Equity analysts create controversy, yet those others -- the technology industry analysts -- cause rumblings too. Gartner, the dominant technology analyst firm, has used its Magic Quadrant to help build a billion-dollar business and make technology companies fear a bad grade. John Finneran explores whether these dominant technology opinion-shapers offer an investment opportunity.
Working as a Wall Street analyst specializing in technology stocks in the 1970s, Gideon Gartner noticed many of his research reports were bought by technology users, not investors. Spotting an opportunity, he started Gartner (NASDAQ:IT) in 1979 hoping to capture a share of that pent-up demand.
Along the way, he created The Magic Quadrant, a two-by-two matrix rating system that evaluates technology vendors on their abilities to execute and the completeness of their vision. Vendors receive grades ranging from the rarely used "niche" to top-of-the-box "leaders." Middle-of-the-box vendors are "challengers" or "visionaries." (Gartner is not flying solo in the space, though, as competitor Forrester (NASDAQ:FORR) has its own shape: The Forrester Wave.) Small shapes can create big fortunes: The Magic Quadrant has helped power Gartner to more than $1 billion in annual revenue.
Similar to their equity counterparts, technology industry analysts broker information between two sides of a market. Technology providers are the sell side, while corporate buyers of technology are the buy side. Unlike their equity equivalents, technology analysts spend less time with a spreadsheet and more time feverishly gathering information. Each year, Gartner's 650 researchers attend 18,000 vendor briefings, along with answering 240,000 client inquiries.
Gartner dominates the top-heavy technology analysis industry. An InformationWeek article from 2006 stated that 80% of the $2 billion in revenue generated by the industry stems from the 10 largest IT analyst firms. Research contract value for Gartner stood at $683 million as of June 30 this year, which means we can ballpark its market share at approximately one-third.
No Henry Blodgets in IT
Accusations of bias plague the technology industry analysts, as they do equity analysts. Gossipy charges of "cash for comment" or "pay to play" -- meaning the more you pay the analyst firm, the better your position in the Magic Quadrant or Wave -- resurface frequently. Gartner has even set up its own ombudsman to combat such allegations.
Hard evidence of abuses does not exist. While analyst relationships appear cozy, there are no clear Blodget-type allegations of abuse. Wisely, they do not break out research revenue earned from the buy and sell sides in their financial reports. Technology analysts do, however, receive substantial revenue from the vendors they rate. Vendors pay for research and ubiquitous marketing documents, called white papers. Based on a stock note from investment firm William Blair & Co., about 60% of Gartner's and a third of Forrester's revenues come from vendors.
Rating the business model
The technology analyst business models deserve high grades from investors for four reasons.
- Research is a highly scalable business. Analysts write research once and sell it many times, all at minimal marginal cost. Hence the handsome gross margins for the research segment: Gartner achieved 63% in its last reported quarter.
- Research has attractive cash flows. Clients pay up front for research contracts, often multiyear contracts. Renewal rates are high, with Gartner's most recent rate running at 82%.
- Research produces intellectual property it can use to enter into adjacent businesses, such as consulting and events. The consulting businesses focus on high-end advisory work -- often delivered by the research analysts -- and avoid competing with the implementation armies of IBM (NYSE:IBM) and Accenture (NYSE:ACN).
- There are many industry growth opportunities. Gartner sees a huge opportunity in selling more research to technology buyers. It believes the addressable market for end-users of its research is $12 billion, yet this business generates only $400 million for the company, and the company has only 60,000 customers out of the 1 million professionals it aims to reach. To exploit this opportunity, Gartner increased its sales force by 25% in the last year to 765 quota-carrying reps.
Yet there are grade-lowering drawbacks, too. There are huge selling, general, and administrative expenses. In the six months ending June 30, 2007, Gartner spent $236 million, or 42% of its revenue, on this expense line. Other businesses based on shared-cost research business models, such as Corporate Executive Board Co. (NASDAQ:EXBD), execute with operating margins double those of Gartner, so there is potential for profit sharpening.
The valuation for Gartner is high, so investors need to buy the growth story. Gartner and Corporate Executive Board both trade with enterprise value-to-EBITDA ratios of around 19, while Forrester, which is behind on its SEC filings because of an ongoing investigation of stock option backdating, has a ratio of 12. In comparison, Accenture comes in at 7 times.
For investors looking for tarnished stocks, Forrester is interesting. The company has no debt, $233 million in cash and a market capitalization of only $510 million. The biggest cloud hanging over the stock is the aforementioned voluntary option accounting investigation.
The risks
Like sell-side equity analysts, the biggest danger to technology analysts is a shift in industry behavior. For equity analysts, it was the rise of independent analysts and the buy-side buildup of its research skills. For technology analysts, ironically, it is an increased shift to using the financial techniques of the equity analysts.
The current model of analyst-intermediated, opinion-based technology buying and selling produces poor financial returns. Across the world, corporate managers spend more than $1 trillion a year on technology. To help managers invest, and technology marketers persuade, $2 billion a year is spent on technology analysts. Yet 70% of projects fail to deliver a financial return, according to the Standish Group and other commentators.
The wrap up
Gartner's dominance in the technology research industry represents an opportunity for the growth investor, while Forrester is of interest for the value-oriented. Both stocks, however, are exposed to the risk of an industry shift to a more financially driven decision-making model, based around investment analysis and business cases. This would put the technology analysts and their quadrants at risk.
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