software woodrow enterprise irregulars

Jeff gets the Microsoft/Facebook transaction exactly right...

Jeff reflects on a recent VC industry event he attended, and addresses the Microsoft/Facebook transaction; getting it exactly right.

Lot’s of grumbling about Facebook being valued at $15 billion and “how could Microsoft do this to us?”. Let’s be clear about something, Microsoft didn’t pay $15b, they paid $240 million out of their well stocked bank vault for pole position and, as Jim Long speculated, it doubtful they spent much time on the valuation. Will Price made the most salient point about this in questioning why FB would do this to themselves considering they have made their future employees options worthless.

Think about that for just a minute, if you already have options in FB the news that the company is worth $15b in that calculation (and it’s unavoidable irrespective of what people think FB is really worth, company valuation insofar as options calculation is a rigid event driven process) is great. I would imagine there were a lot of private wealth managers descending on FB HQ to tell employees how they could collar their options even though there is no market for them at the moment.

If you have yet to be hired by FB this news is no good news because it’s not like FB is going to give you $10m in options for being a senior product manager. I can only imagine some of the awkward conversations FB has been having with prospective employees about options these days. Basically, FB made it a lot harder for themselves to hire good people who understand cap table math.

I was on a blog hiatus at the time of the Microsoft's investment in Facebook but I can tell you that I was baffled at how many people were looking at that transaction through the wrong lens. I kept hearing about the "absurdity" of the $15B valuation as though that valuation has any real-world value. As Jeff says so well, the REALITY is that Microsoft used an infinitesimal amount of its cash hoard to secure:

• A relationship with the fastest growing social network
• A call option on potential future negotiations with Facebook
• A much needed "win" against Google

Now, there are also plenty of reasons why Facebook agreed to the deal, but Jeff (channeling Will Price) does bring up an interesting point as to what this does for Facebook's ability to hire in the future. Then again, that's a problem that all companies face that scale. I'm not a VC, but intuitively it strikes me that it's rare for employee #500 to get rich on stock options at any company. Maybe my VC friends can put some meat on those bones?

Note: This is not a recommendation to buy or sell MSFT or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did maintain a long equity position in Microsoft but reserve the right to alter our holdings at any time. We also may, at times, carry derivative options on underlying positions as a hedge.

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Citigroup isn't paying "junk bond" rates to Abu Dhabi...

When the news came out that Citigroup was acquiring $7.5B in capital in exchange for an 11% piece of commercial paper with mandatory conversion provisions; many (myself included) initially reacted with stunned disbelief. 11% yields are the stuff of junk bonds; and while Citigroup's near-term liquidity is disturbingly constrained, it seemed incredulous to think C would have to pay junk rates. If that were true, was there no end to the potential fallout of this credit crisis?

Hat tip to Andrew Clavell, who seems to have unlocked the puzzle in his post: Citibank, ADIA and that pesky 11% interest rate.

...The dividend enhancement is probably worth 12% of the deal amount of $7.5bn. With sensible assumptions, the net value call spread is around 8% in Citi's favour, so the remaining cost to Citi is around 4% or about 1.5% pa over the weighted average life of the deal. Put another way, Citi has raised tax deductible, upper tier capital funds for 4 years at a cost equivalent to another financing source of Libor+150. Smart business. It may even be that Citi's stock has suffered since the deal was struck in part due to Citi itself hedging out its long callspread position.

The FT and the Wall Street Journal are guilty of sensationalist journalism and have totally missed the point in their quest to find the worst possible slant on any investment bank's activities. I suppose this is in vogue at the moment. Perhaps if they had wanted to batter ADIA instead of Citi, the headline might have been "Unsophisticated Arab financiers write massive put option on US investment bank".

Thanks to Andrew for seeing the forest for the trees here. Let's not pretend these are Halcyon times for Citigroup or that they still don't have a long road ahead of them; but it's nice to have some perspective on the deal from someone who actually understands the structure, versus the deluge of reactionary "The Sky Is Falling" reactions I've been seeing just about everywhere else this week.

Note: This is not a recommendation to buy or sell C or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did not maintain a direct position (long or short) in C. As always, we reserve the right to do so in the future. We also may, at times, carry derivative options on underlying positions as a hedge.

andrewclavell citigroup abudhabi derivatives investing creditcrunch woodrow enterprise irregulars

 

Preparing for a downturn in software spending...

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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Intuit: The real platform play?

With all the talk of platforms of late, it occurs to me that too little is being said about Intuit and its position as arguably THE key enabler for small businesses on the Web. While Intuit's position as the dominant provider of accounting and tax preparation software and services is well understood, the company's ability to profitably leverage its position into other avenues of growth may not be.

There are myriad components toward building a successful platform and/or ecosystem; but it occurs to me that two of the most important are: SCALE and TRUST .

