Sage Software's somewhat confusing transition to a subscription business model

Den Howlett Profile picture for user gonzodaddy December 4, 2015
Summary:
Sage Software's full year 2015 report card looks like steady as she goes. But there is much to confuse the casual reader.

While we are normally fairly quick to discuss earnings results, Sage Software's full year earnings make for an initial difficult reading, largely because Sage chose to modify the way it reports but also because the figures as first reported don't tell the whole story. Let's kick off with the numbers. For this, I recommend that students of accounts grab the investor slide deck. That is where I am taking the main numbers and then parsing back to the press release, earlier statements by the company's CFO and then providing my take. Yes, it's complicated!!

Note: I am not providing a full analysis that includes the geographical splits or detail in the lines of business on this occasion. Instead, I am concentrating on what I believe are the most important parts of the story.

First off, Sage has a habit of playing around with the way it presents its numbers which can make year on year comparisons awkward. On this occasion, the principle change has been the splitting out of payment processing revenue. I welcome this because it provides a cleaner line of sight into the main revenue drivers going forward. The markets of course disagreed and initially hammered the stock (run the 5-day view), but then they recovered later. I'll say right off the bat that the early day knee jerk reaction is a dopey response because taken in the round, Sage's results were very close to those the company signaled back in July. The cynic in me wonders if certain smart brokers placed a shed load of sell orders in anticipation of making a quick buck but that's the conspiracy theorist in me working overtime. Back to the numbers:

Sage Results - 2

Back in July, Steve Hare, CFO repeatedly said the company would likely be looking at growth of around six percent but added that the company could pull some levers to change that if needed. Principally, he was referring to selling more perpetual licenses rather than continuing the push to subscription revenue. As you can see from the above, Sage did rather better than that, getting slightly ahead of where the company signaled it would be. It also demonstrated solid fiscal control, jacking the operating profit 70 basis points. Even so, that left profit down from 2014, an inevitable outcome of several factors, including significant restructuring as part of the transition process.

Like earlier in the year, the company continued to set future margin expectations at 27 percent. That is lower than was achieved in both 2014 and 2015 but again, is all part of the transitional process. In the detailed press release, Sage says it is targeting £50 million in annual savings alongside six percent growth. Based on the published numbers and factoring in the aforementioned savings, that means Sage plans to factor a net drop of around £45 million in absolute terms although the savings compensate for that figure to provide an outcome that will be flat compared to 2015. Assuming Sage is able to execute on this plan, then given the geographic differences and massive product portfolio - which the company is also committed to rationalizing - this will be a good outcome. The markets think Sage is being conservative. I'd like to think that Stephen Kelly, CEO Sage, is giving himself enough breathing space to get the right amount of R&D in place but as I explain later, it is not that simple.

But it is in some of the detail and ancillary numbers where things get a tad wobbly. I was for example surprised that payment processing revenue only grew by two percent. But then I should not have been so surprised given the explosion in competitive payment offerings, the emergence of Apple Pay, Google Pay and the like. Sage will need to watch this one very carefully in 2016 because we anticipate continuing disruption in the general financial services sector and payments processing in particular.

On customer count, Sage made a big play about the growth in the number of subscribers it has added in the last year. On its face the numbers are impressive. In the detailed press release, Kelly said:

We have increased Sage One paying subscriptions by over 100% to 173,000, supported by a strong performance in the UK where subscriptions increased to 92,000. Sage One is emerging as the accounting product of choice for UK start-up businesses in terms of new monthly subscribers. Sage One was launched in Brazil, Malaysia and Australia during the year and global rollout will continue in FY16. We are investing in our digital presence to enhance awareness of Sage One as we target the opportunity of Small & Medium Businesses which are not currently using a software solution to run their business.

Impressed?  Not so fast. In the investor presentation, the company showed how growth was made up as follows:

Sage results - 3

See where Sage One fits? It represents a tiny fraction of the overall organic growth and, in any event, in previous statements, Hare has noted that, as it relates to cannibalization of the prior business model:

...the new license sales which is the point you're making around cannibalization of new license sales into recurring revenue and subscription, but the second thing that we're starting to do, is we're trying to bundle more of the complete package into subscription.

