QUALIPORT
How We Avoided the Misys Crisis

By Maynard Paton (TMFMayn)
July 26, 2001

Carburton Street, London -- Please excuse the title. Misys (LSE: MSY) isn't exactly in a crisis. But like most other IT companies, its recent share price performance could suggest otherwise.

To recap, Misys is a former Qualiport constituent. The shares were bought during April 1999 and October 1999 at an average price of 565p. However, after belatedly peering into their accounts, I decided to sell the shares in September 2000 for 629p each. The decision was based on the company's poor equity reinvestment returns, toppy valuation and a worrying working capital trend.

On the latter point, the working capital chickens came home to roost last week. The software firm published its final results and warned of a fall in forthcoming profits. The group's banking customers were keeping their wallets shut and Misys shares promptly fell 28% to 308p. However, signs of trouble had been lurking within the Misys financials for some time. A decline in the group's deferred income had caused me a lot of earlier discomfort.

Earlier worries

A company's deferred income represents payments received for services that have not been "earned" during the accounting period. Deferred income is part of a company's working capital and is shown on the balance sheet as a creditor item.

For Misys, a good example of deferred income would come from a client paying upfront for an annual software licence. The proportion of that licence payment extending past the financial year end is accrued in the balance sheet and deemed as deferred income. That deferred income then filters through the profit and loss account during the following year.

From an investor's point of view, the beauty of deferred income is the visibility of forthcoming revenues. Significant changes in this respect can be a forewarning of near-term sales difficulties.

With that in mind, I expressed concern about the deterioration of Misys' deferred income balances a year ago:

"Here's how deferred income has altered in the past two years.

                                      Year ended 31st May
                                   2000        1999       1998
                                   (£m)        (£m)       (£m)

To be recognised within one year:
Recurring licence fees             57.1        53.3       43.9
Other income                       33.5        50.8       68.4

To be recognised after more than
one year                           13.0         7.6       12.1

Total Deferred Income             103.6       111.7      124.4

So on the face of it, a worrying trend... What does concern me is comparing "other" deferred income at the latest full-year stage (£33.5m) to that reported at the previous interim point. At the end of November 1999 (with the Y2K "lock down" underway), other deferred income stood at £35m. It's unnerving that this figure should be higher than that declared at the end of May 2000, given the subsequent (and supposed) unbottling of post-Y2K demand for software and services in the meantime."

And this is what Misys had to say last week about the fall in profits. Not surprisingly, the problems had affected the latest deferred income figure:

"There were marked delays in the time taken by our customers to complete negotiations and sign orders, particularly for the larger and more complex orders.  This development was evident in all markets and across all products...As a result Initial Licence Fee ('ILF') order intake for the year, as a whole, was 8% below last year."

"Deferred income in the balance sheet, which represents those amounts invoiced not yet recognised as revenue, is £89m (2000: £104m)... The reduction in this amount mainly corresponds to the reduction in the Banking and Securities ILF order book as discussed earlier."

Summary

Although Misys had been affected by the IT industry's Y2K slowdown, the ongoing deterioration of its deferred income balance looked ominous (especially when the balance had traditionally represented about 20% of the following year's revenues).

While no investor could have been absolutely sure a year ago that revenues would come under further pressure, there was little room for disappointment. Last year, when the Qualiport sold out, the shares were on a price to earnings (P/E) ratio of 41. Back then, you had to place a lot of faith in the upbeat management remarks to justify the valuation. Given that last week's results were the first to specifically explain a deferred income decline, Misys perfectly fitted the summary to the Fool's Guide to Working Capital -- "the actions of customers and suppliers often speak louder than the words of the company itself."

Advance notice

Tomorrow sees the interim results of Qualiport company Lloyds TSB (LSE: LLOY). My comment on the numbers will be published in the morning's Foolish Commentary.

And on Monday, I'll be adding company number 16 to the Qualiport's watch list. Just to whet the appetite, the mystery outfit exhibits many mouth-watering investment characteristics, including: operating within an inherently visible and understandable industry; having a domestic market share of around 98%, and; possessing operating margins of nearly 30%.

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