I recently discussed investing philosophy with a Denver-based money manager. Like me, he looks for fundamentally sound companies that have experienced recent price declines. He thought a software company called SupportSoft (NASDAQ:SPRT) might be one such opportunity.
SupportSoft's products help companies automate and streamline their service and support divisions. Imagine that your computer automatically recognizes that your DSL connection is down, then fixes the problem for you. It beats spending four long hours on the phone with technical support staff.
In the last year, SupportSoft traded near $11. In October of 2004, after several quarters of strong growth, it posted disappointing third-quarter results, and the happy days disappeared. The stock currently trades around $5.20 -- well below its price during its time as a fixture on the Foolish 8 screen in 2003 and 2004.
Obviously, we don't want to buy the stock just because it's lost more than half of its value. Let's check the financials to see if the company is still fundamentally sound.
The industry
Software companies have many attractive characteristics:
- Software is inexpensive to produce and ship, so gross margins (net sales divided by total revenues) are usually high.
- Software development doesn't require factories or other expensive infrastructure, so software companies rarely carry debt.
- Software doesn't take up a lot of physical space, so software companies don't have to maintain costly inventories to protect against demand fluctuations.
- Software is often sold with annual support contracts, providing the company a recurring revenue source.
What's the catch in this rosy world? Competition. Entering software markets is easy and relatively inexpensive. When someone hits on a profitable idea, you can bet that a lot of clones will soon jump into the market.
SupportSoft's recent annual report lists 12 competitors, including heavyweights like Hewlett-Packard (NYSE:HPQ), Computer Associates (NYSE:CA), Siemens (NYSE:SI), and Alcatel (NYSE:ALA), as well as smaller companies like Motive (NASDAQ:MOTV) and private companies like BigFix and PatchLink. Notably, many of the larger players have bought their way into the market through acquisitions. (HP bought Novadigm, BMC bought Marimba, and Kanisa bought ServiceWare Technologies.) On the bright side, a company like SupportSoft could be an attractive acquisition candidate for other large companies looking to enter the fray.
The company
SupportSoft has two main revenue sources. Licensing revenues come from the sale of new products. Service revenues are derived from annual support fees for products SupportSoft has already sold.
SupportSoft's recent market woes result from declining licensing revenues. Same-quarter licensing revenues have fallen in each of the last three quarters. This is disturbing for two reasons. First, licensing revenues' gross margins are close to 100%, roughly twice the margins for service revenues. As a result, falling license revenues cause greater damage to the company's bottom line. Second, dwindling licensing revenues mean that SupportSoft is selling less product. This may lead to fewer service contracts, and in turn, smaller service revenues. Service revenue grew by 60% last quarter, allowing SupportSoft to eke out a modest 2.6% same-quarter revenue gain. As that growth slows, overall revenue growth will turn negative.
Is this revenue decline temporary, or the start of something permanent? A general slowdown in IT spending could explain part of the decline; SupportSoft's competitors have experienced similar revenue issues. IT spending may eventually accelerate again, but no one knows when.
As customer numbers decrease, the software industry's players are fighting for pieces of a smaller pie. Competition will be fierce, and margins will likely decline. (SupportSoft's gross margins have dropped from 86% to 77% over the past year.) In addition, despite their slumping revenues, SupportSoft's same-quarter costs increased 25% or more in each of the past three quarters. That won't make their recovery any easier.
Another worry: SupportSoft gets a large part of its revenue from a relatively small group of customers. Two customers represented nearly a quarter of their total revenues for the past quarter, and two customers represented nearly half their revenues for the quarter ending Dec. 31, 2004. This is a risky situation -- delayed contracts could significantly affect earnings, as occurred in the quarter ending June 30, 2004. Potential customers prefer to invest in products from market leaders (or steadily growing companies) with broadening customer bases. If they need help with the software they've purchased, customers generally like to know that the manufacturer will still be around to support it. If SupportSoft's hardships persist, the company may find it more and more difficult to attract customers.
SupportSoft is keeping a stiff upper lip. In April, it authorized the repurchase of up to 2 million shares (about 5% of total shares outstanding). This represents a large potential commitment relative to its $17 million in cash and equivalents, and indicates that the company feels its stock is undervalued.
We'd hope the company's officers and directors would echo this confidence. But at SupportSoft, members of this group have sold nearly 6% of their total shares over the past six months. If buying back shares is good enough for investors, why aren't the company's leaders following suit?
The verdict
SupportSoft isn't an obvious value. Its struggles result from material weakness in its financial health, and I don't see an obvious light at the end of the tunnel. Before considering an investment, I want to see management reverse the decline in licensing revenues without sacrificing the attractive margins.
Further value-minded Foolishness:
Looking for the market's best value investments? Philip Durell and the Motley Fool Inside Value team are on the case. See for yourself with a free, no-obligation trial.
Fool contributor Jim Schoettler welcomes any comments, suggestions, ideas, or invitations to vacation at your Italian villa. At the time of publication, Jim held no financial position in any company mentioned in this article. The Motley Fool is investors writing for investors.
