Weekly Review: Anticipating Q2 Financial Results

All eyes on Wall Street this week will turn to companies’ financial results for the second quarter — the three-month period that ended on June 30th. The world is watching closely, since the figures will provide real evidence of just how bad the slowdown in the U.S. economy has turned out to be. Observers of the ASP sector have a narrower focus. The Q2 results due over the next ten days will signal whether the publicly quoted leaders of the industry remain on track to achieve their targets for reaching breakeven and ultimate profitability.

McAfee Makes Good on Profits Promise
Security ASP McAfee.com got the season off to a magnificent start for the industry last Weds (July 11th), when it delivered on the promise it made last November that it would reach profitability in Q2 this year.

Close followers of Wall Street will know that the financial community works with various definitions of profitability. McAfee’s achievement is all the more remarkable in that this was not EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) or pro forma profitability. It reached unqualified profitability — the point where revenues coming in actually, really, truly, exceeded total expenditure going out. Although it didn’t manage this for all three months of the quarter, leaving it with what it must have felt was an irritating $134k shortfall (less than 1 percent of revenues), it has now formally passed the all-important breakeven point and can start earning a return on its shareholders’ investments.

Many listed companies — particularly among the ranks of McAfee’s fellow dot-coms — remain so far from breakeven that financial analysts have developed other ways of assessing performance. In the absence of any true net earnings, these various degrees of profitability provide the next-best means of estimating valuations.

Gross margin is the profit made after subtracting the “direct costs” of products and services, but before taking into account the necessary operational costs of any going concern, such as sales and marketing, back-office administration, and research and development. Achieving a positive gross margin is evidently a prerequisite for ultimate profitability, but by no means a guarantee that it will ever be achieved.

EBITDA represents the profit made after subtracting all the necessary direct and indirect costs of operating the business, but leaving out all the costs incurred in acquiring the assets needed to get it to that stage. The letters officially stand for Earnings Before Interest, Taxes, Depreciation and Amortization of assets, but most technology startups give EBITDA a broader meaning, covering not only interest payments, taxes and asset write-downs, but also throwing in the costs of issuing stock and share options to staff, and any other one-off costs such as restructuring. Some ASPs go as far as including amortization of software licences and implementation within EBITDA, when strictly speaking these are direct components of the cost of operating their services. Whatever it chooses to count or exclude, any startup that reaches EBITDA breakeven is still some way from turning a real profit, particularly if it has had to make big investments in building up infrastructure or intellectual assets.

Pro forma is the term used when a company feels that a nonstandard way of presenting its financials will give a clearer picture of how the business is doing — or sometimes just a rosier one. Pro forma profitability normally disregards certain exceptional or unexpected costs incurred during the period. Cash-rich companies use it to count in gains and interest on their investments. It is only useful as a guide to future profitability if the investment income keeps on coming and the supposedly one-off costs don’t return.

GAAP stands for Generally Accepted Accounting Principles, the standard by which company accounts are drawn up for filing with the SEC, the body that regulates the behaviour of U.S. stock market participants. When a NASDAQ-listed company declares an unqualified net income, that means it really has started to bring in more than it is spending, measured in line with the U.S. GAAP rules. Whatever happens to the stock price in between, that is the true point at which the company actually reaches breakeven and begins earning a return on investment — when it can finally start thinking about paying some of that return back to shareholders in the form of dividends.

Will Other Match McAfee’s Results?
Following on from McAfee’s results last week, the five other quoted companies in the ASPnews listing of Top 20 ASPs announce their Q2 financials over the next ten days. Unlike McAfee.com, they all still have some way to go before reaching true breakeven, with two still in negative gross margin as of Q1.

• Leading enterprise ASP USinternetworking , due to announce next Tuesday (July 24th), will be the most keenly awaited. Analysts will be looking to see if it is still on track to reach EBITDA breakeven in Q3 after April’s heavy cutbacks on spending and staff.
• USi’s West Coast rival Corio still had a negative gross margin last quarter, so will be under close scrutiny for signs of improvement when it announces Q2 figures on Thursday (July 19th)
• Enterprise storage service provider StorageNetworks reported storming growth in Q1, but its gross margin remained 21 percent in the red. It too announces Q2 on Thursday
• Healthcare specialist Trizetto Group has said it aims to achieve positive EBITDA by mid-year. Q2 results next Tuesday (July 24th) will show whether it remains on course.
• Online meetings provider WebEx Communications blew away analyst expectations in Q1. Already making 69 percent gross margin last quarter, it is aiming to reach overall profitability by the end of the year. Q2 results are due also due next Tuesday.

This review of the week’s news highlights is by ASPnews.com founder and consulting analyst Phil Wainewright. A comprehensive news digest is published every month in the ASP News Review newsletter, available exclusively to subscribers.