A few days before the new year, Ronald Codd stepped down as CFO of PeopleSoft to take the reins of Momentum Business Applications, a research and development company PeopleSoft decided to spin off last November. The move is clearly a bold departure. Drug companies, such as Alza, Centocor, and Immunex, have done spin-offs, but nothing comparable has been attempted in the software industry. Like the drug companies, PeopleSoft hopes the spin-off will reduce its R&D costs and lift its stock price. Since last spring, the stock price, like that of PeopleSoft's competitors', SAP, J.D. Edwards, Oracle, and Baan, has taken a beating, thanks to a slowdown in earnings growth.
The company attributes the fall-off primarily to customers' uncertainty over capital-spending plans in the face of the Y2K problem and a slowdown in world economies.
But analysts worry that PeopleSoft's historic 60 percent earnings growth rate may be just that, a thing of the past, because of increasing competition and market saturation in its core product area--so-called enterprise resource planning (ERP) software.
The slowdown in earnings growth reflects a changing revenue mix. These days, an increasing proportion of sales comes from maintenance of the company's installed base, rather than from licensing its software to new users. Profit margins in that service-intensive business are much smaller than in the software-licensing business, where costs are limited largely to marketing.
To address the problem, PeopleSoft plans to deepen its reach into new product areas with greater growth potential, including software for supply chain management, manufacturing, and electronic commerce. Yet this plan requires significant new expenditures on research and development, a major acquisition, or perhaps both.
The solution? Spin off Momentum, which, theoretically at least, lets PeopleSoft have its cake and eat it, too.
While the company has moved $250 million in cash off its balance sheet to fund Momentum's R&D efforts, it retains an option to purchase the products, the stock, or both. Meanwhile, PeopleSoft still has another $428 million in cash with which to fund acquisitions.
The Momentum spin-off has generated some criticism. Not only does PeopleSoft retain an option to acquire stock in Momentum for as little as $15.79 a share before the year 2002, but PeopleSoft also owns all of Momentum's B shares, which prevents the spun-off company from merging, liquidating, or transferring assets without PeopleSoft's approval. As a result, some analysts and investors consider the spin-off primarily an accounting gimmick. As Alex Kotlyar, an analyst for Donaldson, Lufkin & Jenrette, put it, "This is designed to preserve [PeopleSoft's] business model, but investors may be tempted to consolidate the results anyway."
At least one will. "I plan to reconsolidate the two companies," says Kay Doremus, an analyst for American Express Investment Advisers, which held more than 3 million shares in PeopleSoft as of last July. "This isn't an arm's-length transaction." In fact, the Financial Accounting Standards Board is expected to propose that companies that spin off R&D subsidiaries in this way must nevertheless consolidate the results for the two companies, though exactly how that would be done remains unclear.
Momentum's stock more than doubled, to around $20 a share, in the first few hours after it began trading on January 19. But the price has since fallen to around $10, about where it opened. As Doremus says, "If they do get investors not to look through this, they will have accomplished something that no one else has."
Meanwhile, PeopleSoft must fend off recent class-action suits from shareholders alleging that the company has engaged in securities fraud. The suits follow PeopleSoft's disclosure that it may have to restate its financial results for the past three years because of an inquiry by the Securities and Exchange Commission into write-offs for so-called in-process R&D in connection with a 1996 acquisition.
Here is what Ronald Codd himself has to say about these controversies and about how he can balance the interests of PeopleSoft against those of the new endeavor, Momentum. The interviews, conducted by senior editor Ronald Fink, took place at PeopleSoft's headquarters in Pleasanton, California, the day after the decision to spin off Momentum was announced, and in a telephone conversation a few days after Momentum's stock began trading.
How do you respond to the charges in the class-action suits? Momentum is on firm ground. It's important to remind ourselves from time to time what GAAP stands for. In the general acceptance category, I would have to put the notion of relatively high in-process R&D write-offs. As recently as six months ago, that was very common practice, and we're talking about a transaction that occurred in 1996. We had an independent third party do the assessment, and our write-off percentages weren't out of line with anyone else's of that day.
