The Starting Line: Quarter end plagues software business

The past week and a half has seen a bevy of profit warnings from business application makers. Bearers of bad news included: Commerce One, Art Technology Group, Epiphany, Internet Security Systems, Informatica, i2 Technologies, BroadVision, Compuware and, most recently, BMC Software. They sell different products, but they share many of the same customers, which decided at the last minute to leave long-pending software contracts unsigned.

That meant sales and profit expectations, which seemed reasonable for 11 weeks, suddenly looked naively optimistic. And there was nothing software companies could do about it except hope deals are signed before the next quarter ends.

Although technology companies have been warning almost nonstop throughout the June quarter, enterprise software pre-announcements in the first week of July exceeded the total for the previous two months. In other words, not until the quarter ended did most vendors of business applications realize results would be disappointing.

For most of the earnings period, the so-called pipeline--the list of pending deals--looked promising, but as always, companies didn't close most of their deals until the last days of the quarter. Industry observers say corporate software buyers have been using end-of-the-quarter pressure for years.

"Customers have been trained to hold the salespeople up," said Damian Rinaldi, analyst with FAC/Equities. "It's a very efficient tactic for a large customer. Customers know if they wait longer in the quarter, they have more negotiating power."

By delaying a contract signing until the end of a vendor's quarter, customers hope to get discounts as software companies scramble to book enough sales to meet their quarterly goals. Companies can get 5 percent to 10 percent discounts on software at the end of a quarter from sales representatives eager or desperate to hit their quotas for the year, said Frank DeSalvo, director of research for Gartner's software asset management unit.

At the other end, many software companies give a larger bonus to sales representatives who can get contracts signed in the first month of a quarter, he said.

Every enterprise software company's sales force feels pressure at the end of a quarter, said John Cox, chief financial officer for BMC Software, which on Thursday warned of lower-than-expected profits in the second quarter. It's human nature for buyers to delay purchases until the last days of a fiscal period, Cox said.

"People tend to put everything off until the last minute," he said. "They are also advised by third-party consultants to exhibit this kind of behavior."

Consulting companies such as the Gartner, Meta Group and IDC say it only makes sense to delay software contracts until the final days of a vendor's quarter or fiscal year.

"First conversation I have with a customer is, 'Do you know when your vendor's year end is?' " Gartner's DeSalvo said. "Why wouldn't you? The vendor's sales force is bulked for this. They're prepared for it."

Shock to the system
Software companies are used to the quarter-ending frenzy by now, but investors remain unsettled by many companies' misses. ISS lost 40 percent of its market value after the security software vendor told investors a week ago to expect poor results for the June quarter. BMC Software gave up more than 9 percent after its caution on Thursday. EMC's Thursday's warning not only sent that company's stock price down 28 percent, but also carved a chunk of the entire storage networking sector; CNET's Storage index dropped more than 26 percent.

That uncertainty exists even in good economic times for enterprise software companies, for which one contract can mean the difference between beating analysts' profit estimates by 100 percent and missing them by half. Closing deals becomes a nightmare in a slow economy.

Industry jargon refers to "longer sales cycles," but there's a simpler way of describing what happens to corporate decision-making during an economic slump: It slows down--a lot.

Contracts are pushed even closer to a quarter's end, and it's still not enough time in many cases. For example, at least 40 percent of Internet Security Systems' expected contracts in the June quarter were delayed into the next earnings period, the company said.

Software providers have reported that many deals now require approval of higher-level executives than before. At some companies, large software contracts are now reviewed by the board of directors, Cox said.

And that kind of corporate indecision occurs even though buyers have all the negotiating leverage these days, analysts and executives said. Software companies might be desperate to close sales, but a Fortune 500 company doesn't need to buy software to meet its near-term quarterly financial targets. Software usually isn't needed right away, said DeSalvo, adding that 95 percent of corporate software contracts involve merely upgrades or extensions of existing products, rather than a completely new customer win.

All this makes it even more difficult than usual to predict enterprise software vendors' quarterly results, and that makes their stocks riskier buys. Only intrepid investors would invest in a company whose earnings wobble from one quarter to the next.

Improving accuracy
Many software companies have tried unsuccessfully to eliminate quarter-end sales blitzes, and most vendors these days have come to accept it as standard practice.

"I'm a realist," BMC's Cox said. "I just don't think you'll get out of that pattern. If you know of an example of somebody doing it well, I'd love to learn from them."

Instead of changing the timing of a deal, several software providers have focused on changing the contracts themselves so that the revenue is recognized over time, as services as rendered. Those "ratable" contracts create a backlog of revenue--and thus profits--that is predictable, because it is guaranteed.

Between 40 percent and 42 percent of BMC's revenue now comes from those ratable deals, Cox said. Although the company has never revealed a specific long-term target for how much of its business it hopes to be ratable, BMC clearly wants more than half of its revenue to be on that predictable stream.

But only so much business can be prorated over time, DeSalvo said. Although customers don't care how a supplier recognizes revenue, software companies shouldn't put too much revenue in the "ratable" category, because that can make it harder to interpret a company's earnings, DeSalvo said. "Investors need to know what the income actually is," he said.

Even with the shift toward different revenue recognition, software companies will always get a significant piece of revenue at the very end of fiscal quarters, analysts and executives said. And the last few days of a quarter will continue to be mad dashes for sales representatives, even for the companies that sell software to BMC itself.

"I just closed a very good deal on the last day of the quarter with a software company that you would recognize instantly," Cox said. "We're guilty of doing what we don't want our customers to do."