On July 26, software developer SupportSoft (NASDAQ:SPRT) announced its second-quarter results. Aside from inking a new deal with Verizon (NYSE:VZ), the company's earnings release appeared to be unremarkable. There were no significant changes from prior quarters, and SupportSoft met revenue estimates. During the conference call, however, management raised an issue that made my ears perk up.
Licensing revenues for the quarter included a $2.5 million customer payment that was not supposed to be received until June 2006. Unexpected one-time events like this often affect the quality of a company's earnings, especially when they represent such a large component of total revenues (15%).
In search of answers, I looked to the quarterly report where I hoped to find a more detailed discussion of this unusual event. Unfortunately, the $2.5 million payment received only a brief mention:
"Additionally included in license revenue for the three and six months ended June 30, 2005 is $2.5 million related to the payment of an obligation originally due next year from a customer that had disclosed that it may not have sufficient funding to meet its cash requirements in 2006. The Company negotiated an accelerated payment with the customer to eliminate any potential credit risk."
This certainly makes the payment sound like a good thing -- SupportSoft was able to collect from a customer that may not have been able to pay a year from now -- but it doesn't provide the details I was looking for.
To investigate further, I requested a conversation with those who would know best -- SupportSoft's CEO, CFO, and CMO. I asked them general questions about their revenue streams, as well as very specific questions about the $2.5 million payment. They were very accommodating, answering each question in significant detail. Here's what I found:
There are a number of factors allowing SupportSoft to be relatively precise in its earnings estimates. First, expectations are announced at the same time earnings figures are released for the previous quarter -- usually about a month into the current quarter. So SupportSoft is really estimating earnings figures for two months, not three.
Second, 40-50% of revenue for the quarter is in the bag before the quarter even begins. This revenue consists of previously negotiated service contracts that the company will complete (and collect on) during the current quarter, as well as term license contracts that are essentially "pay-as-you-go" licensing arrangements.
In addition, SupportSoft knows what, if any, payments are expected from previously signed license contracts that include extended payment terms (the source of the $2.5 million in question). The guesswork in the earnings numbers then is confined to how many new licenses the company will be able to sell in the last two months of any given quarter.
Last quarter, SupportSoft reported revenues of $17 million, which is at the top end of its estimates ($16.6 million to $17 million). Because this revenue included the unexpected $2.5 million extended payment, however, SupportSoft actually sold $2.5 million less in new licenses than it had predicted.
This is a significant miss, since it represents 27% of its total license revenues and more than 100% of its earnings. In other words, without the $2.5 million payment, SupportSoft would have reported a loss for the quarter.
The reality isn't quite as black and white as that. For example, SupportSoft could have offered more aggressive discounts to make up some of the difference. (Digging up an extra $2.5 million in sales in the final month of the quarter, though, is no easy task.) It's worth noting that competitors like Motive (NASDAQ:MOTV) are also struggling to reach revenue targets, which indicates that the challenges have more to do with a soft market, especially in the enterprise sector, than with lack of execution.
Investors should not necessarily let this one-time item overshadow the entire quarter. The Verizon deal is a huge win for SupportSoft, and relationships like this one are the keystone to SupportSoft's growth ambitions as broadband services become more ubiquitous. With the addition of Verizon, SupportSoft now has licensing contracts with eight of the top ten broadband service providers in the nation. The company also initiated the $2 million share buyback program they announced in April by repurchasing nearly 200,000 shares.
There are three lessons we should take from SupportSoft's second-quarter earnings report. First, unusual items that have a significant effect on earnings rarely reflect positively on the quality of those earnings. Second, if management does not dedicate significant time to these issues in its earnings report or significant discussion to the issue in its quarterly report, be skeptical. Third, and most importantly, management has a responsibility to be completely transparent in its financial statements, so that investors can fully understand the nature of the business and the quality of its earnings.
For hardball Foolishness on SupportSoft, click here:
Jim is asking for your spare winter coats so he can make it through the rest of the San Francisco summer. He also appreciates email with your thoughts and questions (maybe include some warm wishes). Jim does not own any of the stocks mentioned in this article.
