Years after Microsoft (MSFT) popularized the phrase "software as service," its latest incarnation -- dubbed "on demand" -- is finally taking off.

The result: More software vendors, ranging from big-caps Siebel Systems ( SEBL) and Red Hat ( RHAT) to smaller companies such as Ultimate Software ( ULTI) and IPO-bound, are collecting revenue on a subscription basis.

Although that means more predictability for investors, the subscription model also requires a change from the traditional way of evaluating software firms' financials. Questions over how to value subscription sales are certain to arise in coming weeks as software companies release their quarterly results.

"We believe that 2004 will be the year the software industry will hit a critical inflection point and move closer to being consumed as an 'on demand' service," Merrill Lynch analyst Jason Maynard wrote in a lengthy note about software on demand last month. "For the investor, the changes in the software business model have deep consequences," he continued. "Normal valuation metrics such as price-to-earnings and price-to-sales may not be appropriate."

Subscription sales change the rules because their accounting is handled differently than a more traditional model. Under the so-called perpetual revenue stream, customers have traditionally paid a big upfront fee for the right to use software forever, with software companies recognizing that revenue upfront on their income statement. Companies also typically pay annual maintenance fees -- about 20% of the license fee -- for the right to upgrades.

By contrast, under a subscription model customers pay a lower subscription fee to essentially rent the software over a set period of time and receive upgrades or enhancements as often as every day. Companies initially recognize the bulk of the subscription sale as deferred revenue on the balance sheet. Then an equal portion of the sale moves onto the income statement each quarter, over the life of the contract. So, if a customer pays $100,000 for a one-year software subscription, the software vendor recognizes $25,000 each quarter for four quarters.

The result is that revenue -- and consequently earnings -- may look lower than if the company had recognized the entire hypothetical $100,000 sale upfront, which in turn can make a stock look more expensive on a P/E or price-to-sales basis.

Measuring the Move

Conventional wisdom suggests that companies collecting subscription revenue should fetch higher stock prices. That's because they offer more visibility and predictability since they can count on a portion of their revenue flowing from their balance sheet each quarter. By contrast, under a perpetual license model, revenue starts at zero each quarter and missing one deal can make a bigger difference in meeting or missing estimates.

"One of the issues with the traditional software model has been it's a very lumpy business," noted Marty Shagrin, a software analyst with Victory Capital Management in Cleveland, Ohio. "You close all your business in the last two weeks of the quarter and a deal slips one day into the next quarter and the whole world thinks it's a major catastrophe," he said. "It's a much more volatile model; that model should be worth something less."

Ironically, Sanford C. Bernstein analyst Charlie Di Bona noted some investors these days seem willing to pay a premium for the increased volatility of a company collecting on perpetual licenses because it offers a greater chance of upside surprise. "It's counterintuitive," he said.

Flavors of Software On Demand
Application Service Provider/ASP A software company charges customers a monthly or annual fee essentially to rent software. Users don't take physical possession of the software, which is often accessible via the Internet instead. A favorite acronym in the late '90s, this model is the basis of and Siebel Systems' new competing OnDemand offering.
Hosting A software company, such as Oracle or PeopleSoft, or a third party, such as EDS, manages the software and sometimes the hardware for a customer, either at the customer's office or the software company's own facility. The software company may charge a subscription fee or a perpetual, upfront license fee for such service.
Business Process Outsourcing A customer gives up its entire business, such as accounting or human resources, and subcontracts it out to another company.
Sources: Merrill Lynch, DRW Research

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), 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."

Still, di Bona acknowledges the attention on subscription revenue has grown, thanks in part to media hound and Siebel's recent launch of its competing OnDemand customer-relationship management service.

But smaller companies like that started on a subscription model may have an advantage over a larger player like Siebel, notes JMP Securities analyst Pat Walravens. "If you've been recognizing license revenue upfront and have a big base of business -- good luck moving the needle selling software for $80 a month," said Walravens, who has a market perform rating on Siebel. His firm hasn't done any banking with Siebel. (Siebel is, in fact, selling its OnDemand service for $70 a month per user.)

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