18 November 2007

BEAS: Financial Analysis through October 2007 (Preliminary)

BEA Systems (BEAS), a developer of software that connects an enterprise's diverse information technology assets, has, at long last, produced 10-Q and 10-K financial statements for the periods that ended in July 2006, October 2006, January 2007, April 2007, and July 2007. The company also released a preliminary report on the October 2007 quarter.

The financial statements had been delayed while the company investigated its practices for granting and accounting for employee stock options. Last February, BEA announced the principal findings, which covered a period of about 10 years. The investigation determined that historical financial statements would have to be revised to include additional non-cash, pre-tax compensation expenses totaling between $340 and $390 million. The estimated charge was subsequently bumped up to $425 million. To put this charge in perspective: BEA had once reported net income totaling $441 million for the five fiscal years that ended on 31 January 2006.

NASDAQ could have suspended trading of BEA shares for failure to submit timely reports in accordance with regulatory requirements. Although the anticipated date for filing these reports repeatedly slipped, a "delisting" decision was never put into effect. This risk is now less of a concern since the 10-Q and 10-K reports identified above were filed on 15 November 2007.

The SEC has asked for, and received, information about BEA's stock option practices. SEC inquiries into these practices are on-going.

Activist investor Carl Icahn purchased shares in BEA this year, and by 3 October Mr. Icahn owned 11 percent of the company. The ownership level increased to 13 percent soon thereafter. Mr. Icahn publicly contended that the company should be put up for sale. On 12 October 2007, Oracle Corp. offered to purchase BEA for $17.00 per share in cash, but BEA rejected the overture as inadequate. Oracle set a 21 October deadline for BEA to accept the $17 offer; however, BEA refused to negotiate unless Oracle first raised its bid. The BEA board set $21 per share as price at which they would negotiate the sale of the company. Oracle refused to meet this demand and withdrew the original offer when the deadline expired.

When this saga was unfolding, BEA's non-compliance with regulatory requirements certainly didn't help the company's negotiating position. And, it complicated plans to hold an overdue annual meeting, which was demanded by Mr. Icahn in a lawsuit. Had audited financial statements remained unavailable, company management wouldn't have been able to solicit proxies for seats on the board of directors. An outside investor, not subject to this constraint, could have exploited this situation to his advantage. These factors might have given management the extra impetus needed to complete and file the delinquent financial reports, which took place on 15 November.

We have performed a financial analysis of BEA using data from BEA's new SEC filings and the preliminary report on the October 2007 quarter. There was a lot of information to examine, and we caution readers to consider the results described below as tentative and subject to change. We relied on (with one exception noted below) the data prepared in accordance with GAAP; however, comparisons of different time periods using GAAP data can sometimes be misleading. Non-GAAP comparisons might have been more valid in some cases.

In the analysis, we reluctantly made one exception to our normal rules. We excluded from the Income Statement for the 31 January 2007 quarter an asset impairment write-down of $201.615 million on land in San Jose. The magnitude of this loss is so great that it obscures our view of company's software business. However, since shareholders' money was, in fact, forfeited on this land, we did not exclude the loss from the Cash Flow Statement.

The data for the October 2007 quarter is limited in that the Balance Sheet was condensed and a Cash Flow Statement wasn't provided. We will update our evaluation after the company submits a complete report for the October 2007 quarter to the SEC in a 10-Q filing.

Using the available data, our gauges display the following scores:

Before we examine the factors that affected each gauge, let's compare Income in the last four quarters to income in the four previous quarters. Please note that the presentation format below, which we use for all analyses, may differ in material respects from company-used formats. The standardization is simply for convenience and to facilitate cross-company comparisons.

4 Quarters
October 2007
4 Quarters
October 2006
1487 1352
Op expenses

CGS (355) (322)

R&D (241) (224)

SG&A (692) (631)

Other (2) (5)

197 169
Other income

Investments 0 0

Interest, etc. 52 36
Pretax income
249 206
Income tax
Net Income
179 134

0.43/sh 0.32/sh

Year-over-year Revenue was up 10 percent. The Cost of Goods Sold (CGS) was steady at a little less than 24 percent of Revenue in both four-quarter periods. Research and Development (R&D) expenses as a percentage of Revenue declined a little from 16.6 to 16.2 percent. Sales, General, and Administrative (SG&A) expenses were trimmed from 46.7 to 46.5 percent of Revenue.

The increase in Revenue pushed up Operating Income by 16 percent.

The recent four-quarter period benefited from an increase in non-operating income of $43 million and a reduction in the effective Income Tax Rate from 34.7 to 28.2 percent. As a result, year-over-year Net Income rose by 33 percent.

Cash Management. This gauge reads 13 points.

The following measures pushed the score up the most:
The following measures held the score down:

Growth. This gauge reads an impressive 19 points.

The following measures pushed the score up the most:
  • Net Income growth = 33.2 percent year-over-year, up from -13.4 percent
  • Revenue/Assets = 64.4 percent, up from 54.6 percent in a year; sales efficiency is improving.
  • Revenue growth = 10 percent year-over-year, down from 17.6 percent.
Net income benefited from a 6.5 percent drop in the effective income tax rate.

The following measures held the score down:
  • CFO growth = -30.8 percent year-over-year, down from 20.8 percent. CFO (Oct 2007 value was estimated) was reduced by the land impairment charge mentioned above.

Profitability. This gauge reads 5 points.

The following measure pushed the score up the most:
  • ROIC = 16.5 percent, up from 14.4 percent in a year
The following measures held the score down:
The increasing Accrual Ratio tells us that less of the company's Net Income is due to CFO, and, therefore, more is due to changes in non-operational Balance Sheet accruals.

Value. BEA's stock price moved up to $16.90 on 31 October as investors waited to see if Oracle would return with a higher offer or if another potential purchaser would step forward. The share price increase pushed the valuation metrics we track into regions the Value gauge is calibrated to deem expensive.

On 15 November, BEA gave us a plethora of new and restated data to digest. Given the change in options accounting, the acquisition of companies such as Plumtree Software, and company's real estate transactions, our understanding of the company's status might be flawed. We encourage readers to check the analysis and confirm the validity of the numbers used and the assumptions made.

The solid Cash Management gauge score indicates a fairly strong and improving Balance Sheet, with debt levels that shouldn't be worrisome. The impressive Growth gauge score hints at why management has expressed confidence about the company's future. The Profitability gauge isn't that encouraging, but it seems have been depressed by the large real estate impairment charge. Current price and earnings metrics are higher than the comfort level of most value investors, but this is often the case for high-growth companies. Whether the company will be able to grow fast enough to stir the Value gauge is an open question.

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