Siebel Dominates

Early last year, the Fool's Zeke Ashton went on an exploration for Rule Maker industries and ceremoniously landed in the software sector. He went on to discuss some of the financial and business model advantages -- including excellent gross and net profit margins, low Foolish Flow Ratios, and low capital expenditures -- that make software companies ideal Ruler Maker candidates. That investigation ended with an examination of graphic design software leader Adobe Systems (Nasdaq: ADBE).

Adobe remains an excellent Ruler Maker candidate in the software industry, given its consumer familiarity. There's a wide range of other software companies, however, that merit examination. Customer relationship management (CRM), Internet security, business-to-business (B2B), and storage software are just a few exciting sub-sectors that contain plenty of Maker candidates. Though most fail on the consumer awareness score, remember that our portfolio owns Cisco Systems (Nasdaq: CSCO) and JDS Uniphase (Nasdaq: JDSU).

The market opportunity for software is substantial. According to market research firm International Data Corporation, more than $150 billion was spent on software applications in 1999. Businesses of all kinds are quickly moving to Web-enable operations. The increased efficiencies and cost savings afforded to companies by moving business practices to the Internet are significant. The software applications employed by businesses are typically chosen based on their return on investment (ROI), affecting everything from revenue growth to the quality of customer relationships.

There are also several economic factors facing businesses that have spurred demand for software. High labor costs encourage organizations to automate specific processes. By employing the technological advantages of software applications, timely and expensive tasks can be reduced, increasing worker productivity. Businesses are also in extremely competitive environments with little pricing power. Software can cut expenses to spur bottom-line growth.

Now the focus of today's column: CRM top dog Siebel Systems (Nasdaq: SEBL). CRM focuses on front-end (external) business practices. Examples include customer service, sales, and marketing. Company websites have become a major investment vehicle by fulfilling every customer need anytime, anywhere. The Internet has improved the flow and quality of information, thereby allowing employees to make critical decisions that improve relationships with customers and suppliers.

Siebel is the leader in CRM, but competitive pressures are high, with formidable challenges from enterprise resource planning (ERP) companies such as PeopleSoft (Nasdaq: PSFT), Oracle (Nasdaq: ORCL), and SAP (NYSE: SAP). The Oracle marketing machine has long claimed it was stealing market share from Siebel. When John and Matt talked about the company, they decided to wait until Siebel reported second-quarter results to see how fast application sales were growing, and if Siebel was increasing market share, to determine the success of Oracle. Fortunately, we now have a full year of results to determine how Siebel has managed the competitive pressures.

Market share is particularly important in the software industry because of increasing returns. In "What the Next Microsoft Will Look Like," Del Vecchio points out this phenomenon developed by W. Brian Arthur of the Santa Fe Institute:

"[Arthur's] theory states that once a company gets a market share lead, it gets farther ahead while competitors fall farther behind. This happens because technology buyers are conservative and they demand technologies that are standard and work effectively with the rest of their infrastructure. As more copies of a leader's software are sold, it increases the likelihood of its becoming the standard, causing even more copies of software to be sold and reinforcing the growth cycle."

In other words, mind share equals more market share. Siebel has displayed increasing returns over the past year. The chart below, derived from figures provided during Siebel's Q4 conference call, displays the company's improved market share in every category:

                          Market Share
Market Segment            1999    2000
Sales force automation     70%     75%
Call center                48%     60%
Marketing automation       20%     34%
Field Sales                21%     48%
eChannel                   30%     61%
Internet self-service       4%     29%
Mid-market                 25%     55%

With Siebel's increasing returns and strong market share across the many market segments of CRM, the company has begun to display all the inklings of a Rule Maker. It probably comes as no surprise that the company passes every single quantitative RM criteria, along with positive momentum in most of its metrics:

Rule Maker Metrics       2000      1999
Annual Sales        $1,795.4M   $813.5M
Sales Growth             120%       98%
Gross Margin              75%       77%
Net Income            $257.8M   $110.0M
Net Margin                14%       14%
Cash-to-Debt             3.89      2.68
Flow Ratio               1.16      1.29
Cash King Margin        19.0%      9.7%

Some observations:

• The company's 120% sales growth is indicative of the demand for applications that enhance relationships with customers. This number is well above our 10% revenue growth target.
• Typical of most software companies, Siebel displays tremendous efficiency. The company boasts gross and net margins of 75% and 14%, respectively. That's well ahead of Maker targets. Gross margins did decline slightly year-over-year, but are still well within the company's internal target of 74% to 75%.
• Siebel's balance sheet is impressive and has improved significantly over the past year. The company has roughly $1.16 billion in cash and $300 million in debt, giving it a cash-to-debt ratio of 3.89. That's well above our 1.5x benchmark, and quite an improvement over the past year.
• In the past, the only Rule Maker criterion that Siebel failed was a Foolish Flow Ratio below 1.25. The company has improved its working capital management over the past year and now has a Flowie of 1.16. Siebel's ability to collect cash from its customers more quickly is also reflected in its days sales outstanding (DSO) figure, which improved from 98 days at the end of 1999 to 81 days by the end of this year.
• Finally, the company generates gobs of cash, with a Cash King Margin of 19%, almost twice that of the prior year. In Q3, the company's improved DSOs alone helped it deliver $170 million in cash flow from operations over the first nine months.

That about does it for the financial breakdown of Siebel. There's little to be disappointed about in the numbers, but there's much more to the Siebel story. The company is still in a stage of hyper-growth, where the emphasis is on increasing the top line. Once revenue growth rates subside (and they will because Siebel won't grow revenue 100% year-over-year forever), the company's attention will turn to operational efficiency and attacking new markets. When we look at the company next Friday, I'll talk about the importance of those areas and size up the risk factors.

Finally today, we're excited to announce our upcoming Rule Maker 2001 online seminar: The Art of Rule Maker. Last year's seminar focused on the craft of understanding and applying the Rule Maker financial criteria. This year, it's all about the art of forward-looking qualitative investment analysis. We'll show you how to apply our four new qualitative criteria: a sustainable competitive advantage, great management, expanding possibilities, and a reasonable valuation. All of the Rule Maker managers will be there to learn along side you. The seminar will conclude with a report on our 25 favorite Rule Maker investment ideas. A lot of great thinking has gone into this seminar, and we're really excited to have you join us. To learn more about this seminar, as well as how online seminars work in general, see our information page: Rule Maker 2001 -- The Art of Rule Maker.

Fool on!  

Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. Mike is not a shareholder in any of the companies mentioned above. The Motley Fool is investors writing for investors.