Commvault: Red Flags Galore

Oct.30.13 | About: CommVault Systems, (CVLT)

There you have it, Commvault (NASDAQ:CVLT) just delivered your typical enterprise software red flag quarter. We got in line revenue growth which came in at half the typical q2/q1 seasonal trend (3% vs 6%). In of itself this number was quite a disappointment because of the CVLT's well established history of low balling the street, but it was even more surprising when you coupled it with the huge bottom line surprise. As I and everyone else were expecting a slight year over year drop in EBIT margins; the 200 bps expansion and 8c beat was of course a big shocker when coupled with the lackluster topline. This phenomena is not unusual in the software space, and is actually quite typical of a companies that over manage the street. To reconcile this you simply need to look at the deferred revenue balance and cash flow statement.

So what happened?

Well, to be clear Commvault missed their sales targets this quarter. Bookings were a major disappointment, and to hit the low bar they ended up recognizing an unusual amount of deferred software license revenue that was still on balance sheet at the end of the June quarter. The net result is a 20% sequential increase in NON-GAAP EBIT despite a slight sequential decline in operating cash flow. This pure profit deferred software license revenue is what produced the beat on eps, and allowed CVLT to hit the consensus revenue number. Without it we get big headline misses on both fronts.

Is this a disaster?

Well, if you are running a enterprise software company you are invariably going to have quarters were large deals in the pipeline don't close. So, in that respect it is no big deal. However, when your stock is trading at a PEG of 4.5x based on consensus forward estimates, and your forward GAAPE EPS p/e is 70x+, this is supposed to be a disaster. But CVLT's CEO goes to great lengths manage this part of the game. He has become a master of playing the street.

Here is the closing sentence from his opening remarks on the the Conference Call:

"We expect to continue to significantly outpace the growth of the market and pick up market share. However, on a relative basis, since last quarter's earnings call, we do believe revenue and earnings risk has marginally increased due to big deal demand and strategic execution risk." -CVLT CEO

This is usually what you would interpret as a warning. The message to the sell-side here is take your numbers down a bit, and I assure you they will take them down. But how do you reconcile this comment, with the following remark later on the call.

"Well, the funnel has improved very significantly. The key is translating that funnel into deals. So yes, the opportunity in a number of deals is up, I'd say pretty dramatically. But we still -- we understand we're in a weak environment and also lumpy. So when you start getting into physically 7-figure and multi-7-figure deals which makes a difference in our performance, we're just issuing a concern. I think the positive is that the opportunities are there and the negative is we're in an environment and those deals get pushed out, there could be some future problems."- CVLT CEO

So, now we temper the warning by saying we have an amazing pipeline and the 'opportunity' is up dramatically. See, this is called trying to have it both ways. Reality is in software closing deals is the measuring stick, and based on the deferred revenue line, CVLT FAILED to close in q2. The CEO has been playing this game with the street for three straight quarters now, and you would think some of them would pick up on it.

Instead, we get this…

CommVault weakness creates good entry point, says Piper Jaffray

"After CommVault reported stronger than expected Q2 results and the company endorsed current consensus estimates for FY14, Piper notes that bears are pointing to the company's decelerating software revenue growth. However, the firm thinks the deceleration was entirely due to timing and software revenue growth is expected to rebound next quarter. The firm reiterates an Overweight rating."

Is this guy serious? Momo's are rolling over left and right, and he is telling you to a good entry point is 10% off an all-time high. I wonder what he considers distressed, 20% down from a record close?

I also like how the analyst with the highest target on the street got to ask the first question.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

"I have 2 -- 1 question and a follow-up for Brian. I'm getting a lot of questions, Bob, from investors on the deferred line. It was up 24%, looks like a good number to me, but because I guess it's not what The Street was expecting. It caused some confusion. How meaningful is this metric, and if you could give some color on that, that will be helpful?"

If I had bought the stock based on Joel's $115 target, I too would be asking you a lot of questions. Deferred revenue was flat versus up 8.1% Q2 last year, so 'looks like a good number to me' doesn't cut it Joel. At for your target, CVLT would be trading at about 90x 2014 consensus GAAP EPS. Do you really think 'looks good' is a sufficient bar?

Honestly, I try to not get irritated by the 'game' that is sell-side coverage at times, but extreme stuff like this makes it hard. Yes, CVLT is without a doubt executing better than everyone else. And yes, there is going to be quarterly noise, and I have no issue with the CEO pointing that out or some analyst covering his bad advice by saying they will make it up next quarter. What I have a problem with is the bar set for this stock is ridiculously low to the point of it being outright negligence for anyone with anything but a sell rating on it. CVLT is not IBM, SYMC, or EMC. They are trading at a ridiculously high multiple compared to their now price cutting peers. This by definition means they have NO MARGIN FOR ERROR. Numbers shouldn't 'look good', they should 'be amazing'. Not only should they be closing large deals no problem, but they should be closing more and more of them. Basically, the stock is completely divorced from its operating performance, and that my friends is why I have parked my bear view here for the past 2.5 quarters.(fyi- I was once quite long the name circa dell-hp/3par)

To put that in perspective, if it was trading at $50 I'd be buying this 'disappointment'. But where it is trading at today, these results make it nothing but a SCREAMING SHORT. And I will bet all the guys with a BUY rating here that this is without a doubt an underperformer/show me stock from now until its next quarter. Of course we already know the outcome of that quarter. It will be another beat because the bar will come down again. I am also pretty sure that the buyback mystically appeared yesterday to put a bid under what was fast becoming a falling knife. Which btw I welcome, as this just makes the risk/reward here even better.

Disclosure: I am short CVLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.