Passing the ISV Stress Test
The economy downturn is revealing the fundamental changes in customer behavior which are taking place in the software industry. Executives must take action now in order to ensure their companies will survive to thrive in the economic recovery.
By Chris Dowse and Ben Galison, Neochange
Jun. 09, 2009
On May 22 the stock market valued the software industry at a 3.7% discount to the S&P500, based on the next-12-month price/earnings ratio. This isn't particularly striking until we consider that for the past five years, the software industry has on average been priced at a 34% premium to the S&P 500.
What could account for this dramatic difference?
While there is definitely widespread uncertainty as to the timing and size of an economic recovery, a swing of this magnitude suggests the market believes something has fundamentally changed the software industry's future capability to generate earnings. It is an indication that the market believes a structural shift is taking place and that the outlook for the coming year is dire.
What does the smart money know? What has the economic meltdown exposed?
The Perils of Swimming Naked: Does the Software Industry Deliver Value?
Warren Buffet has a saying, "It's only when the tide goes out that you learn who's been swimming naked." He goes on to point out that during good times we don't know how much risk exists within any given company - the degree to which a management team has potentially exceeded sustainable levels of the economic drivers for their industry.
The financial services industry provides a familiar example to illustrate this situation. As the economic crisis dawned, many financial company executives continued with risky business practices despite the warnings that the "gravitational relationship" between housing prices and incomes had been exceeded. In the banking industry, these economic drivers are well established, studied thoroughly and reported regularly. In the software industry, economic drivers of revenue and benefit are somewhat less obvious and more difficult to measure; however, data does exist and it presents a disturbing picture.
A 2007 Federal Reserve Board report on US labor productivity reveals that the software industry had exceeded the "gravitational relationship" between software investment levels (customer spending) and software-driven productivity (customer value delivered) well before the economic crisis started. Figure 1 compares the contribution of software to US labor productivity improvement - a macro-level measure of software-driven business benefit - and the relative level of software investment as a percentage of US GDP.
Fig. 1: Software-driven Productivity Had Stalled Before the Economic Crisis
These graphs show that since 2001, software spending moved consistently with the growth of the economy (at a flat rate of around 1.5%), but that over the same period the improvement in growth attributed to software declined nearly 40%.
Software companies cannot expect to continue earning a consistent share of the economic pie when their contribution to customer success has deteriorated so dramatically.
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What could account for this dramatic difference?
While there is definitely widespread uncertainty as to the timing and size of an economic recovery, a swing of this magnitude suggests the market believes something has fundamentally changed the software industry's future capability to generate earnings. It is an indication that the market believes a structural shift is taking place and that the outlook for the coming year is dire.
What does the smart money know? What has the economic meltdown exposed?
The Perils of Swimming Naked: Does the Software Industry Deliver Value?
Warren Buffet has a saying, "It's only when the tide goes out that you learn who's been swimming naked." He goes on to point out that during good times we don't know how much risk exists within any given company - the degree to which a management team has potentially exceeded sustainable levels of the economic drivers for their industry.
The financial services industry provides a familiar example to illustrate this situation. As the economic crisis dawned, many financial company executives continued with risky business practices despite the warnings that the "gravitational relationship" between housing prices and incomes had been exceeded. In the banking industry, these economic drivers are well established, studied thoroughly and reported regularly. In the software industry, economic drivers of revenue and benefit are somewhat less obvious and more difficult to measure; however, data does exist and it presents a disturbing picture.
A 2007 Federal Reserve Board report on US labor productivity reveals that the software industry had exceeded the "gravitational relationship" between software investment levels (customer spending) and software-driven productivity (customer value delivered) well before the economic crisis started. Figure 1 compares the contribution of software to US labor productivity improvement - a macro-level measure of software-driven business benefit - and the relative level of software investment as a percentage of US GDP.
Fig. 1: Software-driven Productivity Had Stalled Before the Economic Crisis
These graphs show that since 2001, software spending moved consistently with the growth of the economy (at a flat rate of around 1.5%), but that over the same period the improvement in growth attributed to software declined nearly 40%.
Software companies cannot expect to continue earning a consistent share of the economic pie when their contribution to customer success has deteriorated so dramatically.
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