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.

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.

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MicroStrategy (MSTR) reported earnings:

First quarter 2007 revenue was $72.4 million versus $69.5 million for the first quarter of 2006, a 4% increase. Product support and other services revenue for the first quarter of 2007 was $55.7 million versus $46.4 million for the first quarter of 2006, a 20% increase. Product support and other services revenue increased primarily due to an increase in the installed base of technical support contracts. Product licenses revenue for the first quarter of 2007 was $16.7 million versus $23.1 million for the first quarter of 2006, a 28% decrease. The decrease in product licenses revenue was due, in part, to the absence of any license transactions in excess of $1.1 million during the first quarter of 2007.

First quarter 2007 income from operations was $14.7 million, or 20% of revenue, versus $21.0 million, or 30% of revenue, for the first quarter of 2006. Net income for the first quarter of 2007 was $9.8 million, or $0.75 per share on a diluted basis, versus $15.0 million, or $1.05 per share on a diluted basis, for the first quarter of 2006.

Analysts were expecting the company to earn $1.27 on $81 million in sales, so this was quite a miss. The license revenue they lost is both highly profitable and a key driver of future services growth. MicroStrategy thus joins BEA Systems (BEAS) among those hardest hit by the weak corporate spending on equipment and software.

The press release spent a good deal of time talking up the recent release of MicroStrategy 8.1 and how the company is promoting its use:

MicroStrategy plans to host a one-hour webcast, “Using Dashboards to Improve Corporate Performance: Top 10 Best Practices,” on May 16, 2007. Showcasing MicroStrategy’s Dynamic Enterprise Dashboards, the webcast will feature demonstrations, commentary from MicroStrategy customers Lowe’s Companies and Classic Residence by Hyatt, as well as insights from Wayne Eckerson, Director of TDWI Research, and author of Performance Dashboards: Measuring, Monitoring, and Managing Your Business. For more information and to register for the event, visit http://www.microstrategy.com/DashboardsTop10.

Unfortunately, this strategy doesn’t appear to be particularly effective:

In the first quarter of 2007, MicroStrategy held a series of events in 45 locations around the world to launch its Dynamic Enterprise Dashboards. More than 2,000 people attended the half-day events, which featured customer presentations and demonstrations of the new MicroStrategy dashboard capabilities.

If only a few of those in attendance had actually ponied up for the license fee, we’d be a little less cynical about this one.  Investors don’t reward companies based on how long the press release is. Until MicroStrategy starts putting up some numbers we don’t care about their symposia, webcasts or shindigs.

We’d venture to guess that not too many people follow both small-cap headset maker Plantronics (PLT) and large-cap enterprise software vendor Oracle (ORCL.) We do, which is probably the only reason we noticed this little gem. Both companies recently issued remarkably similar press releases, each extolling the other’s virtues.

Oracle Standardizes on Plantronics Wireless Headset Systems to Optimize VoIP Communications

“We evaluated numerous headset offerings to complement Oracle’s VoIP deployment, and the Plantronics Voyager 510-USB is clearly ahead of the pack for audio performance, ease of use and style and comfort,” said Mark Sunday, Senior Vice President and CIO, Oracle. “We are also very impressed with Voyager’s performance with Oracle Collaboration Suite. Now employees have a single wireless headset for all of their voice and data communications.”

Plantronics Standardizes Global Operations on Oracle(R) … - Yahoo! News (press release)

“We get a great deal of value and cost savings out of the Oracle system,” said Plantronics Vice President of Finance and Worldwide Corporate Controller Susan Fox. “The external auditors we work with have experience using the Oracle E-Business Suite and have developed proven methodologies for testing and verification. That expertise allows us to reap the benefits of economies of scale and avoid the process of educating auditors on the nuances of our system.”

Now, it’s quite likely that this was simply a way to share cost-free favors (talking each other up in a press release) as each business negotiated a standard supply contract. However, it is always something that should draw attention when two parties enter an agreement that may not be arms-length. It would be better to look at it and decide nothing is wrong than to overlook something that could potentially be a warning.

In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition (aff. link) Howard Schilit has this to say about such deals:

On October 5, 1999 Microstrategy (MSTR) announced in a press release that it had signed a deal with NCR Corporation…. Under the agreement, MSTR invested in an NCR partnership and NCR returned the favor and purchased MSTR’s products. We refer to that practice as a “boomerang.” (p. 44)

Later, Schilit elaborates:

A two-way transaction means that you both buy from and sell to the same party. Questions should be raised about the quality of the revenue recorded on such transactions….

If, as a condition of making a sale, the buyer receives something of value from the seller (in addition to the product) the amount of revenue recorded becomes suspect. This may involve a barter exchange, offering the customer stock or stock warrants, or investing in a partnership with the buyer. (p. 80).

In the cases of Plantronics and Oracle, there were no specifics regarding the size of the deals or time frame over which they extend. Neither is a major (10%) customer of the other, so there is some limit as to how much the deal could help one or the other. Questions investors may want to pursue include:

1. Were the agreements similar in size? Revenue recognized from barter agreement is of lower quality (less likely to recur) than cash revenue.
2. Given that Oracle’s fiscal quarter ends in November, the arrangement could have allowed them to book last-minute revenue. If their revenue for the quarter misses or only slightly exceeds analyst estimates when they report next Monday, a good conference call questioner could ask how much this agreement contributed (particularly with respect to license revenue.)
3. Given that Plantronics is much smaller, they could potentially benefit more from the deal than Oracle but they are potentially in a less favorable bargaining position. Their investors might want more information regarding the size of the agreement for that reason.

Or, as we suggested earlier, it could all simply be PR fluffery. But even in that case it is best if investors know all the details.
Disclosure: Author is long Plantronics (PLT) call options and short Plantronics put options.