Burnham's Beat

Sweet Revenge: Oracle Takes Over Siebel

 There have been a lot of great posts written about Oracle’s purchase of Siebel today, so I won’t belabor the point, however I’d like to offer up that in addition to this acquisition being consistent with Oracle’s somewhat dubious consolidation strategy, it also is sweet revenge for Larry Ellison.

You see when Tom Siebel left Oracle to start Siebel there was, according to many people I’ve talk to, no love lost between Larry and Tom. Indeed, today’s news brought back memories to me of a dinner at the Circus Club in the summer of 2001 where Tom Siebel was receiving the “Entrepreneur of the Year” award from Stanford’s Center for Entrepreneurial Studies.  At the time Siebel’s stock was still around $50/share and Tom Siebel was still running the ship. In his speech, Siebel talked a lot about how he ran the company in a much different manner than “the average Silicon Valley company”.  It quickly became clear that he was really saying that he ran the company much more ethically and professionally than Larry Ellison ran Oracle. He capped off his comparison with a clear and very personal swipe at Ellison when he said something to the effect of “I did not want to found a company where the CEO walks off the corporate jet with the PR floozy of the week on his arm.”  The room was packed with VCs and Silicon Valley CEOs and there was a lot of snickering when Siebel made this statement because everyone knew exactly who he was talking about.

I don’t know if Ellison ever heard about this speech, but if he did it probably only strengthened his resolve to get the last laugh. Fast forward 4 years and it looks like (a now married) Ellison will indeed be getting the last laugh. My guess is that all traces of “Siebel” will be erased within 24 hours after the acquisition closes. A lot of posts are talking about the premium that Oracle paid to take out Siebel however they neglect to figure in that the value of sweet revenge is priceless.

Software's Top 10 2005 Trends: #3 Software As A Service

Software as a service has a bit of a bad reputation thanks largely to the Application Service Provider (ASP) debacle of the mid-1990s.  Back then, a huge amount of money was poured into ASPs such as US Internetworking, Corio, and Interliant in the belief that companies would like to buy enterprise applications as hosted services

As it turned out, not many companies were interested in buying mission critical software as a hosted service. Not only did hosted apps have significant security and performance issues, but they were difficult to customize and integrate into an enterprise’s other systems. On top of this, the economics of providing enterprise software as a service were terrible. ASPs were required to make huge upfront investments in hardware and software but they only got paid a monthly subscription (which could often be cancelled with little notice).  In addition, competition from other venture funded startups drove pricing down and drove customer churn and factor costs (such as hosting and bandwidth charges) up.  This turned out to be a recipe for disaster and many ASP’s ultimately ended up going bankrupt under crushing debt loads.

Fast forward to 2005 and things are now actually quite different.  First off, the main costs required to offer software as a service have declined dramatically.  As Ryan McIntyre outlines in his excellent post on data center economics, datacenter/hosting costs have plummeted in the last 10 years with bandwidth costs declining 88%, storage costs declining an amazing 99.7% and CPU costs declining an even more amazing 99.9%!  (When you think about this from a business economics standpoint it really is stunning.)  With lower costs, the upfront investment required to offer software as a service is actually now quite reasonable.

Outside of lower costs, three other developments have helped make software a service much more attractive.  First, developers have created new applications that have been engineered from the ground up to be offered as a hosted service and even many existing applications have been re-engineered to make them more “hosting-friendly”.  Second, the advent of XML and web services has made it easier for companies to integrate hosted applications and data into their own legacy systems.  From a technical perspective, this has removed one of the last major drawbacks of hosted software.  And finally, 10 years of exposure to the web has made many corporate managers much more comfortable with the idea of hosted-applications.  Even many IT managers, who at first resisted hosted applications as a potential threat to their jobs and influence have now warmed up to hosted-apps as a way to quickly meet business unit needs without adding significant costs to their own organization.  For many developers, selling a hosted software solution is now an easier and faster process than selling installable code.

