Head in the clouds — feet in the dirtPosted: July 20, 2013
As it is the case for all postings in this blog, my standard disclaimers apply for this posting. However, since this posting discusses investments, I urge you to review the disclaimers laid out in the About section with extra diligence. Moreover, even if you have already reviewed these disclaimers in the past, you need to review them again, as they are subject to change without notice. Do it now, and remember that whatever I say in this blog posting is simply my opinion — it is not science, it is not advice, and it is not an attempt to make you act in any way whatsoever.
Lincoln, the joker
Abner Ellis, an acquaintance of President Abraham Lincoln, once recounted one of the more colorful Lincoln jokes, referencing Ethan Allen’s visit to — or, possibly, imprisonment in — England, which I rephrase as follows (I apologize in advance for the language. Lincoln could be pretty crude, making jokes heavily based on defecation and flatulence):
While in England the English took great pleasure in teasing him, and trying to make fun of the Americans and General Washington in particular and one day they got a picture of General Washington, and hung it up in the toilet. The English asked Mr. Allen if he had seen the picture, to which Mr. Allen said that he had not, but that he thought it to be was a very appropriate place for an Englishman to keep it. When the English ask why this was, Mr. Allen said that there is nothing that will make an Englishman shit so quick as the sight of General Washington.
Paraphrasing Mr. Lincoln, albeit in slightly more PG-13 acceptable language, there is nothing that will make the market poop in its pants so quick as the potential for loss — regardless of the basis for, the probability of, or size of such potential loss.
I was reminded of this fact with recent developments around cloud-based computing, specifically those that relates to Software as a Service (SaaS) as provided by Salesforce, a leading CRM company, and, arguably, the first and foremost SaaS provider, and ClickSoftware Technologies.
SaaS, sometimes referred to as “on-demand software,” is, of course, a software delivery and licensing model in which software and associated data are centrally hosted on the cloud and where the SaaS provider carries the cost and risk related to hardware and software maintenance and support.
Salesforce, a pure SaaS software company has benefited immensely from the recent hype surrounding cloud-computing, achieving a market capitalization of 25 billion on the basis of relatively modest revenues of $3 billion in 2012 with losses amounting to $270 million.
Given that the earnings are negative, it is, of course, not possible to compute a P/E ratio, but if we look at the results for 2010, the last year that Salesforce turned a profit, we see that the company’s earnings were $64 million, providing for a P/E of 391 — arguably on a very unscientific basis, but still… 391!
In comparison, Oracle, a strongly profitable company with a history of steady, albeit sometimes slow and modest, growth, more than $35 billion in revenues in 2012, and a record of paying a reasonable dividend has a P/E of less than 15.
So, the market upside to SaaS is P/E boosting. The market downside is that enterprise software companies such as Oracle are now afraid of being left in the dust (yes, pun intended!) and, so, have accelerated their investments in SaaS technology and sales in an attempt to, so to speak, reach for the clouds.
Recently, ClickSoftware Technologies, an Israel based enterprise software company that I have written quite a lot about (for a baseline discussion, go here,) joined in the fray, establishing a separate division solely dedicated to selling and operating cloud-based solutions.
Presumably one of the reasons why ClickSoftware Technologies, which is arguably the market leader in the work force scheduling enterprise software domain, took this step, was that they noted that TOA Technologies, a SaaS based up-and-coming player in the scheduling enterprise software domain, had achieved traction, scooping up increasingly attractive clients.
TOA Technologies has raised an awful lot of money in what amounts to pre-IPO funding and is apparently burning cash like there is no tomorrow in an attempt to get to either a break-even point or an IPO before running out of runway.
Using simple fundamentals, ClickSoftware Technologies with its dividend policy, positive cashflow, near-constant growth, and healthy purse, is a superior investment target regardless of the inflow of cash into TOA Technologies. But, as we know from comparing Salesforce and Oracle, the market often values hype over fundamentals, and, therefore, the leadership team at ClickSoftware Technologies may have felt compelled to compete in the area of SaaS.
And, so, ClickSoftware Technologies engaged.
Unfortunately, in engaging it appears that the company might have forgotten a couple of fundamental facts:
- Selling enterprise class SaaS solutions is essentially equivalent to financing your customers, with the SaaS provider incurring high up-front expenses and minuscule revenues in the hope that the customers’ user counts will grow over time and, eventually, provide a high level of profitability — something that TOA Technologies knows very well, because they are already caught up in the spinning tops mechanics of SaaS.
