Here is Trac Pham, Synopsys CFO, from last weeks earnings call:Greater than 90% of Q3 revenue came from beginning of quarter backlog…the weighted average duration of our renewable customer license commitments was about 2.5 years, and we expect duration for the full year to be about 2.7 years.
What does that mean? Why does anyone care that much? Is that good or bad?
Renewable license means that the license is sold for a given period, usually 2 or 3 years, and then it needs to be renewed. Accounting principles (so called GAAP) force this to be recognized quarterly over the period. The whole order is entered into bookings and then every quarter, one twelfth of it (or whatever is appropriate for the term) is moved from bookings to revenue. From the EDA company’s point of view, this makes for a very predictable business. They enter each quarter with eleven twelfths of the term business already on the books waiting to be recognized, so a good or a bad quarter has much less of a yo-yo effect on the bottom line. Which Wall Street likes, since they don’t like surprises.
Perpetual licenses, on the other hand, are the old hardware business model from the days when EDA companies sold not just the software but the hardware on which to run it. The software is sold in perpetuity and a maintenance fee is paid annually or quarterly. Accounting principles force this revenue to be recognized immediately. Ship a $1M perpetual license on the last day of the quarter and that is $1M of revenue that quarter. There are actually other forms of non-renewable license, such as with a given period, but it is complicated enough already.
I think you can see the temptation. If you can switch a $10M license from a renewable license to a perpetual license then you can recognize it immediately. The customer gets a better deal for the same payment terms. It turns out that under those GAAP rules, whether a license is deemed to be recurring or not can swing on just a few words in the license agreement. That is why Wall Street analysts care about the ratios of license types and and why CFOs tell them every quarter. As long as renewable license percentages are not falling, it is good. Deals are not being switched quietly to non-renewable.
The other thing to watch out for is how long the contract lives are. If a company does a $100M deal for a 3 year renewable license, that is a lot less attractive than the same booking for a 4 year period, since in the first case it will drop to revenue at one twelfth per quarter, and in the second at one sixteenth. You can already hear the salesperson: “will you close today if I give you 4 years for the price of 3”.
It is not just Synopsys. Here’s Geoff Ribar, Cadence’s CFO, from last month’s call:We expect weighted average contract life in the range of 2.4 years to 2.6 years, and we expect at least 90% of the revenue for the year to be recurring in nature.
So both Cadence and Synopsys have a contract life of 10-11 quarters. Let’s say 10. If it was all recurring business then 90% should come from backlog with the remaining 10% or so coming from business booked that quarter. Except there are two wrinkles. Revenue recognition is actually done monthly, and in EDA a lot of business is booked in the last month of the quarter. So with a term of 30 months or so, then perhaps only 1/30 of new business will be recognized in the quarter being reported. If all the business were recurring and all new business was booked in the last month, then 29/30s of revenue should come from backlog, or nearly 97%. So there is actually room for a little non-recurring business in there and still clear the 90% threshold.
So the two things that the Wall Street analysts watch out for is recurring license percentage dropping, and the contract lives stretching out. Even if the company is meeting or even exceeding its bookings and revenue numbers, in reality the business is softening and it will show up in future quarters.
Here is the temptation. If a company was going to miss its number by, say, $10M, then they can take one of their $10M orders and make it perpetual. In fact, since perpetual licenses are worth more, the customer might pay even more than $10M, the numbers are even better. Or they can offer to give a customer who was going to place a very large order for a 3 year recurring license a deal for 4 years at only $10M more. In the first case the amount of revenue coming from backlog will decline (in the future), in the second case the contract life will lengthen.
When there was real indiscipline in the industry there were even more games played whereby companies that were already 2 years into a 3 year deal would get an offer to cancel the remaining 2 years and sign up for a new 3 year deal. Or 5. Or 6. At a huge discount, of course, and at the cost of creating a huge hole a few years out. If you sell a company what is essentially software to be used in 2 years’ time, then they won’t be buying any more in 2 years. The company is eating its seed corn. No hunger now, not so good next fall.
A company that does these sort of things to make their numbers is like someone who keeps opening new credit cards to pay the interest on the old ones. It works for a time. but eventually the wheels come off. There is a huge reset, management gets fired, the new management comes in, takes a huge writeoff, and promises never to do such a thing again and hopefully they never do. But when they have a weak quarter, the temptation is always there. Except these days Wall Street understands the model a lot better and so they insist on being told the data every quarter to make sure.
BTW I am not trying to imply that Synopsys, Cadence or anyone else would be playing these games but for the vigilance of Wall Street. I thought it was more interesting to take the actual comments from the most recent conference calls rather than just invent some dry numbers.