Despite delivering another solid, respectable quarter, when many vendors in the enterprise software sector are failing to meet analyst estimates, Computer Associates is still some way from holding the lodestone to long term growth – a substantial services business. Chairman, Charles Wang, set down the objective in March last year when he confidently asserted that CA would have a $1bn Global Professional Services business by the close of the company’s financial year ending March 1999.
Professional services is key to CA. Investors and analysts alike have been bemoaning the fact that during deals CA has been leaving money on the table by not providing a full spread of consulting and outsourcing services to its 10,000 customers. In providing the consulting services to implement CA products and even outsourcing services to host entire computing environments for customers, the company would achieve even greater account control which would dramatically improve its recurring revenue and top line visibility.
But with just three months to this deadline, service revenues are still only really trickling in. Professional services revenues for the third quarter 1999, CA’s most recent quarter, were just $77m, a fraction of the $1.36bn in overall revenues it saw in the December quarter. Admittedly, this figure represents a 97% growth rate on the same quarter last year, but the number is no where near the $250m average in revenues it would have had to hit each quarter if it is to reach the magic $1bn mark by the intended date.
We need a couple of smaller or a medium-sized acquisitions to build up a $1bn services business, president and COO, Sanjay Kumar, told analysts during a third quarter earnings conference call. We have a solid commitment to building a strong technology differentiated services business. It takes money to do that and in the past we have been criticized for not spending enough to get there. But we are determined to make it a meaningful size to reward shareholders, he added.
While reticent to say whether CA was currently in negotiations with further consulting companies he did say the company was looking for opportunities in both product and services in a bid to invest for the future.
After the highly public, hostile and eventually aborted $108 a share offer takeover bid for Computer Sciences Corporation last March – and the failure of what would have been its preferred ‘one big step’ into the computing services mainstream – CA stated publicly that it would build its Global Professional Services (GPS) business through a series of small, incremental acquisitions. But the ‘Plan B’ strategy is proving slow in producing added revenue. Not only are current revenues below earlier targets, but the acceleration in body count required to guarantee future revenues is crawling along slowly too.
Even before the company made professional services a strategic focus it had 600 consultants. The original plan was to take the headcount to 4,000 – 6,000 worldwide by fiscal 1999. But that figure has only really doubled in the last 9 months despite four acquisitions – Realogic, LDA Systems, QXCOM and Aventura Systems. (Three of these deals were sealed in the last quarter and added 200 to the headcount). That said, according to Kumar, CA also has between 300 and 500 consultants in the midst of product implementation projects.
CA will need to ramp the headcount to accelerate the business. So far its services acquisitions have been relatively little known niche players. Aventura System, its last purchase to date, was a Norwegian electronic data exchange (EDI) specialist while LDA, QXCOM and Realogic were all principally Lotus Notes houses.
While these acquisitions have been set up to win new business in areas beyond CA’s core product focus, the company still needs to build a consulting business around the other three GPS divisions. It has the Harmony division which sells database consultancy on the back of a sale of Ingres, Jasmine or Opal; the OS/390 business which is dedicated over to mainframe scheduling and database consulting; and the enterprise management division which primarily sells services on the back of Unicenter roll-outs.
The company plans to give its ailing object-database business an added service focus in the next 3-6 months in a bid to pull through sales by helping customers build applications on Jasmine, Kumar said. But CA does not seem to have made much headway into the largely untapped revenue streams from Unicenter sales. In the last year CA made $2bn in product sales in Unicenter alone, but the company could supply only the tiniest fraction of the $4bn demand for consulting and deployment services that go hand-in- hand with systems management sales.
Cracks in CA’s earnings model are beginning to appear. Pre-tax margins are beginning to show the strain of increased competition in the systems management market, combined with CA’s increasing investment in services-oriented businesses, which carry an inherently lower pre-tax margin. As Kumar accepted during the teleconference, our margins will have to come down as the services part of our business becomes bigger. Pre-tax margins dropped by 220 basis points from third quarter 1998 levels. This fact alone has caused analysts to remain cautious over CA’s future. We remain guarded on the outlook for CA at current prices. We have not changed our FY 2000 EPS estimates of $2.60 but we are uncertain to the degree of margin pressure that could appear over the next 12-18 months, says Merrill Lynch.
Furthermore, with a stock price that has taken a taken a downturn and closed on Friday January 22 at $48.8125 – well below its 52 week high of $61.94, CA is now in a weaker position than it once was to carry out share-for-share acquisitions, making ‘Plan B’ that much harder to achieve.
