Sure, B2B demand is hotter right now than Big Mouth Billy Bass. But how will investors know when the sector is about to cool? Look at the balance sheet.
Analysts and investors alike were properly wowed by the big second-quarter revenue numbers reported by business-to-business companies like
Ariba(ARBA Quote - Cramer on ARBA - Stock Picks),
Commerce One(CMRC Quote - Cramer on CMRC - Stock Picks) and
i2 Technologies(ITWO Quote - Cramer on ITWO - Stock Picks). Those companies write software programs that allow businesses to buy and sell goods over the Internet, almost like a sophisticated
eBay(EBAY Quote - Cramer on EBAY - Stock Picks).
But much less of a to-do was made over the deferred revenue that has been ballooning on these companies' balance sheets. The deferred revenue, seen in tandem with a company's accounts receivable, offers insight into demand for a company's products.
In the second quarter, Ariba's deferred revenue grew 82% to $153.7 million, Commerce One's grew 35% to $62.3 million and i2 Technologies' grew 15% to $157.1 million.
B2B Unhatched
Realized vs. Deferred Dollars |
 | 2Q Revenue | 2Q Deferred Revenue |
| Ariba | $80.7 million | $153.7 million |
| Commerce One | $62.7 million | $62.3 million |
| I2 Technologies | $242 million | $157.1 million |
| Source: Company filings |
Deferred revenue is important because it's the money that a company collects before it actually delivers a product or does its job. That happens at software companies when they sell and get paid for a computer program before it gets delivered or installed. It doesn't get recorded as straight revenue because if something goes wrong with the job, the money is at risk.
Don't Count on It
"Deferred revenue means you've got the money, but you haven't really counted it yet," says William Fries, manager of the $1.3 billion
(TVIFX Quote - Cramer on TVIFX - Stock Picks)Thornburg Value fund. "It has been paid to you, so lots of deferred revenue is good in a way."
Good, because if people are willing to pay you before you give them something in return, that means there's strong demand. And it's one of the reasons Wall Street analysts get giddy about the balance sheets of B2B companies (other reasons include a lack of sunlight and a liking for words like infomediary).
Thus, while Ariba's top-line revenue of $80.7 million is impressive, its deferred revenue of $153.7 million gave investors an even better reason to cheer. (Cheered they have. The company's stock is up 35% since it reported financial results July 12.)
Deferred revenue is important for another reason, too.
"If demand falls off, you wouldn't see it in the reported top-line revenues first," says Chris Vroom, a B2B analyst at brokerage firm
Credit Suisse First Boston. "You would see it in the deferred revenues."
Just Across the Way
On the other side of the balance sheet from deferred revenue, under a company's assets, are its accounts receivable. They're a mirror image of deferred revenue, because they're recorded when a company has already done its job but hasn't gotten paid yet.
"Receivables show what's going on with the payment cycle," says Vroom. "So, for example, you may find a sales force that's hard-pressed to capture revenue, so they may offer customers easier payment terms. That's not something we like to see."
So regardless of what's happening with the top-line revenue number, if accounts receivable start to rise and deferred revenue shrinks or its growth rate slows, that could be a sign of a sluggish business.
That's why
ING Barings analyst George Godfrey downgraded software firm
Vignette (VIGN Quote - Cramer on VIGN - Stock Picks) to buy from strong buy after it reported its numbers at the end of July, even though the company's top-line revenue grew 419% from a year earlier to $77.1 million. (His firm hasn't done underwriting for the company.)
While its deferred revenue grew to $75.5 million in the second quarter from $55.4 million in the first, its accounts receivable ballooned to $106.4 million from $54.7 million. (The company said accounts receivable rose because of three large deals that closed toward the quarter's end.)
"While the income statement exhibited excellent growth, well above our estimates for both revenue and license revenue, accounts receivable ... increased," Godfrey wrote. "Secondly, deferred revenue did not increase as sharply as we expected."
The stock fell 7% the day after Godfrey's report.
What Can Go Wrong
Don't think, though, that lots of deferred revenue is a uniformly good thing. That's because in order for the money to rise to a company's top line, a job still has to get done. In an area like B2B software, a lot can go wrong along the way.
Consultants and some companies, like online marketplace
Ventro(VNTR Quote - Cramer on VNTR - Stock Picks), have said that technology integration problems have stunted B2Bs' growth. In other words, it's easy to sell a software program, but it's a little harder to plug it in to a company's existing systems.
Many have seen that as an issue only for companies like Ventro and
SciQuest(SQST Quote - Cramer on SQST - Stock Picks), which run online exchanges and need their customers to be up to speed on technologically before they can participate. But it could also affect how quickly deferred revenue translates into actual revenue on the top line for software providers, or at least how profitable that revenue is, if problems persist.
"If you were a real worry wart, you could look at it that you've got this deferred revenue, but you still have to deliver the services," says Thornburg's Fries, who owns software maker
J.D. Edwards(JDEC Quote - Cramer on JDEC - Stock Picks), which records deferred revenue. "You really don't know if you've got a good match between what that's actually going to cost to do that job. So even though you have it in your hand, when you do recognize it, it might not be as profitable as you think it's going to be."
So before you bet on a B2B, take a look at its balance sheet.
Joe Bousquin
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