LGTO, important forbes reflections here
<<NEW YORK. 3:50 PM EST-Storage management software maker Legato Systems (nasdaq: LGTO) received a little accounting lesson this past quarter--one that other software companies may also soon be learning. The company reported earnings of 11 cents a share, far short of the 20 cents a share analysts had expected. On top of that, it had to restate third-quarter revenue from $71.7 million to $65.9 million, and earnings from 18 cents a share to 14 cents. As a result, the company's stock was virtually sliced in half, down $23.75 to $29.88 Thursday afternoon.
Behind this catastrophe was a change in Legato's accounting methods that forced the company to defer revenue it had recognized in 1999 from three different deals to 2000. The largest of these three deals, a $10 million contract with storage application service provider (ASP) StorageNetworks, is troubling some industry pundits since they think it may be a harbinger of things to come for other software companies that sell software to ASPs. Apparently, Legato's auditor, PricewaterhouseCoopers, felt that it wasn't conservative enough for Legato to recognize revenue from a sale to an ASP the way it does from other its other customers.
According to analysts, Legato and many other software companies will sign a contract with a customer and then get paid based on a schedule specified in that contract. The company will book the revenue once that software has been shipped and deployed. ASPs (which are companies that host applications on their servers for users to rent on a subscription basis rather than buy the software themselves and store it on their own hard drives) are not essentially different from Legato's other customers in that it follows this scheduled payment structure.
The only difference is that an ASP derives its own revenue on an ongoing subscription basis from its subscribers. Because the ASP model is new--as are most of the companies in the space--the auditors seem to be worried that if they don't meet their subscriber expectations, they won't be able to meet their scheduled payments to Legato, even though the contract itself isn't contingent on expected subscriber growth. As a result, PricewaterhouseCoopers is making Legato defer the revenue derived from the StorageNetworks contract to this year to more closely match the StorageNetworks' payment schedule.
"Because [Legato] had a non-cancelable, non-refundable contract that was not dependent on the number of subscribers, they believed they could recognize revenue," noted Merrill Lynch analyst Mark Fernandes. "Legato sold [StorageNetworks] the product directly, and they have installed the software across their systems, but since the ASP is dependent on customers being signed up and their payment stream is based on that, the auditors think Legato should be dependent on that too."
The accounting firm also got tougher on the way Legato--considered by many industry experts to already be on the conservative side when it comes to accounting--books its revenue from sales to certain value-added resellers (VAR). Legato had taken a safe approach by waiting to book revenue from these sales until the VAR actually sold the software to an end user, so Legato couldn't be accused of stuffing the channel to make its numbers look better at the end of a quarter, according to Fernandes. Now the company has to wait even longer to book the revenue--until the end user who bought the software from the VAR has actually deployed it. But Legato's chief executive and president, Louis Cole, said that this applied only to certain VARs, notably those that sold complete solutions or what he characterized as "large end-user deals."
Some analysts expect that auditors will impose these more conservative accounting approaches on other software companies that sell to ASPs as well--which could force Wall Street to lower revenue expectations for these companies as more of their revenue becomes deferred. That will be particularly true as the subscriber-based ASP model becomes more pervasive in the industry. "This is a watershed event that will ripple throughout the entire industry," asserted Joseph Payne, an analyst with Hoak Breedlove Wesneski & Co., who lowered his ratings not just on Legato but also on one of its chief competitors, Veritas Software (nasdaq: VRTS), to "accumulate" from "strong buy."
Still, some believe the market may have overreacted to Legato's news and think there's a silver lining to the stricter accounting rules. "There is a certain amount of overreaction and emotion that will subside over time," argued Merrill's Fernandes, who pointed out in a report that the accounting changes will improve the company's revenue visibility. Cole agrees. "Things will be a little more predictable going forward," he noted. "This is more of a market change than anything else, and in the long haul it will be very good for us."
Nevertheless, the accounting changes did knock Legato's expected annual revenue growth rates to 50% from 70%, and that means investors may have to get used to less-immediate gratification--something they haven't shown much willingness to do in this age of out-of-this-world Internet valuations. "Since the stock markets have turned solely toward valuing only accelerating revenue growth rates, this change just might serve to be the trigger toward a trend of valuation compression ahead," said analyst Payne in a report accompanying his downgrade of Legato.
But it may result in stock valuations more in line with reality than what we've seen for many software and Internet companies these days.>>
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