RightNow Tech : (RNOW)

INVESTMENT THESIS This week's Focus Stock of the Week is RightNow Technologies (RNOW: $17), which carries Standard&Poor's highest recommendation of 5-STARS, or Strong Buy. In the current economic environment, we think many companies have a renewed focus on retaining existing customers, particularly since it is more cost effective than acquiring new ones. In addition, it is generally easier to cross-sell and up-sell to existing customers, which can help support the preservation or expansion of margins. Meanwhile, the ubiquity and real-time nature of the Internet has given consumers a powerful microphone through which they can post reviews, "Tweet", or otherwise sound off about their experiences with vendors. The Internet has also greatly simplified consumers' ability to research vendors and, through the use of social media, share their opinions with friends, associates, and complete strangers and impact the way vendors are perceived. We believe all these factors will continue to elevate the profile of RNOW, which provides software applications that help its clients provide a better customer service and Web experience to their customers. After a choppy period, we think the company's sales execution has improved, as measured by overall growth trends in the balance of gross deferred revenues (invoiced and un-invoiced). In addition, RNOW's solutions are available on-demand, and we think the advantage offered by lower upfront costs relative to traditional enterprise software deployments and the flexibility to pay based on usage will have appeal in the current economic environment. For this reason, on-demand software delivery has rapidly gained acceptance and, we believe, will grow sales at a much faster pace than traditional enterprise software.

Finally, we think that after its transition in 2007 to a pure term license model and some sales execution issues in 2008, RNOW's shares trade at a sizable discount (of about 40%, recently) to the average enterprise value/sales multiple we calculate for software-as-a-service (SAAS) peers, based on projected 2010 sales. We believe this discount will narrow as RNOW continues to demonstrate consistency in execution aided by a more complete product set to address an expanding market opportunity, and benefits from notable expansion in operating profitability.

BUSINESS PROFILE Founded in 1995, RightNow Technologies is a leading provider of on-demand (used interchangeably with the term software-as-a-service, or SAAS, in this report) customer relationship management applications. More specifically, the Bozeman, MT-based company provides Web-based applications that help providers of goods and services ensure that their customers have a positive customer service experience. Many of RNOW's solutions are designed to help consumers help themselves without calling in to a call center, potentially alleviating customer service workloads. Such solutions include those that generate tailored "Frequently Asked Questions" (FAQs) on a website, tools that facilitate email or a Web-based chat with a sales representative, interactive voice response systems that help route calls or address simple issues, and desktop-based applications that help front-line customer service representatives resolve customer issues quickly through access to canned responses stored in an internal knowledge base. We think RNOW's recent acquisition of HiveLive will help the company offer a more complete solution to its clients by harnessing the power of social media to create and manage Web-based support communities, encourage innovation through collaboration between employees, and allow companies to monitor what is being "said" about them by customers in the "Cloud." The company introduced RightNow CX (November 2009), a suite that encompasses many of its point solutions (CX stands for Customer eXperience). We think a complete suite will have appeal to large enterprises and government agencies and support RNOW's "land and expand" strategy in which it cross-sells and up-sells to existing customers and expands its overall footprint within an organization. Prior to the release of CX, according to its September 2009 10-Q SEC filing, RNOW has derived, to date, between 87% to 90% of its software, hosting and support revenues through the sales of its RightNow Service. While RNOW's on-demand model has a natural appeal, in our view, to smaller businesses, we note that in 2009, it derived about 46% of revenues from customers with over $1 billion in revenues (versus 36% in mid-2006) and 38% from customers with less than $1 billion in revenues (54%). The balance of revenue comes from the public sector and education. To us, this shift is an indication of both the growing acceptance of on-demand solutions within larger enterprises and the greater capacity of large enterprises to invest in IT amid weak economic conditions. Sales cycles for the company tend to range between 60 and 180 days, including evaluation and implementation of its products. RNOW's customers purchase non-cancelable term licenses for which revenues are recognized ratably over the length of the contract (typically two to three years, but ranging from six months to five years). Recurring software, hosting and support revenues comprised about 75% of sales in 2009. The company used to sell traditional perpetual licenses (up front) but discontinued this in 2007. RNOW sells its products primarily through its direct sales force, and, to lesser extent, through its channel of partners. Domestically, the company's indirect channel is comprised of outsourcers and referral partners; internationally, its channel includes system integrators and resellers. RNOW offers prospective customers the opportunity to evaluate its product suite by deploying it in a pilot program, which can last up to 180 days, without committing to any license fees. The company believes it has experienced shorter sales cycles, higher close rates and larger deal sizes as a result of its pilot program. As of December 31, 2009, RNOW had more than 1,900 customers and had the greatest presence in the following industry verticals: High Tech (20%), Public Sector (16%), Telecom (16%), Retail/Consumer Products (15%).

