Gartner Data Center, Infrastructure & Operations Management Conference 7–10 December 2015 | Las Vegas, NV Focus on These Six Key Financial Metrics to Help Determine Vendor Viability Gary Spivak This presentation, including any supporting materials, is owned by Gartner, Inc. and/or its affiliates and is for the sole use of the intended Gartner audience or other intended recipients. This presentation may contain information that is confidential, proprietary or otherwise legally protected, and it may not be further copied, distributed or publicly displayed without the express written permission of Gartner, Inc. or its affiliates. © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Would You Trust This Vendor? Should I trust this guy? Would You Trust This Vendor? 1 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. But What If They Looked Like This? Polling Question What is your current level of financial expertise? Little to none. Not bad — self-taught. I took a couple of accounting/finance courses. I have an accounting or finance degree. I am an expert at financial statement analysis. 2 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Financial Analysis Skills Are Rare in IT Through 2018, more than 75% of IT leaders will lack the financial statement analysis skills to avoid overexposure to financially troubled vendors. Supporting the SPA: Alternative position to SPA: Briefings and inquiries show I&O will mature faster than a lack of financial analysis skills within IT. I&O leaders are still more focused on operational metrics than on business metrics. 3 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. expected in providing and communicating business value to business leaders. A high-profile vendor failure will cause IT leaders to urgently focus on these skills. Key Issues 1. Why should you care about the financial status of strategic vendors? 2. What are the most critical ratios and metrics to use in advanced vendor financial statement analysis? 4 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Key Issues 1. Why should you care about the financial status of strategic vendors? 2. What are the most critical ratios and metrics to use in advanced vendor financial statement analysis? 5 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. You Need Credible, Viable Solutions! 30+ Years 6 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Supplied by MANY Vendors 7 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. But Some Run Into Financial Difficulties Either Get Help 8 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Or Not! Polling Question How often are your strategic vendors evaluated on their ability to remain viable? Never. Once a year. Every two or three years. Before every contract renewal. Don't know. 9 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Key Issues 1. Why should you care about the financial status of strategic vendors? 2. What are the most critical ratios and metrics to use in advanced vendor financial statement analysis? 10 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Public Financial Statements Income Statement: – Revenue – Spending/Investments – Profitability Balance Sheet: – Assets – Liabilities Statement of Cash Flows: – Sources of cash – Uses of cash 11 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Gartner Vendor Financial Rating Measures: – Growth – Profitability – Ability to meet current obligations/solvency – Cash flow generation 12 Calculate: LTM Revenue Growth (%) Gartner Score Calculate: LTM Profit Margin (%) Gartner Score Calculate: Current Ratio (Decimal) Gartner Score Calculate: LTM CFO/ Revenue Gartner Score Score Rating -1000.0% 0 -1000.0% 0 0.00 0 -150.0% 0 0 Strong Negative -75.0% 1 -100.0% 1 0.60 1 -90.0% 1 9 Strong Negative -34.0% 2 -50.0% 2 0.80 2 -42.0% 2 10 Caution 3 19 Promising -14.0% 3 -25.0% 3 0.95 3 -18.0% -4.0% 4 -9.0% 4 1.10 4 -6.0% 4 25 Positive 1.0% 5 0.0% 5 1.25 5 0.0% 5 32 Strong Positive 6.0% 6 2.0% 6 1.40 6 3.0% 6 16.0% 7 6.0% 7 1.55 7 9.0% 7 36.0% 8 12.0% 8 1.70 8 18.0% 8 76.0% 9 20.0% 9 1.85 9 30.0% 9 156.0% 10 30.0% 10 2.00 10 45.0% 10 2.20 9 2.60 8 3.20 7 4.00 6 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Six Key Financial Metrics 13 Revenue/ Turnover Growth Bookings Growth Profitability — Net Profit Margin Current Ratio Cash From Operations Margin R&D Spending Ratio © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Metric No. 1 — Revenue Growth TTM Revenue/Last Year's TTM Revenue — 1. Metric No. 1 — Trailing Twelve Month (TTM) Revenue (Turnover) Growth: – Information Taken From Income Statement. – Optional: Look at Major Product Growth, License, as Opposed to Secondary Drivers, Like Maintenance or Services. 