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Wednesday, January 03, 2007

Is license growth the right metric for evaluating software stocks?

Was reading a Motley Fool's article at Yahoo Finance regarding Cognos. Cognos is a developer of business intelligence software and in the most recent quarter, it experienced an increase in its license revenues, which is one of the things the article discussed. Last month, Oracle's stock dropped because its license growth from database applications did not meet analysts' expectations even though the company did well in overall revenues.

Being interested in technology stocks, I like reading about such firms. I believe that to a great extent, license growth is a good metric for evaluating software firms such as SAP, Oracle, Microsoft, etc. When a customer buys software (legally) such as Oracle database application, he needs to buy appropriate number of licenses depending on the number of user that will be using that software, or in some case, depending on the hardware configuration on which that software will be installed. The greater the numbers of licenses, the greater is the sales revenue for firms such as Oracle, SAP, etc.

However, the license growth is critical not only because of the revenue it brings to software firms but also because the new licenses drive sales of other ancillary services such as consulting, technical support and education. For example, when a customer buys Oracle or other software applications, chances are he will also buy maintenance services to get technical support from Oracle. In addition, he may also buy education packages and consulting services from Oracle.

The revenues from these ancillary services such as consulting and technical support can sometimes dwarf the revenues from licenses. For example, technical support revenues can be in the 15-25% range of the license sales, and therefore, can be substantial in case of a multi-million dollar deals.

On a million-dollar license deal, at 18%, technical support comes out to be $180,000. This may not seem much for large software firms such as Oracle but the thing is that amount is likely to be earned from the customer every year because most firms continue to have needs for services like technical support every year. Therefore, they often renew their maintenance support agreement every year. Some of these ancillary services, therefore, make up the bread and butter of many software firms since they provide stable earnings from existing customers.

Although license growth is important, in my view, it is important to analyze revenue from these services also. Of course, that does not mean ignoring the license growth which is still critical since it is one of the important drivers of the sales of these ancillary services.

However, if a software firm is experiencing good growth in revenues from technical support, education, consulting, etc, it's worth watching such a company since that means the software firm has been successful in selling such services to its existing user base.

As always, a final disclaimer: I am not a financial expert, and the purpose of my writings or this web site is not to give any financial advice nor make any recommendations. This site is just a blog of my activities, interests and thoughts. Trading options and stocks can be very risky, so you need to exercise your judgment and seek competent advice before investing in such instruments.

Labels: tk; invest

posted by Ruby @ 7:04 AM

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