|  Brian Skiba is a co-founder and Managing Director of Transformation Capital Partners , a private merchant bank in London. He was Head of Software & IT Services research for Lehman Brothers in Europe until May 2001, and was a ranked analyst by Institutional Investor in both Europe and the US as well as Reuters and Extel. Before moving to Europe, Mr. Skiba was in charge of covering Enterprise Software companies for Lehman Brothers from their San Francisco office. The enterprise software sector -
Operating leverage is excessive in a software company. An enterprise software business model is almost all fixed costs (people, facilities, marketing) and extremely low cost of production. Consequently after all fixed costs are met in the quarter, the money flows directly from the top line to the pretax level with often less than 5% cost of goods. When the industry is accelerating, software companies tend to 'crush' their numbers through this extreme operating leverage. This is why investors are willing to pay high price-earnings valuations in good times. The earnings estimates are likely to be dramatically revised upwards. -
Operating leverage works against the company in tough times. Unfortunately, operating leverage works in the opposite way too; and with impunity. When a company falls short on the top-line revenue number by maybe 5%, earnings can be short by 50%. Consequently, a shortfall in revenue is treated as a disaster in a software company, as these companies cannot quickly or easily change their cost structure - implying that forward earnings estimates are likely to plummet. A 50% correction on a software company is the norm when they miss earnings. -
Buy 'real' software companies when they gap down. Software companies are severely punished for missing numbers. And in most cases, a miss of a quarter spells trouble for the next few quarters or perhaps years . Rarely are these problems ironed out in the following quarter. But, for those investors with a 12-month investment horizon, buying an established software company, with a degree of size and maturity following a 50% gap-down can often be a winning strategy. The key is the company must be 'real' with size, scale, brand, product and proven execution skills. Patience will often pay off, but the time horizon must be at least 12 months. -
People remain the key. Good product is necessary but second. Software companies are nothing but a collection of people. The management, R&D talent, sales force, professional service and support organization all determine the execution level of the company. In most software markets, it is execution, not demand that remains the challenge. People must be honest, loyal and motivated to work for the company. Human talent is highly fluid, and once it begins to move from a company, it is like an unstoppable cancer. -
If the software and the story sound too good - be cautious. The world of software investing is littered with companies that had promising ideas, 'cool' technology and staggering industry forecasts as to the growth prospects, but somehow they often don't materialize. One reason is that people want to believe that software can solve world hunger, so they begin to dream about the unrealistic prospects. In some cases, like Lernout & Hauspie, the company made remarkable claims about its speech recognition capability, and the market was not really there yet. To make up for it, it 'created' some $200 million worth of fake sales, defrauded the investors, bankrupted the company and the founders are in a Belgium jail today. -
News flow in normal times moves prices. Valuations for software companies, in the short term , are highly impacted by movements in Nasdaq and in news flow. This is particularly so in a raging bull market. Software companies tend to put out a large number of press releases, the bulk of which are not material to the company's earnings prospects. Nonetheless, it puts the company back on the radar screen for technology investors, and a movement of 5-15% in a day from a press release is not atypical in a hot market. -
Valuing a software company is all about forward growth expectations. Ultimately, the value of a software company is determined by the free cash flow likely to be thrown off over the next 20+ years. Determining that cash flow is near impossible , but an educated guess begins with a model extrapolating forward revenue and earnings growth. Since the software model is an extremely leveraged one, rapid growth is usually combined with margin expansion, thus driving cash flow in the model. A modest drop in growth expectations can dramatically drop the forward expectations for cash flow as the impact works its way through the next 20 years in the model. -
Software valuation movements tend to be highly correlated with the tech sector. Most software companies tend to move in step with the Nasdaq and other technology indicators. In Europe, the TMT (telecom, media and technology) sector tends to move together, though European technology valuation tends to follow the US lead. In most cases, 80%+ of the movement of a software company stock is usually correlated with the technology-heavy indices like Nasdaq. www.transformationcapitalpartners.com 'Few competitive advantages are as difficult to fight as a brand name . An economic advantage can be overtaken eventually, a patent may be lifted, but a great brand can be sustained for years.' ”Mike Kwatinetz |  |