Intuit certainly has both in spades:

• $2.7B revenues
• 15mm TurboTax users
• 7mm QuickBooks users
• 8mm Online Banking customers

Earlier this year Intuit acquired Digital Insight, which was a transformative move (although one that has yet to be proven out); and now they follow the DGIN purchase with today's acquisition of Homestead. Creating synergies in technology mergers is no small feat, but the POTENTIAL of Intuit's acquisitions is impossible to ignore. Small business users need simple, easy-to-implement, reliable and trustworthy solutions. Intuit, Digital Insight and Homestead each, in their own ways, fit that bill.

Note: This is not a recommendation to buy or sell INTU or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did not maintain a direct position (long or short) in any of the companies mentioned but we reserve the right to do so in the future. We also may, at times, carry derivative options on underlying positions as a hedge.

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VC is to Optimism as Public Equity is to...

Last week, I had the chance to catch up with Brad Feld over lunch while he was camped out at Union Square Ventures. It was great to finally sit down and chat with Brad face to face, as we'd played "email tag" far too often in recent months. We missed each other when I was in Boulder in March, and then I couldn't get free in July when he was last in the city.

Alas, good things come to those who wait and we riffed about myriad topics in between bites of delicious sandwiches at 'wichcraft. One of the topics we touched on was a recent post Brad made on AskTheVC:

Q: What is the one common element you’ve seen in successful VC’s?

A: (Brad) This is an easy one.  Before the snarky ones in the crowd answer “nothing”, I’d suggest that its “optimism.” I have yet to meet a successful VC that isn’t optimistic about the future and the companies he is involved in.  I particularly like the Wikipedia description of optimism, which is “the overarching mental state wherein people believe that things will more likely go well for them than go badly.”

We were in agreement that Optimism is a quality universally required by successful venture capitalists. But what about public equity investors like yours truly? Is SKEPTICISM the appropriate analog for public equity investors?

From Merriam-Webster:

Skepticism

skep·ti·cism

Pronunciation:

      \ˈskep-tə-ˌsi-zəm\    

2 a: the doctrine that true knowledge or knowledge in a particular area is uncertain b: the method of suspended judgment, systematic doubt, or criticism characteristic of skeptics

There is certainly an argument to be made for skepticism as a necessary trait of successful public equity investors. Company management will always tell you things are going great, until they're not. The next time a management team signals problems BEFORE a thoughtful analysis of the fundamentals warns us will be the first. Aspire for the best, but prepare yourself for the worst.

But the more I think about the idea the less convinced I am that skepticism, by itself, fits the bill. I also think successful public equity investing requires pragmatism, decisiveness and circumspection.

What do you think? And what qualities do you believe all investors share? I can think of many qualities that successful venture, private equity and public equity investors have in common.

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SuccessFactors IPO a Success

Amidst the ongoing market turmoil, SuccessFactors (SFSF) was able to price a successful IPO this week. The offering (co-led by Morgan Stanley and Goldman Sachs) priced at the top end of its proposed range ($10) and stands at $12.75 after the first two days of trading. Considering how bleak the market has been over those two days, it's an auspicious debut.

SuccessFactors is the latest in an ever-increasing number of SaaS IPOs. The company raised just over $100mm in the IPO and carries a market cap north of $500mm. My good friend and HCM analyst Jason Corsello has weighed in on the company several times:

• The Looming SuccessFactors IPO
• SuccessFactors IPO - My Take and What It Means
• Why SuccessFactors is the Hottest Vendor in Enterprise Software

I'd like to extend a congratulations to Lars and the team; as well as the VCs involved in this successful deal. One of the funds I manage is a passive investor in SFSF by way of Granite Global Ventures; congratulations to them on yet another winner.

With a successful offering comes real opportunity to grow the business; but being a publicly traded company also brings with it new challenges. SuccessFactors competes in a niche of the market that already has several successful public companies; including Taleo (TLEO), Kenexa (KNXA) and Ultimate Software (ULTI). Authoria is also probably not far off from a public listing potentially. In addition, SFSF will need to deliver on quarterly expectations and must dance the delicate balance of maximizing growth and market share, while at least showing a push toward profitability and margin leverage. I'll be keenly interested in whether the company can use its newfound capital to fill out the whitespace in its services offerings and, in turn, prove itself the equal to Taleo; who has tremendous momentum among customers and the financial community.

Note: This is not a recommendation to buy or sell SFSF, TLEO, KNXA, ULTI or any other security, but is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, did not maintain a direct position (long or short) in any of the companies mentioned but did maintain a passive investment in SFSF via our participation in Granite Global Ventures. We also may, at times, carry derivative options on underlying positions as a hedge.

