Strategy Inc quarterly report, Q3 FY2011

Business context and reporting period

MicroStrategy Incorporated’s Form 10-Q covers the quarter and nine months ended September 30, 2011; financial statements are unaudited except the December 31, 2010 balance sheet. The company provides business intelligence software and related support and services, with Angel.com as a smaller, separate business. Amounts below are in U.S. dollars; financial statement figures are in millions unless noted.

Key financial metrics

• Q3 revenue increased 23.7% year over year; nine-month revenue increased 27.4%. Product licenses grew 22.0% in Q3 and 26.6% year to date; core product support and other services grew 24.2% and 26.6%, respectively.
• Profitability weakened despite revenue growth: Q3 operating income fell to $1.5 million from $9.8 million, and nine-month operating income fell to $6.1 million from $31.7 million. Sales and marketing and R&D spending increased substantially.
• Nine-month cash from operations was $32.4 million, down from $55.9 million. Investing used $26.2 million, versus $13.8 million; financing provided $6.0 million, versus $81.3 million used, mainly reflecting no 2011 share repurchases compared with $81.6 million of repurchases in 2010. Cash increased $12.2 million to $186.3 million.
• At September 30, cash and equivalents were $186.3 million; current assets were $310.4 million and current liabilities $193.5 million. The resulting current ratio was approximately 1.60. Total liabilities were $251.2 million. The balance sheet presents no debt line item; the filing does not clearly state a separate total debt figure.
• Deferred revenue and advance payments, net of unpaid amounts, totaled $108.5 million ($97.5 million current and $11.0 million noncurrent). The filing says approximately $150.7 million of deferred revenue and advance payments is expected to be recognized over the next 12 months, subject to performance obligations.

Material changes versus prior period

• Revenue gains were accompanied by higher operating costs: Q3 operating expenses rose 33.6% to $103.5 million, led by sales and marketing (+46.3%) and R&D (+49.4%). For the first nine months, operating expenses rose 38.4% to $291.4 million.
• Cost of revenue grew faster than revenue, contributing to lower gross margins. Consulting revenue grew strongly, but associated consulting costs also increased materially.
• The nine-month effective tax rate was 7.1%, compared with 26.5% in 2010. Management cited a more favorable geographic earnings mix, a U.K. tax settlement, and tax-return adjustments; the rate may fluctuate.
• Cash and equivalents rose from $174.1 million at December 31, 2010, while property and equipment increased to $87.5 million from $65.0 million, primarily reflecting capital spending.

Outlook, commentary, risks and unusual items

• Management said existing cash and expected cash generation should cover working capital, anticipated capital expenditures, and contractual obligations for at least 12 months; it did not expect to need borrowing for operations. No formal financial guidance is provided, and the company says it does not give guidance on anticipated future financial performance.
• Management described investments in BI, mobile, cloud and social-media products and expanded sales, services and R&D staffing. It cautioned that expense levels may be difficult to reduce quickly if revenue disappoints; near-term significant increases in sales and marketing headcount were not expected.
• Foreign operations generated 40.5% of Q3 revenue and 41.7% of nine-month revenue. Most cash was held outside the U.S. ($159.1 million of $186.3 million); repatriation could create U.S. tax. The company had not hedged foreign-exchange exposure and estimated a 10% adverse exchange-rate move would reduce nine-month revenue by 3.8%.
• The damaged corporate aircraft remained subject to ongoing assessment. The company recorded $7.7 million of cumulative impairment through September 30, but disclosed possible damage as high as $45.6 million and recorded the minimum of that range because no other amount was considered a better estimate. Insurance recovery and litigation outcomes remain uncertain; a $0.4 million additional reimbursement was agreed in October.
• The company sold a previously impaired investment in July for approximately $3.4 million, recognized as a gain; a senior executive was also an investor and director of the investee.
• Patent-related litigation with Acacia Research and Database Application Solutions remained unresolved; the court had not ruled on motions filed October 31, 2011, and no liability was accrued. A separate aircraft-insurance case was dismissed without prejudice under a tolling agreement, allowing refiling by September 30, 2012.
• Other exposures include $16.7 million of unrecognized tax benefits, a current German tax examination, $154.8 million of future operating lease payments, competitive pressure, customer spending uncertainty, and revenue-recognition and sales-timing variability. Disclosure controls were assessed as effective at a reasonable-assurance level.

Important facts for investors to verify

1. Whether revenue growth can translate into sustained operating profit as sales, R&D and service-delivery costs rise.
2. Aircraft damage assessments, insurance recoveries and any further impairment charges, including the potential range disclosed.
3. Developments and potential financial effects of the Acacia/DAS litigation and the aircraft-insurance dispute.
4. Cash availability and tax consequences given the substantial cash held by foreign subsidiaries and the company’s reinvestment intentions.
5. Deferred-revenue conversion, customer purchase commitments, and the timing and collectability of customer payments.
6. Tax examination outcomes, unrecognized tax positions, and the sensitivity of earnings to the effective tax rate.
7. Voting control: Class B shares carried ten votes each; the filing states Michael Saylor held 65.4% of total voting power as of October 27, 2011.