As mentioned above, the company sells its solutions under term license agreements and recognizes revenues ratably over the term of the customer agreement. Under this model, some costs are recognized upfront while revenue recognition is spread out (sales commissions are also recognized ratably). Because of this, and due to fixed costs associated with the initial set up of datacenters, profitability can be elusive. (As a company adds scale and new business, profitability can rise rapidly over time as previously deferred revenues are recognized.) Due to RNOW's revenue recognition model, we think it is important to pay attention to invoiced and un-invoiced deferred revenue balances. Un-invoiced deferred revenues are a non-GAAP off-balance sheet disclosure that the company began providing in 2009 as the majority of its business shifted towards quarterly or annual payments from upfront payments. This has resulted in an increase in off-balance sheet deferred revenue balances. In 2009, gross deferred revenues (which includes invoiced and un-invoiced balances) rose 19% to $180 million, improving from a 12% rise in 2008; of the 2009 balance, $121 million was current, as compared to $102 million a year earlier. We believe this gives added visibility into 2010 results. COMPANY OUTLOOK We expect revenues to rise 17% in 2010, to $179 million. Our outlook reflects accelerating growth for software, hosting and support, after growth trends for gross deferred revenues improved in 2009 from 2008 levels. We expect revenues to benefit modestly in 2010 from the acquisition of HiveLive (completed in September 2009). Assuming the economic environment continues to gradually improve in 2011, we see sales rising about 13% to $202 million. We look for gross margins to decline slightly in 2010 to 69.2%, from 69.6% in 2009, reflecting narrower professional services gross margins due to some hiring and pay increases. We see gross margins trending higher over time to 71% in 2011, due to a shift in mix away from professional services, toward software, hosting and support revenues. In 2009, non-GAAP operating margins (before the impact of stock-based compensation costs) were 8%, as compared to an operating loss in 2008. We expect RNOW to continue to manage costs, but since the company plans to add headcount and related infrastructure to support added capacity in 2010, we expect non-GAAP operating margins (excluding stock-based compensation costs) to widen to about 10% for the year. We see a considerable widening in operating margins in 2011, as the company heads closer to achieving long-term targets of 18%-22%. Our model shows non-GAAP operating margins of 18% in the fourth quarter of that year. Contributing to this forecast is our expectation that the economic environment will continue to improve, and that RNOW will realize economies of scale as its business expands. Also contributing to our margin outlook is that under a subscription revenue model, as RNOW recognizes previously deferred revenues, it will receive a boost to margins since some of the associated expense is recognized upfront while the revenues are recognized ratably over the contract terms. As we have said, this serves to depress margins when a vendor transitions to this model, which was seen in 2007, and elevate them as time goes on and scale builds.

After stock-based compensation expense of $0.18 to $0.19 a share, we estimate EPS of $0.16 in 2010, rising to $0.31 in 2011. We note that RNOW expects its tax rate to rise to between 38% and 40% in 2010 (our model has 38%), versus 4% in 2009, and its original expectation of 20% prior to the fourth quarter of 2009. RNOW has attributed this, in part, to better-than-expected recent performance. On a cash tax basis, taxes are not expected to change and it has sufficient net operating losses (NOLs) through 2010 and into 2011. NOLS are expected to be fully used sometime in 2011.

INDUSTRY OUTLOOK We think the prevalence of the Internet and its significant potential as a delivery mechanism contributed to the emergence of "disruptive" software delivery models--such as software-as-a-service (or SAAS)--which we believe could hasten the commoditization of certain elements of the software industry. The popularity of the Internet across organizations of all sizes has enabled some movement away from reliance on proprietary software and toward more cost-effective (at least initially) alternatives. The model has become much more established over the past decade through the evangelism of such pioneering companies as Salesforce.com, (CRM 72, Sell), RightNow Technologies, Concur Technologies (CNQR 41, Sell), and Taleo Corporation (TLEO 25, Hold), to name a few. Providers of on-premise solutions have also gotten into the act, either by developing or acquiring SAAS solutions, although this has been done with varying rates of success, in our view. While many thought the SAAS model would be a natural way to sell into small and mid-sized companies, a recent survey by Forrester Research indicates that it is larger enterprises that are adopting the model rather than smaller ones.

We have seen this trend in quarterly results of several SAAS providers we track. We think the SAAS model was particularly suited for light transactions in which sensitive data is not intensely involved. This is why for business applications, we believe customer relationship management categories such as sales force automation tools and customer service are particularly well-suited to this form of delivery.

