In Tuesday's report, Websense announced second-quarter sales growth of 35% to $36 million. Net income was up 54%, to $8.9 million, and operating margins jumped more than 200 basis points, to 35.3%, quarter over quarter. Total billings for the quarter were up 28%, and customer renewals were in the historic range of 75% to 80%.
Aside from these excellent numbers, Websense has a few other items worth bragging about. First off, the balance sheet has $286 million in cash and no debt. The underlying business also has a favorable billing environment; the company is paid up front, allowing for impressive cash flows. In fiscal '04, reported net income was $26.2 million. Free cash flow, on the other hand, was more than $48 million (excluding the tax benefit from options).
With free cash flow so much higher than net income, the shares are sure to be trading at a discount, right? Not exactly. Whatever value is gained through higher cash flow is knocked out of the park by the negative impact of stock options. By not expensing its massive option grants, management has been overstating earnings ever since Websense went public back in 2000.
I admit that I was so excited about the company's cash flow last summer, I failed to see this crucial point. I eventually sold the shares, as I did my stake in eBay
The important thing to remember is this: Don't downplay the effect of options. Always keep track of your current and potential investments by looking at the most recent annual report. Then check the financial footnotes to see what effect expensing options would have had on earnings.
In the case of Websense, open the most recent 10-K on sec.gov and scroll down to page 47. Notice that earnings for 2004 would have been 43% lower after expensing options, falling from $26.2 million to $14.9 million. This doesn't mean that option grants won't let up once management is required to expense them. Nor does it mean that the company's stock won't continue to climb from here. It does mean, however, that the current stock price is riskier than it seems at first glance. And with this added risk, you need added conviction about the company's future performance before buying in.
Fool contributor Matt Thurmond holds no financial position in any company mentioned in this article.