MicroStrategy, Inc. (MSTR)

Fabulous earnings.

Microstrategy is a provider of business intelligence (BI) software. Business intelligence refers to the process of consolidating, cross referencing, and examining the millions of pieces of data available in corporate databases to provide management (and in some cases, everyday employees) up to the minute information on business performance and trends. Using this information, executives can effectively manage resources to improve efficiency, reduce costs, and increase profitability.

To get a mental grasp on this, take for example one of Microstrategy's customers: Netflix (NFLX). Hypothetically, lets say Netflix has decided to push their movie rental service into a few new markets, say, cities A and B. First the company allocates marketing dollars to promoting the service on television, in newspapers, and so forth in these markets. Those marketing investments are all recorded in a corporate database. As customers begin to sign up for the free trials, Netflix records their addresses in a similar customers database. Eventually some of these trial subscribers will decide that they love the service, and begin becoming paying members. As this process takes place, Netflix marketing managers can see in real time that the marketing dollars spent in city A are resulting in a larger return on investment then those in city B, and decide to pour more money into marketing there. At the same time, the COO sees that city A is beginning to build a large enough subscriber base to consider opening a distribution center there. Business intelligence software makes this efficient use of capital possible. Without it, Netflix may have wasted tens of thousands of dollars in city B before enough evidence piled up that it was a poor geography for investment.

The business intelligence software market is an attractive one. The immediate visualization of company performance and associated efficiency improvements have led to strong demand for it. Gartner estimates the market growing 9% a year through 2011. Additionally, the infrastructure for BI software requires difficult and painstaking installation, leading to high switching costs, recurring maintenance fees, and a fair amount of pricing strength for those maintenance contracts. Lastly, being a software business, there are no inventories to be concerned with and hard capital investment is minimal (software development requires no factories to maintain).

All of these attractive characteristics are reflected in Microstrategy's results. Magic Formula return on tangible capital has averaged nearly 130% per year for the last 5 years, and real return on capital is equally impressive at 82%. The company holds over 162 million in cash with no debt - financial health is not an issue here. Free cash flow margin has averaged nearly 30% for the last 5 years. The beauty of such large free cash flows combined with low capital spending requirements is that the company can use this cash to reward shareholders in the form of stock buybacks. Microstrategy has not been shy about this, reducing share count 29% since 2004.

However, Microstrategy occupies a spot in the Magic Formula screen (and has for some time), meaning investors are reluctant about the company's future. There are good reasons for this. We've discussed the attractiveness of the BI market. This attractiveness has not gone unnoticed by the big boys. Almost all of the big software companies have staked their territory in this market, most of them through acquisition. Oracle (ORCL) purchased Hyperion for 3.3 billion in March 2007, SAP (SAP) acquired BI leader BusinessObjects for 6.8 billion in October 2007, and IBM (IBM) shelled out 5 billion for Cognos in November 2007. Microsoft (MSFT) has been developing BI capabilities internally that integrate with their Office suite, specifically Excel. The problem for Microstrategy here is that these software titans can bundle BI software with their other enterprise offerings, which are in many cases already used by enterprises. This bundling strategy can lead to flexibility on price, and fewer supplier relationships for the customer to manage. And with the titans battling each other on price, smaller players like Microstrategy can see their margins come under heavy pressure as they are forced to drop prices to compete.

MagicDiligence doesn't feel this scenario is necessarily inevitable. Acquired software can often feel tacked on, and not well integrated - and BI software inadequacies are highly visible to those that sign the checks. Microstrategy's platform consistently ranks at the top of customer satisfaction, and it's client base consists of some extremely well-run enterprises (Netflix, Starbucks (SBUX), GEICO (BRK.B), Well's Fargo (WFC), Lowe's (LOW), etc).

However, there are still other, company specific, issues that give me pause. New licenses revenue has been flat for 4 years... Microstrategy is signing new contracts, but is not growing them. Revenue growth has come solely from maintenance contracts from an expanded user base. Management also raises an eyebrow. The company is run by founder Michael Saylor, who set up a dual class share structure that gives him over 60% of the voting control. This can make acquisition by another big fish more difficult - Saylor has the final say on approval. And management loves to reward itself. Saylor makes close to $3 million in total compensation, and the CFO pulls in over a million, pretty steep for a small company like this. Apparently they don't make enough for entertainment though, as the company pays for private parties and country club memberships for it's bigwigs, and management last year purchased a 43 million dollar jet for itself. 43 million dollars is more than all of net earnings for 2008! Was it really necessary?

There are certainly many things to like - the business, the balance sheet, the buybacks. However, competing against 4 determined software giants is not an enviable task. Microstrategy is a solid pick for your MFI portfolio, but just short of a Top Buy.