TORONTO SOCIETY OF FINANCIAL ANALYSTS

AN UPDATE ON OCTOBER 4, 1972

The computer communications industry continues to intrigue investors and the public because of its aura of science fiction, its explosive growth potential, its spectacular advances and its equally massive failures. The computer systems that put men on the moon have also nearly put huge corporations like RCA out of business.

I would like today to talk about a particular segment of this industry that will be particularly important to Canada and hope that in doing so I can help you find a basis for analyzing this industry.

First, let me define the particular part of the industry I will be discussing.

The Canadian Computer Communications Task Force, in its recently released report, described the industry as consisting of ‘those organizations which manufacture or supply computer or computer-related communications goods and services.’ Clearly the computer services industry is a subset of this broad field, i.e., that part of the industry which is not directly involved with the manufacturing of computers or the provision of data communication services. This still leaves two large areas to be filled by Service Suppliers and Other Product Suppliers.

It is these latter two areas which I will be discussing. The CCCTF estimated that in 1970-71 the Service Suppliers’ portion of the industry had gross revenues of $133,000,000 and the Other Product Suppliers segment had revenues of $80,000,000.

After eliminating inter-segment trade, the estimated total revenues in Canada directly attributable to computer/communications was about $560,000,000. To this should be added user salaries and wages of about $380,000,000 for those directly involved in other industries making use of computers and related communications. This total of $940,000,000 makes the computer communications industry one of the larger industries in Canada. However, of far more significance is the expected growth rate which should create an industry of $4-billion by 1980. This is an overall industry compound growth rate of 15.6% and a rise in terms of economic output from about 1% of the gross national product in 1970-71 to 2% in 1980.

Of particular significance for the particular segment of the industry I want to discuss is the fact that the Service Suppliers’ part of the industry is expected to increase by 16.7% and the Other Products segment by 16.2% compound growth rate. There are many reasons for this substantial predicted growth rate. However, the basic reason is that the computer/ communications industry is fundamental to increasing the productivity of other industries. The only thing that could really alter the growth rate would be a substantial change in the desire of other industries to increase their own productivity.

How do you Analyze Such a Growth Industry? It is easy to be oversold on companies operating in such a growth industry as I am sure every investment analyst is keenly aware. The glamour of the industry in the late 60’s led to rash predictions by both the industry and the analysts and this was justifiably followed in the early 70’s by an overly cautious approach by both groups. I hope the time has now arrived when we can look at the industry whose growth potential remains undiminished in a more rational manner. All analysts will have their own headings under which to analyze an industry and the companies within it but I will make some comments under headings which I am sure will appear on everyone’s list of essential things to consider. These would be:

–  A general consideration of the market for all companies.

–  For each company, a consideration of:

–  how aggressively they approach the market,

–  the cash flow to enable them to sustain growth,

–  the management capability,

–  the profit potential.

One should also consider what restraints might prevent the company from developing such as:

–  legislative restraints

–  ability to get people

–  ability to finance.

Let’s look at these in turn.

THE MARKET IN CANADA

I view the market for computer-related services as almost unlimited. This may sound like a return to the rash statements of the late 60’s but if you consider that the computer services industry is essentially there to solve other people’s problems, one can assume that these problems are almost without limit. This is the viewpoint taken by SDL.

If you take the narrower approach of considering computer services as the provision of computer power, then the market is clearly more limited for it is limited to the rate at which others can solve their own problems and get them to a state where they can be put on a computer.

SDL views this as an imperfect way to approach the market for it means that we would not have control over our own rate of growth. We believe we must be in the business of providing total solutions for customers and provide computer power wherever appropriate in this process.

As the EDP Industry Report of September 15, 1972 notes “computer services is the sector that blends the computer industry into almost every aspect of business, and it’s where the action is.” This same report goes on to say that “companies stressing service have a better prognosis than those stressing computer.” This does not mean that SDL views the market for providing computer power over a communications network as being any less exciting than it was. In fact, industry reports indicate that the remote batch business can probably be expected to increase at a rate of about 40% per year over the next several years.

