The Math On Software Maintenance Revenues

I noted previously that maintenance software revenues are supporting software profits and valuations, a view shared by JPMorgan analyst John Difucci. In his last published report, he walked though the math on how software maintenance revenues supports that thesis.

Again, I thought his report was excellent and well thought out and his graph and write up brings home the point as to why I believe that software stocks are one of the best investment tech sectors next to Internet stocks.

Here is a snapshot of his view:

"The power of the typical perpetual software model can be demonstrated with an example. In Table 2, we look at a typical enterprise software company, with about $200 million in total revenue in 2008, of which 50% is license and 50% is maintenance. Ignore any professional services at this point for simplicity’s sake.

Note that professional services have lower margins than maintenance and are likely driven by previous license sales. Professional services may provide a lagging component of the software segment, but from an accounting perspective, they often have little impact on the change in the bottom lines (and sometimes even the top lines) of most software companies. In addition, we provide a spreadsheet for investors to examine this model on the Morgan Markets website.

That said, consider the following development of our example:

• Dramatic license decline of 25% in 2009, then less declines for a couple of years before some growth returns.

• Normalized maintenance renewal rates of 95%, which decline to 90% in 2009, slightly improving to 92% in 2010, before returning to normalized rates thereafter.

• Initial average pricing pressure of 3% on maintenance starting in 2009 and lasting for a couple of years, before declining to 2% pricing pressure, and then is eliminated.

• Maintenance Margins of 85%

• License Margins fluctuate based on License Sales



Even for the above scenario, after license declines in three consecutive years (the first of which it declines by 25%), coupled with pricing pressure and reduced renewal rates, maintenance still never declines. In addition, since the overwhelming majority of profit is derived from maintenance revenue (not license revenue), total profit only declines in 2009, and increases every other year.

Note that in this example, we assumed license came in evenly throughout the year (which is typically not the case, it’s usually back end loaded). Given the ratable recognition of maintenance, only half of the annual maintenance signed is recognized in the year it is signed, with the remainder recognized in the subsequent year."