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The Case for Cognos

By Zaineb Bokhari Ottawa-based Cognos (COGN

; recent price, $37) is a leading provider of business intelligence (BI) software and corporate performance management (CPM) software that supports reporting and query, data integration, and performance analysis. While we at Standard & Poor's Equity Research see the underlying demand for BI/CPM products remaining strong, we note that Cognos has been expanding its license revenue in the mid-teens to mid-20% range over the past three fiscal years, a faster rate than its peers because of strong organic growth and, to a lesser extent, through strategic acquisitions.

While we at S&P see license growth moderating somewhat in fiscal 2006 following a strong performance in fiscal 2005, we continue to expect Cognos to be able to increase license sales faster than its peers, aided by what we consider to be a highly effective sales force, a solid product portfolio, and a capable management team. We expect Cognos to build license revenue in the 11% to 14% range in future periods, thus continuing to expand its market share faster than the underlying 10% to 11% growth we forecast for this segment.

Further, the industry environment remains favorable. We expect corporate spending on BI/CPM software will remain solid in 2005 and in 2006, due to the enhanced business decisions supported by this class of software. We also expect regulatory changes that have taken effect in recent years, such as Sarbanes-Oxley and Basel II, to help drive demand for Cognos' products.

PERFORMANCE METRICS. Based on our belief that at current levels the shares don't fully reflect what we view as Cognos' positive business momentum relative to its peers and to enterprise software vendors as a whole, we have assigned a 5 STARS (strong buy) ranking to Cognos shares.

The company's BI offerings comprise highly scalable component-based software that enables reporting, query, analysis, visualization, and event management across an enterprise. Cognos ReportNet is its next-generation Web-based query and reporting product that has been developed to specifically satisfy all enterprise reporting requirements. Its analysis component, Cognos PowerPlay, enables so-called OLAP (online analytical processing) reporting and analysis, and is fully integrated with ReportNet.

CPM offerings are designed to help managers measure business performance against strategic objectives through score-carding, planning, budgeting and forecasting, and financial consolidation. With Cognos Metric Manager, users can view and interact with scorecards that contain key performance metrics and can analyze each metric individually to understand what constitutes good performance. Cognos Planning covers budgeting, planning, forecasting, and reporting financial performance. Cognos Controller helps automate financial and management reporting.

SALES-FORCE EDGE. Cognos targets large companies worldwide as well as major public-sector organizations. At February 28, 2005, Cognos had 23,000 customers in 135 countries. It uses a direct sales force in all major markets as the primary distribution channel for its products. It believes this system increases its visibility and market penetration, ensures long-term customer contact, and facilitates sales of additional products.

In fiscal 2005, direct sales accounted for 75% of software license sales, up from 73% in fiscal 2004. The balance of sales is derived from its partner channel, which includes resellers, original equipment manufacturers (OEMs), and distributors.

In our view, Cognos' above-average and largely organic growth is due in large part to its best-of-breed BI products, strong product development capabilities, and its seasoned management team. We also consider the direct sales force to be more effective relative to Cognos' peers based on our calculation of the average license revenue per quota-carrying salesperson over the past five quarters. By our calculations, the average Cognos salesperson closed 22% greater license sales than the average Hyperion Solutions (HYSL

: Buy; $43) salesperson and more than double the average Business Objects (BOBJ

: Hold; $33) salesperson, over the past five quarters.

INTERNALLY DEVELOPED. While these comparisons are approximate due to variation in fiscal year calendars (Hyperion's fiscal year ends in June, and Business Objects' ends in December, while Cognos' ends in February) and the difference in reliance on direct vs. indirect sales channels, we believe Cognos' sales execution compares favorably to its peers in this category.

In our opinion, Cognos was ahead of its peers in developing a comprehensive enterprise-reporting product built on a services-oriented architecture. This internal product development was in contrast to the $1.2 billion acquisition of Crystal Decisions by competitor Business Objects and the smaller ($150 million) acquisition of Brio by Hyperion during the same time frame.

We think Cognos was successful in capitalizing on its lead and the distractions of its peers, as evidenced by the strong license growth rates that were considerably above those of its peers, as well as market-share gains (as measured by the proportion of new license deals sold to new vs. existing customers).

POSITIVE SALES MOMENTUM. The coming release of Cognos 8, based on a unified, services-oriented architecture similar to that of its reporting product, should once again give Cognos a lead over peers and, in our view, enhance its opportunity to sign standardization deals. We believe the key to success and, ultimately, greater revenue streams is for corporate customers to standardize on a single vendor. Standardization deals can be large, affording vendors significant opportunity to cross-sell and up-sell into an organization and making competitive replacements less likely.

In our opinion, the window of opportunity we see for Cognos will let it continue to sign large deals and, as a result, increase licenses at a faster rate than its direct peers.

We expect Cognos to continue to benefit from the positive sales momentum behind its ReportNet product, which has helped boost the number of large deals in recent quarters. We also expect Cognos Planning to be a significant contributor to future revenue growth and large deal volumes. We see the upcoming release of Cognos 8 (expected in fall 2005) as a spark for licenses in fiscal 2007, potentially to a similar extent as ReportNet has been. We expect revenues to increase about 13% in fiscal 2006 and fiscal 2007, following 21% growth in fiscal 2005.

