If you've stumbled into my blogspace, chances are you're already familiar with Bill Burnham and his informative blog: Burnham's Beat.
In a recent post, Bill outlines the Ten Early Warnings Signs A Software Stock Is In Trouble:
I'll encourage you to visit Bill's site directly for the full write up (if you haven't already), but here are his ten main points:
- It capitalizes software development expenses
- DSOs are greater than 95 days
- License revenue account for less than 1/2 of overall revenues and are declining
- It reports more than 30 days after the end of the quarter
- EBITDA margins are less than 10%
- It does not provide a cash flow statement when it announces earnings
- It misses ship dates
- Its deferred revenues are declining
- The head of sales and marketing leaves
- Competitors miss their forecasts
- Capitalized software -- There's no question that cap software is a no-no. But as Bill points out, very few public software companies engage this practice any longer for good reason. So, to me, this isn't an early warning sign as much as a sign to steer clear from the start.
- DSOs > 95 days -- Personally, I grow concerned by the trend of increasing DSOs, regardless of the nominal value. Be wary of companies who play the "well within internal targets" card...
- License revenues < 1/2 total revenues & declining -- The second point (beware of declining license revenues) is spot on but not generally an early warning sign in my experience. If license revenues are declining, chances are the stock is already heading lower. As to the first point, as the enterprise software market matures, more companies are growing their maintenance and services bases and building a sustainable business that way (Oracle is practically banking on the idea of using its acquired maintenance to create a utility-like business model), so I'm not sure this litmus test holds as much water as it used to.
- Reports more than 30 days after the quarter -- I would contend this is an issue for any company, regardless of industry. That said, currently I think we as public investors need to give some leeway on this matter as companies wrestle with getting their internal controls in Sarbox compliance.
- EBITDA margins < 10% -- I couldn't agree more. One of the more frustrating aspects of being a software investor is the industry's consistent lack of margin leverage. How many industry's have 90%+ gross margins as a rule yet struggle to lever up even in the maturing phase of a cycle?
- Failure to provide a cash flow statement -- I've been involved in the software sector for a decade and, in my experience, far more companies report WITHOUT a cash flow statement than WITH. While I agree with Bill that providing one is a plus, I'm not sure it's a deal breaker or "warning sign" per se if they don't. However, If a company has a history of providing one and then alters that policy unexpectedly, take heed.
- Missed ship dates -- This speaks to a broader issue of managing Street expectations. Getting a release to gold is never easy, and interim releases (e.g., Version 2.x) are commonplace, so I would rather a company I was involved with get it right rather than meeting an arbitrary date. Companies need to provide the Street with a window of time (e.g., "Version 2.0 will be released in the second half of fiscal 2005) whenever possible and, if they DO miss a release date, be as open and forthright with partners, clients and the investor base as possible.
- Deferred revenues are declining -- For most public software companies, the deferred revenue line is primarily comprised of maintenance and support, and seasonality plays a huge role in this metric. I prefer to model TTM (trailing 12 months) trends on this front, and agree with Bill that directionally you want this growing. For those companies who utilize subscription pricing, deferred revenues can be a more direct viewpoint into bookings. In that case, any delta in the magnitude of bookings is concerning. More often than not, the time to get out of the way of subscription-oriented stocks is when the rate of bookings growth slows (which happens BEFORE we see absolute declines).
- The head of sales and marketing leaves -- The next software stock I own that outperforms immediately after the head of sales leaves (or is fired) will be the first. I would also extend this idea to any senior management position of influence (i.e., CEO, COO, CFO)
- Competitors miss their forecasts -- I'm not so sure about this one. You can't throw the baby out with the bathwater. You have to consider the relative position of the companies in question. If a perennial 3rd tier "me too" vendor has a rough quarter, you can't extrapolate much from that data point. Nearly every ERP company has missed expectations several times over the last two years, yet avoiding SAP as a result would've been a mistake.
And if I may, I would like to add two more warning signs from my own experiences:
- Changing disclosures -- Most public companies (and all worth the paper their stock certificates are printed on) carefully vet every single word in earnings press releases. Corporate counsel, the PR department, the CEO and CFO/Comptroller all have looked over the release in great detail. Remember that as you read through a release and compare it to prior company releases. Has the company removed certain language from its disclosures? Have they drawn your attention to new (or different) metrics? That's not by mistake folks, at the very least follow up with the company to hear the rationale.
- Backend loading full year guidance -- This is not limited to software companies, but they are guilty of it nonetheless. For example, 2nd quarter revenues and EPS come in slightly shy of estimates, yet management "maintains" full year guidance by backloading the "missed" sales into Q4. Rarely if ever a good sign.
By all means, I would love to hear other thoughts on the concept of early warning signs and perhaps some real life experiences as to when these warning signs worked in your favor (or could have worked in your favor if only you had heeded them.)