February 9, 2000

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Heard in New England:
The Bullet Train Carrying Sapient
May Just Have Jumped the Track
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By Andrew Caffrey

Has Sapient lost the Big Mo'?

The Cambridge, Mass., computer consultant is feeling the downside of being a momentum stock. After rising a colossal 417% for 1999 on the strength of its Internet business, Sapient's shares have fallen recently, dropping 35% since Jan. 21 to $89.375. Despite a slight recovery these past few days, some investors and analysts are wondering whether Sapient will drop yet again. They say the year-end earnings report that prompted the decline includes some worrisome indicators for the months ahead.

What was so bad about the report? At first glance, not much. Revenue for the fourth quarter was up 52%, more than what Wall Street analysts were expecting. And whereas many of its competitors don't make money, Sapient posted a pro forma 16-cent-a-share profit, 60% above the prior year's period.

But in the turbo-charged technology market, investors had set the bar even higher for Sapient. In several previous quarters, Sapient had exceeded Wall Street's consensus earnings estimates; this time, though, the 16-cent profit was in line with analysts' predictions.

"The company got crunched because it only met earnings estimates," says Robert Zuccaro, manager of the Grand Prix mutual fund, based in Wilton, Conn. Mr. Zuccaro says he "dodged that bullet" by selling the fund's entire position in Sapient -- 157,000 shares -- at $125, "before it collapsed. We sensed it was breaking down."

Mr. Zuccaro, who follows a momentum style of investing -- buying stocks as they move up and selling them as they are moving down -- says he thinks the hit on the stock was overdone. But he and others are troubled by some wobbly numbers in Sapient's earnings report -- numbers that some analysts say suggest that Sapient's hyperkinetic growth may be slowing.

Both gross margins and operating margins declined for the fourth quarter, even though Sapient's revenue grew at a faster-than-expected rate. The 16.9% operating margin, in particular, was well below the 18% to 19% analysts were expecting. "Margins clearly are getting squeezed a little," Mr. Zuccaro frets.

The concern is that Sapient may soon have trouble increasing profits as fast as its revenue. As the company grows and takes on ever larger and more-complicated computer assignments, it has to hire more seasoned -- and expensive -- programmers and consultants. The higher personnel costs, and administrative expenses associated with running a larger company, eat into margins.

"In the best businesses, revenue increases cause an increase in operating margins because the bulk of expenses are fixed," says Robert Green, a technology analyst in Lincoln, Mass., with the online financial service Briefing.com. Not so with Sapient, Mr. Green says.

Even with the tight labor market for the consultants Sapient seeks to hire, Sapient tries to keep its employees' voluntary turnover ratio to 15% a quarter. But in the 1999 third quarter, the ratio spiked up to 19%; Sapient blamed integration issues relating to two companies it acquired. In the fourth quarter, Sapient successfully lowered the turnover ratio, but at 16% it's still higher than the company would like.

Mr. Green says there is another troubling indicator in Sapient's fourth-quarter performance: After posting higher rates of sequential revenue growth for three quarters, Sapient saw its growth rate decline slightly in the latest period.

And a new potential threat looms on the horizon: competitive pressure from giant Andersen Consulting. The consulting firm today will announce a new initiative to more aggressively pursue Web start-ups by opening 17 centers world-wide, including one in Boston. Andersen says it will offer technical services, management consulting and corporate networking to help these start-ups get off the ground fast.

Sapient officials say the concerns about its business are overblown and that some of the weaker-than-expected finances were driven by factors that don't reflect poorly on the market for its services.

For example, the company had a higher-than-expected share count for the fourth quarter because the company's high stock price brought more stock options into the mix. That reduced the calculation of per-share earnings by about a penny and made the difference between meeting and beating Wall Street's earnings estimate.

And one reason for the lower margins is that Sapient more than doubled the amount it reserves to cover bad debts, to $1.3 million. Sapient says this was a fiscally prudent move because now as much as 15% of its clients are "dot-com" starts-ups that are at greater risk of not paying.

As for the thornier issue of rising personnel costs, Sapient co-Chief Executive Jerry Greenberg says the demand for Internet-based computer services is so intense that, "we'll be raising our prices as we go along." Because Sapient is one of the leading consultants in this market, Mr. Greenberg says clients should expect to pay a premium for its services, enough to cover the higher personnel costs and keep margins from deteriorating. He adds that new entrants to Sapient's sector -- such as Andersen -- only validate the amount of new business available for all the players.

Mr. Greenberg says Sapient expects to continue seeing strong revenue growth in 2000. "The fundamentals of our business are outstanding," he says, adding, "We'll let the stock price follow the business."

With $276 million in annual revenue and 2,100 employees, Sapient is among the largest of the consultants that focus on Internet services. At that size, its growth rates are naturally slowing, and in Internet time, the nine-year-old Sapient is among the senior set of its industry.

But Mr. Greenberg and his partner, co-Chief Executive J. Stuart Moore, have won praise for stepping back and filling Sapient's upper management ranks with seasoned executives. What's more, Sapient's leaders are deliberating trying to control its rate of growth in order to keep the company from getting too unwieldy.

All of this may be good for its business operations, but it also gives Sapient the look of a maturing company, says Mr. Green, the Briefing.com analyst. And in this stock market, he contends, maturing companies don't sustain the kind of high valuations Sapient has now. Even with the recent clocking, Sapient shares are still trading at a pricey 115 times expected year 2000 earnings of 78 cents a share.

Indeed, even Sapient supporters worry about the stock stalling. Karl Keirstead, an analyst at Lehman Brothers in New York, frets about Sapient's "slower growth profile" and, in a recent research note, wrote, "Sapient is unwilling to really accelerate its growth curve, and upside surprises and guidance revisions are modest."

The lack of a catalyst is why Mr. Zuccaro, the Grand Prix fund manager, thinks buying the stock now is risky. The current market demands that "you've got to have a major surprise" coming, and he doesn't see one. "In a very strong technology environment," he adds, Sapient is "just not doing it."

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