Monday, May 08, 2006

Blog of the Week: The Seeking Alpha Network

Growth Indicators for Software Companies — An Investors’ Guide

William Trent (Stock Market Beat) submits: Software companies have unique characteristics that help investors spot potential positive or negative trends earlier than is possible for many other types of companies. Two of these characteristics are license revenue and deferred revenue. If these two line items are growing at a faster rate than overall sales the implications are generally positive for the company. If they are growing at a slower rate, investors may want to inquire further before making an investment decision. Here’s why.

Software companies typically generate (at least) two types of income streams. License revenue is earned when the company provides the software itself. This gives the customer the right to use the software. Frequently customers also pay for maintenance and support, which could include updates, training and other support. It follows that the more computers a company’s software is installed on, the more need there will be for maintenance and support. So trends in licensing revenue can be an early indicator for the direction of future maintenance revenue. Software maker ANSYS (ANSS) offers the following elaboration on page 22 of its recently filed 10Q:

A substantial portion of the Company’s maintenance revenue is derived from annual maintenance contracts. These contracts are generally renewed on an annual basis and have a high rate of customer renewal. In addition to the recurring revenue base associated with these contracts, a majority of customers purchasing new perpetual licenses also purchase related annual maintenance contracts. As a result of the significant recurring revenue base, the Company’s maintenance revenue growth rate in any period does not necessarily correlate to the growth rate of new maintenance contracts sold during that period. To the extent the rate of customer renewal for maintenance contracts remains at current levels, incremental maintenance contracts sold with new perpetual licenses will result in maintenance revenue growth.

The second indicator software companies have is...

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