Early Warnings Signs A Software Stock Is In Trouble

Owning software stocks can be a frustrating experience.  Just when you think they can do no wrong, they often miss their earnings and fall like a rock only to rise up over the next few quarters and then have that renewed optimism crushed yet again by another earnings miss.   It can, and has, driven many a software investor crazy.

In the face of such volatility, knowing when to get out of software stock is critically important.  Given this importance, I thought I would provide a list of the Top 10 Early Warning Signs that a software stock is about to crater.  This list is largely based on my experience on Wall Street and as a VC and is by no means fool proof, but if you own a software stock (or are considering buying one) that has more than a few check marks on this list, you will want to be extra vigilant as there’s a decent chance your stock is headed for a meltdown.

Top 10 Early Warning Signs A Software Stock Is In Trouble (in no particular order)

1. It capitalizes software development expenses.
   According to a very silly FASB rule, software companies are required to capitalize development expenses for a specific product once they are reasonably certain that the product will be completed.  It just so happens that by capitalizing software development expenses software companies can also improve near term earnings by effectively amortizing current development costs over a longer period of time.  Because it’s very subjective just what costs can be attributed to a specific software project, it’s very easy for companies to ratchet up and down the % of development expenses that they capitalize with little or no objections from their accountants.   These factors have combined to make software development capitalization the heroin of software companies:  you get a strong sense of elation when you use it to get by that first tough earnings period, but pretty soon you are completely hooked and are constantly increasing the capitalization rate to achieve the same effect. Thankfully, most software companies do not capitalize software development expenses for several reasons including A) they realize once they start capitalizing it’s hard to kick the habit and B) they know that institutional investors hate it and that it will damage their stock.  That said, a large number of software companies still capitalize software development costs.  Thus, the stock of any company that capitalizes development should be approached with extra caution, especially one where the capitalization rate (Capitalized Costs/Total R&D spending) is increasing.
2. DSOs are greater than 95 days.
   DSOs or Days Sales Outstanding is typically viewed as a measure of how efficiently a company collects its accounts receivable.  High DSOs can potentially indicate two types of trouble at a company:  1) The company may be having trouble collecting accounts receivable because customers are either unable or have refused to pay.  2) The finance department may be mismanaged which raises the possibility that the company’s finance-related processes and  controls are in bad shape.  Some companies have good excuses for high DSOs, such as channel partners who habitually report late due to their own processes, but in general there’s no excuse for high DSOs.  Something in the range of 60-80 should be the norm and anything else should raise questions.
3. License revenues account for less than ½ of overall revenues and are declining.
   Licenses are the lifeblood of a software company.  The more licenses, the more long term revenue growth potential in the form of services, maintenance, and additional license sales/upgrades.  When license sales start declining as a percent of overall revenue it’s typically a warning sign that the market is becoming saturated and that overall revenue growth rates will be lower in the coming years.  Of course, declining license growth is a fact of life for most software companies as they age, so the real key is to make sure that the stock price doesn’t imply higher growth rates than the license revenue trends seem to support.   
4. It reports more than 30 days after the end of the quarter.
   Generally speaking, how fast a company reports it’s earnings is a fairly good indicator of how well managed the company is.   Closing the books on the quarter not only takes good financial systems and processes but also good operational systems.  If it takes a company 2 months to report its quarter, chances are that’s because their internal systems are royally screwed up and/or they are locked in a battle with their auditors over the more “aggressive” elements of their financials.  There are some good reasons that it might take more than a month to close the books (usually related to channel/partner issues), but in general any company taking longer than 30 days should be assumed to have a lot of bubblegum and masking tape holding together their internal systems.
5. EBITDA Margins are less than 10%.
   Software is a pretty good business.  It takes relatively little capital to get going and software products can typically generate gross margins in excess of 90% quite easily.  Indeed, the best software companies can produce net margins in excess of 35%.   In this light, failing to produce at least a 10% EBITDA margin in a reasonably mature software company is pretty much inexcusable.   If a company is unable to generate a 10% margin it means that it is either facing severe price competition or has a wildly bloated cost structure, neither of which is very encouraging. 
6. It does not provide a cash flow statement when it announces earnings.
   Cash flow statements are critical to assessing the underlying quality of an income statement.  If a company announces its earnings but doesn’t provide a cash flow statement it is basically leaving out the most important piece of the puzzle.  Failing to provide a cash flow statement may also indicate that the finance department doesn’t have their act together which undermines the credibility of any forecasts and estimates they are making.  Eventually the company will have to file a cash flow statement with their 10Q, but there a few good excuses for not having it ready when they report earnings.
7. It misses ship dates.
   Software companies are essentially code factories.   If a software company fails to meet an established deadline for shipping a new product it often means something is seriously wrong with the factory.   Granted, there are some legitimate reasons for missing ship dates, but almost any miss by more than a few weeks is strong circumstantial evidence that there are serious problems in engineering, product management or both.   Missed ship dates are not only important because they provide a measure of how well the factory is running, but they also are critical to driving revenues.
8. Its deferred revenues are declining.
   Deferred revenues are revenues that the company is generally guaranteed to recognize a few quarters in the future.  These revenues have become more important as companies are forced by revenue recognition policies and subscription-based licensing to defer an increasing amount of their revenues.  If deferred revenues are increasing faster than GAAP revenues that generally is a sign of strong growth.  If deferred revenues are decreasing that can mean that growth will soon slow down.  It also means that there are less revenues “in the bank” for the next quarter which can increase the risk of an earnings miss.
9. The head of sales and marketing leaves.
   If the company fires the head of sales and marketing it generally means that he is going to or has been missing his numbers.  If the sales and marketing head resigns on their own, it generally means that they think they are going to miss their numbers or can make more money working somewhere else.   Either way, it’s usually bad news for the company over the next couple quarters.
10. Competitors miss their forecasts.
    While it's possible a competitor missed their earnings forecast as a result of competitive pressures, due to the fast growth and relative immaturity of many software markets, it’s more likely they missed due to general weakness in customer demand.  This means that investors should closely follow the forecasts and results of firms that are directly or indirectly competitive with their investments.