14 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Metric No. 1 — Data on Income Statement Microsoft Corporation Yearly Income Statements (In millions, except earnings per share) FY12 FY13 FY14 $ 73,723 $ 77,849 $ 86,833 Cost of revenue 17,530 20,249 26,934 Gross margin 56,193 57,600 59,899 9,811 10,411 11,381 13,857 15,276 15,811 General and administrative 4,569 5,149 4,821 Goodwill impairment 6,193 0 0 Integration and restructuring 0 0 127 Other expenses 0 0 0 21,763 26,764 27,759 504 288 61 0 0 0 22,267 27,052 27,820 5,289 5,189 5,746 16,978 21,863 22,074 0 0 0 16,978 21,863 22,074 Revenue Research and development Sales and marketing Operating income Other income (expense), net Noncontinuing items Income before income taxes Provision for income taxes Net income before accounting change Cumulative effect of accounting change Net income 15 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. What Is Deferred/Unearned Revenue? Why Should You Care? Common in business models with ongoing deliverables — like maintenance, subscriptions Deferred revenue is only recognized as revenue ratably throughout the period Remainder "stored" on the balance sheet Pure subscription models will be slower growth than revenue recognized at sale 16 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Liabilities and stockholders' equity Current liabilities: Accounts payable $ Short-term debt 7,432 $ 4,828 2,000 0 0 2,999 4,797 4,117 782 592 23,150 20,639 558 645 6,906 3,597 45,625 37,417 20,645 12,601 Long-term unearned revenue 2,008 1,760 Deferred income taxes 2,728 1,709 11,594 10,000 Total liabilities 82,600 63,487 Total stockholders' equity 89,784 78,944 172,384 $ 142,431 Current portion of long-term debt Accrued compensation Income taxes Short-term unearned revenue Securities lending payable Other Total current liabilities Long-term debt Other long-term liabilities Total liabilities and stockholders' equity $ Metric No. 2 — "Bookings" Growth Bookings growth = (TTM bookings)/(the year ago TTM bookings) — 1 Bookings is nonstandard — it is not defined the same way by every company. Bookings = Revenue + change in deferred revenue. 17 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Why Is Profitability Important? 18 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Income Statement Example Microsoft Corporation Yearly Income Statements (In millions, except earnings per share) FY12 FY13 FY14 $ 73,723 $ 77,849 $ 86,833 Cost of revenue 17,530 20,249 26,934 Gross margin 56,193 57,600 59,899 9,811 10,411 11,381 13,857 15,276 15,811 General and administrative 4,569 5,149 4,821 Goodwill impairment 6,193 0 0 Integration and restructuring 0 0 127 Other expenses 0 0 0 21,763 26,764 27,759 504 288 61 0 0 0 22,267 27,052 27,820 5,289 5,189 5,746 16,978 21,863 22,074 0 0 0 16,978 21,863 22,074 Revenue Research and development Sales and marketing Operating income Other income (expense), net Noncontinuing items Income before income taxes Provision for income taxes Net income before accounting change Cumulative effect of accounting change Net income 19 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. The Bottom Line Measurements of Profitability Revenue Growth Is Important — but Ultimately, MUST HAVE Profitability. Displays the Ability to Generate Shareholder Value From the Business. Measures: – Gross Margin. – Operating Margin. – Net Profit Margin = THE BOTTOM LINE! 20 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Metric No. 3 — Net Profit Margin Net margin = TTM net income/TTM revenue: Net profit margin IS the bottom line: – Information from the income statement. – Strength depends on sector: Software — over 10% good. Hardware — medium to high single digits. Service — single digits. – If negative — find out why: Growing? Restructuring? Headed for oblivion? 21 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Why Meeting Obligations Is Critical LIQUIDATION BANKRUPT 22 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. INSOLVENT Balance Sheet Microsoft Corporation Balance Sheets (in Millions) June 30 2014 June 30 2013 Assets Current assets: Cash and cash equivalents Short-term investments (including securities loaned of $541 and $579) Total cash, cash equivalents and Short-term investments Accounts receivable, net of allowance for doubtful accounts of $301 and $336 Inventories Deferred income taxes Other Total current assets Property and equipment, net of accumulated depreciation of $14,793 and $12,513 Equity and other investments Goodwill Intangible assets, net Other long-term assets Total assets 23 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. $ $ 8,669 $ 3,804 77,040 73,218 85,709 77,022 19,544 2,660 1,941 4,392 114,246 17,486 1,938 1,632 3,388 101,466 13,011 14,597 20,127 6,981 3,422 172,384 9,991 10,844 14,655 3,083 2,392 142,431 $ Liabilities and