On the strength of these developments, 2005 may very well turn out to be the year that software as a service goes from being an alternative means of delivering software to being the preferred means.

For VCs, the growing acceptance of software as a service combined with its improved economics raises the possibility that it is very risky, if not downright ill-advised, to fund any new enterprise application that is not designed primarily to be offered as a service.  It also raises the prospect that new applications architected from the ground up to be offered as a service may be able to displace well established client-server players in the ERP, database, and vertical application space much as those players did to mainframe and mini-computer vendors in 1980’s and 1990’s.  Indeed some categories of applications, such as inter-enterprise applications, are not even possible unless offered as a service.   All of this adds up to make enterprise applications a much more interesting investment space than it was just a few years ago.

For a complete list of Software's Top 10 2005 trends click here.

Software's Top 10 2005 Trends: #6 Inter-Enterprise Applications

Conventional wisdom in the VC world is that there are very few white spaces left to fund in the Enterprise Applications area.   After all, you can only fund so many CRM and Supply Chain deals.

However, with the advent of web services and technologies such as BPEL (#7) and Composite Applications (#8), the foundation for a new class of inter-enterprise applications is now in place.  These Inter-enterprise applications will automate business processes and work flows across enterprises that up until now have been largely manual.  These new applications will not just facilitate real-time collaboration between businesses but they will continually manage specific business processes across enterprises.  In essence these applications will merge the process oriented features of applications such as PLM and Supply chain with the real time collaboration features of products such as WebEx and Microsoft’s Office Communicator.

For example, processes like dispute resolution in the credit card industry, or clearing in the securities industry, or claims processing in the healthcare industry all involve lots of enterprises working together on a common business process.  While large portions of these processes are automated within individual enterprises much of the process between enterprises remains manually managed (even though a lot of data may be exchanged electronically).  Creating shared visibility across the entirety of a multi-enterprise business process will bring tremendous benefits in terms of reduced costs and improved productivity.  Some interesting examples of companies trying to build such next generation applications include Webify, Viacore, and Rearden Commerce.

Some existing applications, such as PLM and supply chain, may be able to successfully expand their offerings to encompass such inter-enterprise functionality.  Indeed if they don’t they are probably going to go out of business.  However many of these applications will need to be created from scratch given the unique technology, security, and management challenges inherent in automation of inter-enterprise processes.

For a complete list of Software's Top 10 2005 trends click here.

ELOY Update

Well, my ELOY trade did not last long. As I noted in my previous post, I was worried about the stock’s lack of liquidity as well as the “hidden” dilution/overhang from the preferred stock so I decided not to take anything more than a symbolic position and put a stop loss in at $5.75, $0.05 above my cost. As fate would have it, just a few days later the stock traded through $5.75 and my stop was executed … at $5.52/share.

How could my stop loss get executed at $5.52 when it was pegged at $5.75? Primarily because I used a stop instead of a stop limit order. I consciously did this because of the poor liquidity of the stock. I didn’t want the stock to gap down and cross-lock my limit, so I went with a stop order at $0.05 above my cost figuring that the if the stop was activated I would actually get a trade somewhere between $5.75 to $5.70. In fact, $5.75 was indeed the quoted bid for about 15 mins and 2,500 shares cleared at that price about 10 mins before I was filled at $5.52, but my order wasn’t executed. In all likelihood my order wasn’t executed because I made the trade via E*Trade. E*Trade still sells off their orders to wholesalers, who provide retail investors who terrible fills on a routine basis. (Something I have written about extensively in the past.) If I had made the order via Datek/Ameritrade, some if not all of the 1000 shares would likely have cleared at the $5.75 price thanks to Datek’s superior automated execution.

I should mention that ELOY did report Q4 2003 earnings on 2/9. They were in-line with the positive preannouncement and the stock basically did almost nothing the day after. They appear to be making solid progress in rebuilding their business but still burned over $1M in cash in the quarter. Thus, from a fundamental perspective ELOY’s prospects for affecting a successful short-term turn around still seem pretty bright. That said, I hate the stocks complete lack of liquidity (emphasized by my poor fill) and the preferred overhang, so I will just observe the from the sidelines. At least I will be able to give my friend (a Wall Street analyst who recommended the stock) a hard time about his pick.

