PeopleSoft's Pro Forma <BR/>Cost-Cutting

The company's pro forma results left out some costs it included in earlier mergers.
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PeopleSoft's

(PSFT)

surprisingly robust third-quarter results may not be as clear-cut as they first appeared, one analyst suggested in a research note Monday.

Last month, the applications-software maker, under intense pressure to outperform in order to fend off rival

Oracle's

(ORCL) - Get Report

hostile takeover,

reported pro forma earnings of 17 cents a share, beating analyst estimates gathered by Thomson First Call by 6 cents.

But to achieve those pro forma results, PeopleSoft excluded an expense tied to its acquisition of J.D. Edwards that it had included for other previous acquisitions, noted Sanford C. Bernstein analyst Charlie Di Bona, who has an underperform rating on PeopleSoft. (His firm doesn't do investment banking business.)

In particular, PeopleSoft excluded research and development expenses -- called capitalized software amortization in accounting parlance -- related to its purchase of J.D. Edwards.

Such expenses are relatively unique to software acquisitions, and work like this: When one company buys another company, it must allocate the purchase price to various tangible and intangible assets. In the software world, that often means the acquiring company will allocate acquired software to an asset line called capitalized software on its balance sheet.

The acquiring company then basically depreciates that asset over a period of time, moving an equal portion from the balance sheet to a research and development expense on the income statement each quarter.

Under two prior acquisitions, of Annucio Software and spinoff Momentum Business Applications, PeopleSoft included the expense from capitalized software -- totaling $4.2 million -- in its pro forma numbers. But in its third-quarter numbers, PeopleSoft decided to exclude the capitalized software expense related to the J.D. Edwards acquisition -- totaling $8.7 million -- from its pro forma results.

Basically, that means PeopleSoft boosted its pro forma third-quarter results by $8.7 million, which Di Bona figures pushed pro forma earnings per share up a penny to 17 cents a share and operating margins up by 130 basis points to 13.2%.

The difference is important because PeopleSoft has set aggressive targets for both earnings per share and operating margins, which has pushed up its stock price and made the $19.50-a-share bid price from Oracle less attractive. PeopleSoft has said it expects to earn 90 cents a share in 2004, with operating margins reaching 17%.

"We're not saying there's any malfeasance here," Di Bona made a point of saying in a phone interview. "We have some concerns about their ability to get there

to a 17% operating margin in the first place, but we think that the journey itself needs to be evaluated a little differently."

In particular, he says PeopleSoft's pro forma adjustments make it easier for the company to show margin improvements.

PeopleSoft spokesman Steve Swasey responded that Di Bona does not make a fair comparison. The other acquisitions were far smaller than the $1.9 billion J.D. Edwards deal. The company viewed them as nonmaterial and therefore not significant enough to report on a pro forma basis.

"It's a much larger transaction with obviously different and higher costs," Swasey said of the J.D. Edwards deal, noting that the company clearly reconciled its GAAP and pro forma results.

James Brendel, author of Software Industry Accounting and a partner with the Denver-based accounting firm Hein and Associates, said the issue illustrates the problem with pro forma numbers and underscores the importance of results calculated under generally accepted accounting principles.

Brendel said he understands the company's argument about materiality. But "my opinion is if any time you start making adjustments to get to a pro forma number, you should be consistent from period to period," he added. "The problem with materiality is it's in the eye of the beholder."

Had PeopleSoft included the $8.7 million capitalized software amortization from J.D. Edwards in its third-quarter results, its operating margin would have been 11.9%, a sequential decline from 12.9% in the second quarter.

Alternatively, the other way to handle acquisitions consistently across the board would be to exclude capitalized software amortization tied to all acquisitions, Di Bona said. Doing so would have boosted PeopleSoft's operating margin in the third quarter to 13.9%, up from 13.7% in the second quarter, Di Bona calculated.

Under the second scenario, however, the 17% goal set by management -- which included capitalized software amortization from past acquisitions -- should be bumped out to 18% for PeopleSoft to achieve the margin expansion implied by PeopleSoft's guidance, Di Bona says.

Shares of PeopleSoft declined 30 cents, or 1.3%, to close Monday at $22.05. Shares dipped 2 cents in after-hours trading.