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Red Hat stock dives on earnings restatement

CEO says new auditor moved company to recalculate subscription revenue on daily, not monthly, basis.

Red Hat stock plunged Tuesday after the Linux seller announced an earnings restatement and a letter from financial regulators--but the company said recent financial troubles are coincidental and unrelated.

The Raleigh, N.C., company said it is restating earnings for the last three fiscal years, reflecting a move to record revenue from Linux support subscriptions on the day, rather than the month, that a deal is signed. The change delays--but doesn't diminish--the revenue that Red Hat recognizes from sales of annual Linux support subscriptions. Red Hat made the move after its independent auditor, PricewaterhouseCoopers, raised the issue in June.

Red Hat released revised financial statements, but less clear are the implications of a second major announcement: Red Hat has received a Securities and Exchange Commission "comment letter" regarding the company's annual report. Red Hat didn't disclose the nature of the regulators' questions or comments.

Red Hat's stock dropped $4.63, or 23 percent, to close at $15.72.

Investors already were on edge after Red Hat announced one month ago the planned resignation of Chief Financial Officer Kevin Thompson three days before announcing earnings. And though Red Hat didn't highlight the change during that earnings conference call, it had already adopted the new revenue recognition policy.

The revenue change is not significant, but the SEC letter and damage to Red Hat's reputation are, said Katherine Egbert, a securities analyst at Jeffries & Co.

"It's a bit damaging to their credibility, since the change in accounting did not come to light until a month after the announcement of the CFOs departure," Egbert said. And though SEC comment letters are "common," the regulatory questions should be taken seriously: "The SEC doesn't typically engage companies in idle chatter."

Red Hat's defense
In an interview, Chief Executive Matthew Szulik defended the company, saying it has been honest, that business is strong, that the events are unrelated, and that there are no other known financial issues.

"We're dealing with this in an open and forthright way, and the health of the business remains positive," Szulik said.

Thompson's resignation announcement coming at the same time as the new revenue recognition policy was "an absolute coincidence," Szulik said, and "the SEC comment letter we received was independent of the restatement."

W.R. Hambrecht analyst Victor Raisys questioned the necessity of the revenue recognition change. "It is our belief that other software companies with similar business models and revenue streams account for their subscription revenues on a monthly, and possibly quarterly, basis," he said in a report Tuesday.

Discussing Thompson's departure, Szulik reiterated his position that the company needed someone with experience at a larger company, "Kevin had never been a CFO before, and the complexity of our business was increasing," he said.

Szulik refused to disclose the contents of the SEC letter, but said, "As a publicly traded company, the SEC oftentimes has questions about risk or your reporting on a specific topic."

Red Hat's financial difficulties come as Linux foes Microsoft and the SCO Group have launched attacks on the open-source operating system. But so far, the spread of Linux continues unabated. Analyst firm IDC, for example, predicted in June that revenue from Linux server sales will increase to $9.7 billion in 2008--nearly one-sixth of the $60.8 billion total market.

But there could be repercussions as the software industry embraces subscriptions, which involve payments strung out over a long period rather than the prevailing licensing model involving a one-time lump-sum payment.

"We haven't looked in detail at the Red Hat case, but I think it's indicative of the large shift in the software market in the last 18 to 24 months to move to subscription-based pricing," said Dan Starr, chief marketing officer of , which sells subscriptions to its customer relationship management software. "As companies have made that change, they've had to look at their accounting practices. The accountants don't necessarily know how to do it," Starr said.

Salesnet recognizes revenue on a daily basis, so if a deal closes on May 28, the company will book three days' worth of that revenue for the month of May, Starr said.

In a conference call with analysts, Szulik fielded questions on the timing of the restated financial results and why a decision was not made sooner to use daily revenue recognition, given that the company is using the same auditing company it has used over the past five years.

"There were prior discussions with the auditors in the past, but it wasn't pursued until a new (auditing) partner was rotated in," Szulik said. "On June 16, Pricewaterhouse suggested changing the method for revenue recognition from a monthly basis to a daily basis. And a decision that a restatement was needed didn't come until later, when there had been an exhaustive review of the financial statements going back two years."

Red Hat announced its CFO's resignation June 14, sending the stock down. On June 15, the company issued a preliminary forecast that its first quarter results would come in 1 cent higher than what Wall Street expected. On June 16, Pricewaterhouse recommended the change to the revenue recognition policy for its subscriptions. On June 17, Red Hat reported full first-quarter results, using the new revenue recognition policy.

Szulik asserted that there was nothing unusual about the timing of the events and that the decision was triggered by a change in the audit partners, a normal rotation required by accounting rules.

Under the change to a daily revenue recognition policy, the revenue begins getting counted on the day the deal is struck, rather than at the first of the month. For example, if Red Hat signs up a subscriber on June 23, it will no longer begin counting the revenue on June 1, but rather will start the clock on June 23.

For fiscal 2004, the company expects to restate its revenue to somewhere between $123.8 million and $124.8 million, compared with its previously reported $126.1 million. Red Hat is also lowering its net income to a range of $13.2 million to $13.7 million from the previously announced $14 million.

Red Hat also expects to lower its fiscal 2003 revenue to around $89.7 million to $90.3 million, compared with its previously announced $90.9 million. And the company's net loss for the year is now expected to be in the range of $6.9 million to $7.2 million, compared to the previously stated loss of $6.6 million.

The Linux company also plans to revise its fiscal 2002 revenue to between $78.3 million and $78.9 million, from its previously reported $78.9 million. Red Hat's net loss is expected to drop to a range of $140.1 million to $140.5 million, compared with its previously stated loss of $142 million.

SEC's comment letter
Comment letters are written if the SEC has some concerns or questions regarding a filing a company has submitted, an SEC representative said.

Red Hat filed its annual report to the SEC on May 14, according to its electronic SEC filing. Red Hat representatives were unable to say when they received the SEC letter.

SEC reviewers usually take 20 to 30 days to send out a comment letter, the SEC representative said. If the regulators had maintained that schedule, Red Hat would have received its comment letter by mid-June.

Red Hat needed to communicate better with investors about the SEC letter and the other issues, Egbert said.

"These issues in a smaller company may not get noticed, but when you're a $5 billion company and growing fast," it's significant, Egbert said. "They're making misjudgments, and people are paying attention to them."