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Wednesday, October 21, 1998

An Investment Opinion
by Louis Corrigan

JDA Software and the ERP Washout

The carnage lately among enterprise resource planning (ERP) and related software companies has been breathtaking. Among the leading ERP vendors, Germany-based SAP (NYSE: SAP) has dropped 41% from its 52-week high hit just after its splashy American intro late this summer, while its California-based rival PeopleSoft (Nasdaq: PSFT) has plunged 66% and Netherlands-based Baan (Nasdaq: BAANF) has imploded for a 82% collapse. Smaller niche players have also been deeply wounded, including firms working the supply chain management space, which the ERP vendors seem determined to capture. i2 Technologies (Nasdaq: ITWO) trades 68% off its 52-week high, while Manugistics (Nasdaq: MANU) has been manhandled for a 84% beating and JDA Software (Nasdaq: JDAS) has been slashed 80%. So what's happened, and are there any bargains among these tech casualties?

The short answer to the first question is that earlier this year these stocks traded at exceptionally high P/E multiples, often even above the stunning 50% to 70% earnings growth rates many had delivered in recent years. A slowdown in high-margin software licensing revenue has caused earnings multiples to contract even as earnings projections have been cut. This is the double whammy that makes some short-sellers willing to venture into the treacherous arena of highflying tech stocks. While favorable sentiment drives these darlings ever higher, a shift in momentum can lead to a cascade-like washout.

Recent earnings announcements have only added to investors' anxieties. After the market closed yesterday, PeopleSoft reported Q3 earnings of $0.17 per share, up 55% versus $0.11 per share last year and in line with estimates. Yet the company said full year FY98 revenue would increase by just 60%, suggesting a continued drop-off in the current quarter given that revenue is up 71% year-to-date and 67% in Q3. What's worse, the company now expects FY99 revenue gains of just 25% to 35%, in line with the 30% growth in third quarter license fees, which were down from the 58% gain in software revenue seen in the first half of this year. Though that guidance may be conservative, management pointed to uncertainty over big-ticket capital spending, especially given some apparent diversion of information technology (IT) budgets to address the Y2K problem. Also, price-cutting by competitors has hurt profits, with fourth quarter operating margins expected at the low end of the company's 18% to 20% target range. A flurry of analyst downgrades pushed PeopleSoft down $6 to $19 3/4 for the day.

Meanwhile, industry leader SAP added fuel to the fire. Following the firm's preliminary report on October 9, the company's estimate-beating Q3 results came in as expected last night, with revenue up 43% to $1.2 billion and pre-tax profits up 50% to $221 million, or 53% excluding a one-time expense. While revenue growth has slowed from the 63% seen in Q1 and the 59% seen in Q2, sales to the Americas jumped 55% and sales to Europe, the Middle East, and Africa increased 50%. The real sore spot is Asia, where revenue plunged 20% mostly due to currency issues. However, SAP's management doesn't foresee a quick rebound in Japan.

It also expects "some moderation of demand due to year 2000 issues." As a result, the company guided investors to expect a 30% to 35% increase in pre-tax profits for FY98 on 40% sales growth. The problem is that this forecast implies Q4 sales could rise just 16%. That exasperated some analysts, who considered it so overly conservative as to constitute bad investor relations. "You really have to dig and do your own research," complained Credit Suisse First Boston analyst George Gilbert to, in what are surely some of the Wisest words of the week given that that's what analysts are paid to do (or so we've been led to believe).

While concerns about Asia and a shift in IT spending due to the Y2K problem are weighing on these stocks, a report issued today by AMR Research Inc., a leading tracker of the ERP market, found that price pressures, particularly on sales to mid-market firms with annual revenues of $50 million to $500 million, may be the most significant issue facing ERP vendors. A September/October survey of 12 of the top 20 ERP companies traded on U.S. markets found that the average firm does 66% of its business with U.S. corporations, 22% with European companies, and just 9% with the Asia-Pacific region. Nearly all expect steady or increasing sales to the U.S. and Europe, with Europe looking a bit weaker than the U.S. Even more interesting, three-quarters of the firms surveyed said they were "seeing more deals because of Y2K," with one vendor claiming 25% of the deals "were closing faster" because of the issue.

Bruce Richardson, VP of research strategy, said AMR continues to forecast "solid growth in most parts of the enterprise applications market, including ERP, supply chain management, and customer relationship management" but that "the growth is not being shared by all vendors." While sales cycles have lengthened as companies make sure they're getting the best product functionality and service, AMR expects sales will remain strong even during economic downturns. This makes sense given that productivity gains and cost-cutting at Fortune 1000 companies have been partially driven by the adoption of such enterprise and supply chain software.

While SAP and PeopleSoft seem like inevitable winners in the coming consolidation of the overall enterprise space, getting a handle on product differences among industry players and tracking sales (which often come in a flurry -- or not -- at the end of a quarter) can be a challenge for individual investors. Indeed, trying to invest in this area often feels like an endeavor best left to Peter Lynch's lame brained Houndstooth. On the other hand, some of the niche players seem like potential takeover candidates at their current prices.

Consider JDA Software, a provider of enterprise software products and related services that help retailers track inventories and purchase orders. Its customer list includes the likes of Gap (NYSE: GPS), Gucci (NYSE: GUC), CompUSA (NYSE: CPU), and Williams-Sonoma (NYSE: WSM). JDA's stock fell $5 1/4 to $7 3/4 yesterday after reporting its second straight quarter of disappointing results. While revenue jumped 64% to $38.9 million in Q3, net income increased just 19% and EPS (due to dilution from a follow-on offering last spring) came in at $0.17, up from last year's $0.16 but below estimates of $0.22. Overall license fees edged up just 23%, down from the already disappointing 29% increase in Q2. The problem was that international license fees plunged 40% after dropping 20% in Q2, due partly to vacant management positions in Europe. The only positives were that U.S. license fees increased 130% while services revenues soared by 95% and gross margins from services exceeded expectations by vaulting to 36% from 31% in Q2.

The major ERP vendors have all targeted the retail market for growth. While retailers such as Wal-Mart (NYSE: WMT) have traditionally devised their own systems, manufacturers increasingly want retailers connected to their systems. That's driving sales of packaged applications in what is said to be a $3 billion market. SAP just this week acquired Campbell Software, a maker of workforce automation software for the retail market. Oracle (Nasdaq: ORCL) is collaborating with Richter Systems, while PeopleSoft recently paid $45 million to acquire longtime partner Intrepid, a maker of merchandise management software with $20 million in FY97 revenue. JDA has beefed up its own offerings by paying $44 million for Comshare's (Nasdaq: CSRE) Arthur line of decision support tools for retailers. And in August, JDA announced a joint venture with Baan to create and sell new global-retail software.

Baan has been rocked by accounting issues, charges of conflicts of interest among top management, and a sales slump -- none of which is reassuring for JDA investors thinking that Baan might find JDA's strong U.S presence of considerable value. Nonetheless, JDA may be a bargain, especially considering its 540 customers worldwide. Backing out the $86 million in cash from its roughly $187 million market cap gives us an enterprise value of $102 million, or 0.75 times the trailing 12-month sales of $136 million. That looks cheap considering JDA reported 10% net margins even in the weak third quarter. Meanwhile, trailing 12-month earnings stand at $0.76, giving the stock a P/E of 10.4 or just 5.7 after backing out the cash. Although analysts have cut their estimates substantially, Hambrecht & Quist, for example, still expects Q4 revenues of $41 million and EPS of $0.19. Although technology shipwrecks often have trouble rising from the depths, JDA is one of several bloodied software outfits working the enterprise space that looks worth investigating.