Trade of the Week: E-Loyalty (ELOY)

I purchased some shares of E-Loyalty (ELOY) yesterday. E-Loyalty is a fairly unremarkable Customer Relationship Management (CRM) consulting company. It was spun-out of a company called Technology Solutions in early 2000 in a crass and fairly typical attempt to capitalize on all things remotely Internet related (thus the E-Loyalty name). Its venture backers were TCV and Sutter-Hill, two later stage players who likely saw an opportunity to take a call center consulting company, gussy it up a bit and make some quick money.

Incredibly, E-Loyalty hit a high of almost $350/share in mid-February of 2000, just a couple weeks after the spin-out became effective, likely giving the VCs hundreds of millions in paper profits. But the worm quickly turned and the stock headed into a free fall. It was down 50% just a couple of months later and by the end of 2003 was trading at just $3.65/share, down almost 99% from its high.

It’s not that there haven’t been good reasons for the stock’s price decline. The company’s revenues declined from $212M in 2000, to $147M in 2001, to $87M in 2002, and what looks to be about $80M in 2003. GAAP losses in 2003 will probably be between $17M-$20M, up from last year’s $15M. The company only has about $29M in net cash on hand it looks like it will continue to bleed cash for at least a few more quarters.

So why in the world did I buy such a “winner”? First, and most importantly, it was recommended to me by a friend of mine who is an analyst and who use to cover the CRM software space. He knows that I like “fallen angles” with compelling valuations that are arguably in the midst of a turn around so he told me about ELOY. I tend to buy at least token positions in all the stocks he recommends because even if they go down I will at least be able to give him a hard time about it. It doesn’t hurt either that the last stock I bought on his advice, Chordiant (CHRD), made me some decent money. His advice along with a quick peak at the fundamentals on Yahoo! Finance was enough for me to buy 1,000 shares yesterday.

What I found when I looked on Yahoo! Finance was that from a financial standpoint, E-Loyalty had many of the characteristics that I look for when I screen software stocks for new ideas (although ELOY is clearly not a software stock). According to Yahoo, ELOY had a market cap of $39.9M and, as I quickly calculated, a net tangible book of $47.2M, meaning that the company was selling at 15% discount to tangible book which provides, as Benjamin Graham would say, a nice margin of safety. Net cash was $29M and operating cash flows, while negative, we only in the $2M-$3M/quarter range indicating that the company could operate for a minimum 2+ years without having to raise more capital. Revenues were likely to be about $80M in 2003, which means that the company an enterprise value to sales ratio of only 0.14.

While overall financial performance has indeed been terrible in the past few years, there were indications that revenues were either stabilizing or even growing. In fact, the company pre-announced a positive quarter earlier this month that resulted in a single day jump of over 36% from $3.56 to $4.85. Since then the stock had been climbing steadily upward as new buyers trickled in, many likely drawn by some of the same things I was now seeing.

Outside of the revenue growth, a few other things attracted me to the stock. One was that I had already seen stronger than expected Q4 software license sales at a number of CRM vendors, such as Seibel and E.piphany, indicating that the CRM software market was indeed coming to back to life a bit (and with it, presumably CRM consulting) and another was the fact that consulting firms tend to have highly leveraged exposure to incremental revenues. What I mean by this is that because consulting firms must eat the cost of unbillable consultants, any increases in the utilization of consultants drops almost entirely to the bottom line. With gross margins of only 16% in Q3 03, ELOY clearly had very poor utilization (healthy consulting firms have around a 50% gross margin). Given this, even modest revenue growth would likly have a significant impact on the bottom line, possibly generating the company’s first ever GAAP profitable quarter sometime in 2004 and my experience with these kind of stocks suggests that once they hit GAAP profitability they tend to experience another leg of significant price appreciation as the market bids them up into a comparable multiple range vs. their competitors. One final factor that attracted me was that the stock was very thinly traded (only 17,000 shares/day). This lack of liquidity suggests that if the stock has in fact turned the corner, it could run up very rapidly and that even slightly positive news could generate significant gains.

