The Safety of Profits

In the wake of Christmas '99 and Hack-Attack '00, investors are hearing earfuls about how much money e-commerce sites have to spend to attract and satisfy customers. It's a bit depressing. That's why we at SmartMoney.com decided to write about a happier subject: e-commerce software. It's a realm where demand doesn't wear a company thin, and bottom lines are fattened, not broken, by more users. We like that.

Of course, software's potential isn't a huge secret. Microsoft (MSFT) (you've heard of it) wears the biggest market cap around. But when a rush of brand-new software companies crowds into the market — with big ideas and big net losses — investors can forget that established companies are already cashing in on similar concepts.

In today's screen, we looked first and foremost at profitability. We chucked aside companies with red ink in the last fiscal year as well as those projected to lose money this year. But because we believe there are good reasons to grab e-software land (i.e., market share) right now, we ignored one-time charges (namely, acquisition-related expenses) and instead focused on profits from ongoing operations. We also wanted at least five analysts to follow our software stocks and praise them with Buy or Strong Buy ratings. So what did our recipe cook up? A few of the usual suspects, like Microsoft, Oracle (ORCL) and the unstoppable Broadvision (BVSN). But there were some lower-profile players as well.

To sort through the 43 contenders, we chose a theme: front-office software. Also known as customer relationship management (CRM) software, it's used to streamline sales efforts, manage inventory and generally keep customers happy. This field is exploding as companies move online and spend wads of cash. Needless to say, software tools that promise cost-cutting efficiency have potential for growth. In fact, AMR Research of Boston estimates that CRM software sales will grow from $2.3 billion in 1998 to $16.8 billion in 2003. That's a robust compound annual growth rate of 49%.

IPO activity is another way to gauge the popularity of CRM plays. Tuesday, Chordiant (CHRD) started trading and soared 119% in its IPO. Last week we saw Delano Technology (DTEC) triple at the get-go and Witness Systems (WITS) double. The week before that, Firepond (FIRE) soared 355% on its debut. Chordiant, Delano, Witness and Firepond have more than just their successful February IPOs in common: they are also all money-losing "eCRM" companies sporting newly won multimillion dollar valuations.

But recent IPOs have yet to corner the CRM market. Not by a long shot. Even last year's cream of the CRM crop — Kana Communications (KANA) (which has agreed to purchase Silknet (SILK) for about $4.1 billion), Calico Commerce (CLIC), e.Piphany (EPNY), Pivotal (PVTL), eGain (EGAN) and Quintus (QNTS) — can't (yet) touch the market share of the traditional CRM market leader, Siebel Systems (SEBL).

Siebel wowed analysts in 1999 by increasing its net income 116%, to $122.1 million. Where's all the growth coming from? Siebel's Internet-enabled CRM applications, which include sales-force automation, marketing, field services and contact-center software, have really taken off. Early adopters of new eCRM products, including high tech, telecom and financial services companies, have embraced its products. And, big shot Internet clients like Yahoo! (YHOO), Excite@Home (ATHM) and WebMethods (WEBM) have helped Siebel's Street credibility.

"We believe that eCRM applications will be one of the most strategic and highest growth software markets for the next several years,'' wrote William Driscoll of Deutsche Banc Alex. Brown last week, "and Siebel is the undisputed leader in the market." The catalyst for his outpouring was Siebel's new deal with IBM to resell Siebel software in Asia and Latin America, two regions Siebel hasn't penetrated. CE Unterberg, Towbin estimates Siebel will earn $100 million from the IBM (IBM) deal over the next two years.

Siebel's bright prospects have not gone unnoticed. In the last 12 months, its stock price has climbed 455%. At the same time, fellow software-powerhouse- turned-e-commerce-darling Oracle's (ORCL) stock has risen 235%. In that same period, Siebel's income has grown 116% while Oracle's has risen 40%.

If there's one downside to Siebel, it's the company's high valuation — the stock is trading at 96 times EPS estimates for 2000. To find a safer bet with a lower multiple, we looked at Dendrite International (DRTE). Dendrite, which specializes in sales force automation applications for the pharmaceutical industry, currently trades at 34 times EPS estimates. Even with long-term growth estimates factored in, it looks cheap. Here's why: the company expects to grow 30.4% over the next three to five years, compared to 40.6% at Siebel. That means Dendrite's PEG ratio (forward P/E divided by long-term growth rate) is 1.11 — less than half Siebel's PEG of 2.36.

That's because shares of Dendrite have taken a beating this year. Though the company beat expectations for its fourth quarter on Jan. 25, investors were unimpressed with prospects for 2000.

Dendrite defender Robert Willoughby of Credit Suisse First Boston says those worries can be linked to pharmaceutical companies not making big spending decisions in the first quarter — especially when there's so much industry consolidation talk swirling around.

But at least one big merger — the Pfizer (PFE) / Warner-Lambert (WLA) deal — should be a big positive for Dendrite, says Willoughby, because both companies are Dendrite clients. "It could add conservatively 2,000 additional sales representatives worldwide to those DRTE already has under contract," he wrote on Feb. 8. While Pfizer was already one of Dendrite's biggest customers, Warner-Lambert's sales force has used some of Dendrite's offerings, too. That's why Willoughby thinks Dendrite could soon play a larger role in the merged company.

With new entrants raising IPO capital daily, and older companies like former number two e-commerce software-maker Vantive and No. 3 player Clarify (CLFY) recently bought, we think the surviving, profitable players may be worth a sniff. After all, e-commerce moneymakers are a rare breed these days.

"We expect a bloody battle ahead as the [CRM] vendors in the space wage digital jihad over technology, platforms, architectures, product emphasis, user interfaces and much, much more," wrote Marshall Senk of Robertson Stephens in his weekly software report on Friday. He concludes, "To the winner goes the customers. All of them." Such battles don't come cheap.