NetSuite beats street in Q3 but un-nerves analysts on billings

Earlier today, NetSuite announced its Q3 earnings results. It beat the financial analysts' consensus on all measures, forecasting top line revenue for the full year at $192 million, edging closer to CEO Zach Nelson's magic $200 million. However, on the earnings call, analysts beat up on the company, repeatedly coming back to explanations about what the company calls 'calculated billings.' In after hours trading, analysts' nervousness about this number got the better of the share price, sending it down five percent after the closing bell. By the headline numbers:

• Revenue of $49.7 million, representing 19% year over year growth
• Recurring revenue (subscription and support) grows to $41.8 million, again representing 19% year over year
• Net loss narrowed from $8.3 million to $6.9 million year over year
• Operating cash flow $4.5 million, a 12% increase compared to Q3 2009
• Customer additions: 285 but flat year over year

On the face of things, this is a very good result, coming as it does on top of a second quarter where the company exceeded analysts' expectations. However, analysts are concerned that NetSuite's implied mismatch between what NetSuite terms 'calculated billings,' invoicing in plain english, compared to revenue for accounting purposes is not well explained. For the first time since I've been listening into NetSuite analysts calls, the CFO spent the majority of the time explaining the billings situation.

Ron Gill, NetSuite CFO attempted to defuse the discussion saying that calculated billings is 'an imperfect measure,' that the company 'doesn't provide guidance based on this measure' and that internally, the company doesn't particularly use it although he did throw out a tentative 20% increase in this number for 2011. I find that hard to fathom since billings are the starting point for cash flow management.

Mr Gill argued that calculated billings is a mish mash of moving parts that can change within quarters and so give rise to some lumpiness. That still didn't satisfy analysts and was reflected in after hours trading. I'll go off on a tangent here and offer a tentative explanation based upon recent dealings with NetSuite customers.

When customers are faced with renewals the first thing they usually see is an invoice. Sometimes that invoice can include items they were not expecting. Sometimes that same invoice can be for a renewal amount that doesn't jibe with what the customer thought they were contracting. Sometimes there are ongoing discussions where the customer is mid-implementation. All these issues have an impact on what the customer is prepared to pay. A negotiation ensues that mostly (but not always) ends up with a downward adjustment to the originally invoiced number or a splitting of the invoice over accounting periods. NetSuite will endeavor to close out the situation within a quarter since that has a direct bearing on 1. what it can count as revenue and 2. the likely cash flow impact. Given NetSuite is hefting some 6,000 plus accounts, that can have a significant in quarter impact although over time it should equal out. Mr Gill pretty much acknowledged that.

This should not be construed as a NetSuite business model problem but more one of internal processes not necessarily matching what's needed for accounting purposes. Given the attention NetSuite has been giving to improving customer service in the last year, sometimes with good results, sometime not so much, it should be no surprise that doubts arise in the minds of financial analysts looking for any chink in the explanations the company offers.

The fact NetSuite continues to concentrate on winning or upselling in larger OneWorld accounts should mean this issue falls away if for no other reason than the fact that larger account customers will expect a higher degree of transparency from the get go. Witness Phil Wainewright's illuminating commentary on the RightNow deal. That in turn will require tweaks to customer management.

Whatever you may feel about the potential for uncertainty, NetSuite is feeling its way and constantly evolving its business model while growing in double digits. That's not a huge task at $50 million in revenue, it's a big ask at $200 million and growing. My concern lays more with what Mr Nelson said about sales.

On the one hand he is bullish about the contribution coming from the channel saying total channel growth in the year to date is running at about 60%. On the other hand, he said the company's internal sales effort is 'constrained' by head count that is lagging demand. I'm not sure that makes sense. If the channel is well organized then it should not make a huge difference, should it?

He also said the company intends to push implementation services into the channel rather than grow that element internally. The theory leads Mr Nelson to believe this will accelerate growth and improve margins. I am conflicted on this. No software vendor knows its software better than the IP owner but that doesn't mean third parties can't do great things. Salesforce.com'a Force.com platform and AppExchange are testament to that. But NetSuite is different.

NetSuite is building out a complex suite and so while Mr Nelson correctly points to building a broad based suite with verticals being drawn into the mix, there is the expectation that third parties will also build vertical offerings.

Is NetSuite mature enough for that to be realistic? If I think about RootStock for manufacturing or OpenAir for professional services then the answer is a qualified 'yes.' But as Mr Nelson correctly points out, there are many sub verticals around in the spaces he wants the company to occupy. Therefore, the channel will need to quickly ramp but in a controlled manner if NetSuite is not to find itself arbitrating all manner of problems among customers.

To the broader market dynamics, Mr Nelson pointed to Microsoft Dynamics Great Plains replacements as the defining characteristic of 2010 deals as compared with 2009 where replacements were coming from QuickBooks. It is telling that he said the company rarely sees Sage in deals though it regularly replaces them. The same I suspect is true for Microsoft. This is one of the big problems for the on-premise vendors trying to make the switch to the cloud - they don't often get invited to the tendering party. It is something I see repeated time and again in EMEA so my feeling is that NetSuite's assessment is about right.

On Business ByDesign, I sense that Mr Nelson went too far. In response to an analyst question that suggested she is hearing about BYD deals, he said: "I still don't believe it is...more than...a 0.5 release...I don't think you can buy it." On that he is flat wrong. Mr Nelson can get away with such remarks by caveating with 'believe' and 'think.' I am seeing BYD in deals and interestingly, he did not refer once to an SAP replacement. Where Mr Nelson would be more correct is in saying that SAP has yet to rev up BYD's marketing visibility.

So - overall? Another good performance and more of the usual Zach Nelson banter but I got the sense we're about to move into a more serious phase where growth, which has dominated thinking, is tempered by a need to pay close attention to all the business moving parts. Q4 will be an interesting call.