However, we believe that the market is better approached if one can take control of the whole problem in an application area rather than just providing a more efficient way of processing. If one writes programs and takes responsibility for running these to provide results, customer loyalty will continue to be very high and the whole approach will be far less price sensitive.

In a word, SDL believes that the market is vastly increased if one’s product is increased effectiveness rather than just increased efficiency.

The CCCTF described the market as a triangle and pointed out that those companies providing only remote batch services tend to appeal to the tip of this triangle only, i.e., those companies who are already sophisticated in the use of computers. By providing a sophisticated combination of systems analysis, programming services and computer power, a company should be able to approach much further down the triangle into medium-size businesses and ultimately into very small businesses where such organizations have all the problems of large businesses but obviously cannot afford the technical staff to provide effective solutions.

THE INTERNATIONAL MARKET

The market for providing raw computer power in the United States is very competitive. SDL believes that by providing a total solution approach we can offer a service in the United States that can compete very effectively. Competing companies in the United States can buy equipment as large as that owned by SDL but cannot buy people whose talents are any better than those of Canadians operating in the field.

We also believe that the concept of how to run a computer centre as well as SDL’s increased industry and problem solving knowledge are very exportable products.

It is for these reasons that SDL established SDL International to handle the marketing of our services in the United States and possibly elsewhere.

THE SDL VIEW of the MARKET

In general, then, SDL views the market which it could go after as being all segments of the Service Supplier area, Other Product Suppliers and the area covered by user salaries and wages. In 1980, these areas are estimated to be:

Service Suppliers $ 513,000,000

Other Product Suppliers 356,000,000

User Salaries and Wages 1,475,000,000

This could mean a potential market of over $2.3-billion dollars in Canada alone in 1980 even assuming that SDL makes no moves in the data communications area or in the area of hardware manufacturing itself. Added to this potential would be markets in other countries.

This does not mean that SDL presently has service offerings in all of the areas shown in the attached Appendix but it does mean that it is the corporate intent to cover as much of this within the computer/communications field as can be handled on a profitable and manageable basis.

SDL’s approach will be to aggressively expand over the next decade to be a broadly diversified Canadian-owned company operating within the computer/communications field.

F.G. Withington of Arthur D. Little, Inc, when addressing the 1971 Annual Conference of the Association of Computing Machinery, suggested that in the data processing industry “opportunities will be many and so will failures, but – one thing for sure – any competitor who tries to remain within one of the traditional subdivisions of the computer industry, however, large, will be lucky if he is around in 25 years.”

As people’s problems change, so must SDL’s ability to respond for we fully intend to be around in 25 years.

THE SDL APPROACH

SDL started in the computer communications field by providing computer time on a remote batch basis over a communications network. We now have what we believe to be the largest and fastest computer in Canada, the largest network of high-speed data communications terminals, the largest revenue of any Canadian-owned computer service company and the largest staff. Our growth rate in revenue during our first three years of operation has been:

1969-70 $1.4-million

1970-71 $4.0-million

1971-72 $5.8-million

The cashflow from this operation has increased to the point where we can now invest in a diversification program to cover the areas of the market noted above. However, I wanted to emphasize that this diversification into other high leverage areas does not imply any lessening commitment to our original product. SDL is committed to a program of expanding our capability in new areas of providing computer time. This will include an expansion in the ways in which this computer time can be accessed through other types of terminals and will certainly include an expansion of our capability in the Virtual Memory system area. Fortunately, we are in a good position to take advantage of the new technology while keeping incremental costs to a minimum. Having already bought the largest System/360 /370 compatible machine in Canada, which itself has ample capacity still available, we need only front-end this machine with a Virtual Memory machine at a small incremental cost. This machine, which will be a System/370 Model 145 will be added sometime next year and it will be used by our Systems Support Group to develop proprietary techniques for effectively using this new capability as we have done with earlier products. The Virtual Memory capability will then be gradually expanded as we require more capacity. .

