JMP Securities Briefing: Strategies and considerations for modeling maintenance in 2009.

Presentation

Operator: Good day and welcome to the JMP Security’s call with ServiceSource. All lines are currently in a listen only mode. Later you will have the opportunity to ask questions in our question and answer session. Also, please note this call is being recorded. It is now my pleasure to turn the conference over to Mr. Patrick Walravens. Please go ahead.

Patrick: Great. Thank you Tasha. So, we’re delighted to have Mike Smerklo with us today. Mike is the Chairman and CEO of the ServiceSource. ServiceSource is a San Francisco based company. They are about $100 million in revenue but interestingly, they manage over 3 billion dollars of maintenance revenue for about 45 blue chip companies, some of whom include Adobe, Aruba, Blue Coat, Extreme, Motorola, F5 among others. And previously, they had BEA as a client before it was acquired by Oracle. So, this should prove to be a pretty good opportunity for us all to dig into what maintenance renewal rates will be like, how we should think about them in 2009, and what we’ll do is start out by having Mike describe his background a little bit, describe ServiceSource a little bit, and then I’ve got a couple questions, and then we’ll open it up to the audience for questions, if there are any. And we should wrap this up in less than 45 minutes. So, Mike, thank you so much for joining us.

Mike: Yeah, it’s great to be here.

Patrick: If you could just start by describing your background and how you got to ServiceSource that would be great.

Mike: Yes sure, happy to. I started out my career and started as a CPA then worked on Wall Street as an Investment Banker for about six years and then moved over to the operating side 10+ years ago. Bought this business about seven years ago and have been running it ever since. ServiceSource was founded by a couple of folks from Cisco Systems Maintenance Sales Team who saw an opportunity, part of the business most technology companies weren’t focusing on way back then, back in the late ‘90’s and really saw an opportunity to increase revenue, improve visibility, better reporting, better metrics for a part of the business that was just usually overlooked and since that time, so I’ve been running it for about seven years, and we’ve expanded quite rapidly over that time period.

Patrick: Great. And can you just introduce ServiceSource to us and help us understand what exactly it is that you do?

Mike: Yeah, sure. We think of ourselves as a complete end to end solution to drive maintenance and service revenue on behalf of technology and health care IT companies. And what that means in a nutshell is we begin working with companies to do what we call a Service Performance Assessment. It’s a free assessment of their maintenance and service business. We look for areas of opportunity where they may not be able to achieve maximum revenue be it a product line, be it a geography or a certain customer segment. We also look at how they approach the market place in terms of their value proposition and look at their metrics and reporting and see where there are gaps. Once we find an opportunity to get going, we build a dedicated sales team and all that goes with it. So it starts with high end sales professionals but then all the support that goes with it - whether it be the reporting infrastructure, the sales operations and intelligence, and probably one of the more unique aspects of it is we also bring to bear benchmarking across our 50+ clients - so they can see both performance in their own business but relative performance against others. And so we do this now under their brand name so we form dedicated teams so there is no ServiceSource in the marketplace. We have dedicated teams within one of our four service centers around the globe and we begin the sales engagement and manage all parts of the maintenance sales process. And then our business model is simply getting paid only a percentage of the revenue we generate. So we have no hidden costs, no set up fees, no technology costs. We only get paid for the revenue we generate which brings our incentives completely in line with our clients.

Patrick: That’s great. So, I guess if you could highlight a little bit and then we’ll drill down, just big picture what sort of trends you’re seeing in the maintenance business at the moment with the economy acting the way it is.

Mike: Yeah, sure. There’s no doubt that we’re seeing across the board. We subdivide it by technology categories. But across the board, two major themes which I won’t be describing in this call, deferral of new product purchases, so everyone pretty much across the segment is looking to defer cap-ex spend and squeeze more life out of their existing assets. The second thing that we’ve seen is a marked increase in pushback from customers around the value proposition for maintenance support. Fortunately, this plays well into our strengths but really we’re seeing customers wanting to see things like an understanding of usage statistics or ROI metrics on dollars paid, pushing for discounting, not wanting to enter into multi-year agreements given the uncertainty of the economy. So all things that we’re highly trained and prepared to deal with, but we’ve really seen, and especially in prospects that do not have value-based selling programs and all the infrastructure you need to go with this, I think they’re going to see real gaps in their business. So, gone are the days where an IT manager will simply look at his or her 18% cost of sale on a historic asset purchase and go, “Yeah, I’m going to budget that and assume that I have to pay that as an annuity or an add in.”

