Decoding BEA's stock

Some years ago, when I carried a bag as a salesguy, I noticed that in the short term there wasn’t a strong correlation between my firm’s performance in a quarter and our stock price. To be sure, the stock usually did go up on the strength of a good quarter or down on weakness, but there were plenty of times when the opposite would happen. It was frustrating to have a good quarter and see the stock actually go down the day earnings were announced! 

Take BEA Systems last quarter. They actually posted revenue right at the top end of the guided range, reporting total revenue of $392M against guidance between $378M and $392M. The license revenue guidance between $159M and $176M implied a midpoint of $168M. BEA actually printed $169M, which was also in-line with analyst’s expectations.

So what happened? The stock closed at $13.20 and then dropped to 12.40 in the aftermarket when the numbers came out. That’s a 6.1% drop for meeting stated guidance. What’s worse is that the stock dropped another 3.6% in the next day’s trading, closing at $11.95. All told, BEA lost 9.5% of its value. Put another way, BEA lost about a half billion in market cap, dropping from $5.3B to $4.8B.  

So what REALLY happened? Obviously the market didn’t like something it saw or heard. And to understand that, one needs to figure out the key metrics that investors follow to determine if management’s stated growth strategy is working or not.

There are many data points provided in a firm’s financials, but in BEA’s case there are six or so that investors place a higher priority on than others. They are:

1. License Sales
2. Total Revenue
3. Operating Margins
4. EPS
5. Deferred Revenue
6. Backlog
7. Cash Flow from Operations
8. Guidance for the next quarter and full year

• License revenue is pretty obvious: it sheds light on whether or not customers are buying new product. Exceeding investor expectations is good news for the stock. The opposite is also true. You find expectations by looking at a bunch of sell-side models and calculating the average estimate for license revenue.
• For BEA, total revenue paints the rest of the picture which is primarily that of maintenance growth. The expectation for this number is easy to find – go to Yahoo Finance and click on “Analyst Estimates.” The name of the game is to meet or beat expectations.
• Operating margins – this is how investors get a handle on how BEA is managing expenses. The company runs in excess of 20% historically and investors want to see this number go up over time. The company has made some promises about expanding this number, but what’s important to notice is how the # is trending. Up is good. Down is bad.
• EPS. So many institutional investors look to this metric that, agree with them or not, it is hugely impactful to the stock price. Once you have the revenue and operating margin, you have the revenue/expense story… EPS takes that and factors in all the other stuff like taxes, interest income, and so forth. The key with EPS is to see if the company exceeded, or disappointed expectations (which can be found on Yahoo Finance) and if they did so was it a one-time event or was it something that will likely happen again in the future?
• Deferred revenue and Backlog. Investors pay attention to this metric because this gives some headlights onto what sort of maintenance revenue impact will be. It also gives some sense for how BEA is tucking away license revenue into backlog.

Backlog is a funny concept – it isn’t a hard and fast GAAP rule. Every company out there has their own interpretation of how to treat backlog, but as long as they are consistent they are perfectly legal. To BEA’s stock, Backlog represents something like a piggy bank where some license revenue goes that isn’t recognized as revenue or put in deferred. Whatever BEA’s conditions are for determining backlog, it ultimately represents the BEA’s ability to smooth out quarters. No backlog means no cushion. When deferred revenue goes up, investors assume backlog also goes up a bit. 

You’ll notice I didn’t say that “deferred revenue equals backlog” but instead implied the two are correlated.

• Cash Flow from Operations – this is obviously important but hard to predict because quarter over quarter so many things can impact cash flow that it’s probably more useful to look at      it on an exception basis as well as a historical trend basis. In other words, if this spikes or      plunges, that’s going to hit the stock price. And if it is consistently going up or down that will also drive a stock up or down. The stock price doesn’t track against quarterly gyrations – it tracks to the long term trend.
• Guidance. Usually overlooked by the retail investor, this is crucial to how the stock should perform in the future. You can find what Wall Street is expecting for total revenue and EPS pretty easily – check Yahoo Finance for “analyst expectations” and there’s your quick ‘n’ dirty gauge.
• Day’s sales outstanding (DSO’s) – if they spike, then the quarter was really back end loaded which is bad. Or they’re being forced to offer extended payment terms to close deals which is bad, or collections could be bad. The opposite is also true.

So what happened to BEA? In a nutshell, they printed great revenue numbers as well as very strong deferred numbers. But the guidance was disappointing in that most investors were expecting something around $140M and instead the company guided to something around $134. It doesn’t sound like much, but it was enough to tank the stock.

Comments

[Mongo]

Not bad sir.

However, you left out one line item and one concept.

Gross margins are also an important part of the analysis. If license gross margin gyrates alot, you have to ask what happened. Did your royalty rates change? Did you resel a large chunk of 3rd party software? If services gross margin flys around, the same concept applies. Did you discount maintenance to spur renewals? Did you give away consulting revenue to win license business? Did the utilization of your consultants spike because you booked alot of new business?

Secondly, you are too mathematical when you discuss expectations. Street consensus is the mathematical average of published estimates. However, expectations are warped by the buy side and sell side whispers, so they don't always equal a number that you can see. Perhaps everyone knew a company was going to miss or everyone expected a company to beat and raise guidance? A great example was one of your favorites, Salesforce.com. The published consensus for subscriber adds may have been 75K or so, but the whole Street was buzzing about a number closer to 90K. My point being that expectations are always visible to the naked eye. However, they are obviously very important in determining where the stock goes after an earnings report.

[Mongo]

Sorry, one correction:

My point being that expectations are "NOT" always visible to the naked eye.

[Fin guy]

This is very compelling information for believers in "perfect information". The concept of perfect information implies that all participants in financial markets get the same information, at the same time.

Consider this: Imagine that you are 'special' trader (like a large institutional trader). As a consequence of your relationship with a particular company (i.e. the company wants you to say nice things about them) you might hear "whispers" (before the general public) that the company is going to report strong results. This is a huge 'information advantage' that you can leverage in the same way that you would likely adjust your bet in Vegas if you 'accidentally' caught a glimpse of the dealer's card at a black-jack table.

So how do you leverage your information adavntage? Well, if you know that a stock is about to rise, then you'd be a fool not to buy shares (or options) that would increase in value when this information becomes public.

However, when this information finally becomes public you lose your advanatage. So what do you do? You take your profits and go looking for another information advantage. When you sell your huge block of shares, you flood the market with "stocks for sale" signs which force the share prices down in the same way that housing prices tend to fall when there are a lot of "for sale" in your neighborhood.

[Ron]

BEAS just reported 59% earning growth year after year, I think Oracle has to double its offer price to $35 in order to get this deal done

[Idetrorce]

very interesting, but I don't agree with you
Idetrorce

[LILY30]

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[bheconsulting]

Thanks for the information, we will add this story to our blog, as we have a audience in this sector that loves reading like this deferred revenue software .

[Balsafferce]

HI, I just joined this community. I m from romania. I like this forum.......hope to learn lot of things here ;-)





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