Business software maker MicroStrategy Inc. (MSTR) said Thursday its first-quarter profit declined, as increasing operating expenses overshadowed growth in product license revenue and support. Investors appeared to be surprised by the news, taking the shares down more than 16%.

They shouldn’t have been. I warned three months ago that MicroStrategy looked cheap for a reason:

A look at recent customer wins shows a concentration of retail, financial and healthcare markets. Not exactly the clients one wants during a consumer and financial crunch.

Indeed, it looks as though the toll was already being felt when MicroStrategy reported third-quarter results. Although gross accounts receivable were basically flat during the first nine months of 2007, the allowance for doubtful accounts was increased by nearly 50% to $2.8 million. This suggests that the company may be having trouble collecting from some customers.

Both net income and cash flow from operating activities declined during the first nine months of 2007. Though service and maintenance revenue grew, product licenses declined more than 3%. Since customers must license a product before they can service or maintain it, the falling product licenses suggest that profits may continue to fall, especially if customers indeed prefer the convenience of one-stop shopping offered by IBM, Oracle and SAP.

In fact, profits would have been lower still had MicroStrategy expensed all of its software development costs, as it did in early 2006. In the first nine months of 2007 $2.7 million of such costs were capitalized, and the capitalized software balance increased by $1 million. Had the development costs been expensed as incurred, cash from operations would have been $2.7 million (4%) lower and net income would have been $641,000 ($0.05 per share) lower.

The allowance for doubtful accounts continued to rise, despite continued declines in the gross receivables. And the capitalized software costs are coming back to bite, as the expenses are now being recognized and no additional costs were capitalized.

To be fair, though, the latest miss came following a run-up in the stock price. Today’s severe decline in the shares merely leaves me looking like a bit less of an idiot than I did yesterday. Since I wrote the article, MSTR shares are up 4.9%, compared to a 1.4% rise in the S&P 500.

Disclosure: At time of publication, William Trent holds no financial position in the companies mentioned in this article.

My latest post is up at RealMoney.

In it, I extend yesterday’s observations about the hidden strength in durable goods orders to specific industries that might benefit. Among those industries were primary metals, computers and electronic products, and motor vehicles and parts.

These industries may prove to be a good starting point for further research.

My latest column is up at RealMoney. In it, I explain why I think the negative reaction to BMC Software’s (BMC) purchase of BladeLogic (BLOG) was overdone. In summary:

BladeLogic is growing nearly 40% annually, compared to just 5% expected growth in BMC next year. By my calculations, it increases BMC’s revenue growth rate by 180 basis points, which should have a significant impact on valuation models.

What’s more, I think there were signs that BMC’s growth was due to accelerate on its own. Deferred revenues had declined slightly over the past nine months, which can act as a drag on revenue growth in future periods. But license sales are up 13.5% so far this year, compared to total growth of less than 9%. Today’s license sales should increase future maintenance and service revenues.

Although the BladeLogic deal is expected to reduce BMC’s 2009 per share earnings by 10 or 11 cents, BMC’s estimates for 2009 had already risen by a similar amount. Effectively, the dilution from BladeLogic offsets BMC’s organic improvements for a year.

Meanwhile, BMC has generated more than $540 million in free cash flow over the last 12 months. Some of that is unsustainable, as it comes from collecting on financed receivables. However, I think the sustainable free cash flow is more than $400 million. That still amounts to a 6.5% free cash flow yield at a time when five-year Treasuries return a paltry 2.2%.

Alternatively, I think the stock can generate double-digit returns over the next few years by virtue of its growth, despite a potential reduction in valuation multiples.

Disclosure: William Trent has no financial position in the companies mentioned.

Last month I wrote about IBM (IBM - Annual Report) and said:

IBM is now trading at a P/E of 12.7x 2008 earnings, compared to a five-year average P/E of nearly 18x. It offers a free cash flow yield of nearly 7% at a time when 5-year Treasuries are yielding 2.8%.Expected long-term earnings growth of 11% annually marks a modest slowdown from the 13% generated over the last five years. It is also well below the sustainable growth rate of 29%, which is further evidence of excess cash flow that can be used for more share repurchases.

