With Blodget Downgrade, Inktomi's Problems May Have Only Just Begun

New criticism is emerging that points to worrying trends: a drop in deferred revenue and an increase in days sales outstanding.
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SAN FRANCISCO -- Highflying Internet stock



lost some altitude today after a high-profile Internet analyst raised a number of questions about its growing expenses.

Merrill Lynch

analyst Henry Blodget downgraded the Internet infrastructure software company to neutral from accumulate, even though Merrill has an underwriting relationship with Inktomi. The stock closed down 17 7/16, or nearly 15%, to 103 1/16.

In his report, Blodget was concerned about larger-than-expected increases in sales and marketing and product development costs. But there are also a number of questions about Inktomi's slowing growth.

On Thursday, Inktomi reported an operating loss of $7.1 million, compared with a $9 million loss in the year-ago quarter. However, after excluding gains from a stock offering in August, the company showed a net loss of $4.9 million, or 9 cents per share, compared with a loss of $8.5 million, or 18 cents per share, last year.

Money managers argue that Inktomi showed a big drop in deferred revenue. Increasing deferred revenue is a sign of financial health, indicating strong cash flow and sales growth going forward. Conversely, decreasing deferred revenue signals slowing sales growth. For the quarter ended March 31, Inktomi reported deferred revenue of $3.1 million, which then increased to $5.3 million in the following quarter. But in this most recent quarter, deferred revenue sagged to $2.2 million.

Inktomi CEO David Peterschmidt dismissed fears that the company was seeing slowing growth. He said his company's deferred revenue is not an accurate indicator of sales strength. "It could suggest we took no orders that required the delay of revenue recognition," he added. As for Blodget, Peterschmidt was less than kind. "I don't think Henry understood all the issues," he said.

Critics point out that Inktomi relied on a big jump in interest income to beat analysts' earnings estimates by a penny. Last quarter, interest income came in at $870,000, but in the most recent quarter, interest income, fueled by the cash generated by a secondary offering, increased to $2.2 million.

"The fact that their interest income went up so much indicates that they didn't have enough revenue to make their quarter," says one money manager who requested anonymity. (This money manager sold his position in Inktomi on Thursday.)

With increased competition, any disappointment can become a crisis. Traffic servers, which help manage network bottlenecks, are Inktomi's biggest source of revenue, but recently the company has come under pressure from a hot start-up called


that is about to go public. (


first highlighted Akamai in a

story on Sept. 17.)

"The question is: Is this a trend or a one-time blip? If they're losing that race to other providers, that's a problem," says Mike Dubrow, a senior analyst with

Jacob Asset Management

who is long Inktomi.

A further troubling sign is a considerable rise in days sales outstanding, or DSOs, says the money manager who sold his position on Thursday. Increasing DSOs are a measure of decreasing financial health and could signal that the company may be offering more generous terms to customers to close a deal. It also indicates that more business is occurring at the end of the quarter, rather than at an even pace throughout the quarter. (DSOs can be calculated by dividing accounts receivable by average sales per day.)

In the recent quarter, Inktomi's DSOs jumped to 79 days from 66 days. Inktomi has guided analysts to expect DSOs to fall within a range of 65 to 80, and it blames the rise on two European accounts that came in late after the quarter closed.

Goldman Sachs

analyst Rakesh Sood expects DSOs to trend down to the mid-70s in the next quarter. "There was a whole bunch of overreaction," says Sood, who has Inktomi on Goldman Sachs' recommended list. Goldman was an underwriter to the company.

Still, most analysts have not downgraded the stock and are quick to point out that Inktomi is still the leader in Internet search and caching technologies. But in the current season of earnings shortfalls, any sign of trouble is punished heavily. And the accounts must be squeaky clean.