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 Salesforce.com, 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 MoveConventional 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 Salesforce.com 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|