ServiceSource (Nasdaq:SREV) has been a tough company to stand behind in its brief time as a public company. While it quickly ran from a debut price in the low teens to over $20 a share, successive disappointments have pummeled these shares into the single digits. That process has certainly taken a lot of the half-baked optimism out of sell-side projections and targets, but the question remains as to whether ServiceSource can deliver to a degree that makes it worthwhile for turnaround investors to consider.
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ServiceSource Steps Over the Kiddie Hurdle for Fourth Quarter
While investors don't seem all that excited about fourth-quarter earnings from ServiceSource (granted, it's a down market as of this writing), at least it looks like expectations have been reset low enough to where the company can start making or beating numbers.
Revenue rose 11% as reported this quarter, good for a small beat relative to the sell-side. Revenue in North America was basically flat, but the company saw good growth in both Europe and Asia. For the quarter, annual contract value increased 13% to over $270 million.
Leverage is still elusive for ServiceSource, but the company did better than expected. GAAP gross margin declined by a point and a half, while year-ago operating income reversed to a loss. On a non-GAAP basis, the company did report operating income of over $7.9 million, handily beating expectations, while EBTIDA of over $8 million nearly doubled the sell-side target.
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2013 Still Presents Challenges
Perhaps part of the subdued reaction to this earnings beat was the fact that management didn't really go nuts with its guidance for fiscal 2013. While the full-year revenue guidance was consistent with prior expectations, first-quarter guidance was a bit soft. Likewise, while full-year EBITDA guidance was strong relative to prior expectations, it's going to be more weighted towards the back half of 2013, as first-quarter guidance was revised down substantially.
Given the nature of the ServiceSource model, I'm not too troubled with these numbers. Part of the issue here is that the company's offering to customers includes a dedicated sales service team and that means hiring/allocating costs early on - well before the revenue contributions really ramp up. In other words, growing the business a little faster can actually make the near-term earnings outlook worse. At the same time, the company has a relatively new sales team that isn't operating at peak efficiency, while also trying to aggressively push new offerings like Avalon and Renew OnDemand.
I expect that there's also a "won't get fooled again" aspect to the skepticism around ServiceSource. The "trust us, it'll get better" idea has been tried before with this stock, and management didn't deliver. Along those lines, it's worth remembering that the sell-side target on these shares 18 months ago was north of $19 (below $10 now), and many buy-side analysts and managers have gotten burned on this one.
But It's Still a Good Idea
I still believe that there's a real market and a real opportunity for what ServiceSource offers. Tech companies derive a substantial amount of revenue from service, support, updates, renewals and other "non-core" services, and this can be a surprisingly cash-rich revenue. Unfortunately, most tech companies aren't really structured around maximizing this opportunity - they focus their energies on selling the big "whatever" that is at the center of their model. Likewise, they typically structure sales commissions in such a way that going back around to established clients and signing up service/support renewals isn't really a profitable use of time. Consequently, a lot of potential revenue slips through the cracks.
ServiceSource is in business to try to plug those cracks. Estimates of the size of the addressable market range from $170 billion to nearly $300 billion, but whatever the real number is, it's quite large compared to the company's $244 million or so in revenue.
The company uses a suite of cloud apps and dedicated sales teams to essentially act on behalf of its customers, and make sure that the customers' customers keep renewing (and/or upsizing) their maintenance and support agreements. This is a labor-intensive process, but the company operates with multi-year commission-based contracts that fit in well with customer sales structures. (They would have likely paid commissions on those maintenance/support agreement renewals, anyway.)
A Good Core
ServiceSource certainly boasts some high-profile names on its client list. Companies like VMware (NYSE:VMW), Red Hat (NYSE:RHT) and SAP (NYSE:SAP) all use ServiceSource, and the company has seen clients like BMC Software (Nasdaq:BMC) and Dell (Nasdaq:DELL) try their services, leave and then come back.
Given the nature of its business, ServiceSource succeeds as its clients succeed, particularly in signing up new customers and its expanding the customer base. That's something of a challenge now, as many IT companies have seen sales slow significantly in recent quarters, particularly VMware. While ServiceSource does have the opportunity to increase its penetration rate at existing customers and drive better client/account results, the underlying reality is that ServiceSource cannot do well if its customers are not attracting new business.
It's also worth noting that the tech sector M&A is a good news/bad news opportunity for the company. Sometimes, the acquisition of a client allows ServiceSource to not only continue its business, but expand it into the parent company (as happened when SAP acquired ServiceSource client Business Objects). In other cases, though, it works the other way. Oracle (Nasdaq:ORCL) has acquired multiple companies that were ServiceSource clients and then terminated the relationships, choosing to handle service/renewal business internally.
Where's the Competition?
One potential criticism of the ServiceSource thesis is that if it's such a good idea, why aren't other companies actively pursuing this business? For the most part, ServiceSource competes with the do-it-yourself option that virtually every tech company has in regard to its service revenue. While many companies either don't want to bother with the follow-up required to maximize service renewals or aren't very good at it, others are (or believe they are).
And it's not entirely true that ServiceSource has no direct competition. Rainmaker Systems (Nasdaq:RMKR) competes in some aspects, and consulting/business outsourcing companies like Accenture (NYSE:ACN) also offer services in this area. I would also think that companies like Salesforce.com (NYSE:CRM) and NetSuite (NYSE:N) could move into this space without considerable difficulty. Ultimately, though, competition comes down to results - if ServiceSource can show real improvement in subscription retention and offer a solid value proposition, it's likely not worth the disruption of trying another vendor.
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The Bottom Line
ServiceSource has only a miniscule share of its total addressable market, and frankly I don't expect that to change. Even without becoming a major player in percentage of market terms, ServiceSource can still see considerable revenue growth if it continues to demonstrate that using its services is a value-add. At present, then, I believe that ServiceSource has an opportunity to grow its revenue at a long-term rate in the low teens. Given the nature of the business, I don't expect the company to ever sport robust free cash flow margins, but I do believe that low teens margins are possible down the line.
What that all works out to is a fair value today of about $8 per share. Against a current price near $6, that's worthwhile potential. Moreover, I have no problem in acknowledging that my numbers may be conservative if the company can attract bigger and better clients and growth with them.
All in all, ServiceSource is hardly a sure thing, but selective investors can often do well with supposedly broken tech stocks that aren't as broken as the market believes. There's a good chance that this story (and stock) won't work, but careful due diligence and risk tolerance could pay off for investors in this case.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.