Subscription Software Is Changing the Rules

It's also one more reason why the move to subscription-based models is going to change the rules for investing in software. Because the bulk of subscription revenue first lands on the balance sheet, investors should use other metrics to value a company under that model. Analysts advise tracking bookings growth as well as cash flow, using such measures as enterprise value-to-operating or free cash flow.

Subscription Revenue Metrics
Deferred Revenue	An increase in deferred revenue typically indicates an increase in subscription sales, but investors should ask what portion of deferred revenue comes from subscriptions vs. maintenance tied to perpetual licenses.
Total Bookings	Revenue + Net Change in Deferred Revenue. This is a more accurate measure of new sales than revenue, which includes past deals still being recognized on the income statement over the lifetime of the contract.
EV/OCF	Enterprise Value (market cap + long-term debt - cash) / operating cash flow (net income + change in deferred revenue + change in working capital). Using cash flow instead of earnings more accurately tracks performance because revenue -- and consequently earnings -- are understated under a subscription model.
Sources: Merrill Lynch, DRW Research

A preference among software customers to pay as they go rather than shell out a hefty license fee upfront is partially driving more vendors to jump on the subscription bandwagon. Subscriptions also enable software companies to generate more reliable revenue at a time when their market is maturing and growth is slowing, notes Michael Sansoterra, a software analyst with The Principal Global Investors in Des Moines, Iowa.

The bad news for investors is the transitions are rarely smooth. Computer Associates (CA Quote), an early adopter of subscription-based revenue, provoked allegations that it was trying to hide slower growth amid concerns about its accounting practices and generous executive pay.

"I was following CA when they made that change and let me tell you, it was just a head-scratcher," Sansoterra recalled. One problem was that to create an apples-to-apples comparison, the company reported historical numbers as if it had been recognizing revenue as a subscription all along. That was a "nebulous calculation," Sansoterra said.

Under generally accepted accounting principles, Computer Associates posted a 53% decline in revenue in its first-quarter collecting subscriptions, ending Dec. 31, 2000, due in part to its transition to a subscription model.

"When a company moves from that perpetual to subscription [model], it really has a negative impact on the income statement and most investors freak out about it and the stock goes down," said Pat Adams, chief investment officer of Choice Funds, whose only software holding currently is Microsoft.

Mister Softee's Subscription Speed Bump

However, it's on Microsoft's balance sheet that the world's largest software vendor has endured the most damage from its move to a subscription revenue model. Collecting subscriptions helps Microsoft address the problem of customers using old versions of software for years without buying the latest upgrades. (Buying a subscription entitles them to upgrades at no additional cost.)

But recent drops of hundreds of millions of dollars in deferred revenue alarmed investors and revealed that some customers -- particularly smaller ones -- prefer to buy new software every few years or so, rather than pay Microsoft a set fee every year for upgrades they don't necessarily want or need.

In fact, the resistance of some Microsoft customers to the company's subscription model shows it won't work for everyone, said Bernstein analyst Di Bona. "Some would argue that this is the next big thing," he said. But "I don't think this is one of those earth-shattering changes."