Software companies have unique characteristics that help investors spot potential positive or negative trends earlier than is possible for many other types of companies. Two of these characteristics are license revenue and deferred revenue. If these two line items are growing at a faster rate than overall sales the implications are generally positive for the company. If they are growing at a slower rate, investors may want to inquire further before making an investment decision. Here's why.
Software companies typically generate (at least) two types of income streams. License revenue is earned when the company provides the software itself. This gives the customer the right to use the software. Frequently customers also pay for maintenance and support, which could include updates, training and other support. It follows that the more computers a company’s software is installed on, the more need there will be for maintenance and support. So trends in licensing revenue can be an early indicator for the direction of future maintenance revenue. Software maker ANSYS (NASDAQ:ANSS) offers the following elaboration on page 22 of its recently filed 10Q:
A substantial portion of the Company’s maintenance revenue is derived from annual maintenance contracts. These contracts are generally renewed on an annual basis and have a high rate of customer renewal. In addition to the recurring revenue base associated with these contracts, a majority of customers purchasing new perpetual licenses also purchase related annual maintenance contracts. As a result of the significant recurring revenue base, the Company’s maintenance revenue growth rate in any period does not necessarily correlate to the growth rate of new maintenance contracts sold during that period. To the extent the rate of customer renewal for maintenance contracts remains at current levels, incremental maintenance contracts sold with new perpetual licenses will result in maintenance revenue growth.
The second indicator software companies have is deferred revenue, which is accrued when a customer pays for a service but does not get recognized as revenue until a later date. The reason for the delay in recognizing the revenue is that the service has not been fully provided. Consider antivirus software. Usually the customer pays a fee to receive not only the initial software package but also one or more year’s worth of updates that will protect against newly developed viruses. If the company is obligated to provide these updates it books a portion of the money received as deferred revenue, and recognizes it on the income statement on a pro rata basis as the support period elapses. Since today’s deferred revenue is tomorrow’s revenue, the deferred revenue line can be a useful indicator of future trends in revenue.