As I said, this quick analysis, plus the opportunity to give my friend merciless grief if the stock went down, was enough to buy the token 1,000 shares of the stock yesterday. I did resolve however to spend some time this morning doing a more thrurough analysis of the stock to see if I should try to take a meaningful position in it.

With that in mind, this morning I went through a number of Eloyalty’s recent SEC filings. As often happens, this closer level of analysis revealed some negative surprises. The first and most important surprise was that the company had actually issued about $21M in 7% Preferred stock in December 2001, mostly to its VCs TCV and Sutter Hill. I should have caught this when I looked at the balance sheet on Yahoo! Finance but I didn’t (preferred stock is listed in the shareholder’s equity section, not as debt). The net effect of this was to dramatically reduce the “margin of safety” in ELOY by putting $21M in preferred stock ahead of the common. Thus rather than trading at a discount to tangible book of 15%, ELOY is actually trading at over 1.5X tangible book. Since the preferred is convertible into common it means that there were about 65% more shares outstanding (on an “as converted” basis) than I thought meaning that despite what Yahoo! Finance said, the effective market cap of the company was $63.6M instead of $39.9M. (In my experience incorrect market caps are a consistent issue with Yahoo! Finance, I highly recommend taking their market cap numbers with a grain of salt. It makes you wonder how many people are making decisions using the wrong numbers…)

Another negative surprise was that the preferred was sold to TCV/Sutterhill at about $5/share and has been freely registerable since mid-2002. With the stock now suddenly trading above their cost, there’s a risk that the VCs could start selling their shares or worse yet, distribute them all at once to their LPs, which would kill a highly illiquid stock like ELOY.

While these were significant negative surprises, it’s not clear that they outweigh the positives. Indeed, most of the factors that were initially appealing about ELOY proved true on closer inspective. Staff utilization was indeed depressed at around 60% thus indicating the potential for significant margin expansion should revenues grow. Revenue declines and negative cash flows were also decelerating sharply and the company could clearly become profitable with a little bit of wind at its back.

So what to do? On the one hand, the preferred stock really makes ELOY an unattractive holding. It eliminates what appeared to be a big margin of safety and it creates a huge (relative to its liquidity) overhang on the stock that could fall at any time. On the other hand, if ELOY’s revenue growth is for real, the stock could quickly turn GAAP profitable and start generating cash, something that would likely lead to significant stock price appreciation given what has happened to other stocks in similar situations recently.

My decision is made complicated by a few more facts: 1) I know that my friend will be talking up the stock to other people on the street potentially giving the stock a lot of trading momentum. (He even convinced his boss to buy it which is a very risky move.) 2) I bought the stock at $5.70 yesterday (E*Trade screwed me on my fill relative to the market but that’s another post…) and it closed at $6.27 today, up just under 10% in 48 hours. Given the stock had only average volume today that indicates to me that there are almost no sellers out there right now which is a good technical situation for the stock. 3) The company reports next Tuesday. Stocks typically are either strong or weak going into an earnings report and this stock is clearly strong. Thus there’s little reason for the positive trend to reverse itself prior to the report next week.

All that said, I am not going to add to the position. The liquidity will play against me if I try to buy a lot of shares and if bad news comes out I will get creamed. I am also scared to death of that overhang, especially in light of the fact that the VC’s are now sitting on a 25% gain. I suspect there will be pressure on them to start some limited sales shortly because the same thing happened to us at Mobius with a couple of our illiquid small-cap holdings. Net, net I am probably just going to put in a stop-loss at $5.75 (I have learned my lesson on stop-losses) and let it ride until just before the earnings call (2/10). I’ll reevaluate then and see if I want to risk the report or not.