Patrick: Interesting. So, lets drill down a little bit. You segment your business or the maintenance stream really by technology, by geography and method of distribution, right?

Mike: Correct.

Patrick: Can you walk us through those and tell us if there are any differences? For example in the different types of technologies for how things are holding up?

Mike: Yeah, so again, I guess for our, probably more for our prospects because I think most of our customers are all doing a pretty good job on this, without being too self serving, but by geography, we’re seeing - and obviously North America got hit 6-9 months earlier -that our European business is now really starting to see a pretty dramatic, I think we wanted to be much more challenging in Europe than more like Q3 was in North America. So we’re seeing that as just an interesting geographic differentiation. On the technology, ranging everything from large enterprise application vendors are really getting hurt and I think that while they do have a built in stickiness given the underlying technology, I think we’re seeing the biggest price pushback with our application software companies on maintenance. We don’t do much on the desktop, but I think anyone who is in consumer electronics and desktop is clearly in real pain. And interestingly enough, we’re seeing pretty good business momentum with vendors who are in security, in anything that’s around data center optimization so folks that can add on pretty easily, no customer concentration, geographically distributed businesses and can do add-on technology buys, so they’re still doing well. And then storage and security seem to be holding up reasonably well. And then by distribution, we think of it as whether it’s direct, one-tier or two-tier. I think anyone who is selling through two-tier, and using more in Europe, it’s almost all two-tier, the channel is just scrambling. I think that the channel always has problems with multiple priorities but right now, you think about if you’re a mid-size, value-added retailer distributor and you’re trying to deal with cash flow, inventory multiple vendors, renewals are just really falling off the table from a priority standpoint, so a lot of our heavy lifting helps in facilitating in renewal throughout the channel. Again, be it one-tier or two-tier.

Patrick: And the direct is, how’s that holding up?

Mike: Direct is fine. I think direct, and typically this is more in the enterprise software companies who don’t use the channel nearly as much as hardware or networking companies do, I think that’s where we’re just seeing you’ve just got to be all over value-based selling to avoid the discounting. That’s where you’re seeing the biggest pushback. And I don’t care if you’ve been my vendor of choice for the last five years and in the last four years, I’ve just mailed in my maintenance check without asking. This year I’m going to ask and I’m going to push you. We’re seeing people saying: “Tell me your product lifecycle.” “Show me what upgrades I’m paying for.” “Tell me how many times I’ve called into the help desk.” “Why can’t I get a discount on it?” And if you’re not trained and ready for those type of metrics, the pushback can really be painful.

Patrick: Great. So one of the questions that I get from the buy-side a lot so I’m going to push it on you, is how should maintenance be modeled in 2009? I mean is there another period that we you think is similar to this? How should people think about that?

Mike: Yeah, that’s a great question. I don’t think the “.com” bubble is a good parallel. That was kind of an industry phenomena. It wasn’t nearly as widespread and certainly didn’t hit as many companies as we’re seeing now. So, that one may be a good one from a technology perspective, at least technology sales but probably not good for maintenance, meaning that it was the technology industry that was hurting. It wasn’t Home Depot, for example. I think the best way to model this is really to drill into this at the level that you do on the product side. I mean, I’m always amazed that when I sit in on investor calls, folks will ask a good 10-12 questions on the product side: “How many sales reps do you have?” “What’s your quota?” “Why are people saying no?” “Who is losing to competitors?” Etc., etc. And then when it comes to maintenance, they usually ask one question: “What are your renewal rates?” And quite frankly, the person on the other phone usually tells you that it’s somewhere between 88 and 92% and then the question is done. And I think that’s really, if I was modeling the business, I’d ask you know a good 8 to 10 to 12 questions to the CFOs to really understand how deep they’re in to this business and how much predictability they actually have.

