CanaccordGenuity on Enterprise Software: earnings visibility is key

Canaccord’s Richard Davis has taken a necessary look at his tech coverage universe in light of the much discussed fears about an economic slowdown. I don’t share much equity research with you any longer (on the assumption that’s not what you look for in blogs), but I found this long piece warrants the intervention into your morning. VCs should take note, as well, as Mr. Davis makes some good points at the end about the impact a slowdown would likely have on various subsectors of the tech economy:

Investment summary

• We have lowered our economic assumptions. This is a worldwide phenomenon. High frequency data such as ISM, retail sales, consumer confidence, etc. are all pointing down. Markets-wise, the two-year – 10-year
Treasury spread has been flashing slowdown for three consecutive months. As for macro forecasts, we now expect US real GDP to run at 0-2% pace for the next 3-6 quarter versus our previous implicit forecast of 2-5%. We are not particularly worried about the BRIC countries as we expect a modest deceleration to mid- to high-single-digit real GDP growth. We are concerned that Europe’s unresolved travails could lead to an incrementally more difficult, seasonally slow September quarter.

• What’s next on the macro front? To a degree, this is a catch-up note of caution. The operative question is whether three months of bond market signals followed by a two-week equity market rout are precursors of a
downturn. On the bullish side of the docket, if the market has bottomed and stock prices rebound sharply, we will all chuckle about an anxiety attack exacerbated by Congressional buffoonery. Alternatively, if the decline in the stock market causes quite financially stretched consumers to fully retrench, our business software companies will feel the after-shocks later because they operate a few concentric circles outside the epicenter. In this scenario, the greatest impact will emerge in management’s 2012 guidance opinions (although stock prices would likely roll over before then). However, we have proactively reduced estimates on some our companies to reflect, at a minimum, the current dynamic of slower economic growth over the next few quarters. We considered downgrading a handful of stocks most susceptible to a downturn and we have highlighted them a couple of paragraphs below. We didn’t do so because the stocks are already down a lot and the data we have on a slowdown is entirely macro.

Company-specific view: companies become more bullish the further west they are from Manhattan. It is a gloomy world east of the Hudson River (and south of the Charles River in Boston). Prospective bonuses have shrunk and Zillow tells us that our house values are dropping 6% per month. However, travel west and the story evolves. Large parts of the Midwest are booming as a result of high agricultural commodity prices. Texas is thrilled to have a lot of fossil fuels. However, by the time you get to Silicon Valley, the attitude is a bemused detachment from the dour East Coast sentiment. Silicon Valley is not California, but Silicon Valley is booming. This is more than a Facebook phenomenon; the average privately held business software company that we
talk with expects 40% revenue growth in 2011 and 30%+ in 2012. Even adjusting for these firms’ relatively small size, that’s good growth – and none of them have seen the slightest deterioration in the pipeline as of a couple of days ago. Could this change? Of course. But then again, maybe the East Coast asset management world is simply reliving the epic fear that 2008-09 brought. It might not be different this time, but history rhymes far more often than it repeats itself.

• Three data points this week: Salesforce, Autodesk and Intuit. Apparently, the investor relations people at these firms don’t talk to each other because a large percentage of the sell-side follows all three companies. In any case, we expect a solid quarter from CRM and a middling quarter from Intuit. We expect at least in-line result for ADSK, and unless the firm guides down meaningfully, the sentiment and our wholly unscientific measurement of the number of people short this stock going into the print could set the stock up for a decently rewarding “relief pop” after the Thursday night report. This is what happened to Pegasystems, which rose 20% the day after a good, but not spectacular quarter.

• Investors sell first, ask questions later. Excluding exceptions like overcrowded short names, we do not believe that we are at the point where equivocal financial results will produce relief rallies. Indeed, in this earnings
cycle, the punishment for a misstep is 4-5x more downside than the upside you get for a positive surprise.

• However, historical precedents for software stocks are good. In two of the three past collapses over the past decade, software stocks as a group have outperformed the S&P 500 (we considered the 1985, 1987 and 1991
corrections, but while software outperformed in both 1985 and 1987, there were so few firms that the data wasn’t valid. We also note, of course, that the past cannot absolutely predict the future). The underperformance was post Internet Bubble, an outcome in retrospect that should not be too surprising given the fact that valuations had reached 30-50x revenues for some then super-hot companies like Ariba, CommerceOne, Broadvision, and i2. The good news for software investors is that the past three shakeouts have
decisively shifted the mix of public companies toward SaaS business models and away from the last-minute crash-and-burn perpetual license companies (winnowing due to M&A and take privates). These next-generation SaaS/cloud firms are at the foothills of multi-year upgrade cycles.

• Stock selection: Earnings visibility is the key. Investing is about comparing fundamentals to valuations and tilting the odds in your favor. In this punishing tape, this means caution is the word of the day for companies
whose earnings visibility is even a bit foggy.

