CIBC software outlook

Here is a long report from CIBC’s equity research team on the names they cover in the enterprise software market (U.S. focus). What’ll be relevant for our readers is the confidence that U.S.-based C-level tech executives have about the capital spending environment and the overall U.S. economy:

“We are optimistic on the outlook for the industry as we head into the seasonally strong period for software stocks following The 7th Annual CIBC World Markets Enterprise Software Conference in New York City. The management teams we spoke with were by and large upbeat on the spending environment and noted that they have not seen any meaningful slowdown in the U.S. economy or demand environment to date.

As we look into the second half of the year, we continue to favor companies like TLEO, KNXA and ULTI that are exposed to the burgeoning HCM marketplace, hospitality and retail names like MCRS and JDAS, as well as CHRD, ARBA and RHT. Below we highlight some of the key takeaways on these companies from the conference.

JDA Software: CEO Hamish Brewer and CFO Kris Magnuson gave an upbeat assessment on the state of the operational turnaround at JDAS. The company continues to see a meaningful opportunity to improve productivity in the sales force and expects to see further improvement in this metric in the coming quarters. Management is also upbeat regarding its opportunity both in the MANU installed base and with the MANU product set, believing that it is well-positioned to build on 2Q’s $6.9 million of MANU license revenue.

We continue to believe that JDAS is an attractive investment opportunity for small-cap investors given ongoing improvement in the company’s sales methodologies and attractive valuation (P/E 13.5x, 3.7x EV/Maintenance and 7.5x EV/EBITDA based on our 2008 estimates) and think this is a stock to own in 2H07.

Chordiant: CFO Peter Norman was optimistic on CHRD’s ability to continue the momentum the company has seen over the past nine months. He was clear that CHRD has not seen the recent credit worries in the financial industry have any effect on its business to date.

Mr. Norman credited the company’s strategic decision to embrace partnerships with large SIs like IBM, ACN, TCS and Bearingpoint for helping to dramatically increase the number of deals CHRD is exposed to. He believes these relationships should continue to improve and expand over time as CHRD’s partners work to ramp up the number of consultants available to do CHRD
implementations.

In terms of verticals, Mr. Norman noted that CHRD is seeing a meaningful uptick in interest for its solutions from the insurance industry following the Cigna and Wellpoint transactions announced in recent months. Mr. Norman was optimistic that CHRD is well positioned to continue the momentum in this important vertical.

The one potential cause for concern was on the length of time it is taking CHRD to hire additional quota carrying sales reps, which have been around 18-20 for several quarters now. Mr. Norman indicated expanding its sales footprint was a top priority for management and that it is committed to taking the time to find the right people who can close multi-million dollar transactions. Mr. Norman believes its current salesforce and the additional bandwidth provided by its SI relationships are sufficient at present but acknowledged that it could become a
potential bottleneck in the future.

We continue to like CHRD for its superior growth profile, improving margin outlook and attractive valuation (P/E 18.5x).

MICROS Systems: CFO Gary Kaufman gave a very upbeat outlook on the state of demand in MCRS’ end markets. In response to the ubiquitous question about the health of the domestic economy, Mr. Kaufman was emphatic that the company is not seeing any evidence of a slowdown from its customers. In fact, he noted that the biggest constraint to growth from the company is in hiring enough employees to adequately install and support its expanding installed
base.

In terms of its acquisition strategy, MCRS expects to spend ~$60 million a year on acquisitions going forward and is committed to doing accretive deals at attractive valuations. Mr. Kaufman reiterated that its first focus is on doing deals that expand its retail footprint and increasing the contribution from software revenue to 20% from its current 17%.

Mr. Kaufman reiterated the company’s FY09 revenue target of $1.1 billion and noted that CEO Tom Giannapolous recently outlined a FY10 goal of $1.35 billion on the top line, inclusive of approximately $100 million of acquired revenue.

While certainly a lofty goal, we believe MCRS is in a position to meet this target given the continued solid demand environment and its high growing maintenance base, which Mr. Kaufman believes can maintain the 20% growth rate it has seen over the past couple of years.

Overall we believe MCRS is likely to deliver strong F4Q results at the end of the month and that it is well positioned to drive 15%+ revenue growth and 100+ bps of operating margin expansion for the foreseeable future. We believe valuation remains attractive at P/E of 21x on our CY08 EPS estimate of $2.78 and view MCRS as one of the highest quality names in our coverage universe.

Ultimate Software: CEO Scott Scherr and CFO Mitch Dauerman reiterated their optimistic outlook for 2H07 already outlined on its recent conference call. Management was very clear that it expects to meet its 25% ARR growth target for the full year, noting that it only needs to generate an incremental $2 million of ARR in 2H07 vs. 2H06 to meet this target. With a salesforce that is markedly larger (+11 so far in 2007) and a broader addressable market than 12 months ago, we believe this is a reasonable target for the company.

We continue to view ULTI as a good way to play the burgeoning HCM market and believe the company is well positioned to drive 20%+ revenue growth and 300+ bps of operating margin improvement for at least the next couple of years. However, with the stock trading at 28x P/FCF on our 2008 FCF/share estimate of $1.23, we think current valuation reflects much of the good news and would wait for a better entry point before getting more aggressive.

Taleo: Having just reported its 2Q07 results, our discussion with TLEO CFO Katy Murray centered on more long-term topics, including its operating margin structure. The company expects to exit this year at a high single-digit level. Looking out to next year, the company would like to exit the year in the 12-13% range. We view this as a very realistic goal even as the company incurs costs related to the launch of its performance management suite and ongoing building out its sales force. Ms. Murray further indicated that a 2009 timeframe would be reasonable for the company to post 15% operating margins, which would expand another couple of hundred basis points in the following year. From an operating structure perspective, the company believes there is leverage in its G&A and R&D lines, as well as on the COGS side, especially with respect to its services-related cost of sales.