Valuation aside, things seem a little dicey here. The new guidance seemed sufficient to spark a better rally than we got. If IBM can’t move when estimates are jacked up by $0.25, what will make it move?

I can’t claim to be expert in technical analysis, but a look at the charts, especially the moving averages, suggests that $109 may be a make-or-break price point for many investors. In today’s market environment, I think I’d rather keep my powder dry than chase a possibly elusive extra four percentage points of upside.

But I’ll be watching. I also might be tempted to find some approach using options. For example, the March $110 call options would provide upside in the event of a strong rally, and could largely be paid for by writing $100 puts. Since I think the valuation is reasonable, being forced to buy at $5 lower wouldn’t hurt my feelings too badly, and I’d still get the exposure to the additional upside if the stock does rally.

$109 did prove to be a make-or-break area, and the effectively zero-cost call option I proposed would be worth almost $6 as of Tuesday’s close. Maybe I should take up technical analysis.

Or maybe I shouldn’t. Given the way some of my fundamental picks (where I do consider myself an expert) are working lately I may be better off sticking with the naive approach.

The following article is a reprint of my February 6, 2008 RealMoney column

Hewitt (HEW) is a leading global provider of human resource benefits, outsourcing and consulting services. On Tuesday the company reported $0.59 in earnings per share, beating analyst estimates by a full $0.20 per share. Given that it currently sports a healthy 9.1% free cash flow yield, I thought it was worth a further look.

Unfortunately, the full year guidance given was that Hewitt is “maintaining our fiscal 2008 guidance despite absorbing what we expect will be about six cents per share in dilution from the divestiture of Cyborg over the balance of the year.” After a $0.20 beat in the first quarter, ideally estimates would be raised by $0.14 (or more) despite absorbing a $0.06 per share dilution.

Hewitt’s surprise was largely driven by the fact that its Human Resources Business Process Outsourcing (HR BPO) business, which accounts for 20% of total revenue, lost less money in the company’s fiscal first quarter 2008 than it did in the prior year. Still, there are contracts that the company is trying to restructure to achieve profitability that are in “sensitive” stages.

Given how much most companies hate the human resources function, one would think that those willing to take on others’ headaches would be able to earn high profits. Unfortunately, there are a surprisingly large number of companies willing to take on those headaches. In the latest 10K, management says that “The principal competitors in our HR BPO segment are technology consultants and integrators such as Accenture (ACN), Affiliated Computer Services (ACS - Annual Report, EDS/ExcellerateHRO (EDS) and IBM (IBM - Annual Report) and; companies that have extended their services into human resources outsourcing such as Automatic Data Processing (ADP) and Convergys (CVG).

On the conference call, management indicated that the outsourcing business was counter-cyclical, with customers outsourcing more in downturns in order to reduce costs. Yet they seemed to contradict this statement by saying that the current market environment was causing their new contract signing pace to be behind schedule. Hewitt’s Zacks rank declined last week from 1 (best) to 2. Although the current rank still puts Hewitt in the top 20% of companies measured for earnings momentum, the cautious guidance and talk of a light pipeline are likely to result in some estimate reductions for the remainder of the year.

Despite the lower sales pipeline and ongoing restructuring of unprofitable contracts, Hewitt paid higher performance-based compensation in the fourth quarter. This resulted in first quarter free cash flow being $4 million lower than last year. The company also expects to spend more on capital expenditures this year, which will dampen free cash flow generation.

Furthermore, while earnings are improving the quality of those earnings is not. To gauge earnings quality, I measured the accrual ratio (change in net operating assets as a percentage of net operating assets) over the past several years. The accrual ratio gives an indication of the extent that earnings are driven by cash flows versus accounting choices. The closer the ratio is to zero, the better. Hewitt’s has been declining.

Source: Zacks Research Wizard, compiled by William A. Trent

So, after looking under the hood, I see a company with falling earnings momentum, falling free cash flow yield and falling earnings quality. The only thing rising in recent quarters has been the share price. As a value oriented investor, I’d rather it was the other way around.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

This article is a reprint of my January 31, 2008 RealMoney column.