What do you say to those investors who plan to consolidate results for Momentum and PeopleSoft? PeopleSoft owns none of Momentum's voting shares. There's no affiliate relationship. It's a completely independent entity. It has $250 million to spend and an executive management that is focused on responding to the fiduciary obligations that management has to its shareholder base.
From my perspective as CEO of Momentum, I don't really care whether we're consolidated into PeopleSoft. It doesn't change anything about Momentum. If we are suddenly deemed, for financial accounting purposes, to be part of Ford Motor, I don't care. Ford doesn't have any influence over the affairs of Momentum. In the same fashion, PeopleSoft effectively has no influence over the affairs of Momentum, outside of the contractual agreements that Momentum has with PeopleSoft.
And from PeopleSoft's perspective? I'm sure they'd prefer not to consolidate Momentum, and not to have the analysts add the numbers together and effectively treat them as one company. One of the important goals from PeopleSoft's perspective was to exclude a set of activities that are strategic in nature, somewhat unpredictable in terms of how much money might be spent. The goal is to manage these projects opportunistically. If there's an opportunity to spend faster suddenly to get more results quicker, I'm incented to do that. But if I were to do that as part of PeopleSoft, I might damage the quarterly-earnings expectations and make it more difficult to manage those earnings.
But PeopleSoft has the option to buy the company. It has the right, not the obligation. But it can't buy 50 percent of the outstanding equity and squeeze the rest, or something like that.
Doesn't this arrangement mean that you are, in effect, serving two masters? No, not at all. I'm serving the master of Momentum shareholders. I'm no longer an officer of PeopleSoft. My fiduciary obligations are to Momentum's shareholders, and that's how I'll run the company. And today I would assess my best option for maximizing Momentum shareholder value to be an exit through PeopleSoft exercising its purchase option.
What about the B shares, which give PeopleSoft say over the use of Momentum's assets? I've analyzed this thing for both sides, and from my perspective at Momentum, I do think that the interests of both PeopleSoft and Momentum investors are reasonably aligned. I don't think they run significantly contrary to each other. Again, that's not an unusual situation for two independent companies that have a business relationship.
What happens if FASB goes ahead and issues a rule that forces PeopleSoft to consolidate Momentum's results? We would hope that we're grandfathered in, because we will have done the transaction prior to the establishment of the rules.
And what if you're not? What do you consolidate? PeopleSoft has no voting equity interest at all in Momentum. So, sure, you can say that it has to be consolidated, but then through the minority interest you'd effectively eliminate 100 percent of the consolidated amounts.
Why did PeopleSoft choose to do this now? The stock has been under considerable pressure. We think the decline has been a function of a slowing growth rate in the overall market for ERP. If you add the results of all the different ERP vendors, you can see that growth rates have slowed from 50 or 60 percent to more like 20 or 30 percent. It may be an increase in competitive intensity in the marketplace. The field seems to be narrowing in terms of who counts--who's a have and who's a have-not. Economic uncertainty isn't helping either.
But the long and the short of it is, investors have been asking us three questions recently. One: How is PeopleSoft going to compete in the long run with SAP? Two: What is it going to do with all the cash that it is accumulating? And three: What is it going to do to re-accelerate the growth rate of the company?
Momentum really is an answer to all those questions in one big action. Also, this truly is a much more strategic use of cash than a simple stock repurchase program or a dividend. A dividend or a stock repurchase program is kind of a dead-end. The money gets consumed, and once the results of that have been factored into it... You're back to square one. Exactly. In this case, PeopleSoft is setting aside a $250 million war chest to invest aggressively in new development programs--programs that are not really active today internally but that we believe will provide some very strong growth opportunities for the company going forward. The wonderful thing about this structure is that it's, in effect, a $250 million guarantee of spending on these development projects and nothing but these development projects.
The tyranny of the annual budgeting process, the challenges associated with quarterly-earnings management, and the need to adjust on a very tactical basis spending plans, allocations of resources, and the like internally, all get pushed aside by this [strategy]. As a matter of fact, the goal is to develop the products as fast as you possibly can. Time to market is your only real goal here, because you're not subject to other kinds of fiscal pressures.
