Updated from 8:49 a.m. EDT Red Hat ( RHAT) shares tanked Tuesday after the Linux vendor said it will restate results for three fiscal years and the first quarter it reported June 17. The decision came after new accountants decided the company would be better off with a more precise method of recognizing software subscription revenue. Raleigh, N.C.-based Red Hat also disclosed it is in the process of responding to comments and questions from the Securities and Exchange Commission regarding its 10-K annual report. Asked about the SEC inquiry on a conference call, Red Hat CEO Matthew Szulik said he could not describe the nature of those questions. Despite company assurances that its overall revenue totals should stay the same, one analyst downgraded the stock and investors, loath to hear about accounting issues of any kind, sold the stock. Red Hat shares were recently down $4.24, or 21%, to $16.02, although they remain well above the 52-week low of $5.95. The accounting changes top a string of disappointing announcements from Red Hat, beginning last month when the company announced the
sudden resignation of its CFO. After that, Red Hat preannounced quarterly results as a form of damage control and subsequently released lower-than-expected first-quarter revenue. "You have some credibility issues there," said Steve Roth, an analyst with the ( NTTFX) John Hancock Technology fund. "Given the valuation of Red Hat, it's a justified reaction," Roth said of the selloff. (His fund doesn't hold Red Hat shares.) Even with Tuesday's drop, Red Hat is still trading at a heady 67 times estimated 2005 earnings and 38 times estimated 2006 results. The accounting practice in question is Red Hat's policy of recognizing revenue from software subscriptions as if they began on the first day of the month in which they started -- regardless of the date the subscription actually began. That method called for a system of pro-ration that made up for the small calendar imprecision in later months. In changing the policy, Red Hat will adopt its accountants' suggestion that revenue recognition start on the day the subscription actually begins. That will shift revenue previously recognized in the early part of the month under the old method to the end of the subscription under the new one.
"This correction in method has no effect on the amount of revenue that the company will ultimately recognize from the subscriptions to the company's Red Hat Enterprise Linux product that the company has sold over the last 24 months, nor does it affect the sequential quarterly growth in the number of subscriptions sold over the last two fiscal years or the increase in operating cash flows that has resulted from the increase in the number of new subscriptions sold over this period," Red Hat said. For the quarter ended May 31, 2004, the company's previously stated revenue of $41.61 million will be restated to a range of $41.2 million to $41.7 million. The year-ago first quarter's previously stated revenue of $27.18 million will be restated to a range of $25.6 million to $26.1 million. For the fiscal year ending Feb. 29, 2004, the previously stated revenue of $36.97 million will be restated to a range of $36.3 million to a high of $36.8 million. In a note downgrading Red Hat to market perform from outperform, Wachovia Securities analyst Kash Rangan said the restatements raise concerns, given the recent series of events beleaguering the company. "Linux remains a transformational force in the software industry and it will keep us engaged in this name subject to us gaining more confidence in the company's accounting issues and its eventual CFO choice," Rangan wrote. (His firm has done investment banking with Red Hat.) Roth, meanwhile, acknowledged that the accounting restatements don't change the company's fundamentals. "Everything is just getting stated in different time frames," he wrote. But management's credibility gets called into question because the company didn't disclose the change when it announced its quarterly results June 17, Roth suggested. On the conference call, Szulik said PricewaterhouseCoopers advised management to consider changing its accounting for subscription revenue on June 16, a day before the company announced its results.
"It is quite disconcerting. All the timing doesn't seem to be quite in sync," FTN Midwest Research analyst Trip Chowdhry told management during the call in an uncharacteristically blunt moment. "I am quite amazed by it." Jefferies & Co. analyst Katherine Egbert further noted Tuesday that the timing of the restatements shortly after the announcement of CFO Kevin Thompson resigning is another issue. The perception a month ago was that Thompson's resignation was unrelated to any accounting issues, noted Egbert. "And now there is an accounting issue, albeit a minor one," Egbert said, expressing doubt the two events are unrelated. "There's a credibility gap." (Egbert has a buy rating on Red Hat and her firm hasn't done any banking with the company.)