When International Business Machines (IBM - Annual Report) reported earnings a couple of weeks ago, the consensus among Wall Street’s finest was that the company would earn $7.98 per share in 2008. The company smashed that number, providing guidance of $8.20 to $8.30 per share. Even Papa Bear called it impressive.

The market reacted by enthusiastically doing, well, pretty much nothing. The shares were up a smidge the next day, then dropped back and recovered in line with all the market weirdness. The conference call featured one question after another about the macroeconomic environment.

It’s true that there were some signs that the results were built on a wobbly foundation. Fourth quarter revenues were up 10%, but 6% of that growth was due to currency fluctuations that may or may not reverse next year. If I want to bet on a rising Euro I think I’ll play the currency rather than IBM.

Worse, though short-term global services contracts were up 8%, total contract signings declined 13% compared to the prior year quarter. That means a big drop (25%) in long-term signings, which likely explains why analyst estimates for 2009 only rose by about a nickel after the 2008 guidance hike.

On the bright side, though, the short-term contracts likely mean that the $8.25 guidance midpoint for this year is pretty well in the bag. Since this year is likely the point of maximum economic uncertainty, that is a good thing.

The company also generates plenty of free cash flow, and mostly uses it the way I would want them to. In 2007 IBM generated $16.1 billion in cash from operations, $5.5 billion of which stayed on the balance sheet as increased cash holdings. The company used:

• $18.8 billion to buy back shares,
• $5.0 billion for capital expenditures,
• $2.1 billion for dividends, and
• $1.0 billion for acquisitions.

Debt increased by $12.5 billion, to just over $35 billion. Most of the debt is related to its financing operations. With $16 billion in cash on hand and free cash flow generation of more than $11 billion, I don’t see the debt as a concern at all.

IBM is now trading at a P/E of 12.7x 2008 earnings, compared to a five-year average P/E of nearly 18x. It offers a free cash flow yield of nearly 7% at a time when 5-year Treasuries are yielding 2.8%.

Expected long-term earnings growth of 11% annually marks a modest slowdown from the 13% generated over the last five years. It is also well below the sustainable growth rate of 29%, which is further evidence of excess cash flow that can be used for more share repurchases.

Valuation aside, things seem a little dicey here. The new guidance seemed sufficient to spark a better rally than we got. If IBM can’t move when estimates are jacked up by $0.25, what will make it move?

I can’t claim to be expert in technical analysis, but a look at the charts, especially the moving averages, suggests that $109 may be a make-or-break price point for many investors. In today’s market environment, I think I’d rather keep my powder dry than chase a possibly elusive extra four percentage points of upside.

But I’ll be watching. I also might be tempted to find some approach using options. For example, the March $110 call options would provide upside in the event of a strong rally, and could largely be paid for by writing $100 puts. Since I think the valuation is reasonable, being forced to buy at $5 lower wouldn’t hurt my feelings too badly, and I’d still get the exposure to the additional upside if the stock does rally.

This article was published on RealMoney on February 1, just 4 hours before MicroStrategy surprised investors with a blown earnings report. Although I typically take a long-term view, you can never count on having the luxury to do so.

Looking at my screens this week, I noticed that MicroStrategy’s (MSTR) Zacks rank had jumped from 2 to 1, a rank that puts the company’s earnings revision momentum among the top 5% of companies ranked. Looking further, I found that estimates for both 2007 (yet to be reported) and 2008 had been hiked by more than $0.25 per share in the last 90 days.

Meanwhile, the stock has declined from $110 to $72 during the same period. A declining stock amid rising earnings estimates was something I had to investigate further. Upon doing so, however, my conclusion is that there may still be further downside in the shares.

One thing that has buoyed software stocks in recent years has been the consolidation wave. According to company filings, MicroStrategy “competitors that are primarily focused on business intelligence products include, among others, Actuate (ACTU), Business Objects (BOBJ), Cognos (COGN), Information Builders and the SAS Institute.”