stockholders' equity Current liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued compensation Income taxes Short-term unearned revenue Securities lending payable Other Total current liabilities Long-term debt Long-term unearned revenue Deferred income taxes Other long-term liabilities $ Total liabilities Total stockholders' equity Total liabilities and stockholders' equity $ 7,432 2,000 0 4,797 782 23,150 558 6,906 45,625 20,645 2,008 2,728 11,594 $ 4,828 0 2,999 4,117 592 20,639 645 3,597 37,417 12,601 1,760 1,709 10,000 82,600 89,784 63,487 78,944 172,384 $ 142,431 Current obligations MUST be met. If not, results could be default, bankruptcy, liquidation! Metric No. 4 — Current Ratio Current ratio = Current assets/current liabilities. Measures ability to meet near-term obligations with cash (or soon to be cash). Normally want to see ratio greater than 1. Ideally want to see at or greater than 2. Deferred revenue can skew the value — watch for this. 24 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Why Is Cash Flow Important? 25 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Cash Flow Statement Measures the cash generated three different ways: – Operations Statement of Cash Flows – Investments – Financing Cash from operations — the most important; Operating Activities measures how business activities generate cash Cash used for investments: – Includes capex Cash flow from financing: – Includes cash from issuing/buyback of stock, debt, dividends 26 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Investing Activities Financing Activities Metric No. 5 — Cash From Operations Margin TTM cash from operations/TTM revenue. Measures ability of business to generate cash. Cash inflow Be wary if consistently negative. Gain comfort when consistently over 20%. Similar sector dynamics as net profit margin. Cash in hand Cash outflow 27 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Metric No. 6 — R&D Spending Microsoft Corporation Yearly Income Statements (In millions, except earnings per share) TTM R&D expense/ TTM revenue. FY12 Revenue Monitor spending on research and development to gauge vendor commitment to product enhancements. Sector Communications Equipment Average Technology Hardware, Storage and Peripherals Average Diversified Telecommunication Services Average Internet Software and Services Average IT Services Average Semiconductors and Semiconductor Equipment Average Software Average Wireless Telecommunication Services Average Electronic Equipment, Instruments and Components Average Source: Gartner (November 2015) 28 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. R&D as a percentage of Revenue 14.9% 12.7% 1.9% 16.8% 3.5% 12.0% 18.8% 0.4% 11.2% $ 73,723 FY13 $ 77,849 FY14 $ 86,833 Cost of revenue 17,530 20,249 26,934 Gross margin 56,193 57,600 59,899 9,811 10,411 11,381 13,857 15,276 15,811 General and administrative 4,569 5,149 4,821 Goodwill impairment 6,193 0 0 Integration and restructuring 0 0 127 Other expenses 0 0 0 21,763 26,764 27,759 504 288 61 0 0 0 22,267 27,052 27,820 5,289 5,189 5,746 16,978 21,863 22,074 0 0 0 16,978 21,863 22,074 Research and development Sales and marketing Operating income Other income (expense), net Noncontinuing items Income before income taxes Provision for income taxes Net income before accounting change Cumulative effect of accounting change Net income Action Plan for I&O Leaders Monday Morning: Identify the key strategic vendors in your organization. Discover which contract renewals arise in the next three months. Collect financial information on those vendors. Next 90 Days: Calculate the six key metrics on those relationships due to renew in the next six months. Determine where the best source of financial information is for each vendor. Develop proficiency in this exercise. Next 12 Months: Utilize awareness of financial status in negotiations. Illustrate the financial analysis when requesting authorization in product acquisition. 29 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. Recommended Gartner Research Analysis of Income Statements Exposes Secrets to Reduce Risks of Vendor Obsolescence Gary Spivak (G00261495) Analyze Vendor Balance Sheets to Reduce Risk of Vendor Obsolescence Gary Spivak (G00262389) Analysis of Vendor Cash Flows Helps Predict and Mitigate Risk of Vendor Obsolescence Gary Spivak (G00263515) How to Re-evaluate Strategic Vendors Acquired by Private Equity Gary Spivak, Colin Fletcher and Robert Naegle (G00267514) Understanding Gartner's Financial Ratings of IT Vendors Joseph Baylock, Frank Marsala and Others (G00166659) For more information, stop by Gartner Research Zone. 30 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved. 31 © 2015 Gartner, Inc. and/or its affiliates. All rights reserved.