- It is infinitely easier to sell SaaS solutions as the nexus strategy, than to transform yourself from being a provider of on-premise solutions to being a provider of mixed SaaS and on-premise solutions.
- The market may like to for a publicly traded company to be in the SaaS business, but it does not like seeing losses caused by ramp-up expenses necessary to securing SaaS customers.
ClickSoftware Technologies and its equity, CKSW, which were already stretched to the breaking pint by an annual guidance pointing to 20%, or so, growth for the 2013 year, was, however, in for a lesson in these three facts.
On July 8th, 2013, the day after ClickSoftware Technologies conducted its somewhat controversial annual shareholders meeting (read more about this here,) the company announced that it anticipated revenues for 2013 to grow substantially less than indicated in previous guidance and, also, that the company anticipated to incur losses in its second quarter:
The Company primarily attributes the lower than expected growth rate in revenues to a faster than expected shift in its revenues to cloud-based software-as-a-service (SaaS) sales. As this revenue shift is happening, there are some delays in closing certain contracts with customers that are performing additional due diligence comparing our cloud and on-premise offerings. The transition to a SaaS model is a positive development for ClickSoftware’s long term growth prospects; however this shift and the tendency of customers to lower up-front investment are having an impact on the Company’s short term growth rate. Additionally, while the Company has started to gain traction in its geographical expansion, the deal closing processes are taking longer than expected.
Based on preliminary estimates of operating costs, a net loss is anticipated for the quarter ended June 30, 2013 in the range of $2.7 to $3.1 million …
“Overall we view the transition to cloud SaaS-based revenues as a positive development. Our shift to cloud-based sales – including for large enterprises – is occurring faster than we anticipated, and, by its very nature, impacts our ability to grow our short term top line at the rate we originally expected, therefore influencing our quarterly earnings,” said Dr. Moshe BenBassat, ClickSoftware’s Chairman and CEO.
“During the second quarter we closed a relatively higher number of new contracts, including a growing number of cloud-based engagements. Some of these customers are initially implementing our service to a smaller user base but have the potential for a larger number of users once a full roll-out is completed. We also have a number of prospect customers in advanced stages of closing during the remainder of 2013 and are encouraged by our pipeline. In fact, one large deal already closed in the first week of the third quarter….” he concluded.
The market reacted promptly and violently, bringing the per share price of CKSW down from $8.50, or so (I approximate,) to $7, or so, and, as usual, the Yahoo Finance message board buzzed with panic.
As far as I can see, the market reaction and associated panic was really based on three distinct factors highlighted by the company’s announcement: 1) the immediate slowdown in revenue growth manifested in the second quarter, 2) the occurrence of a loss in the second quarter, and 3) the reset of the full year revenue guidance, dropping revenue growth by almost 50%.
The slowdown in revenues and the incurred loss are somewhat trivial (although unfortunate, of course,) in that they were to be expected if the company was successful in entering into the cloud business, leaving only the hindsight question of whether the company should not have been able to foresee such success and, therefor, should have been preparing for it in a measured way and the forward-looking question if the company has sufficient gas (i.e. cash and cash flow from operations) to continue to accelerate the spinning top now that it has stepped on board it. After all, unlike TOA Technologies, who needs only keep spinning until the IPO valve brings relief, ClickSoftware Technologies will have to keep spinning until the accumulated gains exceeds the losses — an entirely different — and potentially much more painful — proposition.
With more than $50 million in the bank and a history of sustained growth, and good, strong profitability, hopefully the company can sustain the costs that it will incur.
The slippery slope of hybrid guidance
The reset of the guidance is far more interesting and far more complex than it appears on the surface, where, I guess, it looks like it is a simple extension of the transformation of revenue profile from the high-low of sales of on-premise solutions to the low-high of sales of SaaS solutions. In fact, it is a two-pronged issue.
The first prong is that of slowdown and cannibalization, an issue that I learned to appreciate from working with consumer goods companies such as Colgate and Gillette.
In a nutshell, what ClickSoftware Technologies is learning is that if you are a leader in a segment and you introduce an alternative in the market with the — presumably good — intention of competing in another segment, you run the risk of slowing down the market’s decision process and cannibalizing your bread-and-butter segment.