You have only a certain amount of money to spend. That doesn't mean you put a match to it. But it means that if you can hire more developers today, you don't have to wait until you have budgetary authorization in six months to do it. So it's a way to significantly elevate the probability of success.
By the way, part of [the downturn in earnings growth] probably reflects Y2K. There are companies that might be going into the bomb shelter during this sensitive time period. With this Momentum initiative, we will be ready with some products when they come out.
Prior to this announcement, some analysts speculated that PeopleSoft might be planning some acquisitions. Does this in any way change the likelihood? Because this is a material spin-out, for some period of time--generally a minimum of about six months-- PeopleSoft is not poolable. So for that time, it is not likely to do anything material in an acquisition. That doesn't prevent it from doing smaller acquisitions for cash.
Doesn't the spin-off make it more difficult to make acquisitions? I would certainly agree that $250 million is a significant amount of cash. But PeopleSoft had, exiting the third quarter, a total of $678 million. Plus, another $50 million will soon be coming on to the balance sheet from warrants issued in 1995.
What impact would FASB's proposed elimination of pooling and the SEC's crackdown on write-offs for acquired R&D have on PeopleSoft's ability to do deals? Life would get much more difficult. In the case of the intellectual-property industry, most of the value in a company is not reflected on a balance sheet. As a result, you're going to have a huge amount of the value of the purchase price allocated to intangibles. The question the SEC and the investment community as a whole need to wrestle with is, How do you deal with that allocation of intangible value? If you force companies to capitalize and amortize it over an extended period of time, you create an enormous noncash charge. I can say almost with certainty that what the investment community will likely do is simply look through those charges. They'll almost have to, because those charges become irrelevant.
The SEC is missing one important point here. It can legislate accounting policy. It can't legislate investor perception of value.
But if those perceptions don't change, why would deals be any harder to do? We're not going to see the investment community adopt this different perspective of valuation overnight. It's going to take some time. But it will happen. If you think about the vested interests of investment bankers, accountants, and attorneys, they certainly don't want to have deals discouraged.
If the SEC is successful in discouraging these transactions, certainly the bankers and the other folks who make a lot of money in these transactions will be motivated to find a way to reverse the effect. And since they have the analysts working for them, and the analysts basically earn most of their money through the bankers, it seems to me likely that the analysts will come around.
So much for the Chinese wall. It's a fairly frail wall. Certainly in some investment banking firms analysts are going to be compensated at least in part by the corporate finance business.
How do you see Momentum in terms of what's happening to PeopleSoft's revenue mix? R&D supports new licensing activities. What Momentum did was take away the uncertainty. PeopleSoft was able to come back [to analysts] and report, "One thing we can say about operating margins next year is, essentially, they will not be adversely impacted by R&D." In fact, PeopleSoft knows that because it can pursue all these new initiatives with these dollars, it will be able to support all of its ongoing development activities.
Even if it has a period of difficulty, ultimately it will be able to extend R&D to a level that not only supports those activities properly, but also results in no adverse impact on its historical operating margin targets.
Doesn't that assume that analysts will decide not to consolidate Momentum and PeopleSoft, at least in terms of the income statement? We had a conference call on this, and one of the analysts did say, "Gee, what's to keep us from adding these numbers together?" I said, "Nothing. It's a free country."
The fact of the matter is that right now the way the world works is investors are very focused on things like earnings per share and price/earnings ratios. No matter how the analysts try, I don't think they are going to have a lot of success in adding these things together and creating a set of metrics that don't match PeopleSoft's earnings releases.
I find that a fundamentally difficult proposition, given the models they use and the guidance they receive. How could PeopleSoft go on record projecting any earnings at all if it's not obligated in any way to do what the analysts expect? It's also possible that analysts will be unconsolidating companies that FASB deems should be consolidated. If at the end of the day some analysts decide to add in Momentum, I don't see that changing the overall investment community's views.