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Thursday, October 15, 1998

An Investment Opinion
by Alex Schay

Documentum Roars Back

Back in the 1980s when approximately $8 billion per year was spent on paper business forms, the productivity gains inherent in transitioning from hard form to binary units made the shift a slam dunk. The realization that for every dollar spent on a form, a company could wind up spending twenty more on filing, copying, routing, amending, and ultimately getting rid of the darn thing, led to a kind of urgency described by the authors of the The Profit Zone, "Help my organization -- which uses 20,000 different types of paper forms -- to transition from paper to an electronic forms system so that we can lower our total systems costs from $20 to $10."

Today the concept of "total ownership cost" has been taken to its logical (and absurd) extreme as personal finance columnists admonish their adherents to conduct the calculus on their pets, cars, etc. It looks like Spot has got to go -- administrative costs skyrocketed in the most recent quarter, which brought up Total Dog Cost Per Year (TDCY) as a percentage of salary by 50 basis points. Sorry Spot ol' buddy, the marginal gains in utility are just not there anymore. Anyway, now that paper forms carry the stigma of the Dark Ages, new costs need to be strained out of the system -- but like an orange that's already been given a mighty squeeze, the second time around always yields a little less liquid. Wait a second, you're still doing that by hand? Let's introduce the Electric Juicer.

According to an industry report conducted by IDC Research, roughly 80% of corporate data is still unstructured. Electronic data sits in a dizzying array of formats: text files, word processing documents, spreadsheets, graphics and images, as well as video and audio. On top of this, all of the data types also exist in multiple formats by virtue of having been created by different applications. Compounding the problem even further (despite the omnipresent desire of Information Technology managers for technological homogeneity) are software applications running on a variety of computer platforms that may be geographically dispersed with little data sharing capability. Enter the enterprise wide document management companies -- in a time where there is a continuing convergence between the document companies and and the imaging and production workflow segments.

Fears that capital spending in the document management area will dry up during the coming economic cataclysm have clobbered the entire group over the last month -- as well as the broader enterprise software market. As of yesterday's close, here is how some of the significant players have fared in terms of price declines for the last month:

FileNET (Nasdaq: FILE) -71%
Open Text (Nasdaq: OTEXF) -6%
PC Docs (Nasdaq: DOCSF) -34%
Documentum (Nasdaq: DCTM) -45%

Today, however, Documentum (Nasdaq: DCTM) roared back almost 25%, gaining $7 5/8 to $31 5/8 on the heels of the release of its third quarter financials. Excluding a merger-related charge, EPS grew 36% to $0.19, up from $0.14 in the third quarter of 1997 and ahead of estimates of $0.17. From its inception in 1990 through December 1992, the company's activities consisted primarily of developing its products, establishing its infrastructure, and conducting market research. Documentum shipped the first commercial version of its Server product in late 1992, and since then most of its revenues have been from licensing its entire family of enterprise document management system (EDMS) products and related services, which include maintenance and support, training, and consulting services. The company launched EDMS '98 during the quarter, and investors skeptical about incremental revenue flow from the "new options" were heartened today.

It's easy to misunderstand the return on investment characteristics surrounding the implementation of these packages, but when a company like Novartis is looking to recoup its initial investment in roughly two years and then see permanent cost and productivity benefits thereafter, it's worth a closer look at some of the case studies -- if only to get a handle on the IT decision-making involved. Perhaps Documentum's greatest asset is that EDMS includes solutions for integrating with popular desktop, groupware, and enterprise applications like Microsoft Office, SAP R/3, PeopleSoft, Adobe FrameMaker, Lotus Notes, AutoCAD and MicroStation, allowing the firm to piggyback on the success of some of the enterprise resource planners (ERPs).

In addition, the company's Relevance acquisition will not result in the actual movement of new products until the fourth quarter, but the first application that will be shipped is a sales intelligence system that complements other sales force automation systems from Siebel, Vantive, Clarify, PeopleSoft, SAP, and Oracle. This is going to provide Documentum with some very high visibility moving into 1999. The dilutive effects of the acquisition are expected to be offset by the accretive benefits (in 1999) to the tune of $0.02 per share in earnings.

With a trailing return on invested capital (ROIC) of 9.6%, Documentum is not yet getting a juicy spread on its cost of capital, but the firm ultimately may be looking at some sustained competitive advantage period (CAP) if its claim that it is winning 8 out of every 10 engagements with FileNET is to be taken at face value. Interested investors -- comfortable with analyzing the still relatively rich valuations in the enterprise software segment -- should check out the pricing environment and the IT adoption issues. At the very least, it wouldn't hurt to cut these companies into a broader watch list along with the ERP behemoths.

[Correction: In yesterday's "Fool on the Hill" column about Ziff-Davis (NYSE: ZD), we incorrectly said that CNET (Nasdaq: CNWK) has an alliance with Disney (NYSE: DIS) for the new Snap! portal site. CNET's partner is actually NBC.]