Making Money On M&A - The Deferred Revenue Factor

Jul. 2.13 | About: Datawatch Corporation (DWCH)

In conjunction with Datawatch's (NASDAQ:DWCH) recently acquisition of Panopticon, we discovered empirical evidence that strongly suggests that shares of DWCH could be in for a rocky ride over the next several quarters. In M&A transactions such as these, the accounting treatment of deferred revenue can have a significant impact on how the acquirer's stock trades in the year following the initial M&A announcement.

Many, including analysts in my organization, are optimistic about the ultimate value the DWCH / Panopticon deal will bring to shareholders. However, most are unaware of the negative impact it will have on near-term results.

Specifically, in most cases where the acquiree's deferred revenue is derived from recurring sources (i.e. maintenance or subscription fees), accounting standards dictate that a substantial portion of the acquiree's deferred revenue must be written off. In doing so, the acquiree's reported-revenue contribution will be negatively impacted for a few quarters. At the same time, its expense structure will remain a full-force drag on the acquirer's results (excluding any synergistic efficiencies that the acquirer wrings from the deal) -- we expect this to be the case for Datawatch.

As a result, many of these deals prove dilutive in the initial 1-2 quarters, before becoming accretive. Once accretive, the return of deferred revenue to the balance sheet (via contract renewals) generates a tailwind (bullish) for the acquirer's reported revenue growth. However, after the anniversary of the deal, the tailwind abates (and with it, the perception of accelerated growth).

From 2003 (when it acquired PeopleSoft) until the anniversary of its Sun acquisition, Oracle (NASDAQ:ORCL) did a masterful job of timing acquisitions to optimize the impact of this dynamic. Each year, until 2010, ORCL would acquire a large vendor around the same time of the year (after New Year's, but prior to its fiscal year-end in May). During this timeframe, shares of ORCL nearly triples, handily outpacing the S&P, which returned less than 50% (about 5% annually).

The end of its large-acquisition spree marked the end of ORCL's market outperformance. This is exemplified by the fact that ORCL's shares have delivered a 10% loss to shareholders in the two years since the anniversary of its Sun acquisition (the last "large" acquisition that undertaken by ORCL). This, while the broader market has climbed by 20%.

This knowledge enabled investors to make market-beating calls during the 2007-2009 bear market. This was done by identifying 1) attractive acquisition targets with high deferred revenue balances and 2) entry and exit points in the acquirers' stock. The performance on both counts was documented via a proprietary study by PoisedToTriple Research, which was recently made available to the public.

According to the study, the best acquisition targets were those who had a high deferred revenue balance relative to their enterprise value, especially those who also had operating structures that were most conducive to an accretion M&A transaction. With regard to acquirers, Pipeline Data tracked M&A transactions where the acquisition price represented a notable percentage of the acquirer's market cap & where the acquiree held a relative large deferred revenue balance.

Acquisitions of this sort don't happen often, but when they do, they offer numerous low-risk / high-reward trading opportunities. They are most prevalent during market declines. Witness that only 7 occurred in then 2.5 years ending 6/30/07 (2 in 2005, 4 in 2006, and just 1 in the first-half of 2007). In the 2-years that followed (July 2007 through the market trough in 2009), that activity spiked to 13 deals. In the 27-months after that, only 4 took place.

Among acquirers, the initial market reaction to 56% of these deals was negative, producing a -4% return on average (regardless of initial reaction). However, investors quickly came around, bidding up 75% of the issues. The average issue outperformed the market by an annualized 40% from the initial reaction through completion of the acquisition.

Upon completion of the transactions, investors came to realize that deferred revenue would be written off, negatively impacting near-term results. Accordingly, 63% of the issues underperformed the market driving the entire group to underperform the market by an annualized 30% in the months following deal-completion.

After 1-2 quarters, when the negative impact began to reverse, 63% of the issues outperformed the market in the ~8 months that followed by an aggregate annualized average of 15%. Upon the anniversary of the completion of the transaction, our coverage ceased.

If the markets begin to decline again, we expect that this sort of M&A theme will reassert itself. In the meantime, we still find the occasional deal that fits the bill.

With Datawatch's acquisition of Panopticon, we have already seen our thesis play out. DWCH's shares skyrocketed in the days following the announcement. Accordingly we expect a pullback to occur once investors and analysts come to realize the negative near-term impact this deal is likely to have on DWCH's reported financials. Of course, pro-forma documentation will ease some minds, but as the PTT Research study showed, it will also cause the sort of confusion that investors usually choose to avoid until greater clarity surfaces.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.