This could hurt,
March 24, 2000
Is the MicroStrategy Disease Contagious?
By Cintra Scott
LAST WEEK, VENTRO (VNTR), the company formerly known as Chemdex, sent out its first-ever annual
report to shareholders. In the report, Ventro introduces itself as "a leading builder and operator of vertical
business-to-business e-commerce marketplace companies." In English, Ventro aims to set up
industry-specific marketplaces where buyers and sellers can gather online. It's the same basic game plan
as its rival VerticalNet (VERT).
Despite a $5 billion market valuation, Ventro, like other B2B boomers, is still a young, money-losing
company. So naturally investors weren't looking for profits in the report. Revenue growth is more important
at this point ? as it is for most Internet companies. And in 1999, Ventro/Chemdex saw $30.8 million in
net revenues. That's more than a thousand times better than the $29,000 in revenues the year before.
But before you say bravo, heed the fine print. It said, "Under most of our supplier agreements we are
acting as a principal in purchasing products from our suppliers and reselling them to our customers so
that we recognize net revenues equal to the amount paid by our customers and cost of revenues equal to
the amount we pay to our suppliers for these products."
This disclosure may appear to be a boring bit of minutiae, but it's actually a big deal ? crucial, in fact, if
you want to invest in Ventro. And it raises a troubling issue about how B2B companies account for
revenue that is becoming increasingly sticky for an industry trading at multiples that might give Icarus
hives.
What the boilerplate says is that the company is claiming as revenue the entire value of the chemicals
and beakers that pass through its Chemdex marketplace. Never mind that it only keeps a small fraction of
that in the form of transaction fees (and perhaps other services down the road).
Of that $30.8 million in "net revenues" reported last year, for instance, $29.3 million of it is what Ventro
calls "cost of revenues," or the difference between the full price buyers pay and the fee Ventro takes out.
Subtract those "costs" and "gross profit" comes to a mere $1.5 million for the year. And when you take
out Ventro's real operating costs, the company's net loss quickly balloons to $48.6 million.
Here's the real question: What if Ventro's net revenues were restated as $1.5 million to reflect its actual
cut of the sales? That's a whopping 95% lower than the revenue it listed. The company's $5 billion market
cap might look a little precarious perched atop such a tiny pedestal. It's fair to say the market wouldn't
treat Ventro stock kindly. MicroStrategy's (MSTR) 62% freefall on Monday speaks to that.
The B2B revenue question is troubling because Ventro, SciQuest (SQST), Onvia.com (ONVI) and
Priceline.com (PCLN), to name just a few, all account for revenue this way. Trouble is, the Securities
and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are both
questioning whether it's appropriate.
In December the Securities and Exchange Commission issued Staff Accounting Bulletin 101 to clarify
gray areas in accounting like this one. And FASB's task force took it up on March 16, discussing what it
refers to as Issue No. 99-19. So far, nothing's been resolved. But when the March meeting's summary is
released to the public (either next week or the week after, according to FASB), accountants and analysts
will scrutinize it for clues. And 99-19 is likely to appear on the task force's agenda again when it meets in
May. In the meantime, companies and their accountants are trying to decide how to deal with the SEC's
bulletin.
The great fear, of course, is that a tighter interpretation of the rules will cause a wave of restatements (a la
MicroStrategy) that could undermine the Internet sector. A look at how gray a gray area this is doesn't do
much to ease anxieties.
According to SAB 101, a company that counts gross revenues (the value of the entire transaction) instead
of net revenues (the commission from the transaction) must "act as a principal in the transaction" and
"take title to the product." Of course, retailers with inventory act as principals, but what about an Internet
company that may only "own" the product for a split second, while the title is transferred from vendor to
buyer?
"Under our principal-based agreements, we are responsible for selling the products, collecting payment
from customers, ensuring that the shipment reaches customers and processing returns," says Ventro's
annual report. It's true, for instance, that Ventro briefly takes title to the lab equipment sold on
Chemdex.com ? once a buyer is found. But does it actually risk not being able to sell that equipment as
a retailer holding inventory does? The answer is at the heart of the matter.
A spokeswoman for Ventro couldn't elaborate at press time, noting that the company is in the midst of a
follow-on offering. (Ventro plans to sell another 1.8 million shares and $300 million worth of bonds that are
convertible to stock.) But, acknowledges accounting analyst and CPA Janet Pegg of Bear Stearns, "It's
difficult to determine. It comes down to deciding what the risks and rewards of ownership are."
So far, Ventro's accountants at Ernst & Young, who must go by the generally accepted accounting
principles (GAAP) and adhere to the SEC's guidelines, have ruled the company's revenues are A-OK.
(E&Y wouldn't comment for our story, citing company policy, but they did stamp their approval on Ventro's
10-K. Of course, PriceWaterhouseCoopers gave its seal of approval to MicroStrategy's books for the two
years the company ultimately restated.)
And in its annual report, Ventro is careful to spell out the risk it takes by counting gross revenues: "If we
are required to change our accounting policies, we may in the future report substantially lower revenues,
and we may be required to restate the results from earlier periods," the company stated. "This could
cause the market price of our common stock to fall significantly."
Yikes!
"Of course it would rattle the market.... It's crazy to think it wouldn't," says Ed McCabe, an Internet
analyst at Merrill Lynch specializing in B2B stocks. "Ideally, it wouldn't matter, because investors would
know that the fundamentals hadn't changed." McCabe recommends investors look at cash flow, not
revenues, to judge valuations as the industry matures. That, however, is tricky. Because these companies
are so young, analyzing cash flow in any meaningful way is difficult, McCabe and senior analyst Henry
Blodget acknowledge. "Valuing B2B market makers is tough at this point," they say in a recent report.
One analyst who does follow Ventro, and rates it a Strong Buy with a $300 share-price target, basically
thinks the problem will go away. "Based upon our understanding of the business models and relevant
accounting practices, we believe Ventro and SciQuest will likely be allowed to continue to report revenues
on a gross basis," concluded Mark Gulley of Banc of America Securities in a note last week. Gulley
explained that there is a risk, but it isn't likely that the company would have to change its accounting
practices. "In summary, we believe investors should remain cognizant of this issue," he wrote.
Bear Stearns' Pegg, though, foresees potential turbulence ahead. "As 10-Ks come in, we're seeing more
and more disclosures," she notes. "And we'll definitely see more."
Consider yourself warned.
smartmoney.com
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