According to a forecast update published in July 2009, market researcher IDC sized the customer service portion of the broader market for customer relationship management applications at about $3.3 billion for 2008, up 9.7%. At that time, IDC expected the recession to slow market growth to 2.5%, or $3.4 billion, in 2009. We await an updated tally for 2009, but note that IDC expected the customer service segment to grow to $4.3 billion by 2013, a compound average growth rate of 5.4% from 2008 to 2013. The top five vendors of customer service CRM applications include large, traditional enterprise software vendors, Oracle (ORCL 25, Buy) and SAP (SAP 46, Hold), software and services provider Amdocs (DOX 30, Hold) (although we think Amdocs is more narrowly focused on the communications and media industries), and on-demand peer Salesforce.com, with RNOW rounding out the top five. VALUATION RNOW shares recently traded at a 2.6X enterprise value-to-sales multiple, on projected 2010 sales of $179 million, a 40% discount to the mean we calculate for software-as-a-service peers.

The shares have traded at a discount to its peer group over the past two years (ranging from 38% to 44%), based on enterprise value to forward sales. We think this is due to several factors, including uneven past sales execution and a difficult transition to a pure term license revenue model from a hybrid model under which it sold both perpetual licenses and term licenses. In addition, in September 2008, cash flow from operations turned negative as cautious customers pressed the company to offer the flexibility of periodic payment terms versus paying upfront for contracts signed. We think this was a reflection of rising uncertainty and customers' desire to conserve cash as economic conditions worsened sharply and the credit markets contracted. Much of RNOW's business is signed under these periodic payment terms, but operating cash flow has since rebounded. Based on our view of RNOW's more consistent sales execution, and the rising visibility and profitability we project, we think the discount to peers will narrow from past levels. We derive our 12-month target price of $21 by applying a 3.3X enterprise value-to-sales multiple to our 2010 sales projection. At recent levels, this multiple is 21% below the average multiple we calculate for peers, based on 2010 sales. CORPORATE GOVERNANCE RNOW has a classified board of directors structure with three classes of directors, each serving a staggered three-year term. We believe this is possibly designed as an anti-takeover measure, although we note that the company has no poison pill in place. The roles of chairman and CEO are combined, a factor that we view as unfavorable. Chairman and CEO Greg Gianforte is also president and founder of the company and at September 30, 2009, he and his wife had voting power over 25% of outstanding common stock (13.8% direct ownership). Several factors that we consider favorable from a corporate governance standpoint are that, with the exception of Mr. Gianforte, the board is comprised of independent members; the audit, compensation, and nominating committees are comprised entirely of independent members; and, in light of Mr. Gianforte's prominent role at RNOW, a CEO succession plan has been approved by the board. INVESTMENT RISKS There are risks inherent investing in a small-cap pure play vendor in what is still considered to be an emerging, albeit rapidly growing, segment of the software industry. Specific to the on-demand segment of the market, where the solutions are hosted and maintained in a provider's datacenter, a major disruption in service or a widespread breach of security could result in customer loss and skepticism about the viability of the on-demand delivery of software. While the company introduced its new suite RightNow CX in November, prior disclosure indicated that RNOW derived a significant portion of its software, hosting and support revenue from the sale of its RightNow Service. The company also competes in the customer service applications marketplace with several large, well-established traditional software vendors and diversified competitors.

Other risks to our recommendation and target price include the potential for a sharp decline in IT spending and a deceleration in the global economy, which could result in declining bookings and much longer sales lead times. If the economy worsens notably or the company's customers have difficulty gaining access to working capital to fund their businesses, they may delay payment or request extended payment terms, which would negatively impact cash collections. We also note RNOW has a relatively short history as a publicly traded firm, following its initial public offering in August 2004. The shares are thinly traded, with an approximate three-month average trading volume of about 200,000 shares per day, and can be volatile. There are shareholder concentration issues to be aware of. The top five institutional holders of RNOW collectively owned about 29.6% of the shares as of December 31, 2009. Since we consider RNOW shares to be thinly traded, a decision by a large shareholder to reduce their ownership could have an adverse impact on share price. Also RNOW's founder, chairman and CEO Greg Gianforte had voting power of more than 25% of the shares. CONCLUSION As economic conditions continue to stabilize, we believe large enterprises are showing a willingness to spend. We think RNOW is well positioned with its customer service, call center and social offerings, and believe its on-demand delivery has appeal to cost-conscious businesses of all sizes. We also think sales execution is improving, with increased visibility into future results due to rising balances of on- and off-balance sheet deferred revenues. We expect hiring in 2010 to temper near-term operating margin expansion, but see a significant widening by late 2011, to the upper-teens level. In view of added visibility and our outlook for margins, we think the shares' steep discount relative to peers makes the valuation compelling. Our recommendation is Strong Buy./Zaineb Bokhari

08-Mar-2010 10:00:13 (15197059)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.