We end our review of customer relationship management (CRM) top dog Siebel Systems (Nasdaq: SEBL) today, talking about the importance of a value chain and addressing the company's valuation. Our initial assessment had reached a conclusion last Friday, when we talked about operational efficiency and CRM as a repeat-purchase business. After reading the Rule Maker discussion boards, it's clear there's more worth discussing.
The importance of Rule Makers building a strong value chain -- a string of companies working together to satisfy the market's demands -- can't be overstated. In his book The Gorilla Game, Geoffrey Moore discusses how the process of determining competitive advantage has shifted, particularly in the high-tech industry, from focusing on actions under a company's direct control, such as cost controls, to the role it plays in large cooperative ecosystems.
"These cooperatives are called value chains because they involve the linking up of numerous entities to fulfill a specific value proposition to a target customer," he writes. "Like all other human institutions, value chains need clear and stable power structures to sustain themselves going forward. The companies that gain ascendancy within these value chains, however, not only have the power over the chain, they have the power of the chain. That is, they can compete using the chain itself as a weapon, not just their own company's offers."
Rule Maker Microsoft (Nasdaq: MSFT) is a great example of a company forging a strong value chain. A 1998 McKinsey study estimated that Microsoft's revenues made up a mere 4% of its entire value chain, consisting of applications and services developed for the MS Windows platform. By powering the chain, and allowing others to provide valued additions, the company and its partners were able to stay within their core competencies and provide the best solution to the market.
Four percent might not sound like much, but consider that the $15.3 billion in revenues Microsoft posted in 1998 came from a value chain worth nearly $383 billion. Similar stories exist for other Rule Maker Portfolio holdings, such as Cisco Systems (Nasdaq: CSCO) and Intel (Nasdaq: INTC). Hence, a value chain is important, but controlling the value chain is critical, and one of the first conditions I look for in a company.
The do's and don'ts
A great deal of Siebel's success can be attributed to its value chain. CEO Tom Siebel calls it the "Siebel ecosystem." By forging relationships with companies such as supply chain leader i2 Technologies (Nasdaq: ITWO), middleware vendor BEA Systems (Nasdaq: BEAS), and Finnish phone maker Nokia (NYSE: NOK), Siebel has ensured its products can be used with other best-of-breed offers. Those partnerships ultimately enhance its value proposition to customers and provide access to new markets.
The "Siebel ecosystem" has more than 600 partners that market and sell their products to businesses that have purchased Siebel software. There are also partners that resell Siebel's applications. Strong relationships with systems integration partners IBM (NYSE: IBM) and PricewaterhouseCoopers have helped the company build its market share, but it's not completely dependent on either. Siebel develops the applications, but without Siebel's software there'd be nothing for IBM to integrate. That means IBM needs Siebel more than Siebel needs IBM.
When we began our review of the software industry last year, video game software maker Electronic Arts (Nasdaq: ERTS) was high on our list because of its consumer familiarity. I'd venture to say EA would pass all of our quantitative criteria, given the financial and business model advantages of software companies. The company also exhibits many of our qualitative criteria we look for, such as a repeat-purchase business and expanding possibilities. However, EA falls well short of controlling its value chain. The best evidence of this came when it recently reported a revenue shortfall.
With Sony's (NYSE: SNE) PlayStation 2 in short supply over the holiday season, retailers were forced to sell EA video games for game consoles that weren't available. New games have little consumer value unless there's a corresponding machine. EA is also reliant on PlayStation 2's consumer success. Its expensive price tag of $299 and the forthcoming Nintendo GameCube and Microsoft Xbox might have consumers looking elsewhere. In other words, EA's part of a huge value chain with Sony and Microsoft, but doesn't have the type of control we look for in Rule Maker companies.
Is Siebel overvalued?
After our first look at Siebel several weeks ago, the discussion boards quickly filled with comments like "Yes, Siebel's a good company, but what about valuation?" It should come as no surprise that the main concern among Rule Maker investors is business quality. We're looking for companies that dominate their industries with sustainable competitive advantages. First and foremost, your efforts should be put toward identifying good businesses, not attractive valuations.
Investors consumed with valuation will likely miss out on several unbelievable investment opportunities. When Richard McCaffery wrote about valuation last year, he noted investors that chose not to pay top dollar for Coca-Cola (NYSE: KO) in 1972 underestimated the company's growth potential. Even Rule Maker Co-Manager Zeke Ashton confessed that when looking at Siebel in 1999, he was scared off by the hefty price. Zeke admits he should have looked closer at the company's growth potential, but that's often the case when a business is difficult to understand, as is customer relationship management.
The question we need to ask ourselves is this: Can Siebel's market cap double in five years (2x/5y)? Two times its current market cap puts Siebel at about $66 billion in five years. Let's assume 5% dilution because of stock options, which would translate into a necessary market cap of $69.7 billion. Further, let's assume an expected profit margin of 20%. Currently, Siebel's net margin is at 14%, but with a software company's inherent increasing returns to scale, it's not unreasonable to expect Siebel to produce 20% net margins in five years. (By way of comparison, consider that Microsoft's net margins are currently in the ballpark of 40% and Oracle's (Nasdaq: ORCL) are around 23%.) With these assumptions, let's take a look at what level of sales growth will be necessary to achieve 2x/5y at various future P/E multiples:
Projected P/E 40 30 20 Year 5 Earnings ($B) 1.74 2.32 3.48 Year 5 Revenue ($B) 8.71 11.62 17.42 Growth Rate for 2x/5y 37.1% 45.2% 57.5%
In order to appreciate two times in five years, Siebel would have to post $8.7 billion in revenue in year five, growing its top line 37% annually. That seems pretty reasonable to me, particularly considering the CRM market is expected to grow 54% annually over the next five years. Then again, we've assumed that Siebel will have a P/E ratio of 40. That's in-line with other high-growth companies in the S&P 500. However, if we were to lower that P/E to 20 (pretty low for a high-margin software company), the company would need to grow its top line more than 57% annually to get to 2x/5y. That's a tad faster than the rate at which Siebel predicts the rest of the CRM market to grow. (By the way, we'll be exploring the 2x/5y valuation analysis technique in more depth in our upcoming online investment seminar, The Art of Rule Maker -- only $49 and with a 100% money-back guarantee if you don't love every bit of it.)
At the current price, Siebel certainly doesn't look overvalued. This is an emerging Maker we'll be keeping our eye on.
This coming Monday is a holiday, but on Tuesday, we'll begin a nine-day back-to-basics series in which we'll review the core Rule Maker investment criteria. Cisco will be our focus company during this series. Have a great weekend!
Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. At the time of this writing, he owned shares of Nokia. To see his other holdings, view his profile. The Motley Fool is investors writing for investors.
