Foggy metrics obscure the value of cloud businesses

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Cloud computing companies have been in high demand on Wall Street this year, enticing investors with their rapid growth and reliable, subscription-based business models.

the BVP Emerging Cloud Index, led by companies like Adobe, Salesforce and Zoom, is up 84% this year, compared to a 36% increase on the Nasdaq and 13% on the S&P 500.

But investors and other financial experts warn that the seemingly bullet-proof revenue streams and future order books of cloud companies aren’t always what they appear to be.

A new revenue accounting regime has made it difficult to assess industry performance, and the key criteria that are widely used to value cloud companies are based on metrics that leave a lot of flexibility for companies to choose the most treatment. favorable.

The difficulties arise from adapting traditional accounting rules to a new generation of companies that sell services on multi-year contracts, said Tien Tzuo, CEO of Zuora, a cloud company that provides software to run businesses. subscription-based.

He and other cloud software experts described the resulting discrepancies as startup problems, rather than signs of deeper financial problems. But with many cloud companies now trading sky-high valuations, there’s little room for error.

Recognize future income

At the heart of the matter is how to account for revenue generated by cloud software contracts and assess future revenue that investors can count on.

Cloud companies typically sell bundles that include some up-front work, like implementing a new software system for a customer and training staff, as well as multi-year subscriptions to their products.

Investors have rewarded companies that can show reliable future income, prompting companies to characterize as much of the income as possible as repeat business, noted Ravi Kumar, a Connor Group partner who advises investors on accounting matters.

“People are trying to build every piece of the value proposition into the software,” said Byron Deeter, partner at Bessemer Venture Partners, a venture capital firm that invests in cloud start-ups. Venture capitalists are usually able to dig deeper into a company’s contracts and can do their own valuations, he said, although stock investors get less information.

When to register income?

A related problem arises from determining what part of a contract has been performed in a given period – meaning that revenue can be recognized rather than carried forward to a future period. Companies that sell three-year contracts can split the revenue evenly or vary the amount based on how much value they believe was delivered in a given year. New cloud computing companies often lack procedures to accurately assess how to allocate revenue from complex contracts, Kumar said – a problem that could spill over to Wall Street as high demand for cloud stocks leads companies to enter. on the stock market at an earlier stage.

Revenue timing has become particularly pressing for mixed-business software companies, selling both cloud services and traditional “on-premises” software. A new accounting rule that came into effect for public companies two years ago, ASC 606, requires companies to immediately book all on-site sales, even if the business relationship lasts long into the future.

This has penalized companies with more on-premises activity and could produce distortions as they seek to channel more of their sales to the new, more popular segment of the cloud, said Tomasz Tunguz, of Redpoint Ventures.

It marks a complete reversal of how a previous generation of software companies were judged. Accounting scandals of the past – like that of Computer Associates, which led to a 12-year prison sentence for its CEO – often stemmed from efforts to report income immediately, when it should have been spread over future periods. .

“In the old days, regulators wanted to make sure you didn’t set aside too much revenue up front: now they’ve completely shifted,” said Jason Child, former finance manager for Amazon’s international operations and now CFO. . at Splunk, an analytics software company.

It has yet to lead to high profile scandals, although some complaints have spread in public view. Oracle recently asked a judge to dismiss a lawsuit seeking class action status over allegations it required customers buying its traditional on-premise software to also take out cloud contracts, in order to exaggerate that part. of its activity.

Informal measures of success

At the same time, the focus on long-term income has led Wall Street to focus on a set of informal measures, outside of accounting principles, which are applied “extremely differently” and create inconsistencies “when you compare a company to another, ”Kumar said.

One of these new metrics, known as net dollar retention, aims to measure the volume of business a business generates in a given year by the customers it had the previous year. For example, a company that loses customers representing 5% of its turnover, but generates 15% more sales than those it retained, could claim a net dollar retention rate of 110%, sign of healthy growth and business.

Differences in the definition of who should be considered a “new” customer, however, make this calculation much less clear than it appears, Deeter said. Some software companies account for new sales to different parts of a large group as to the same customer, while others treat different subsidiaries or different geographies separately.

Some customers are also excluded from the calculations. Box and Zendesk, for example, exclude their smaller customers. Zoom last week reported a strong 130% net dollar retention rate for its largest customers. But it excluded small customers who now represent 38% of its turnover.

Calculation of the churn rate

Another imprecise measure is the churn level, or the rate at which customers don’t renew their contracts when they expire. Most cloud computing companies don’t divulge this figure as a given, although it is commonly reported at the time of an IPO.

How the number is calculated can make a big difference. For example, a company that started the year with revenue of $ 50 million and lost customers worth $ 10 million, but added enough new business to reach $ 100 million. dollars, could report an churn rate of 20% (the proportion of its original business lost) or 10 percent.

“If you’re a high-growth company, you can probably hide attrition for a while,” Child said at Splunk. Splunk shares fell nearly 26% last Thursday after reporting lower than expected earnings.

Are the revenues really recurring?

Wall Street’s most popular new benchmark for valuing cloud companies, known as annual recurring revenue, is also open to interpretation. A measure of revenue that a business can count on each year, it has become the gold standard for subscription businesses.

But what should be considered “recurring” is not always clear. If customers have the right to terminate a three-year contract after the first 12 months, for example, it can lead to differences of opinion, Kumar said.

This has led some companies to modify their contracts, he added, “bundling and repackaging” the same company differently to produce different financial treatment, without making any underlying changes to their business model.

The appeal of ARR has spread far beyond the software world. Companies in other industries that can claim a high level of guaranteed business renewal have also started to adopt the term.

They include online pharmacies such as Alto Pharmacy, which can point to customers with long-term health issues that have led to repeat prescriptions. The startup, whose investors include Japanese tech investor SoftBank, boasts that it is “on track to reach $ 1 billion in ARR by 2021.” In theory, however, customers of businesses like this could take their prescriptions elsewhere at any time, Kumar said.

Despite the pitfalls, investors like Deeter say Wall Street’s enthusiasm for cloud software companies is well founded. Their subscription business is inherently more stable than the one-time license sales that software companies previously relied on, and the new metrics offer a better way to judge them than they did before.

However, with industry stocks priced to perfection, that still leaves a lot of room for disappointment.

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