LHS Group and the Case of the Unbilled Receivables

SAN FRANCISCO -- Maybe LHS Group (LHSG) needs some new accounting software.

The Atlanta-based company is making some investors and analysts nervous with its billing and accounting practices -- which is ironic, considering LHS Group sells billing software and helps companies use it.

Critics charge that LHS' way of accounting for its bills isn't comparable to its peers and masks the true state of the company's health. As a result, almost half the company's fast-growing revenue comes from bills it hasn't even sent.

Unbilled receivables are not entirely unheard of among software companies. But LHS Group is seen as using them in an aggressive way to boost revenue and profits, creating both risk and uncertainty for investors.

So far, LHS' accounting moves, which are perfectly legal, have not deterred investors. But short-sellers think the strategy is going to catch up with the company, which trades at a significant premium to its peers. On Thursday, LHS Group had a price-to-earnings ratio of 134 times trailing 12-month earnings, compared with competitor Saville Systems' (SAVLY) 56 times expected fiscal 1998 earnings, according to First Call.

LHS did not return repeated phone calls for comment. Despite the company's reticence, one group is paying a growing amount of attention to LHS stock. Short interest in the company stands at 4.2 million shares in the current month, or just more than 8% of shares outstanding. That's up from just over 1.7 million shares, or about 3.3% of shares outstanding, in the previous month.

Software companies generally split revenues into licenses and services on their financial statements. License revenues are usually easily definable because a company either sells a license for its software or it doesn't.

But with services, things get a little murkier. Sometimes services are not fully paid for because complications emerged and extra hours had to be billed. As a result, software companies often have accounts receivable, or money that is due from clients, on the balance sheets that have also been recognized in the current reporting period as revenue.

Bloated accounts receivable figures are dangerous for investors because the company runs the risk that its clients won't pay, leaving it unpaid for work already done. Another concern is that the company has encouraged buyers to take product they don't yet need, perhaps with the tacit promise they can pay off their bills more slowly than usual.

That is why LHS Group's growing accounts receivable, particularly from service activity, should be seen as a red flag.

To gauge the growth in accounts receivable, analysts generally watch the change in a metric called day sales outstanding, or DSOs. DSOs can be calculated by dividing the amount of accounts receivable by the company's average daily sales.

LHS' DSO figure appears in line with the rest of its industry. It surged to about 85 days in the first quarter from roughly 71 days in December, which initially alarmed some investors and analysts. In the second quarter, the company's DSOs stabilized near 85, which is at the high end of the industry's average of 60 to 80 days, some analysts say.

But short-sellers have chosen to focus on the substance of that DSO number. What makes them wary is huge growth in a category called "unbilled receivables," which are not included in the calculation of DSOs.

Unbilled receivables, or bills that are not sent to customers though the work has been done, rose 83% to $16.8 million in the quarter from $9.2 million a year ago. This line climbed year-over-year at a faster pace than revenue, which rose 62% to $37.8 million from $23.3 million over the same period.

"It's been hypothesized that [the companies] are not billed because the companies can't pay," says Brian Skiba, analyst at Lehman Brothers, which has no investment banking relationship with LHS Group. "So rather than age [the account receivable], they'll put it into unbilled receivables, and it doesn't show up in day sales outstanding."

Skiba, who rates the stock a buy, says "it's not unusual for a company to have DSOs between 90 and 100 days."

But a hedge-fund manager who is short the stock and declines to be named says LHS Group's "unbilled receivables are totally out of proportion to other companies." He notes that the total unbilled receivables of competitor Amdocs in its third quarter ended June 30 were $3.6 million, or about 4%, of $95.2 million in service revenue. LHS Group's unbilled receivables, on the other hand, were 79% of service revenue in the second quarter.

Saville Systems does not have a specific term on its balance sheet labeled "unbilled receivables." Instead, it subtracts "doubtful accounts" when tallying total trade accounts receivable. In the quarter ended June 30, Saville said it had $3.4 million in doubtful accounts that it subtracted from accounts receivable.

The hedge-fund manager says LHS Group's balance sheet gets even uglier when you factor another set of receivables -- this one not even explicitly stated as such on the balance sheets -- into the DSO figure. These "long-term" receivables, or bills that customers have not paid in at least 12 months, are lumped under "other" assets on the balance sheet, he says. He says the company acknowledged another $1 million in long-term receivables in its conference call in July when it reported second-quarter earnings. That would push the true receivables figure to $52.9 million.

"When you add up the trade receivables, unbilled receivables and long-term receivables, the company has the longest day sales outstanding in the industry," the hedge-fund manager says. By dividing this total figure -- $52.9 million in total receivables by average daily revenues for the quarter of $415,384 ($37.8 million in revenue divided by 91 days for the quarter), he calculates LHS Group's real DSO is 127 days, not the 85 that the company claims.

Even more worrying, LHS Group has been seen aggressively expanding this year in Asia and the Americas, areas it has said are generating the most unbilled receivables after Asia's economies collapsed late last year. "That means the growth in [unbilled] receivables is coming from all the wrong people," the fund manager says. "So, not only are the [unbilled] receivables growing, but they are coming from vulnerable places."

Another fund manager speaking on condition of anonymity, who has been shorting the stock, is convinced that LHS Group's aggressive accounting tactics will eventually backfire. "It's too bad I only got in on this a month ago," he says. "The only thing holding up the stock now is that there aren't any shares around to borrow."

Short-sellers often borrow shares to sell and then replace them by buying them back when the price goes down. The difference between the higher selling price and the lower buyback price, less any interest paid to borrow the shares, is the short-sellers' profit.

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