Track record of consistent growth
Australian software company, Technology One (TNE) has a track record of reporting consistent growth. Profits have risen 14-16% almost every year over the last decade, as Figure 1 shows. The unusually low volatility suggests smoothing of earnings, as TNE’s high operating leverage means any extra short-term revenue falls straight to the bottom line. TNE has been moving from a traditional “on-premise” model, where software is run on the customers’ computers, to cloud-based “software as a service” (SaaS), although the former still accounts for the majority of its revenue.
Inflating revenue growth
TNE’s revenue took a big hit when new accounting rules on revenue recognition[1] came into effect in FY19. It must now recognise almost all its revenue evenly over the full contract period, having previously booked a high proportion upfront, sometimes years before receiving the cash. TNE has hidden a major slowdown in recent years, using various accounting tricks to pull forward revenue and inflate growth during the transition to the new rules. We estimate underlying revenue was flat in FY18 and grew just 1% in FY19, compared with reported growth of 9% and 13% respectively.
Pulling forward revenue in FY18
The first clue that TNE pulled forward revenue in FY18 is the substantial increase in unbilled revenue (now called contract assets). This is revenue that has been recognised, even though payment is not yet due. Under the previous rules, TNE booked a significant proportion of the revenue it would receive over the life of SaaS subscriptions (lasting up to five years) at the start of the contract. It recorded unpaid amounts as unbilled revenue, which rose 76% in FY18 to A$46m, as Figure 2 shows. The A$20m increase in unbilled revenue in FY18 (up from just A$6m in FY17), which represents the contribution to total revenue, boosted growth in FY18 by around 5ppts.
The second way TNE artificially boosted FY18 revenue was by changing the annual renewal date for some of its customers, bringing them forward from FY19 to the end of FY18. Under the old recognition rules, TNE booked most of the revenue from annual support upfront on the renewal date. TNE was able to record revenue on the new renewal date that otherwise would have been recognised in FY19. For example, if a customer’s renewal date was moved from just after to just before the FY18 year-end, TNE could recognise almost a full year of extra revenue. The company confirmed to us that it booked additional revenue in FY18 from changing renewal dates but would not say how much[2]. However, it is probably the main reason for the unusually strong growth in annual support revenue of 23% in the second half of FY18, up from just 6% in the first half, as Figure 3 shows. Assuming underlying growth in 2H18 was the same as 1H18, we estimate TNE recognised A$13m of additional revenue in FY18 by changing the renewal dates, boosting full-year growth by around 5ppts.
The final indication that TNE inflated revenue in FY18 is the slowdown in growth in deferred revenue (also referred to as unearned revenue and prepaid subscription revenue), which is included in current liabilities. This represents amounts customers have paid in advance that have not yet been recognised as revenue. Previously, deferred revenue primarily comprised annual cloud-service fees that had been paid, but which TNE recognised evenly over the contract period. Deferred revenue had been rising rapidly, reflecting strong growth in the SaaS business, but increased just A$3m in FY18, or 12%, as Figure 4 shows, despite continued growth of 56% in revenue from cloud-service fees. The small increase in deferred revenue supports our contention that additional revenue was pulled forward into FY18.
We estimate the factors discussed above inflated FY18 revenue as originally reported by around A$33m in aggregate. Adjusting for them, underlying revenue was flat in FY18, compared with reported growth of 9%, as Figure 5 shows.
Boosting revenue in FY19
TNE restated its FY18 financials when the new recognition rules came into effect[3]. FY18 revenue fell A$44m, or 15%, to A$253m, taking it back to the level in FY16, as Figure 6 shows. The extra revenue pulled forward into FY18 was reversed and can be recognised again in FY19 and future years.
Reported revenue growth of 13% in FY19 was only achieved by recording substantial amounts of new unbilled revenue. The balance outstanding at YE18 had been almost wiped clean on restatement, falling from A$46m to just A$2m. However, it quickly rebounded in FY19 rising to A$25m by the year-end, as Figure 7 shows, boosting FY19 revenue by around A$22m. The company told us that the increase was primarily because of several large deals where customers were allowed to pay in instalments. This was reflected in revenue from on-premise initial licence fees, which TNE continues to recognise upfront, more than doubling year-on-year in 2H19. The suspicion is that TNE is structuring contracts to achieve profit targets. At best, this extra revenue was a one-off benefit, which artificially boosted revenue and profits in FY19.
While it is not always inappropriate to recognise revenue before the customer has been billed, high levels of unbilled revenue are often a sign of aggressive revenue recognition. Excluding movements in unbilled revenue, we estimate underlying revenue growth was just 1% in FY19, as Figure 8 shows.