RISING EPS. At S&P, we forecasting Cognos' gross margins to remain flat in fiscal 2006 at about 82%, as modestly lower margins on product licenses are offset by small improvements in product support and service margins. We see services margins benefiting from lower reliance on third-party subcontractors. In our view, gross margins should widen a bit in fiscal 2007. We project expenses to rise about 12% in fiscal 2006, due to planned increases in head count. We expect growth in expenses to moderate somewhat in fiscal 2007. We look for operating margins to remain flat in fiscal 2006 and widen modestly in fiscal 2007.

We expect earnings per share to benefit somewhat from stock repurchases, in light of Cognos' growing cash and investments balance. Our EPS estimates are $1.60 for fiscal 2006 and $1.85 for fiscal 2007, up from fiscal 2005's $1.39 (excluding tax benefits).

Our S&P Core Earnings estimates are $1.48 for fiscal 2006 and $1.72 for fiscal 2007, up from $1.30 in fiscal 2005, reflecting the negative impact from stock-option expense, a common issue for technology companies. In anticipation of the adoption of accounting standard SFAS 123r, we expect the dilution from stock options to decline in fiscal 2006 and fiscal 2007, a trend we have seen at other software vendors in our research coverage.

SHORT-TERM "ISSUES"? The differential between Cognos' S&P Core and as-reported EPS is at the lower end of the range for software companies in our coverage universe. Therefore, we regard the quality of earnings to be above average relative to peers.

The shares have been somewhat weak since Cognos uncharacteristically pre-announced first-quarter fiscal 2006 results that were just shy of our revenue and EPS forecasts as well as Street estimates. While it attributed the miss largely to "sales execution issues," upon further examination and conversations with the company, we believe that a number of these issues are likely to be short term in nature and fixable.

The shares trade at a discount to peers on a relative basis according to price-to-earnings and p-e-to-growth (PEG) analysis. We believe this reflects investors' concerns regarding Cognos' second-quarter (ending in August) results. Over the longer term, however, we expect the shares to trade at a premium to peers due to what we see as the company's superior execution over the past 15 quarters (excluding the most recent quarter) and our expectation that it will compare favorably to peers in competition for standardization deals.

GOOD GOVERNANCE. Our 12-month target price of $48 is derived by applying a p-e multiple of 26 times to our fiscal 2007 EPS estimate of $1.85, near the high end of the historical range for the shares of 16.3 to 27.5 times. Our target price is supported by our analysis of discounted cash flows.

We view favorably Cognos' corporate governance practices, which we believe are conservative in many respects. In our opinion, its board of directors is sufficiently independent, as it is controlled by a super-majority of outsiders. The nominating and compensation committees are both made up of solely outside directors.

The board is elected annually, and its guidelines are publicly available. We note with some concern, however, that shareholders do not have cumulative voting rights for directors and that there's no disclosure of term limits for directors. Although Cognos has no poison pill in place, it is based in Canada, which has anti-takeover provisions.

BIG RIVALS MOVING IN? We believe our recommendation and target price have several risks. The positive sales growth rates, healthy margins, favorable pricing, and attractive deal pipelines reported by business intelligence software vendors have attracted the attention of larger software vendors. Oracle (ORCL

: Buy; $13) has built additional BI capabilities into its Oracle 10g release, and Microsoft (MSFT

: Strong Buy; $27) has enhanced the reporting functionalities of its SQL server, just to name a few.

Other competitors for whom we believe BI would be a natural complement to their existing product offerings include Siebel Systems (SEBL

: Sell, $8), which is attempting to decouple sales of its existing analytics businesses from its slowing CRM product, and SAP (SAP

: Buy, $42), which has seen strong growth for its data warehouse products.

These vendors have considerably greater product development and marketing resources and large installed bases. We consider the potential for future competition from these players to be a key risk for a BI/CPM pure play, like Cognos, although we note that the independence and "data agnosticism" of the pure-play vendors is widely considered by industry analysts to be an advantage over the larger software vendors mentioned above. Nevertheless, we recognize the significant potential threat of the larger application vendors, particularly within their respective installed bases, at least initially.

LESS OF AN EDGE? We also expect heightened competition from direct peers, as the gap between the product offerings has narrowed over the past few months, particularly among top-tier vendors such as Cognos, Hyperion Solutions, and Business Objects. For a time, Cognos also benefited from the distractions created by Business Objects' sizable $1.2 billion acquisition of Crystal Decisions and Hyperion's acquisition of Brio. However, these integrations have since been completed.

In addition, while we believe Cognos 8 will offer a competitive advantage due to its updated architecture and better integration across Cognos' BI/CPM portfolio, we expect to see ongoing investments in product development from peers and upcoming new product releases (such as Business Objects XII, expected in the fourth quarter and Avalanche from Hyperion, expected in fall 2005) to trim Cognos' advantage somewhat.

Other risks include potential foreign exchange headwinds and the potential for pricing compression, which we see as likely with the competitive environment heating up.

Analyst Bokhari follows shares of enterprise software companies for Standard & Poor's Equity Research Service

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