• This is a winner-takes-all valuation world. There are two drivers to this dynamic. Today’s cloud software companies are fundamentally network effects business models that benefit from unprecedentedly low incremental cost of customer acquisition and ongoing maintenance (e.g., fewer quota salesmen, reduced professional services installation expense, and near zero legacy support costs because deployed code is always up to date). Businesswise, firms that achieve escape velocity from their peers exponentially gain market share and economies of scale. Today’s balance sheet recession means low growth for most of the world, low interest rates, and by extension, a rational intellectual argument for low discount rates/high multiples for predictable growth companies. It’s a wonderful life if you grow consistently fast. It is a world of near instantaneous and severe punishment if the “fear” component of your discount rate jumps due to an execution misstep.

• Trimming estimates: cautious stance already reflected in stock prices. We have haircut estimates on four of our coverage stocks: ORCL, ADSK, CTCT and SQI. Copies of our revised models are included in the back of this report.

o Oracle (ORCL : NASDAQ : US$27.57| BUY).: lowering August (Q1/12) hardware revenue estimate to low end of the range and slightly trimming software expectations to mid-point of guidance. EPS unchanged.
o Autodesk (ADSK : NASDAQ : US$29.45| BUY).: trimming C2012E non-GAAP EPS from $1.93 to $1.88, which assumes operating margin expansion of 150 bps (to 25.1%) versus our previous estimate of 230bps.
o Constant Contact (CTCT : NASDAQ : US$17.80 | BUY).: slightly trimming C2012E revenue by $2M to $260M and lowering EPS from $0.92 to $0.85 as we expect management to continue to run the business for top-line
growth and aggressively market the firm’s highly anticipated social release.
o SciQuest (SQI: NYSE : US$14.95 | BUY).: trimming C2012 FCF estimates from $17M to $16M as we anticipate modestly slower bookings activity.

• Five favorite stocks we’d buy now – two Growth, three GARP – CRM, SFSF, AZPN, NUAN, DSGX. Salesforce reports tomorrow and while it is an unguided and variable figure, we believe there is a better than even chance that the firm posts an upside to our calculated billings growth of 29%. SuccessFactors reported outstanding growth for June, its outlook is strong, and the stock trades at a nearly 30% discount to Ultimate Software on 2012E EV/FCF. On the GARP side of the house, we believe Aspen remains under-followed and under-owned, and investors have underestimated the firm’s FCF growth prospects. The stock seems too cheap to us at 13x a conservative 2012E FCF estimate of $0.96. Nuance reported another “no drama” quarter; EPS growth over the next three versus the past three quarters looks to accelerate from 15% to 25%, which seems very likely to boost a 2012E non-GAAP P/E of 11x to something higher. Finally, for those who can buy thin traders (130,000
shares/day on TSX and 18,000 on NASDAQ), we believe Descartes’ growth is accelerating, which if true will make skeptical investors and competitors eat their words.

Ranking software by susceptibility to a downturn. The following is our relative ranking of which software categories and companies’ earnings estimates could be most susceptible to an incrementally worsening
economy. In many cases, the stock prices of the obvious firms have already moved well in advance of our “insight.” Indeed, we have BUY’s on some of these names, and a few are slotted in both the challenged and favorable buckets.

Consumer and Small Business

These buyers have the least cushion to handle another down leg in SMB

Constant Contact, Adobe, Convio, VistaPrint, Paychex, Intuit, OpenTable, Rosetta Stone

Large Deals

Short-term, buyers can elongate services engagements and in 2012 IT buyers can postpone decisions SAP, Oracle, IBM, SciQuest, Ariba, NetSuite, VMware, Citrix, Responsys, PROS Holdings, Demandtec

Postponable Infrastructure Upgrades

New infrastructure has to deliver more than just soft dollar, “it will save everyone 20 minutes a day” savings
CA, BMC, Red Hat, Compuware, NetScout, OPNET, Sourcefire Exposure to Manufacturing, Real Estate and Electronics Supply Chain

Buyers in electronics, general manufacturing and real estate will stick with their old stuff if the economy rolls over

Ansys, Autodesk, Dassault, PTC, RealPages, Progress Software

Government Spending Exposure

The key here is to make the purchase decision a “no brainer” inasmuch as there is nearly zero up-front costs
(e.g. – no spend money to save money because government’s don’t have any money to spend)

Deltek, Tyler Techhnologies, SciQuest

Financial Services Exposure

If the firm drives revenues, like Bottomline, then you’re in a much higher level on the IT budget food chain

Pegasystems, Bottomline Technlogies, Jack Henry, Intralinks

Human Resources Management Upgrade Cycle

The “tell” in this sector is the fact that companies are replacing their entire HR system rather than just tinkering
around the edges

SuccessFactors, Ultimate Software, Taleo, Cornerstone OnDemand, Kenexa, Saba

Next Generation Marketing

We believe there is a lot of “white space” in a segment that within five years will end up supporting more large
public companies than the HR segment.

Salesforce.com, Responsys, Vocus, Constant Contact, RightNow, LivePerson, Convio

MRM