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Is there a youth vacuum in enterprise software?

M.R. Rangaswami, one of my favorite minds in enterprise software, has penned a guest column on Om's blog (another fave) where he reflects on the aging of enterprise software's leaders:

Enterprise Software's Youth Drain

One need only look at the hairlines of today’s software leaders. The current wunderkinds are not looking to create the next wave of corporate computing applications, but are instead gravitating toward emerging fields, such as web 2.0, biotech, and anything “green.”

Bill Gates was 19 when he founded Microsoft (MSFT). Steve Jobs started Apple (AAPL) at 21. Even Marc Benioff was in his 30s when he founded Salesforce.com (CRM) — and at 42, he remains one of the industry’s youngsters.

Software companies need to do more to attract the next generation of business leaders who will drive the evolution of the industry for decades to come...[continued]

M.R. goes onto talk about how he looked around his famed Enterprise 2007 conference and saw the average age of the crowd (50 years old) and then expounds on his recommendations for how enterprise software can re-ignite the youth movement.

I couldn't make this year's Enterprise conference; but at 32 years young I guess I would've probably dropped the average age to 49; would that have mattered? :)

In all seriousness, I think M.R.'s recommendations for attracting young talent are generally well thought out, but I'm not sure I see the aging issue as a real problem. One, we have to remember that the INDUSTRY is maturing. When Bill Gates was founding Microsoft (as M.R. mentions in his column), the concept of "enterprise software" was still very much nascent. Today a big chunk of IT spending is on software; the industry has grown up. It's that very maturity which is driving the wave of consolidation we all have talked about so much lately.

On top of the clear industry trends; it seems hasty to dismiss the very potent youth movement. Take a look at the software companies that have gotten major funding of late. Or those startups that have garnered exits. The Keiden guys (bought by Salesforce) are barely old enough to drink. The biggest VC exit of the last 12 months, YouTube, has extremely young and fresh faced founders. Sure, YouTube isn't an "enterprise software" play per se, but I think that speaks to the broader issue of where the innovation opportunities really lie.

Give it a year or two. With VMWare trading at ungodly valuations and just about every investor dying for "other ways to play virtualization" (a friend and fellow fund manager's words, not mine), you can be sure we'll see more young people venturing into that arena. We're also going to continue to see younger engineers make pushes into SaaS-y models.

Maybe I'm getting old, but I'm much less concerned about the AGE of people in the industry as I am the underlying factors which drive and encourage INNOVATION. To that end, one could argue the industry is better off than it's been in some time. With the stock markets (domestic and abroad) doing well, the IPO market back open, and plenty of global liquidity; plenty of people are feeling the itch to try something more entrepreneurial. And that's what really matters...not whether they're old enough to drink legally.

Note: This is not a recommendation to buy or sell any security, but is merely a personal analysis to foster discussion for informational purposes only.

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The myth of "pull" economics vis-a-vis SaaS?

Charles Zedlewski is one of a handful of bloggers I selfishly wished blogged more often (before the jokes start, yes I realize I firmly deserving of that label too, of late). Every time he puts fingers to keyboard, I know I'm in for thought-provoking analysis.

With the recent rash of SaaS filings, Charles decided to look at the costs associated with the SaaS model and whether or not the "pull" aspect was in fact playing itself out.

What struck me with all three companies was the losses. The first order explanation is quite simple: all the companies spend a ton of money on sales & marketing (between 65% and 100% of revenues). Most of these businesses are the farthest thing from the oft discussed but seldom witnessed “pull model” that’s supposed to lead to superior profits.

The root cause for the losses is a little more subtle. In a recent article, McKinsey consultants asserted that the primary cause is scale. In fact they go so far as to say that these scale economies are nearly identical to those of on-premise software companies.

It's hard to argue with Charles' conclusion, which is that, at least to date, SaaS vendors have foregone margin as a trade-off for growth.

I also wholeheartedly agree with him that it's a question of scale and, Salesforce.com is approaching a point where they will need to make good on the promise of margin delivery. As long as the incremental spend translated one-for-one to the top line, one could make a logical case to continue, but now that the marginal utility of each additional SG&A dollar is driving less than a dollar in revenues, show me the profits.

Note: This is not a recommendation to buy or sell any publicly-traded security nor is it a recommendation to participate (or not to participate) in upcoming IPO offerings of Constant Contact, SuccessFactors, NetSuite or any other company. This discussion is merely a personal analysis to foster discussion for informational purposes only. At the time of this writing, I and/or funds I maintain discretionary control over, maintained a long equity position in CRM and, through a passive investment in a venture capital firm, have exposure to SuccessFactors (privately held). We may, or may not, have interest in participating in the IPOs of these companies or other securities listings. At times, we may maintain derivative options as a hedge on underlying positions.

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