Updated from 2:05 p.m. EDT Mercury Interactive ( MERQ) shares dropped sharply Wednesday after the company reported unexpectedly weak second-quarter earnings and issued disappointing guidance for the third quarter. Shares of the Mountain View, Calif., software company closed the day at $37.93, a drop of $4.80, or 11.2%, as shareholders rushed to sell them. When the dust settled, more than 28.9 million shares had changed hands, in excess of 13 times an average day's volume. Mercury, which makes software to test and tune business applications, posted revenue of $159 million in the June quarter, a year-over-year increase of 35%, but below Wall Street's expectations of $166 million. Net income for the quarter was $11.6 million, or 12 cents a share, well under the same quarter last year when the company earned $16.9 million, or 19 cents a share. Excluding a $9.2 million charge for expenses related to Mercury's move to a new headquarters, and $5 million of other charges, the company earned $22 million, or 22 cents a share. Analysts polled by Thomson First Call had expected the company to earn 25 cents a share. However, the miss may not have been as worrisome as the numbers indicate on a first glance. Mercury reported that deferred revenue grew to $26.2 million in the quarter, compared with its forecast of approximately $15 million, noted analyst Jason Brueschke of Pacific Growth Equities. Therefore, the $11 million the company expected to put on the income statement instead went to the balance sheet and blew the revenue forecast. The spike in deferred license revenue also hits earnings, because expenses for deferred revenue are taken up front, while the revenue is taken over a period of time. Brueschke explained that some of the company's products are sold on a perpetual basis only, others on a subscription basis only, and some are sold either way depending on the customer's preference. Therefore a change in the mix can make a large difference to the top and bottom line of a particular quarter without actually reflecting a real change in sales.
In the future, deferred revenue will move off the balance sheet and onto the income statement -- and will be pure profit because the expenses have already been booked. "By the fourth quarter, the company starts to move to the promised land
as deferred revenue comes on line ," said Brueschke during an interview. (His firm doesn't do investment banking with Mercury.) Piper Jaffray analyst David Rudow also made allowances for the unexpected surge in deferred revenue, but noted that there was also a sequential decline in subscription revenue during the quarter. (Subscription revenue is deferred revenue that has moved onto the income statement.) "We are unsure of why this decline occurred during the quarter and feel it may signal an issue with renewal rates and/or a change in buyers behavior toward subscription contracts. This is an area of concern for us," he said in a note to clients. Guidance for the third quarter was within the range of Wall Street's expectations, but definitely on the light end. The company told investors to expect pro forma earnings of 22 cents to 27 cents a share, on sales ranging from $160 million to $170 million. Analysts were projecting a profit of 27 cents a share on sales of $170 million. Guidance for the full calendar year was somewhat better. The company expects to earn a pro forma profit ranging from $1.04 to $1.12 on sales of $665 million to $685 million. Wall Street was expecting earnings guidance of $1.10 per share on sales of $681 million.