While the company has held off on guiding to a specific ’07 cap-ex figure, we got the sense that a $3-4 million sort of level in 2H07 is likely reasonable. Looking out to 2008, the company may have to invest in another datacenter, which would require an additional $4-5 million in cap-ex to build. That said, we believe the build-out of another datacenter is a “good” sort of problem to have, as it is a bullish indicator of strong demand for its solutions.

The company remains very bullish on its upcoming performance management suite. Management believes it should be able to sell its performance management products at about 50% of the current cost of its Enterprise Edition. This is significantly higher than its other add-on products it has released over the past 12 months, which sell at only 10%-15% of the cost of the Enterprise product. While its e-recruiting solution has historically been the lead-in product when selling to a new customer, TLEO believes the performance management
suite could evolve as the lead-in solution in coming quarters. From a revenue standpoint, the company believes it will begin recognizing performance management-related revenue starting in 3Q08, with the suite being a 2H08 and beyond revenue growth driver.

Regarding future growth areas, the company was very clear that it has no interest in entering the payroll market, given the complexity and competition there. However, incentive compensation could be a possibility, though it is unclear whether the company would partner or buy its way into the segment. When asked about content, the company indicated that it would prefer to partner rather than go it alone, given the level of maintenance and input it
requires, from both a people and data standpoint.

With its shares trading at 4.0x and 23x our CY08 revenue and FCF per share estimates (below the SaaS group averages of 4.4x and 29x), we continue to view TLEO’s shares as one of the best ways for investors to capitalize on the rapidly growing HCM market, given the ongoing
business momentum, recent and upcoming product releases, improving operating performance, and potential for margin expansion translating to EPS upside in coming quarters.

Kenexa: With the company just two days from reporting its 2Q07 results, CEO Rudy Karsan focused on broader topics as well. Not surprisingly, he indicated that he has been getting peppered with the “economic impact” question as it relates to Kenexa’s business. While admitting that the last downturn impacted the company’s business rather heavily (due to its vertical exposure), he remained uncertain as to the potential impact should we enter into another recession. The company’s exposure to the financial vertical is just 10% (while
healthcare is the largest at 14%), and he has yet to receive any calls from customers expressing concerns over the macro environment.

In terms of deal sizes, the company indicated that 70% of outbound RFPs are multi-solution prospects, more than double the year-ago level. And while the multi-solution RFPs slow down the sales cycle, they also speed up the procurement process.

On the acquisition front, the company continues to review opportunities, but has yet to find a suitable, appropriately valued, target. With its valuation at 4.0x and 20x our CY08 revenue and FCF estimates (below the SaaS group averages of 4.4x and 29x), KNXA remains one of our favorite HCM names given its solid growth, superior margins, and continued overall outperformance.

Ariba: Our time with Ariba CFO Jim Frankola was focused on the Ariba Supplier Network as well as its recent KDS partnership on the T&E side. While the ASN missed its revenue target in fiscal 2007, the company is now more driven than ever to monetize the platform, which is more than ten times bigger than its next largest competitor’s. It remains confident that it will hit its $15 million revenue target next fiscal year, despite the longer than expected monetization
opportunities from buyer/supplier contract signings.

Regarding the KDS partnership, Ariba indicated that the relationship adds similar capabilities to those Concur gained with its acquisition of Outtask, enabling the automation of T&E from travel book to expense report data fill. Ariba’s shares remain attractive in our view, trading at 14x our CY09 FCF per share estimate of $0.64 and ~3.5 EV/recurring revenue (subscription +
maintenance), given the momentum in its subscription business, improving operating structure, and anticipated ramp in FCF generation.

Red Hat: Overall, management remains upbeat regarding the Red Hat’s growth prospects, as the recent RHEL5 and JBoss product releases should help drive solid bookings in the coming quarters. Of note, the company indicated that while it is still early in the product cycle, RHEL5 uptake thus far has exceeded that of RHEL3 and RHEL4 at this juncture in their cycles.

Turning to JBoss, the company believes the division is where core Red Hat was five years ago. While JBoss had great technology (pre-acquisition), it lacked commercial expertise. In essence, Red Hat has replicated its model with the JBoss group, to drive developers from free to paid JBoss subscriptions, much like Fedora and RHEL. The company expects the paid conversion efforts to begin to bear fruit in the back half of this fiscal year, with strong momentum seen in FY09.

Red Hat also discussed plans for an upcoming extended support program (similar to Oracle’s applications unlimited initiative), which will enable customers to stay on legacy versions of RHEL for as long as seven years after the subsequent release of the OS platform. While few details were shared, we get the sense that pricing for the extended support will be structured to
mitigate/offset the ST lost opportunity of upgrading the customer to the current platform. Red Hat also addressed its recent cash flow performance, pointing out that 1Q08 CFO was negatively impacted due to working cap shifts within A/R and A/P. All in, the headwinds hurt Red Hat’s cash flow performance by ~$8 million, which should reverse course over the near term. Based on our conversation, we believe the company’s 2Q08 cash flow will likely benefit from a lift of each of these items, which the Street may have not fully appreciated in its current
estimates. However, investors should also remember that the company faces a difficult FY3Q as last year it signed and collected on a $5 million deal. Net net we still believe the company is well positioned to drive solid cash flow growth this year and at least meet its targets.”

MRM