Cognos is being acquired by International Business Machines (IBM - Annual Report) and Business Objects by SAP AG (SAP - Annual Report). Another competitor, Hyperion, was already bought by Oracle. It is increasingly looking like MicroStrategy is among the wallflowers at this dance.

And without an acquisition, things aren’t looking so hot fundamentally. A look at recent customer wins shows a concentration of retail, financial and healthcare markets. Not exactly the clients one wants during a consumer and financial crunch.

Indeed, it looks as though the toll was already being felt when MicroStrategy reported third-quarter results. Although gross accounts receivable were basically flat during the first nine months of 2007, the allowance for doubtful accounts was increased by nearly 50% to $2.8 million. This suggests that the company may be having trouble collecting from some customers.

Both net income and cash flow from operating activities declined during the first nine months of 2007. Though service and maintenance revenue grew, product licenses declined more than 3%. Since customers must license a product before they can service or maintain it, the falling product licenses suggest that profits may continue to fall, especially if customers indeed prefer the convenience of one-stop shopping offered by IBM, Oracle and SAP.

In fact, profits would have been lower still had MicroStrategy expensed all of its software development costs, as it did in early 2006. In the first nine months of 2007 $2.7 million of such costs were capitalized, and the capitalized software balance increased by $1 million. Had the development costs been expensed as incurred, cash from operations would have been $2.7 million (4%) lower and net income would have been $641,000 ($0.05 per share) lower.

The $84 million in free cash flow MicroStrategy generated last year amounts to a 7.5% free cash flow yield. This is more than the 100% premium to Treasuries that I would like to earn from my risky investments. However, the ongoing declines in cash flow mean that I want to be compensated for falling cash flow as well. Each percentage point of expected decline should equate to another percentage point of cash flow yield.

Using the 3% decline in license revenue as a starting point, and the 2.9% Treasury yield as a base, I would want to earn a free cash flow yield of at least 8.8% (2.9 + 2.9 + 3) on MicroStrategy. To get to that yield, the shares would need to fall to $57.

In the meantime, it just looks too risky for me.

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

My long-term orientation doesn’t typically fare so well in short term stock picking contests. Nonetheless, I have decided to enter the blogger face-off over at SINLetter. You can check in to see which of us are making the best picks between now and the end of March.

My picks were long SMH, short Diebold (DBD) and long CSG Systems (CSGS).

My RealMoney article from December 7, 2007:

CSG Systems (CSGS) is a leading provider of customer care and billing services for cable operators, including Comcast (CMCSA), Echostar (DISH - Annual Report), and Time Warner Cable (TWC). Since July, when the company announced in a shortfall in cash flow from operations, the shares are down more than a third. The current price may be a good opportunity for investors to buy a stable cash flow generator.

The cash flow shortfall in the second quarter was “due to unexpected changes in certain operating assets and liabilities at quarter end” as was largely made up in the third quarter. But don’t get me wrong - there are plenty of good reasons to explain the recent share price decline.

Let’s start with customers - the relationship with Comcast has been touchy at times, stemming from lawsuits related to Comcast’s 2002 acquisition of AT&T (AT&T’s former cable assets). That relationship seems stable now, but things could always get dicey again.

Then there is all the talk about Echostar being taken over. A merger with a company like AT&T (T - Annual Report) that does not use CSG’s services could mean CSG loses its number two client.

Next, even without any mergers and acquisitions activity going on CSG stands to lose when its customers have fewer bills to send out. Increased competition from telephone companies like AT&T and Verizon (VZ - Annual Report), along with trouble related to the housing market, have led both Echostar and Comcast to cut customer growth estimates recently.

So, suffice to say there are plenty of reasons to be concerned about CSG’s prospects in the near term. Now we have to figure out whether today’s one-third-off sale fully reflects those potential concerns. I think it does.

The Positive Side

If there is one thing to like about CSG Systems, it is that the earnings are predictable. Consider the last 12 quarters, which I charted below.

Source: Zacks Research Wizard

The knock against predictability, of course, is that the earnings are going nowhere. They have been stuck in neutral at $14-$16 million per quarter for much of the last three years. On the other hand, the company generates tons of cash - $105 million worth of free cash flow (cash from operations less capital expenditures) over the last 12 months.

