Thursday, April 18, 2013

Is the Market Being Harsh on Ixia?

I'm a bit bemused by the events at Ixia $XXIA. Recently, the stock took a massive battering after announcing accounting errors that reduced 2012 income, and will hit revenue in Q1 2013. It sounds grim enough, but in reality, no contracts have been lost, cash flows haven't disappeared, and -- at least for now -- the only major impact appears to be over the timing of how it reports revenue. Let's find out what is going on.

Ixia reports accounting errors

On March 19, Ixia filed a notification to the SEC that it would be late in filing its 10-K as a consequence of having identified an accounting practice error related to how it recognizes revenue from its warranty and software maintenance contracts.

This was followed by an 8-K filing on April 3, which identified a separate implied arrangement error related to how it dealt with revenue recognition after extended warranty and software maintenance contracts have been signed. Ixia finally filed its form 10-K on the April 4.

Now I know what you are thinking and you would be right. This does sound like tortuous accounting and legal jargon, and I'm not impressed by the accounting errors either. I wasn’t expecting this when I bought the stock, but are these errors really a big deal?

Accounting practice error

I’ll start with the accounting practice error and quote directly from the 8-K form  regarding its historical practice which…

was to begin recognizing revenues relating to the Company's warranty and software maintenance contracts commencing on the first day of the calendar month following the effective date of the contract, as though the warranty period commenced on the first day of such month and extended for its full duration thereafter”

In plain English, this means that if a contract was effective on April 15, then the company previously recognized revenue on May 1, rather than on the effective date. It will now have to report them from the effective date instead. Frankly, I don’t think there is anything dubious or sinister going on here. It was probably easier for the accounts people to aggregate revenue in this way, and the practice had the effect of reducing near-term revenue and income. Not something you would do to massage numbers.

Implied arrangement error

The second error was defined thus

“The Company has determined that it was required to cease to defer revenues related to the implied warranty and software maintenance arrangement upon the receipt from the customer of the first substantive contract for extended warranty and software maintenance services, and will recognize the applicable previously deferred revenues balance related to the implied arrangement, provided all other revenue recognition criteria have been met.”

This is more a serious issue as Ixia was deferring revenue recognition while it waited to establish that it could enforce its warranty and software maintenance contracts. The good news is that it only relates to one contract. In any case, here are the material effects expected for 2013 for both errors.

  • Ixia doesn’t believe the accounting practice error will have a material effect on Q1 2013 or the full year

  • The implied arrangement error will move $4.15 million of the previously expected $4.9 million in revenue from Q1 to previous years' results. No impact is predicted for the rest of 2013.

So it looks like just an issue over revenue recognition timing.

Previous years?

I think the market has been fretting over the loss of revenue and income for this year, rather than looking at the implied increase in revenue and income for previous years. Indeed, the 10-K outlined that net income would be going up around $360,000, $3 million, $1.6 million, and $2.9 million in the years from 2008 to 2011, respectively.

Meanwhile, 2012’s net income was reduced by nearly $1.8 million and the ‘loss’ of $4.15 million from Q1 will likely reduce net income accordingly. It’s not good, but is that the only way to judge a company?

And this leads us to the crucial point. This is an issue of the timing of recognizing revenue, and whether it is recognized as revenue or deferred revenue at any particular time. From a free cash flow (FCF) perspective, there isn’t much difference. For example, in the years outlined above (where Ixia is now recognizing more revenue and income) there isn’t a change to its FCF generation.

A company is best judged on its cash flow generating abilities, and I think it’s being treated a bit harshly here. In fact, it generated $62.4 million in FCF last year and that’s not a bad evaluation for a company with a $1.34 billion market cap and high growth prospects.  

Where next for Ixia?

Of course, none of this includes any analysis of what to expect in the upcoming results. For that, you will have to look at its major customers like Cisco $CSCO (13.5% of revenue in 2012), Alcatel-Lucent, Juniper Networks $JNPR, and the major telco carriers. Its competitors include companies like Spirent, JDS Uniphase, Gigamon, and Danaher.

Cisco is obviously the first port of call, and its wireless solution revenue has been growing at 20%-30% for the last four quarters. Indeed, Ixia confirmed that revenue from Cisco grew 30% last year. With AT&T and Verizon both stressing that wireless is an investment priority in 2013, Cisco should report good numbers in this segment.

Moreover, Juniper has been reporting better results of late as it continues to beat estimates. Although wireless isn't a core part of its revenue, it is one of its fastest growing segments. Analysts have been gently raising forecasts over the last few months, but the key news is that Juniper is seeing strength (in a weak environment) in areas like mobility, high performance networking, wireless, and the cloud.

These are all good drivers for Ixia’s testing equipment.

As for JDS Uniphase, it reported CommTest revenue at the high end of the guidance, and spoke of a return to spending by Tier 1 carriers in 2013, although its customers are expected to start releasing their budgets in March.

In conclusion, accounting errors are never a good thing, but I don’t see the reason for the stock to get beaten up so badly. In addition, the company recently announced that it expected revenue to come in line (excluding the $4.15 million reduction discussed above), so the underlying trends seem okay. The accounting errors aren't expected to affect future quarters and this looks like a timing issue to me. It also looks like a buying opportunity, so I topped up.