Kerchunker profile: ServiceSource transitions to the cloud

Last week, I attended the Northland Growth Conference in NYC. It was an exciting day spent with some of the fastest growing SaaS (software as a service) companies in America. One of the intriguing meetings was when I sat down with ServiceSource (SREV) International's CEO Mike Smerklo and CFO Ashley Johnson. In the past two years, ServiceSource has unbundled its service offering and essentially built its own startup SaaS company on the fly. It's been no easy task from a business perspective but it was the best decision for its long term growth prospects.

IPO and Transition

When the company went public in 2011, it was a managed services provider in service revenue management, providing solutions that drive increased renewals of maintenance, support and subscription agreements. Customers would outsource the renewals of contracts to ServiceSource. This was a bundled service that included software and associated services, and the company was paid based on performance. In less than 10 years, Smerklo build the company from startup to a $200+ million revenue business. This legacy business is consistently profitable but also people intensive.

The technology space is changing at breakneck speed. Cloud adoption has been widely accepted and businesses have been shifting to recurring revenue models. This plays right into the strengths of ServiceSource who has over 12 years of leadership and experience in using data analytics to increase renewal rates and increased productivity. In recent years, clients began asking for an unbundled software solution. Smerklo made the tough decision to offer a cloud-based product called Renew OnDemand. In the short term, investment into this new startup offering has hurt margins and ServiceSource is expected to post a loss of 7 cents in 2014 as per street estimates. This would be their first loss since going public.

ServiceSource currently manages $14.5 billion in recurring revenue for the world's largest and most respected technology and B2B companies. This is just the tip of the iceberg. The company views the total addressable market as a $310 billion market opportunity and $115 billion within their installed base. Recent deals with Aria and Accenture should help bolster the sales efforts of the ServiceSource offering.

Insider Buying

While insider activity doesn't always tell the whole story, it is encouraging to see CEO Mike Smerklo investing more of his own money in SREV stock over the past year. In 2013, Smerklo purchased over 88 thousand shares at an average cost of 7.34.

Complicated Valuation

Because ServiceSource is still largely a managed services play with a cloud startup, investors may be confused at how to value this entity. So far the stock market has taken a wait and see approach on its transition to a cloud company. The stock price has largely followed its revenue growth as it decelerated in 2012 and bottom out in the first quarter of 2013. As revenue growth has accelerated, the stock has bounced off the lows.

While it will take time for the cloud sales to scale for ServiceSource, they are growing at a very fast rate. JMP Securities analyst Patrick Walravens forecasts $12 million in sales for 2013, $38 million in 2014 and $74 million in 2015. A slide from last year's analyst day shows the potential positive impact of Renew OnDemand on sales growth and margin expansion.

The stock is currently covered by 6 sell side analysts: 2 strong buys, 3 buys and 1 hold. The mean price target is $12.88 or 53% upside from today's price of $8.40. Pure play SaaS providers are trading at lofty multiples. Workday (WDAY), a ServiceSource customer, trades at 18x price to sales. Cornerstone OnDemand (CSOD) trades at 16x. Concur (CNQR) trades at 10x. Using the JMP estimate for 2015, ServiceSource is trading at 9x price to SaaS sales which means you are getting the profitable managed service business for free. There is a lot of room to unlock value over time with ServiceSource. Eventually, management may need to spin out the fast growing SaaS business. Not only to get proper value for the asset but also to keep their top talent in place. This is an interesting Kerchunker growth company to watch over the next few quarters to see how their Renew OnDemand efforts are progressing.

Are you a ServiceSource investor? What do you think the future holds?

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