And it uses most of that cash flow to buy back stock. In the third quarter of 2007 there were 17.5% fewer shares than there were in the same quarter last year. As a result, the earnings per share are far from stagnant. In fact, the last 12 months of EPS were 16.1% higher than the preceding 12 months.

Now that the share price has come down, the buybacks are having a bigger impact than ever. At the current pace, the company could take itself private within six years.

Free Cash Flow Yield

With $95 million in free cash flow and a current enterprise value of $638 million, CSG is sporting a free cash flow yield of more than 16%. Even if the $65 million they spent on acquisitions this year is deducted, the free cash flow yield would still be a healthy 6.2%, offering a solid risk premium over Treasuries.

With that kind of risk premium, investors look to be well compensated for the risks I outlined.

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

This article was originally published at RealMoney on November 6, 2007.

Parametric Technology (PMTC) develops software used for Product Lifecycle Management (PLM) and Enterprise Content Management (ECM). At a P/E of approximately 15x and a 5.3% free cash flow yield, Parametric appears cheap relative to other technical software developers. However, its earnings quality has historically been low and it faces more severe competition than some of its peers. With earnings quality improving and the valuation favorable, PMTC certainly bears watching. But for now I think Dassault Systemes (DASTY) and Ansys (ANSS) have sufficiently better prospects to justify their higher valuations.

Compared to companies like Ansys, which develops highly technical products and has relatively few competitors, Parametric has significant competition in each of its business segments.

PLM competitors include Dassault Systemes SA, Siemens (SI) subsidiary UGS, Autodesk (ADSK) and Agile Software (AGIL). They also compete with larger enterprise-solution companies such as SAP (SAP - Annual Report) that have entered the PLM market and offer solutions integrated with their other enterprise software applications.

ECM competitors include EMC (EMC - Annual Report) Documentum, IBM’s (IBM - Annual Report) FileNet, OpenText, Adobe (ADBE) Framemaker, and the Microsoft (MSFT - Annual Report) Office suite.

Parametric suffered mightily during the tech downturn, but since 2004 the company has been engineering a turnaround based on improved profitability and a return to growth. Current consensus growth estimates for the next five years are just 7%, or half the rate expected for the industry. The lower growth estimates are part of the reason for the cheaper valuation. However, they also make for a lower bar to clear, and the recent reversals of its deferred tax valuation allowance are a signal that the company is now “more likely than not” to earn sufficient income in future years to utilize tax losses from prior periods.

There are a few other issues that cause me to think Parametric’s low valuation is justified. For example, 58% of revenues are derived in North America, which faces an uncertain near-term economic outlook.

Another issue is earnings quality. Gross margins have been declining due to a higher percentage of revenue being derived from consulting and training rather than license and maintenance revenue. A bad debt charge-off in 2006 and increased customer financing activity are other signals that earnings quality may be low.

To get a feel for overall earnings quality, I calculated the accrual ratio, or the change in net operating assets divided by average net operating assets. This ratio describes the percentage of earnings contributed by discretionary accounting items rather than actual cash flows. An ideal accrual ratio would fluctuate around zero. Parametric’s has been all over the map, though it has been improving for several quarters.

Sources: Zacks Research Wizard, William A. Trent

If Parametric continues to improve its earnings quality, or if it gives back some of the stock gains it enjoyed post-earnings (or preferably both!) it could become an attractive buy candidate.  In the meantime, interested investors may find an option play worthwhile.

The January 17.50 puts were trading recently at $0.50/$0.75. If you could write the option for $0.60 it would offer a 3.1% 2.5-month return on the money at risk, which annualizes to nearly 15%. You’d be forced to pay $17.50 for the shares if they drop between now and then, but the option premium would give you an effective price of just $16.90. At that price, the 6.0% free cash flow yield would probably be enticing enough to justify a buy anyway.

Disclosure: Short naked put options on Ansys (ANSS)

William Trent currently has a short position in put options related to Office Depot (ODP).