Website testing and monitoring software provider, Mercury Interactive, reported third-quarter earnings of $0.18 per share, up 100%, as revenue rose 67% to $79.5 million. The company is building a lead in its niche, which for software providers means a premium price.
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So what?
With a market value of $11 billion, Mercury Interactive is the leading provider of performance management software that enhances a company's Web application performance, scalability, and usability. According to Mercury, "The company's performance management products and hosted services are open and integrated to best test and monitor business-critical Web applications."
Being top dog, the company has strong momentum in signing new customers. More than 10,000 companies, including many of the large names that we all know, now use Mercury Interactive products. This large client list is made more attractive by the fact that the revenue is typically recurring. If a client wants to continue using Mercury's products, it will continue to repay the license fees.
Like most software providers, Mercury's products also work to build a protective moat around its business. Why? Because client's websites are built around the testing and performance monitoring of Mercury's software. If clients then switch to a Mercury competitor, they will typically lose the advantages gained by staying with the same company year after year.
Mercury's market share lead and large client list in the less-than-glamorous but necessary Web-testing and monitoring industry is, in part, what led me (an investor writing for investors) to buy shares.
Now what?
At $135, or $11 billion in market value, Mercury isn't "cheap." It trades at 156 times year 2001 consensus earnings estimates of $0.86 per share. Those estimates will likely rise a few pennies following today, but the stock is still selling for a premium price. Leading software companies typically do, especially when young. Siebel Systems (Nasdaq: SEBL) is a good example at over 300 times earnings.
Niche-leading software companies are priced as such because margins are high, but more than that, it's because as they begin to "lock down" a particular software niche, their chances for success grow greater and greater. Why?
Because the companies may become the de facto software provider in a niche as customers start to want to use what everyone else is using. Siebel leads the customer relationship management (CRM) software industry, hence its premium price.
The other advantage: the high-margin, recurring nature of the software business. The potential for software upgrades and annual license fees can make the business financially exceptional.
Volatility will continue to affect high-growth stocks like Mercury and Siebel. At these prices, you need to invest long-term and watch to see if such companies continue to lead their niches (and grow their leads). If the companies don't, your investment thesis will need to change, or you'll have to rethink your purchase.
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