RECENT SDL MOVES

Two of the points I originally suggested that analysts would be interested in would be the aggressiveness of the approach to the market and the cashflow. I have already indicated

that SDL will push into any area of the computer/communications industry where profit potential appears high. I have also pointed out that our cash from our original product, even at breakeven operation, would be accumulating at over $120,000 a month and we must find good ways of investing this cash to get a high leverage, SDL management has therefore decided to invest some of this cashflow as well as some shares in the parent company in two recent acquisitions. The first of these was Softwarehouse Limited, This Canadian organization had 23 people when it joined SDL. It has nearly doubled in size and is now operating in Toronto and Montreal as well as from its original base in Ottawa. Softwarehouse is helping SDL move toward a total systems approach by providing industry expertise in a variety of business-oriented application areas. SDL now has the capability of analyzing a problem, creating a computer-based solution and providing results on a continuing basis for almost any size of business.

As well as concentrating on the information needs of business SDL wanted to get involved in the major application areas which Volume 2 of the CCCTF Report indicated would be the significant growth areas in Canada and elsewhere over the next decades. These are the automation of payments and credits, applications in education and applications connected with Canada’s health care delivery system. SDL already had considerable industry expertise in the areas of bank automation. The Canadian company with the greatest depth of application knowledge by far in the latter two fields is the Systems Research Group. This Toronto-based organization of about 65 people applies sophisticated analytical techniques to arrive at computer-based solutions in the areas of education, health care, urban development, environmental control and other fields of social concern. SRG operates extensively in the United States as well as in Canada.

Both Softwarehouse and SRG have well-established records of profitable operation and will contribute not only to the profitability of the parent company but have the desired effect of expanding the range of SDL services to new application specialities.

These companies also add to SDL additional marketing and management potential.

During our last fiscal year, SDL established a wholly-owned subsidiary in the computer consulting field called Systemplan Limited. This subsidiary uses our expertise in the management of computing centres and the very important systems support techniques we have developed to advise other companies on ways of improving their own efficiency. This can be done either by Systemplan alone or in conjunction with a major management consulting firm. The overhead on this operation is kept low and the advice given the customers of high quality by making use of talent from many areas of SDL loaned to Systemplan for a specific proposal. This ensures that those involved in consulting through SDL are as current as possible in the techniques on which they are consulting.

SDL also stays alert to other profit-making possibilities in the management services area should we decide that the correct solution for a client would be facilities management or some other approach. It can be seen from the above that some of our expansion is by acquisition where we believe we need new areas of industry knowledge and some by development from within. Either kind of expansion must be handled with care. We must be very sure that the areas into which we are expanding will have a synergistic effect with our present business and will themselves be profitable operations. We are also paying particular attention to the financial and legal control that must be provided across all these operations. These functions along with the overall corporate planning function are, at the moment, receiving particular attention from an organizational standpoint. I mentioned earlier that a company expanding as rapidly as SDL must pay particular attention to management development. We believe we are taking the right steps in this important area by making extensive use of AMA training courses and by periodically checking our own thoughts on organization and control through the use of outside management consultants.

THE PROFIT POTENTIAL

Having outlined the general philosophy of SDL and the attention we are paying to managing this, I should now address the point I mentioned that would be of key interest to an analyst – profitability. It is one thing to become profitable, but another to sustain profitability. As you know, SDL started operating profitably 25 years after its inception and I am pleased to report that we have just completed our third consecutive profitable quarter since then. We expect that our sales for our fourth operating year ending June 30, 1973 should be in the area of $9,000,000 including the prorated contribution of our most recent acquisition. This is an increase from the $5.8 million in the year just completed.

I remain very cautious about making projections in a field as fast moving as the computer/communications industry. However, as our acquisition of SRG is on an earn-out basis and may, therefore, be somewhat more complicated for the analyst to assess, I did make the prediction the other day that our earnings per share for this fiscal year before tax and before debenture conversion would be about 80 cents. I cautioned at that time that SRG would certainly incur a tax liability although SDL itself would not be taxable in this year. This is a turnaround in one year from our loss of 26 cents last year.

This indicates there is a high leverage in our original product line to which we have added the effect of our two new already profitable acquisitions. I am optimistic that we are in a very sound position with our broadened approach to the marketplace to maintain a steady growth rate and believe that we are making the right moves to enable us to approach this huge market.

WHAT CONSTRAINTS COULD THERE BE?