Patrick: Yeah, why don’t you give us a couple of those?

Mike: Yeah, so I would look at some real things. Let’s start with “How are your renewal rates by customer segment?” I’d go renewal rate in quarter. “What were your renewal rates in quarter?” I’d ask both on contract and dollars because one can mask the other. I’d ask how those renewal rates varied by enterprise versus SMB. I’d ask several things around no services, meaning when customers said no. Why did they not renew? How much was the average attrition? What competitors did they go to? And really try and help them understand that if a customer says no on maintenance, was that a good thing? Did they perhaps buy new technology from you, or was it a bad thing and they left? They didn’t see value. They went to a competitor. Or they didn’t have budget. And then I would really start to look at whether or not they’re working with a channel. I’d ask them, are they able to tell what channel partners are performing or not? What is the difference in renewal rates if it’s direct versus in the channel? And I’d ask how they are thinking about differentiating their channel partners based on performance? Pretty granular but much different. And then I’d ask them how they are reporting on maintenance in terms of their infrastructure. So, can you tell me at a moment’s notice what my bookings were versus my revenue? And can you tell me what my average discounting rates have been? How many customers am I able to up sell to a higher level of support? A bunch of questions that are again pretty granular but really help you understand. I think when people say a 92% renewal rate, it might be, but it may be missing a lower end customer segment. It may be pulling renewals from the future. There may be a bunch of reasons that can mask performance, and if you stop at that one question, you’re really going to miss what’s really going on.

Patrick: Great. Okay, so let’s apply some of that to two stocks that I cover. When you look at Oracle and when you look at SAP, how would you sort of compare and contrast their approach to selling maintenance?

Mike: Yeah, I’ll copy that by saying I have really good knowledge of one of them because they bought three of our customers: Hyperion, Agile and BEA. And that’s Oracle. And we’ve heard consistently that when they do their diligence, they’re excited to see the acquisition targets working with us. First is SAP, which we have. We worked with them several years ago on a consulting project. We don’t know them that well, but I think it’s a pretty marked difference. I think Oracle has clearly subscribed to the way we think of the world: You differentiate church and state between product and services. You don’t let product sales go in and steal discount maintenance or do a tech refresh in order to sell new licenses because they know the value annuity stream. They have built out an incredibly powerful sales engine. They have obviously been able to push forward price increases, unlike SAP, because they aggressively sell value into their install base. SAP, on the other hand, had a historical approach, which is we auto invoice (meaning once a year) and they just send out an invoice to their customer. They tried, as you documented recently, to pass on a price increase via an auto invoice. So imagine you’re a customer, and you have a million dollars in maintenance annually with SAP. And every year, you just get an invoice in the mail. And it says, “Time to pay again.” Well, maybe that worked a few years ago, but now the pushback I think they’re seeing is, and all the things I highlighted, question on the value, question on price, question on usage. Simply, from my prospective, which is limited, they’re not prepared to handle, versus Oracle, which has been building on this machine now for 10+ years. And I think also Oracle made the decision a few years ago that while they continue to build great products, and I’m not an Oracle shareholder , I hope they don’t buy any more of our customers, but I’ve just seen them close up. They knew a long time ago that this install base had to be sold to aggressively and that maintenance was a critical asset. They’ve probably done more to advertise the value of maintenance than anybody and helped us in our business versus SAP which I think until recently was really sticking to a product-led strategy.

Patrick: Great. Why don’t we, I have several more, but why don’t we open up the line for Q & A and see if there are any questions out of the audience and if so, great. And if not, I’ll keep going. So, operator, can we pull the audience for questions?

Q&A

Operator: Yes, if you would like to ask a question, please press the star then the one on your touchtone phone. To withdraw yourself from the question queue at any time, you may press the pound key. Once again, to ask a question, please press star then one on your touchtone phone. We’ll take our first question from Richard Peterson with Levin Capital. Please go ahead.