Cash receipts reflect slowdown
Growth in cash receipts from customers, shown in the cash flow statement, provides support for the slowdown in underlying revenue growth. Cash receipts increased just 1% in FY18 and 4% in FY19, much lower than the reported growth in revenue of 9% and 13%, as Figure 9 shows. Moreover, adjusting cash receipts for movements in receivables, growth was negative in both FY18 and FY19 at -1% and -2% respectively.
Exaggerated profits
TNE filled the hole in its profits resulting from the new revenue recognition rules by capitalising development costs for the first time in FY19. However, most of the benefit was due to the low initial amortisation charge, which will increase over the next few years and should be a major headwind for future profit growth. In addition, almost all the extra revenue pulled forward in FY18 and FY19 will have fallen straight to the bottom line, artificially boosting profits. Overall, we estimate TNE exaggerated pre-tax profits in FY19 by over 200%.
Filling a hole
The A$44m decline in FY18 restated revenue from the new revenue recognition rules resulted in a A$42m reduction in pre-tax profits[4]. Restated pre-tax profits of A$25m were 63% lower than the A$67m originally reported, as Figure 10 shows. To fill this ongoing hole in its profits resulting from the new rules, from FY19, TNE started capitalising a substantial proportion of its development costs, including A$32m in FY19, having previously fully expensed them, Capitalised costs are recorded on TNE’s balance sheet and amortised over 3-7 years. Its earnings benefited by almost the full amount as the amortisation charge in the first year was less than A$1m. Without the decision to capitalise development costs, TNE’s FY19 pre-tax profits would have been around A$45m, 41% lower than the A$76m reported level.
Amortisation headwind
TNE’s decision to start capitalising development costs while technically permitted is, in our view, aggressive. Having previously expensed all such costs as incurred, it capitalised around 53% of total spending on R&D in FY19. Accounting rules require development costs to be capitalised if certain conditions are met although management has significant discretion on whether and how much to capitalise. In practice, most software companies globally capitalise no development costs, or only relatively small amounts. Indeed, capitalisation on such a large scale appears limited to a small number of ASX-listed companies, such as WiseTech and Xero.
More importantly, most of the current profit benefit is because TNE has not previously capitalised any development costs. As a result, the amortisation charge is very low. However, as the amortisation increases, it should be a major headwind to profit growth over the next few years. We estimate that if TNE had amortised development costs all along, amortisation would have been roughly A$24m in FY19. With the actual charge close to zero, it implies A$24m of the A$32m profit benefit in FY19 was from the decision to start capitalising. We estimate the total profit benefit from capitalising will fall to around A$10m by FY24, as Figure 11 shows, as the amortisation charge increases and the introduction benefit declines to zero.
Aggressive revenue recognition
TNE’s profits are extremely sensitive to the timing of revenue recognition. In general, any extra revenue in the short-term falls straight to the bottom line as costs remain unchanged. We assume the additional revenue pulled forward (A$22m in FY19 and A$33m in FY18) has inflated profits by a similar amount. Excluding this revenue and the A$32m benefit from capitalising development costs, we estimate adjusted pre-tax profits were just A$22m in FY19, 71% lower than the reported level of A$76m, as Figure 12 shows.
Declining tax charge
Another indication that TNE has inflated profits in recent years is the decline in the current tax charge in the profit and loss. While the overall tax charge has risen in line with profits, an increasing proportion has been deferred. Current tax has fallen from around A$13m in FY17 to just A$7m in FY19. It suggests profits reported to the taxman are significantly lower than profits disclosed in the financial statements.
The amount of tax paid has remained broadly constant over the last five years at roughly A$11m, as Figure 14 shows. Furthermore, an increase in current tax assets to around A$7m at YE19 suggests that TNE has paid too much tax in recent years.
Lagging cash flow
The decline in TNE’s underlying profits in FY19 is reflected in its weak operating cash flow which fell 16% on a like-for-like basis after deducting capitalised costs, despite substantial inflows from declining trade receivables and rising trade payables. TNE’s cash flow should be strong relative to profits as customers typically pay in advance. However, TNE’s aggressive revenue recognition means that operating cash flow has been consistently lower than cash profits[5] and has failed to keep pace with profit growth; operating cash flow has declined from over 90% of cash profits in FY16 to just 56% in FY19, as Figure 15 shows. In our view, TNE’s problem is not weak cash flow but overstated profits.
About GMT Research
GMT Research is an accounting research firm, based in Hong Kong and regulated by Hong Kong’s Securities and Futures Commission. We provide research to our clients who are institutional investors and do not take positions ourselves in any of the companies we write about.
[1] AASB 15, which is the Australian equivalent of IFRS 15
[2] It also included additional wording in its FY18 Annual Report making clear that revenue was recognised on the new date. See note 1, p107
[3] For the full impact, see FY19 Annual Report, note 1, p107
[4] See FY19 Annual Report, note 1, p107
[5] Calculated as reported pre-tax profits plus D&A and share-based pay, minus cash tax
