The Fine Print on Keynote Systems' Earnings Beat

| About: Keynote Systems, (KEYN)
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Living in a Fed-induced speculative market makes for interesting times. In particular, favored sector companies like Netflix (NASDAQ:NFLX) that post earnings beats can make big moves. Looking under the covers at some of these “beats” makes you wonder if investors are reading anything other than the headlines, or if trade-bots are firmly in control at this point. The latest, best example is a company by the name of Keynote Systems (NASDAQ:KEYN).

Keynote provides internet and mobile test and measurement services. Sounds exciting, if you don’t have any context. In reality Keynote is a former dot com highflyer whose business is a well-established single digit grower (at best). The company has limped along with lackluster revenue growth and profitability for going on a decade now. Amazingly for a company in an ostensibly hot sector in a recovery year, Keynote actually showed an organic revenue decline for its fiscal year ending September 2010.

So at first blush its Q1 FY 2011 results seemed exciting. Total revenue was $24.8M against $20.7M a year ago and management guidance of around $22M. Earnings were up even more, $0.23 vs. $0.07. The B. Riley analyst covering the stock raised his revenue estimate from $88.4M for the 9/30/11 fiscal year to $98.1M. Pretty exciting, right? The stock surged from under $15 to over $19, a gain of 28%. Growth has gone from lackluster to scintillating- why wouldn’t the stock take a big jump?

Well, for investors who read the press release and listened to the conference call, the results seem a lot less impressive. As KEYN forthrightly disclosed in the press release, much of the apparent earnings beat and the subsequent increase in analyst estimates is due to a one-time accounting change that will benefit KEYN’s reported revenue growth this year. As repeated several time throughout the press release:

Effective with fiscal year 2011, new revenue accounting guidance was adopted by the Company that had the primary effect of recognizing SITE systems revenue, excluding maintenance, at the time of acceptance rather than ratably over the contract term. SITE orders received after fiscal year 2010 are reported as System licenses for the hardware and software elements of those contracts and as Maintenance and Support for the remaining elements. SITE orders received prior to the beginning of fiscal year 2011 continue to be recognized ratably and are reported as Ratable license revenue.

The company further quantified the effect of the accounting change as a $2M benefit to revenue. Since this change involved recognizing software license revenue earlier, the vast majority of the benefit falls to the bottom line. So of the $2.8M that revenue exceeded the midpoint of management’s guidance, $2M (71%) of it came from a simple accounting change and $0.8M (29%) came from actual outperformance. Backing out the rev rec change revenue grew 10% year over year, better than the negative growth in fiscal 2010 but hardly the stuff of high multiples and 30% stock moves. If you assume a $2M benefit from the accounting change for each quarter of fiscal 2011, over 80% of the increase in analyst revenue estimates is purely due to more up-front revenue recognition, a one-time benefit for fiscal 2011 that gives the company less revenue visibilty going forward.

Stuff like this really makes me wonder about the current state of the market. Are investors so lazy and desperate to jump on a hot story that they don’t even read the entire press release? Are algorithmic programs that look only at the magnitude of earnings beats and estimate revisions now the price setters? I don’t blame the company at all here, they did not even remotely try to hide the accounting change, but it seems that investors aren’t bothering to listen. I generally think KEYN is a decent company with a solid balance sheet but couldn’t resist putting a little out for a trade yesterday.

Disclosure: I am short KEYN