Richard: Hi. Thank you. Could you just talk a little bit more about pricing generally? Especially, I know you’ve been discussing maintenance, but for the on demand software subscription type models, could you just talk a little bit more about what you’re seeing customers do there? I mean it’s a similar model to the maintenance that you’ve been describing in some ways. And are you seeing any of the same things happening in pricing for the subscription models? Thanks.

Mike: Yeah, I’ll differentiate between the work we do with historical software vendors that have a part of their business that is subscription. We don’t have any customers that are in the pure place SAAS model. So I’ll just differentiate that. On the subscription business, it is very similar. I think that even though you have established a subscription model and a billing infrastructure that goes with it, we’re seeing very similar sales cycles. So, a lot of the same questions. A lot of the same questions around value, and a huge push for price discounts. So, we don’t see, and again, I’ll be careful because it’s somewhat limited. But for our vendors, our clients that do both product and subscription models are very similar in terms of the pushback we’re seeing and the demands from customers.

Richard: Thanks.

Operator: Once again, if you would like to ask a question, please press the star then one on your touchtone phone. We’ll pause just a moment for questions to queue. We have no further questions on the phone line.

Patrick: Okay. So, one of the other questions I was hoping to ask is have you had, well, I’m sure you have actually. Wwhen your customers go through an acquisition, when they do one or are required, what sorts of things do you see happening to the maintenance?

Mike: What you tend to see happen when they go through an acquisition is depending on the proficiency of the acquirer, we tend to see it get left adrift for several quarters. We recently signed and we signed a couple of large cap technology companies that have acquired in the software space and we’ve seen, you know, the first priority is product integration, product road maps, and then customary acquisition checklist. Where can we save costs? Where can we migrate into a single system of record? What we tend to see is the maintenance gets left pretty far down on the checklist. And as a result, several months or quarters go by without the customers really being touch and contacted. The other thing we see consistently is merging contract, administration databases and CRM databases, as you all know is really, really hard. And given that the maintenance is usually a combination of contract administration, CRM and financial billing systems, it can be a real disaster. So we’ve seen most people really lose. I’d say most companies kind of forget about this as part of their acquisition diligence, and this part of the business tends to really go stale pretty quickly.

Patrick: Oh, sure, I understand that. And then, what sorts of customers do you have in your pipeline for 2009? Who is coming to you?

Mike: Well, you know, it’s interesting. Our pipeline has never been better, which is a good thing. We are seeing everything from geographic expansion, so we’re opening a service center in Asia-Pac now that the Asia-Pac has seen growth and it is depending on region there. But we’ve seen that with the product growth, the maintenance needs to follow product growth. So we’ll see that as that’s in huge demand from our client base. But we’re seeing everything. We’re also beginning conversations with some of the fast players as they start to see this install base that was deemed to be sacred and untouchable. That doesn’t happen when you start to see layoffs and cost pressures come in. So, we’re really starting to see, pretty much across the board, demand for the solution, so we’re pretty excited. It does run the gamut of technology companies.

Patrick: Great. And are you seeing, so if a customer calls up, one of your clients, and basically says, “Listen, I can’t afford this. I need to downgrade my maintenance.” Somehow, you know, Oracle supposedly just won’t budge at all on that. How do you handle that kind of situation?

Mike: You mean when we’re selling the contract?

Patrick: Yeah, when you’re servicing the, yeah.

Mike: Well, what we do is again, it gets back to all the things I spoke a couple times about, the value based selling. But we follow the customer’s policy, and we encourage folks to take Oracle’s point of view, which is if you can really identify what the value is, if you have strong entitlement so people can’t sneak by and get service for free, and you have a product road map that supports existing maintenance, all the things we bring to bear, and then you build ROI calculators so you can say, “Gosh, you’ve called in this many times,” etc., etc. If you can do all those things, you should be able to hold, or actually exercise, price increases in this environment, even in this environment. But you mess up on any one of those things, you’re going to have to give. And especially if you don’t understand how to sell, you’re probably going to give. We really encourage our clients not to discount because once you do it, you know, it’s kind of like anything, once you do it once, you’re going to do it throughout your entire customer base. So we really avoid discounting like the plague. But then again, we follow what our customer’s policies are on that.

