Enterprise software provider Technology One (ASX: TNE) rocketed 8% yesterday, to $4.74, and has risen a further 7%, to $5.07, at the time of writing.
The seems to be a reaction to the company announcing that changes to its revenue recognition policies – as required by new accounting standards – won’t reduce profits as much as investors feared.
The old business model
Up until relatively recently, software companies like TNE would generally sell a perpetual or annual licence to their products. This software was typically housed “on premise” ie on the customer’s computers.
In addition to the upfront licence fee, companies could earn revenue from implementation and consulting services in relation to their software, as well as from various special projects along the way.
Finally, fees for ongoing customer support – including rights to minor upgrades and revisions and helpline support – would also be charged.
For accounting purposes, TNE currently recognises 100% of the revenue from sales of perpetual or annual licences in the relevant accounting period, and treats ongoing customer support revenue the same way.
However, revenue from providing implementation services, consulting services and projects is recognised over the period in which the service is provided.
Practically speaking, with many of its customers purchasing annual rather than perpetual licences that are renewed in the second half of each year, TNE’s earnings have traditionally had a large skew to the second half. 85% of TNE’s 2017 profit was recognised in the second half of 2017.
Moving to a SAAS model
But consistent with the trend across the software industry, TNE has been moving its customers to a software-as-a-service (SAAS) model.
The SAAS model involves moving to a subscription model, where customers subscribe to the software for a certain period (which could be for a number of years) and pay regular subscription fees (perhaps monthly or yearly). And the on-premise software is moved “into the cloud” ie hosted on third party servers accessed via the internet.
Under a typical SAAS model, the monthly or yearly fee entitles the customer to instantaneous upgrades to the software when they are released by TNE (as the company just updates the previous version of its software stored in the cloud rather than having to update the various versions of its software stored in its customers computers), along with support should the customer need it.
Now, putting aside the accounting treatment for a moment, moving to a SAAS model is sensible.
One of its benefits is that it ultimately smooths revenue and profits – and there’s nothing investors hate more than volatile profits. This is why investors tend to pay higher multiples for recurring or “annuity-type” revenue.
A SAAS model can also increase the lifetime value of a customer, while also potentially expanding the market (as companies often find it more palatable to pay smaller amounts on a regular basis rather than forking over a larger amount upfront).
A classic example of both is the movement of small business accounting software into the cloud, led by cloud-only Xero (ASX: XRO) and quickly replicated by previously desktop-only competitors MYOB (ASX: MYO) and Reckon (ASX: RKN).
Look out below!
The only problem with moving to a SAAS model is that it usually results in a (temporary) decline in revenue and profits as customers gradually stop paying upfront licence fees and move to the subscription model.
This problem has been exacerbated for TNE by the new revenue recognition accounting standard, which has essentially hastened this transition effective 1 October 2018 (the company has a 30 September year end).
Firstly, TNE has been forced to adopt more conservative accounting and recognise revenue from on-premise annual renewals on an equal amount each day over the term of the licence (in this case, 365 days) rather than upfront.
This change leads to an estimated $10m fall in 2019 NPBT.
But that’s not all.
For clients who are now on SAAS deals – TNE offers one or five-year subscription contracts – the company previously split the revenue into a licence fee, a cloud fee component, and an ongoing customer support portion.
Readers might not be surprised to learn this accounting treatment meant a good portion of the revenue in relation to these one or five-year subscription contracts was recognised upfront when the contract was signed.
The fact that TNE is growing quickly exacerbated the sugar hit to its P&L from this accounting policy.
However, the new revenue recognition policy means these fees will now be combined into a single SAAS fee, which will be recognised rateably over the length of the subscription.
This reduces estimated 2019 NPBT by another $17m, for a total fall of $27m or around 36% of TNE’s estimated 2019 NPBT.
A big problem
As well as hating volatility, investors dislike even temporary falls in profits, so this large fall in TNE’s estimated 2019 NPBT would have been a major problem for the company and its shareholders.
But what makes it an even bigger problem for TNE is that it is growing quickly and is priced accordingly.
TNE’s forward PER of 29 implies investors have very high expectations of its future growth – and like any company with high expectations, TNE’s share price would likely fall dramatically should it not meet those expectations.
Hence TNE’s creative accounting.
It can’t do anything about the change in accounting standards in relation to revenue recognition but happily, the inherent flexibility in many accounting standards – in this case, the one in relation to the treatment of research and development expenditure (R&D) – has saved TNE’s bacon.
Software companies generally spend a lot of money on R&D and TNE is no exception: R&D expenses were 18% of revenue in 2017.
The most conservative accounting treatment is to expense the lot, which is what TNE has previously done.
However, it has now decided to adopt a more aggressive accounting policy and capitalise 40-60% of R&D expenses and amortise them over 3-7 years.
The company justifies the change by arguing that the new revenue recognition accounting standard encouraged it to review all its accounting policies, and that the change to the treatment of R&D brings it into line with SAAS peers such as Wisetech Global (ASX: WTC) and Xero.
Frankly, I doubt whether the R&D expenditure in question really has an effective life extending to perhaps 5 or 6 or 7 years, but the beauty of this new treatment is that it makes it easier for TNE to incur a “non-cash” writedown of any capitalised amounts in future years.
And while the company is well within its right to adopt this treatment under accounting rules (“development” expenses can be treated as such), the real reason is to reduce the hit to its P&L from the other changes forced on it by the accounting boffins. The change in its R&D accounting policy increases estimated 2019 NPBT by $26m (assuming 50% of R&D expenditure is capitalised).
It is no coincidence that this pretty much offsets the $27m hit to TNE’s estimated 2019 NPBT arising from the changes to its revenue recognition policy mentioned above.
Look at cash flows too
While it is true that there is ”no change to cash or cashflow”, management knows full well that most investors just concentrate on earnings and never actually get to the cash flow statement.
So it’s no surprise that the net effect of all these accounting changes is that TNE’s 2019 earnings are likely to be higher than they would have been had the company just changed its revenue recognition policy.
TNE’s share price rises suggest investors have taken the bait but hopefully those who have read this article know better.