PeopleSoft Gaining Momentum but at What Cost?

Software shop PeopleSoft PSFT has delayed closing its acquisition of Momentum Business Applications MMTM for about a week, but even in the final days of its existence, the spinoff continues to generate controversy.

The acquisition, now slated to close April 9, will end an era in which PeopleSoft has been dogged by questions about Momentum's effect on its financials.

PeopleSoft created Momentum in 1998 and seeded it with $250 million. Under the arrangement, Momentum pays PeopleSoft to do research for it. PeopleSoft then licenses the resulting products from Momentum and pays a small royalty on the products it sells.

Fueled by the fact Momentum has only one employee, critics have charged that the spinoff allowed PeopleSoft to offload research and development costs and inflate earnings.

PeopleSoft had expected to buy back Momentum for $90 million in cash by March 31. Ron Codd, CEO of Momentum and former CFO of PeopleSoft, said in a recent interview that the Securities and Exchange Commission told PeopleSoft attorneys it would have minor comments on its forms covering the acquisition. "That is the only thing preventing this thing from closing at this point," Codd said.

PeopleSoft spokesman Steve Swasey added that those were nonmaterial editorial comments and PeopleSoft made some changes to address them.

While the acquisition date approaches, however, questions continue swirling over Momentum and PeopleSoft, which earlier this week reported its software licenses would come up about $30 million short in the first quarter. The miss seemed to vindicate PeopleSoft detractors who had been saying the acquisition of Momentum, combined with declining deferred revenue, will set the company up for disappointment this year.

PeopleSoft shares have lost about one-third of their value since the beginning of the week. Shares fell 59 cents, or 2.3%, to close at $25.17. Shares rose a penny in after-hours trading.

"I think the interesting thing about the preannouncement the other day is it really laid to rest two myths that have been perpetuated by the bulls on PeopleSoft," said Nathan Schneiderman, an analyst with Wedbush Morgan Securities, who rates PeopleSoft hold. "One of those myths is that PeopleSoft's accounting doesn't matter because it was disclosed, and the second myth is PeopleSoft in 2002 is going to suddenly benefit from robust cross-selling from PeopleSoft 8." PeopleSoft 8 is the firm's latest Web-based version of its enterprise software, released in the fourth quarter of 2000.

Schneiderman's firm hasn't done any business with PeopleSoft.

Momentum Pushed Earnings

Detractors, including Schneiderman as well as Boca Raton, Fla.-based Avalon Research Group, figure Momentum allowed PeopleSoft to overstate pro forma earnings in 2001 by 19 cents a share. The consensus estimate for PeopleSoft earnings in 2002 is for earnings of 67 cents a share, according to Thomson Financial/First Call.

That's only a 14% jump from the earnings reported by PeopleSoft in 2001. But compared with 2001 earnings without Momentum's payments, the bar is raised considerably, to a 68% increase in earnings. Given the size of that jump, PeopleSoft critics have been predicting the company would start missing estimates after it brought Momentum back into its fold.

Changes in the way PeopleSoft writes contracts with customers also overstated earnings, Schneiderman and others say. Schneiderman says PeopleSoft swept deferred revenue from its balance sheet onto the top line of its income statement, overstating earnings by about 3 cents a quarter since the first quarter of 2000.

Deferred revenue fell to only $16.7 million at the end of the fourth quarter of 2001. So PeopleSoft no longer had much there to shift over to its top line in the first quarter, which led many to expect the miss.

In a note released Friday, Schneiderman raised yet another question about PeopleSoft and Momentum. He wondered whether PeopleSoft Chairman and former CEO David Duffield's ownership in Momentum increased because the filing this week showed his shares at 302,669, or 6.3% of outstanding shares. A filing last year indicated he owned less than 5% of outstanding shares.

But PeopleSoft's Swasey said Duffield's ownership in Momentum has remained at 4.9%. To be on the conservative side, PeopleSoft merely decided in its latest filing to add about 70,000 shares owned by an animal rights foundation called Maddie's Group, which is affiliated with Duffield, Swasey said.

Either way, Duffield stands to enjoy a modest windfall from the acquisition, drawing attention from some short-sellers. Including a $1.85-per-share dividend paid by Momentum this year, Duffield stands to gain $4.8 million. Codd, who owned 134,398 shares as of July 18, will receive $2.8 million, including the dividend.

That windfall has gone up since July, when PeopleSoft and Momentum agreed to raise the purchase price from $75 million to $90 million. Executives said they increased the price as part of a larger deal that also lowered the short-term royalty payment PeopleSoft would have to pay Momentum, and raised long-term rates if PeopleSoft didn't exercise its option to buy back Momentum.

Codd, who estimated he spent 20 hours a week on Momentum, said the venture turned out to be a "way to make an elegant exit from PeopleSoft." Codd said he probably would not work for PeopleSoft after it acquires Momentum.

But given all the lingering controversy, would he do it again? "I wouldn't recommend this transaction in the current environment simply because of the concerns over special purpose entities," he said. "It's one of these things that is out of style right now."