Investors should carefully consider any change a company makes to its accounting practices. In Ariba's case, the accounting change was very aggressive, recognizing more revenue up front. The shift from perpetual licenses to term-based licenses muddies revenue predictability. Trading at 80 times next year's earnings, Ariba's slowing growth and little visibility make it a much riskier investment than before.
When procurement software vendor Ariba (Nasdaq: ARBA) reported better-than-expected first-quarter results recently, investors cheered. However, the company also announced a new accounting practice. It's important to consider the impact of any accounting change. In this case, Ariba's change was very aggressive, switching to term-license deals that recognize more revenue up front.
Everyone expected Ariba to blow away estimates. New CFO Robert Calderoni -- formerly of both IBM (NYSE: IBM) and Apple Computer (Nasdaq: AAPL) -- stated days before the announcement that the economic slowdown didn't pose a threat to the company. He cited the return on investment (ROI) of Ariba's applications. Top-line growth is slowing nevertheless, increasing sequentially 26% this quarter, compared to 67% and 100% growth in the previous two quarters.
While slowing growth raises concerns, the accounting change is more troubling. In the past, many of the company's procurement application deals were sold for large onetime fees, and then Ariba realized the revenue over a four-quarter period. Ariba is now switching to term-based contracts. That means customers will sign up for a defined period of time, usually two or three years, at a discounted price. Once the term expires, Ariba will then attempt to sign up the customer again.
In the conference call, management stated the change would benefit both Ariba and its customers. According to Ariba, lower initial costs to license the software would create a more compelling ROI proposition for customers. The company also indicated the new practice would create barriers to entry and would increase visibility. For example, high switching costs would compel customers to extend their relationship with the company. In addition, with customers re-signing every few years, Ariba would develop recurring revenue.
Why the change is troubling
The change is troubling because sales will be booked entirely in the quarter the deals are signed. That diminishes the importance of deferred revenue as a leading indicator of growth. In the past, the portion of the sale that hadn't been realized would go into the deferred revenue account on the balance sheet. Deferred revenue is a good liability because it represents revenue that has been collected before some portions of the services have been performed.
Moreover, deferred revenue is an important indication that management is not overstating its business success. On the cash side, it's important because it provides a great deal of up-front capital. That capital can lead to further investment and acquisition opportunities, an area where, in the past, Ariba stood above competitors like Commerce One (Nasdaq: CMRC). Prior to the change, investors were able to look at deferred revenue growth and get an idea of forward-looking license revenue visibility. That's no longer the case with the new accounting practice.
Despite management's assertions that term deals increase visibility, that's simply not the case. Prior to the change, Ariba knew exactly how much revenue it would begin the quarter with, given the deferred revenue account. However, now its quarters will be more back-end loaded and its sales force might be pressured into cutting deals at the last minute to meet revenue targets.
The supposed recurring revenue stream is also contingent on Ariba's ability to sign customers back up. With competition in the business-to-business market heating up, who's to say Ariba will have the most innovative applications two to three years from now? The term model should generate greater revenues over the life of the customer -- if customer renewal rates are high. Still, that's a big if, one any investor should consider carefully.
With near-term revenue recognition ramping up, one would expect Ariba's recent guidance to increase as well, but that hasn't happened. In the next quarter, the company is calling for top-line expansion of 6% to 9%.
That's not all
There are other troubling signs, with accounts receivable (A/R) increasing 94% sequentially in the quarter, compared to sales growth of 26%. It's never a good sign when a company's receivables are growing faster than sales. If receivables growth exceeds revenue growth, it's an indication that a large amount of sales haven't been paid.
The A/R line represents money owed to a company. Although typically it's turned into cash, sometimes a company is forced to write off accounts that can't be paid. That's where the allowance for doubtful accounts comes in. The allowance for bad debt is money set aside to cover the possibility of bad customers. Doubtful accounts jumped to $13.8 million by year's end (Sept. 30), compared to $30,000 a year ago. Management declined to provide a Q1 figure in the conference call.
In the past, in addition to its business prospects, one of the most compelling reasons to invest in Ariba was its conservative accounting. Microsoft (Nasdaq: MSFT) and Veritas (Nasdaq: VRTS) are other good examples of conservative accounting. The shift from perpetual licensing to term-based licensing muddies revenue predictability. If that's not enough for concern, the company has also stopped disclosing key metrics such as average selling price and the number of new customers per quarter. When I attempted to discuss these issues with the company, my calls weren't returned.
IT budgets have been slashed and businesses are growing more selective with technology initiatives, but Ariba claims to be withstanding the slowdown because its applications provide significant cost savings. At the moment, investors are taking the company's word for it, and the new accounting change makes that an even greater leap of faith. While I remain bullish on Ariba's long-term prospects, the company's growth is clearly slowing. Trading at 80 times next year's earnings, Ariba's slowing growth and little visibility make it a much riskier investment than before.