And what I mean by that, is that initially when we're doing some of the upgrades. We would see, we'd sell somebody an upgrade and we'd sell them that feature on subscription, but they'd still have separately a maintenance and support contract and they didn't necessarily have a complete bundled solution. what we're trying to do more and more now, is bundle it all together and as a result, maintenance and support, standalone maintenance and support is not really growing.

So standalone maintenance and support is starting to flatten out, as we take more of that maintenance and support and bundle it into a subscription contract. Now what we're obviously trying to do at the same time as we bundle, is we're trying to deliver more value to that customer. So we're not just taking, what they've exist, what they've already got and putting it into a new contract.

We're trying to bundle it in with a new feature, with a new upgrade etc. now part of that is always the trying to take the whole thing and bundle it into a single priced offering rather than having the granularity of the sort of individual component parts.

OK - in this answer and others around the same topic, it is clear that Sage is anticipating significant swaps out of perpetual licensing and into subscription. But that masks the true organic growth which we already know was as predicted but modest by anyone's standards, albeit from a large number. We also know that X3, which is largely sold as on-premise performed much better than analysts might have expected. What does that leave? We cannot say with certainty because Sage does not split out the swaps from net new business.

I have argued for a long time that while I have no problem in Sage trumpeting stellar growth, it is hard to be sure what this means when weighed against the overall result. We have asked Sage for clarification but they were unable to provide us with any additional color. Sage does however say that there is a clear appetite for subscription based deals in the UK and North America at the SMB end of the market. That should be no surprise given the growth that competitors have seen in these markets. Whether Sage can get on nodding terms with Intuit and Xero as the main competition in the US for example is far from clear.

Clearly, the company is talking up its overall momentum in the expectation that its brand will carry the day against competition. That is not a done deal by any means and Sage will need to tread very carefully if it is not to over extend expectations. So far that's not been the case and when you read closely, Kelly is hedging some of his bets. But I wonder whether there is enough money in the R&D pot to make the kinds of stride that Kelly believes are possible. It is a fact of life that with accountants as the primary influencers, features and functions matter a great deal. But with only about £140 million to go around 100 products globally on our reckoning, there ain't much room for mis-steps.

The rationalization of the product line under the "Sage One" banner will help fuel R&D, as will the massive rationalization of website properties and other ongoing cost savings. Will it be enough? We cannot know the answer and Sage isn't telling. But seeing as Sage has adopted a more US form of report style and tempo, it won't be long before we know more. In the meantime, it is worth remembering Brian Sommer's quick take on the 2015 US partner summit where he said:

While the conference was well-attended and more upbeat than some I’ve attended in recent years, the volume of material product announcements and long-term vision statements seemed thin.

In one executive Q&A, I pointed out that the company has had strategic relationships in the last few years with Microsoft, Amazon and, most recently, Salesforce. And then, in a Tuesday morning keynote, there was Microsoft’s CEO on video, talking about a deepening relationship between the two companies. So, will Sage pick one platform and standardize on it? The short answer is no. They’ll pick platforms by major product lines and customer needs.

I also wanted to know if Sage will use more of the new Azure capabilities, notably the cool infrastructure tools, that offer more than Azure SQL and cloud computing. Those new capabilities are being scooped up by 3-4 cloud ERP vendors that I know of include big data support, enhanced analytics, machine learning and more. There were no announcements or even whispers of such at the event. Even when I pressed executives on this, the reaction was more of one where they’re still investigating the new tools and the business case for the use of same.

In similar vein, Derek duPreez warned that while Kelly makes a convincing and impassioned presenter, there are many layers to convince inside Sage and in the partner ecosystem.

As I said at the top of the post, when it comes to understanding Sage, it's complicated. The company has gone to great lengths to ensure that its numbers are easier to understand at the top level. However, the devil in the detail remains confusing and at some point will need to be ironed out. Simplification of product lines will unquestionably help and, as a by-product, allow more targeted marketing spend, an area where Sage has plenty of wiggle room if Kelly chooses.

As always, watch this space. :)

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