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Strategies & Market Trends : Gorilla and King Portfolio Candidates -- Ignore unavailable to you. Want to Upgrade?

To: paul_philp who wrote (52358)	7/29/2002 12:25:59 PM
From: Greg Hull	Read Replies (1) \| Respond to of 54805

Gus posted this article on the EMC board, and I thought it had G&K overtones. Greg A HARD TURNAROUND FOR SOFTWARE Software companies caught in a downward spiral find it exceptionally difficult to escape. Yet a determined few succeed Mark Blumling, Kevin A. Frick, and William F. Meehan III The McKinsey Quarterly, 2002 Number 3 While executing a turnaround in any industry can be a difficult task, digging a software business out of trouble is a Herculean one. Certain product, financial, and labor market forces unique to the sector reinforce one another when a software company is performing well—and also when things start to go wrong. With the right formula, companies can ride a wave to fantastic success. When the environment changes, they must battle mightily to avoid being sucked into the abyss. The odds against turning a software company around are thus extremely high. A McKinsey study showed that out of 492 companies defined as struggling, only 13 percent were subsequently able to revive themselves (see sidebar, "About the research")—an unusually low proportion. Yet turnarounds are possible, and the rewards make the effort worthwhile. Why is it so difficult? Software turnarounds are tough because, at the first signs of trouble, forces specific to the industry can combine to create a deadly downward spiral. Take product market forces. Software is a winner-takes-all business in which three factors—the need for compatible technology in networked environments, high switching costs, and increasing returns to scale—unite to ensure that only a small number of players in most market segments survive in the long run. SAP, the German provider of enterprise-resource-planning (ERP) software, illustrates the phenomenon: by the mid-1990s, it was such a clear leader in its market segment that it was able to claim, "We spend more on R&D than our competitors have revenues." This winner-takes-all phenomenon favors companies as they race toward market leadership but exacerbates the difficulties of companies that fall on hard times. Switching costs, for example, are high because software is expensive to integrate into corporate IT systems; this hurts the losers because once a network has been configured around new software and employees have been trained to use it, the company isn’t likely to switch to a vendor that might not be around to provide upgrades and service in years to come. Forces in financial markets are another consideration. The volatility of share prices in the software sector reflects the cyclical nature of demand for information technology and, more important, the intangible nature of assets such as employees, customer relationships, and technology. The importance of these intangible assets—the essential drivers of economic value for software companies—is magnified by their scalable character and the winner-takes-all dynamic of the business. But it is notoriously difficult to price them, so investors must rely on revenue and earnings streams as proxies for their value. Software companies benefit when their performance is rising, as their return on invested capital can exceed 50 percent and grows extremely quickly. During a downturn, however, they are hit twice—once for their actual financial performance and again for what it implies about the value of their assets. If insolvency looms, investors flee because there are few residual assets to divide. Finally, labor market forces contribute to the spiral. In most software companies, stock options form a large part of the employees’ compensation. Once a company starts to fail, it can suffer a massive attrition of its workforce as options lose their appeal. The most valuable employees tend to leave first, diluting the company’s intangible-asset base at the time of greatest need. If the company tries to hang on to this talent by increasing pay, net income suffers, thus further reinforcing the vicious cycle.......... mckinseyquarterly.com