Can the dot-com party go on forever? Not likely. The cops have finally burst in. And they're warning investors to stop acting like intoxicated college students on spring break. It's time to hit the books.
The Securities & Exchange Commission's crackdown on the aggressive accounting practices that have taken off among many dot-com firms really began last December, when it quietly issued new guidelines to refocus corporate management and investors on those very books. To rein in what it saw as an alarming trend in inflated revenue reports, the SEC required companies using lax accounting practices to restate financial results by the end of their next fiscal year's first quarter.
Enter MicroStrategy Inc., a Vienna (Va.)-based software company. On Mar. 20, its shares plunged a spectacular 62%, from $226 to $86, when it announced a restatement of 1998 and 1999 financial results. Last year's $12.8 million profit turned into an estimated loss of between $33.6 million and $39.9 million. Shares fell an additional $14 the next day, and the company has been forced to postpone a planned secondary offering.
MicroStrategy's faux pas? It had recognized millions in revenues too soon. In the second half of last year, for example, it originally reported $36.5 million out of $103.5 million in three new contracts as revenues, deferring the rest to be reported when the work was completed. But to comply with the SEC, it now plans to defer all of that revenue until each contract is completed. That will be a few years from now.
Already, some 32 other companies have similarly restated earnings based on the SEC guidelines, according to Bear, Stearns & Co. Yet none did so with MicroStrategy's ignominy. The company's misfortune is a wake-up call to all dot-com investors. The message: It's time, at last, to pay attention to the numbers.
The SEC has also directed the Financial Accounting Standards Board to review a range of Internet company accounting practices that could boost revenues or reduce costs unfairly. Under the scrutiny, more companies are likely to issue restatements of financial results, and fast growing dot-coms may see their revenue growth slow. And that, in turn, "can't be good news for market valuations," says accounting watchdog Howard M. Schilit. "Being a good stock-picker will become important again."
Indeed, over the last several years, investors have all but ignored old-fashioned financial analysis when it came to investing in Web startups or other tech favorites with little or no foreseeable profits. As momentum investing completely overtook the tech-driven bull market, they didn't need to. To pick winning stocks, it became far more important simply to choose companies that other investors assumed were destined for fast growth and hop on for the ride. Many people have made an awful lot of money in the last couple of years by refusing to look too closely at how solid the underlying revenue or income statement numbers actually were.
Now, though, the SEC is stepping in to remind investors that sometimes a more hard-nosed evaluation of a company's prospects is needed. MicroStrategy's case has hit an especially sensitive nerve. "Investors haven't been caring about the quality of revenues--just whether revenues are going up," says Jack Ciesielski, editor of the Analyst's Accounting Observer, a Baltimore-based newsletter. Now, "tech companies are going to have a little more trouble pulling off some of the hokier forms of revenue recognition." MicroStrategy says it thought its original accounting was reasonable.
The exaggeration of revenues is particularly problematic for dot-com investors. Since many of these companies don't have earnings, investors are relying on revenue growth as a key benchmark. That focus has resulted in "pressure on these companies to book revenue up front" and as soon as possible, says Chuck Teubner, CFO of Annapolis (Md.)-based USinternetworking, a software service provider.
To do so, they sometimes stretch the limits of sensible accounting. Companies that act as brokers or travel agents, such as priceline.com Inc., often book the full cost of the airline tickets they sell, instead of just their commission as a real-world travel agent would. Priceline contends its accounting is sound, because unlike agents, it does take ownership of the ticket for a short period of time during the transaction.
Others have found favorable ways to account for expenses. Amazon.com Inc. is one of a number of companies which assigns some costs to sales and marketing expenses rather than to the cost of goods sold. That's an advantage because investors view dot-com companies' marketing expenditures as a necessary ramp-up cost, while cost of goods sold eats into gross margins. The SEC is also examining other issues, including the bartering of online ads. By exchanging $1 million worth of ads on their respective sites, for example, two online companies can each inflate revenues with no cash ever changing hands.
Even MicroStrategy CEO Michael J. Saylor, who has relentlessly promoted his company to investors, says he's learned one lesson. "Our stock doubled after we announced our secondary offering [on Feb. 24], but the company wasn't twice as good," he says. "Yesterday, the stock was chopped in half, but the company wasn't half as good, either."
Still, once-exuberant investors have wisely taken the SEC's cue and become less sanguine. "All these high-multiple stocks have come down because everyone's wondering who's next," says Alan Loewenstein, co-manager of the $2.1 billion John Hancock Technology Fund. That renewed acknowledgment of risk is welcome, as the fairy-tale market gets more in sync with reality. The happy ending just might be smarter investors basing their decisions on real numbers.