When procurement software vendor Ariba (Nasdaq: ARBA) reported better-than-expected first-quarter results recently, investors cheered. However, the company also announced a new accounting practice. It's important to consider the impact of any accounting change. In this case, Ariba's change was very aggressive, switching to term-license deals that recognize more revenue up front.
Everyone expected Ariba to blow away estimates. New CFO Robert Calderoni -- formerly of both IBM (NYSE: IBM) and Apple Computer (Nasdaq: AAPL) -- stated days before the announcement that the economic slowdown didn't pose a threat to the company. He cited the return on investment (ROI) of Ariba's applications. Top-line growth is slowing nevertheless, increasing sequentially 26% this quarter, compared to 67% and 100% growth in the previous two quarters.
While slowing growth raises concerns, the accounting change is more troubling. In the past, many of the company's procurement application deals were sold for large onetime fees, and then Ariba realized the revenue over a four-quarter period. Ariba is now switching to term-based contracts. That means customers will sign up for a defined period of time, usually two or three years, at a discounted price. Once the term expires, Ariba will then attempt to sign up the customer again.
In the conference call, management stated the change would benefit both Ariba and its customers. According to Ariba, lower initial costs to license the software would create a more compelling ROI proposition for customers. The company also indicated the new practice would create barriers to entry and would increase visibility. For example, high switching costs would compel customers to extend their relationship with the company. In addition, with customers re-signing every few years, Ariba would develop recurring revenue.
Why the change is troubling
The change is troubling because sales will be booked entirely in the quarter the deals are signed. That diminishes the importance of deferred revenue as a leading indicator of growth. In the past, the portion of the sale that hadn't been realized would go into the deferred revenue account on the balance sheet. Deferred revenue is a good liability because it represents revenue that has been collected before some portions of the services have been performed.
Moreover, deferred revenue is an important indication that management is not overstating its business success. On the cash side, it's important because it provides a great deal of up-front capital. That capital can lead to further investment and acquisition opportunities, an area where, in the past, Ariba stood above competitors like Commerce One (Nasdaq: CMRC). Prior to the change, investors were able to look at deferred revenue growth and get an idea of forward-looking license revenue visibility. That's no longer the case with the new accounting practice.
Despite management's assertions that term deals increase visibility, that's simply not the case. Prior to the change, Ariba knew exactly how much revenue it would begin the quarter with, given the deferred revenue account. However, now its quarters will be more back-end loaded and its sales force might be pressured into cutting deals at the last minute to meet revenue targets.
The supposed recurring revenue stream is also contingent on Ariba's ability to sign customers back up. With competition in the business-to-business market heating up, who's to say Ariba will have the most innovative applications two to three years from now? The term model should generate greater revenues over the life of the customer -- if customer renewal rates are high. Still, that's a big if, one any investor should consider carefully.
With near-term revenue recognition ramping up, one would expect Ariba's recent guidance to increase as well, but that hasn't happened. In the next quarter, the company is calling for top-line expansion of 6% to 9%.
That's not all
There are other troubling signs, with accounts receivable (A/R) increasing 94% sequentially in the quarter, compared to sales growth of 26%. It's never a good sign when a company's receivables are growing faster than sales. If receivables growth exceeds revenue growth, it's an indication that a large amount of sales haven't been paid.
The A/R line represents money owed to a company. Although typically it's turned into cash, sometimes a company is forced to write off accounts that can't be paid. That's where the allowance for doubtful accounts comes in. The allowance for bad debt is money set aside to cover the possibility of bad customers. Doubtful accounts jumped to $13.8 million by year's end (Sept. 30), compared to $30,000 a year ago. Management declined to provide a Q1 figure in the conference call.
In the past, in addition to its business prospects, one of the most compelling reasons to invest in Ariba was its conservative accounting. Microsoft (Nasdaq: MSFT) and Veritas (Nasdaq: VRTS) are other good examples of conservative accounting. The shift from perpetual licensing to term-based licensing muddies revenue predictability. If that's not enough for concern, the company has also stopped disclosing key metrics such as average selling price and the number of new customers per quarter. When I attempted to discuss these issues with the company, my calls weren't returned.
IT budgets have been slashed and businesses are growing more selective with technology initiatives, but Ariba claims to be withstanding the slowdown because its applications provide significant cost savings. At the moment, investors are taking the company's word for it, and the new accounting change makes that an even greater leap of faith. While I remain bullish on Ariba's long-term prospects, the company's growth is clearly slowing. Trading at 80 times next year's earnings, Ariba's slowing growth and little visibility make it a much riskier investment than before.
