The Great Software Debate?
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About Dave TaborsCurrent Areas of Interest:Dave is interested in investing in software companies of all shapes, sizes and business models. Current Investments and Boards Include: |
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EmailIntroduction
A Reuters article from May 2003 starts off:
“Larry Ellison, captain of the Valley's biggest software shop Oracle Corp., kicked off the great debate at the start of the year by declaring that the industry's best days are over. Ellison, known for his outspoken views, was downcast in January as he told Barron’s weekly newspaper that high-tech's mind-boggling growth spurt is over — never to return again. “It's [Silicon Valley] not coming back…The industry’s maturing. The Valley will never be what it was,” Ellison said. Tom Siebel, Ellison's biggest Silicon Valley rival and CEO of Siebel Systems Inc., has shot back with the view that the industry is poised to start growing again soon.”
Well, we all know who was right in that argument…or do we?
Three years later, the debate still goes on. I don’t think there’s one “right” answer. We have to recognize that while the software industry has no doubt changed, it’s not going away. And that means opportunity. So instead of one right answer, we are wise as investors to continually focus on the central question of how to think about the software industry today, and how to continue re-evaluating the market as it changes in the years ahead. Is it the industry of Salesforce.com at 9x revenue and heady growth rates? Or is it the industry of the 200+ public software companies with over $20m in revenue that trade below 1x revenue? Is it just growth rates that matter? The sector? Business model? Profitability? It’s always a combination, isn’t it? Let’s take a look at each of these factors — maybe there is a discernable pattern here.
Hot Sectors = High Multiples, Right?
Not so fast. It would appear that sector is not the key. A quick
scan of the 13 software sectors that WR Hambrecht uses for their software
universe breakdown shows median enterprise value to revenue ratios of a low
of 1.8x to a high of 3.2x, with 9 of the sectors between 1.8x and 2.5x. What’s
the highest multiple sector? Is it one of the hot sectors: security,
systems management, business intelligence, or wireless? Nope. Design
automation and PLM. Go figure.
It’s All about Profitability
So it’s not about the sector, at least not only about the
sector. So how about profitability? Here the data starts to make
a little bit more sense. That design automation segment does have the
strongest median net income of the pack with the “hot” segments
of wireless, security, and BI also showing up well — but on a profit
basis. So the old school thinking wins out, that’s interesting.
Maybe profitability is really the key. But don’t tell that to
Opsware (9.5x revenue), Salesforce.com (9x revenue) or RightNow (5.1x revenue) – none
of which will be showing material profit this year. Let’s keep
looking.
Recurring Revenue is the Ticket
Sector — part of the story. Profits — good to have, but not
always required by investors. Could the secret be a recurring revenue
business model? That would explain RightNow and Salesforce.com. But
what about the ERP vendors — the stickiest of all sticky software? It
is one of the lowest segments on an EV/Revenue basis (2x) and the lowest
on a PE basis (20x). This is despite the fact that most of these vendors
have well more than 50% of their revenue coming from recurring maintenance
contracts, and often a big piece of the rest of the revenue is recurring
in nature as well. You’d think that recurring revenue is never
a bad thing. But clearly it’s just one piece of the puzzle.
Making Sense of the Puzzle
So what’s a smart investor to do? I suppose it’s
stating the obvious that it’s a combination of all of the factors discussed
above — and more — that make up a company’s valuation. And
the valuation is always very specific to a particular company’s situation;
sometimes it follows the others in the market, and sometimes it doesn’t.
So, do we toss logic out the window? Of course not. But this is a
far different landscape from the “rising tide lifts all boats” market
of the 90s (early or late). In today’s market, it’s easy
to make a mistake and find that 9x revenue company trading at 1x if the growth
goes away. The reverse is also true. My favorite thing to do
is look at Akamai’s stock price in September of 2002 when it was under
$1/shr. Now it is over $30.
So what does all this mean? Well, those of us who try to make a living investing in software companies have a lot to think about. It’s not just about growth anymore. It’s not just being smart about sectors. The number of inputs into the thought process keeps expanding. That is the bad news. The good news is that experience helps. Finding smart people to work with and invest in helps. And thinking a little differently from the crowd certainly doesn’t hurt.
There are still plenty of growth areas within the software markets. Take one of our portfolio companies, BladeLogic, for example. The company is sitting in the middle of an exciting market with a great product and a great team and is growing organically at an amazing clip. We started with this team in 2000, as entrepreneurs-in-residence, so they make me believe there’s growth to be had.
There are also great opportunities at the other end of the investment spectrum. We bought Made2Manage in 2003 — a micro-cap public software company with no history of profitability. Within 3 weeks, we had it on a 30% EBITDA margin run rate. Via acquisition, it has subsequently doubled in revenue while maintaining margins at 30% without adding any new equity investment.
The bottom line is that there are great opportunities across the software investing spectrum – if you take the time and do the work to find them. Despite the ultimate fate of Siebel’s company, maybe both he and Ellison were right.
© 2006 Battery Ventures. All rights reserved.