Finally, I mentioned that analysts would want to consider any possible constraints that might dampen the expansion rate predicted by the CCCTF. Naturally, one must consider moves by competitors. A market as large as the one discussed will obviously attract a number of firms into the field. However, the very size of the market means that there should be more than enough room for many large firms. It is interesting that the organizations now in the field are somewhat different from those that started out. Some of the originals such as Computel remain but many of the new entrants are from outside the computer industry. We expected an impact from these companies and I am sure will feel some pinch in some areas for these companies can sustain large losses over a long period of time if they choose to do so. However, as we broaden our own approach, we find that we are really approaching a market in which size is not necessarily an advantage but industry know-how certainly is. I believe the market is amply large enough to allow healthy competition and profitable operation by a number of firms in the field.

A second possibility would be that legal constraints might be put on our industry. This concern has fortunately now been cleared away. The CCCTF report specifically recommended that the computer services industry remain unregulated. The Task Force went on to say that no restrictions should be imposed on the entry of any organizations into this business unless such entry would lead to unfair competitive practices. We believe that this concept is fair and we applaud the CCCTF Report for going on to note that for this reason some restrictions should be placed on common carriers, banks and universities should they choose to operate in the commercial computer services field. Another de facto constraint on the field could be IBM. No industry of any size is so dominated by one company as is the computer industry in general. However, in the United States it is interesting to note that IBM accounts for only 5% of the computer services industry. This percentage is higher in Canada but this does indicate that IBM does not have the dominance in the service field that it has in the hardware field.

In a way, the provision of raw computer time is directly competitive to the installation of an in-house computer and so to some extent we are in direct competition with IBM. SDL, however, has generally taken the approach of avoiding a head-on clash with IBM, Bell Canada or other giants in the field by becoming users of their know-how and adding to this capability our own total problem-solving approach to customers’ problems. This puts SDL in a rather unique position where, by solving the customers’ problems, we are also expanding the sales of IBM, Bell Canada and others who might otherwise be head-on competitors.

The only other constraint I mentioned that would affect SDL’s ability to continue to grow at rates greater than the already impressive industry projections would be our inability to obtain enough people. We are approaching this in two ways. First, we are expanding our internal education program to allow us to hire more people directly from universities and provide the necessary supplemental training ourselves. Secondly, we are gaining very competent professionals through our acquisition program. Our staff has increased as follows:

June, 1968 – 4

June, 1969 – 65

June, 1970 – 100

June, 1971 – 167

June, 1972 – 200

Now -265

I believe that we can hire and develop staff fast enough to sustain the desired growth rate.

Finally, it would appear that we will be able to finance our growth internally and we do not anticipate having to come back to the capital market for additional financing.

SUMMARY

I believe that Canada can be very proud of its computer services industry which has come through some very difficult times with fewer casualties than in other countries. The SDL corporation is now one of the largest investor-owned companies in the computer services industry in North America and I believe we can play a significant role in Canada’s development in the years to come.

APPENDIX

Source: Report of the Canadian Computer/Communications Task Force:
Volume 1, May, 1972

SERVICE SUPPLIER

Functions

Consulting
Analyzing
Designing
Programming
Report Writing
Preparing Data
Selling
Operating
Managing
Training

Products & Services

Feasibility Studies
Models
Simulations
Hardware Tender Design
Equipment Evaluation
Equipment Selection
Systems Analysis
Systems Design
Efficiency Audits
Special Systems
Operating Systems Software
Applications Software
Communications Software
Data Preparation
Computer Power/Time
Facilities Management
Personnel Placement
Education & Training

 

OTHER PRODUCT SUPPLIERS

Functions

Research
Development
Designing
Manufacturing
Assembling
Importing
Distributing
Selling
Exporting (?)
Training
Maintaining

Products & Services

Data Cards
Data Tape
Print-Out Forms
Forms Bursters
Forms Decollators
Magnetic Tapes
Magnetic Disks
Magnetic Drums
Tape Cleaners
Miscellaneous Products
Specialized Furniture
Raised Flooring
Non-Combustible Files
Fire-Proof Vaults
Air Conditioning Equipment
Stand-by Generating Equipment
Field Maintenance

 

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