The slowdown is something that the company’s CEO, Dr. Moshe BenBassat, a highly educated man, ought to have been aware of as he has undoubtedly encountered Hick’s Law in his academic career.
The cannibalization, likewise, should not have been a surprise, since Dr. BenBassat, as a seasoned executive, should understand the power of incentives on performance and should have understood that, unfortunately, the easiest way to achieve a certain level of sales performance is to steal customers from your colleagues.
On a side-note, it is important to keep in mind that we are talking about two different — but equally dangerous — types of cannibalization here: The first type of cannibalization is indirect and consists of the funding of one segment of the business using resources earned by or possibly better used by the another segment (this is the cannibalization that we mostly see expressed an increase in overall expenses,) and the second type cannibalization is direct and consists of the intrusion of one segment into another segment’s sales cycle, leading to delays in closing and/or reduced closure rates for the intruded-upon segment.
The second prong relates to the balancing of guidance and is far more of a gotcha! Essentially, the release of two alternative pricing models by a company for an offering creates a situation where the company in developing its guidance need to discriminate between the two offerings, and, since the company has no historic data providing a basis for such discrimination, it is forced to choose the lowest possible guidance.
To understand the issue here, imagine that you issue guidance for $100 million in revenues for a certain time period, T, based on ten deals of $10 million each and with substantially no revenues to be realized after T expires. Imagine, further, that the ten prospects for the deals are committed to buying from you, so that you will not have to worry about weighing the opportunities — a bit of a stretch, of course, but please follow along.
Your creative product marketing department then launches an alternative offering with a different deal structure, targeting the same prospects, effectively providing the ten prospects with two different ways to deal. With the new offering, the prospects may only provide revenues of $2.5 million for the time period T, but may provide an additional $17.5 million over a time period of T*2.
Assuming, of course, that you don’t need the revenues immediately and all else being equal, certainly, the second offering is more attractive to your shareholders who will now see their company recognizing a surefire $200 million over the T*2 time period.
But in the topsy-turvy world of guidance, you have several problems. The expectation, set through your previous guidance, is for $100 million in revenues during time period T, and you now have to determine what the impact of the new offering is on this guidance.
Since you don’t know how many of your ten prospects will choose thee new offering and since the operative word when doing guidance is conservative, you probably need to set the guidance at…. horror of horrors… $25 million. For sure, your shareholders are going to be unhappy.
Add to this forced guidance the generally prevailing uncertainty of closing, the new issue of slowdown, and the new issue of cannibalization, and you begin to appreciate the trouble that ClickSoftware’s management team may be finding itself in.
The Kranz Dictum
We won’t know for sure what caused the revision of the annual guidance and the unprecedented quarterly loss before the final release of the second quarter earnings results and the related conference call on July 24th, 2013.
Hopefully, we will learn on July 24th that these events were not caused by lack of understanding or competence by ClickSoftware Technologies’ leadership team, but, rather, by an unexpected acceleration of known events that ultimately will benefit the company.
I, for one, would be severely disappointed to learn that, by engaging in the pursuit of SaaS opportunities, ClickSoftware Technologies has entered into uncharted waters where it no longer can control its destiny with the same degree of certainty that it could just a year ago.
If these events are in any way related to a lack of competency, then the ClickSoftware technologies leadership team need to take a hard look at its culture, remembering the Kranz Dictum guidelines for leadership:
Competent means we will never take anything for granted. We will never be found short in our knowledge and in our skills. Mission Control will be perfect.
Regardless of the underlying reasons, the market’s reaction to the company’s announcement seems extreme. Although, at a per share price of $8.50, CKSW did carry a hefty P/E before the announcement, and, so, arguably, the market had high expectations prior to the announcement, the seasoned follower of ClickSoftware Technologies was aware of the fact that this lofty P/E ratio was mostly predicated on deliberate and sustained investment program by the company, aimed at super-charging the company’s growth above the $100 million revenue market, and that, without this investment, the P/E ratio would, in fact, be quite low.
There is little doubt that in the medium to long term CKSW remains an attractive investment from a fundamentals standpoint. Right now, the issue is simply whether or not it will be an attractive investment in the short term, as well.
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