by Bradley Cipriano, CPA
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

The software industry is rapidly adopting a Software-as-a-Service (SaaS) subscription model, which tends to drive higher lifetime customer values, and lower volatility in revenue and earnings growth compared to the traditional software licensing model. SaaS companies, which provide their software on a subscription basis via the cloud, have grown at a rapid pace in recent years. Moreover, they are poised to continue their strong growth trajectory as more enterprises adopt cloud-based services. And yet according to Synergy Research Group, SaaS revenue accounted for only about 23% of the total software market in 2019 despite growing 39% YOY and eclipsing $100 billion in annual sales, as shown below in Chart 1.

Chart 1. Enterprise SaaS Market Growth

The relatively low penetration rate of SaaS models implies that there is plenty of runway left for increased adoption. Unfortunately, when companies migrate toward a subscription billing model, financial transparency diminishes as the financial statements are impacted by the change. For example, sales growth tends to decelerate and cashflows tend to decline. These trends can be misconstrued as a sign of a financial distress when instead the company is rapidly growing while transitioning its billing model. However, sometimes the distress is real.

Given the benefits and the relatively low penetration rate of SaaS models, we believe that software providers will increasingly migrate towards a subscription model going forward. Therefore, we likely will continue to observe software companies reporting decelerating growth and deteriorating cashflows during the migration. However, we also must be on the lookout for companies that are under fundamental pressure and are using the SaaS migration explanation to disguise growth and cashflow headwinds.

In this article, I attempt to discern between these two possibilities. First, I describe how transitioning from a licensing sales model to a subscription billing model can impact a software company’s financial statements. Then, I examine two different companies that have undergone a SaaS billing model transition – Adobe Inc. (ADBE) and MicroStrategy Inc. (MSTR) – and point out key differences between them that can help investors differentiate between an apparent slowdown in sales caused by a successful SaaS transition and an actual slowdown caused by fundamental headwinds. In my view, ADBE is an example of a successful SaaS transition, while MSTR is an example of a company that was struggling to grow sales all along but temporarily disguised these issues as a “normal” transition. I conclude by applying the same analysis to Splunk (SPLK), which is in the midst of its own transition to a SaaS billing model.  Read on...

Ryan DesJardin  by Ryan DesJardin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Here at Gradient Analytics, our focus extends far beyond domestic equity research. We are known to cover an extensive group of publicly traded companies whose shares trade on a wide variety of stock exchanges around the globe. Our team of analysts must be vigilant in keeping up to date on new accounting standards issued by both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). More importantly, our team must be able to understand and reconcile the key differences between United States Generally Accepted Accounting Principles (US GAAP) and International Financial Accounting Standards (IFRS) in order to accurately assess a firm's financial health.

The ability to distinguish between these accounting standards has become a crucial skill for investors as IFRS has become increasingly prevalent in recent years. Today, more than 140 countries worldwide (including the United States in some cases) either permit or require the use of IFRS for publicly listed companies. In fact, there are only three major capital markets that don't currently mandate the use of IFRS for publicly traded firms: Japan, China, and the United States. Since 2010, when Japan added IFRS to its list of approved standards for domestic issuers, more than a third of companies traded on the Tokyo Stock Exchange have either adopted or instituted a plan to adopt IFRS in the near future. China continues to amend its accounting standards to broadly align with IFRS. Furthermore, domestic investors must also be mindful of the variations between accounting standards as the SEC allows foreign issuers to report under IFRS despite trading on US exchanges.

In 2002, the FASB and IASB entered into the "Norwalk Agreement," which aimed to eliminate the many variations between US GAAP and IFRS. Since then, the boards have worked together to issue several accounting standard updates in an attempt to enhance the consistency and comparability of global accounting standards. Despite these ongoing efforts, many key dissimilarities remain between the two standards that present a number of obstacles to investors. This article uses earnings quality and fundamental perspectives to discuss key challenges while providing tips on evaluating a firm’s true earnings power.  Read on....

Rachel Bradley  by Rachel Bradley
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

At times, there are conflicts of interest between a company’s management and its investors, specifically shareholders, which creates a structural agency problem. So, it is common for companies to try to align the monetary interests of management with shareholders by awarding a large part of executive compensation in equity. As a result, management performance metrics often create an incentive to present the current period financials in the best light possible, even if it is unsustainable in the longer-term. This dynamic creates opportunities for a forensic accounting firm like Gradient Analytics, which specializes in assessing the quality of reported earnings of publicly traded companies to both vet long candidates and to identify short candidates.

An astute investor might ask the perfectly reasonable question, “If publicly traded companies are regulated and audited, then aren’t all reported earnings of passable quality?” However, consider that it is possible for a company to engage in “earnings management” by publishing financial statements that may mislead investors as to the firm’s true financial health without violating accounting standards. Moreover, we would argue that even though two given companies both followed GAAP accounting standards and received clean opinions from their auditor, earnings growth at Company A may be dramatically more sustainable than at Company B. Of course, it can be quite valuable for an investor to know when a firm is showing signs of unsustainability in its reported earnings growth.

In this article, I use three real-life examples to provide a high-level overview of our analysis process, which includes assessing earnings quality, anomalous insider trading activity, audit control risk, and corporate governance. Although Gradient does not employ a team of investigative journalists to knock on doors, interview company employees, or rummage through the trash for evidence, our comprehensive analysis of the published financial statements (and, importantly, the footnotes) can help stack the odds a little bit more in investors’ favor.  Read on....

Bradley Cipriano  by Bradley Cipriano, CPA
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

As interest rates remain at historic lows, mergers and acquisitions (M&A) have soared in recent years. With the rise in M&A activity comes a rise in accounting complexity, introducing a plethora of ways that management can cosmetically improve their as-presented results – and mislead investors. Gradient Analytics specializes in forensic accounting analysis that helps to uncover these types of financial shenanigans, including overstated assets and revenues, understated liabilities and expenses, and weakening earnings quality. This type of analysis is useful for both vetting long positions and generating short ideas.

In this article, I describe four acquisitions that we believe were used to obscure underlying financial weakness at the parent company by temporarily shoring up growth and earnings. Key takeaways are how management can utilize acquisitions, purchase price accounting, and non-GAAP adjustments to optically improve their as-presented results. In each case, the theme will remain consistent: the acquiring company was under fundamental business stress.

The subject transactions include:

  • SodaStream (SODA) acquisition of its distributors in 2012 and 2013
  • SNC-Lavalin (SNC) acquisition of WS Atkins in 2017
  • Belden Inc. (BDC) acquisitions in 2017 and 2018
  • The Walt Disney Corporation (DIS) acquisition of 21st Century Fox in 2019

Read on....