Patrick: And outside of your customer base as you look around, do you think the amount of discounting on maintenance is increasing?

Mike: I think it’s going to be rapid. I would actually, if I would add to my list of questioning, I would ask specifically that, which is not on general overall bookings. I’d say in the quarter over quarter, for renewals that were coming up in that quarter, what percentage increase did you see in discounts? And then I would ask a follow up question. I’d ask them to break that out for me by their customer base. Because what they may say is, “We’re not seeing discounting.” They may not be at the low end, but they certainly are at the high-end customers. If someone can’t answer that question, then I’d get really worried.

Patrick: So, two more questions and then we’ll end with sort of a big picture. The one I have for you is our previous call was with a company called Rimini Street. Are you familiar with them?

Mike: Yes. I know them reasonably well.

Patrick: Do you? Okay, so they do 3rd party support basically for application software, and I’m wondering, it’s a relatively small company though. So, I’m wondering if you’re seeing any impact to peoples’ maintenance businesses because the enterprise are saying, “Well, listen. If I don’t get a better deal here, I’m going to go to some 3rd party outfit.” I mean, what are the alternatives for these enterprises? It doesn’t seem like there are a lot.

Mike: Yeah, I think the alternatives are, first and foremost, ask for a discount, push for a discount, demand a discount. Two, go to a third party maintenance provider like Rimini Street. For each segment, there are guys that do that on the hardware side. There are channel partners that offer that in the healthcare IT space. There are local providers that do that. So they exist in every subsection of the industry. There aren’t a ton of alternatives, but I think the biggest challenge you have for a vendor, for an OEM manufacturer of technology, to avoid customer losses going to a 3rd party maintenance advisor, is to be out in front of it. You know, basic stuff. Talk to your customers, understand their needs, understand what their push is. If you’re doing that well, frankly 3rd party maintenance providers like Rimini Street really shouldn’t have much of a business. Not to discount what they’re doing. But you know, it’s really in the OEM’s control to prevent that.

Patrick: Yeah.

Mike: If they’re doing all the things they need to protect the install base.

Patrick: Right. Okay, so my last question for you Mike, and this is definitely stepping away from what you do. As you interface with all these CIOs, are you seeing them embark on new projects? What do you think 2009 has in store for us in terms of IT spending?

Mike: I think it’s worse than expected. Even now, I think that everyone is going in to slight improvement. You know, what’s necessary to keep the engines running and this is across the technology universe, and I think Europe is much worse than people are factoring in and the Asia-Pac as well. I just think that people are still overly optimistic. The good news is, I’m hoping that we’re 10, 12 months away from some light at the end of the tunnel. But I don’t see ’09, I don’t see really any pockets of optimism anywhere and again, I think the emerging market, especially the European markets are still, at least from what I see, you guys do it every day, but I think people are still overly optimistic as to what’s going on there.

Patrick: That’s a cheery note to end on. So, if we have companies that we’re looking at and we’re like, “Man, these guys could do a better job on their maintenance.” How do we get them to you guys?

Mike: I think the best thing you could do is, well, so my email is mike@servicesource.com and I think that if you ask these questions that I’ve gone through and the CFO can’t answer them, I would just underscore. It doesn’t mean that the CFO or CEO doesn’t know what they’re doing. It’s just that most people haven’t thought about their business at this level of detail. So what I’d recommend is there is a company out there that does a free service performance assessment, and we not only look at their performance, but we benchmark them against other industry leaders and it’s free. So, it’s kind of like a Harvard-educated physician standing outside your office willing to give you a free physical. If you say no to that, there is probably something you’re afraid of.

Patrick: That’s great. Mike, thanks so much for joining us today, we really appreciate it.

Mike: Yeah, I appreciate it. Good luck.

Patrick: Yeah, thank you. Bye bye.