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Computer Associates: A Long Climb out of a Deep Rut


Another day, another black eye. That's how it goes for Computer Associates International Inc. (CA), the Islandia (N.Y.) maker of software for managing computer networks. The latest jab came on Feb. 5, smack in the middle of CA's sale of $1 billion in bonds, when Moody's Investors Service said it was concerned about weakening cash flow and would review CA's credit rating. CA's stock dropped 13.5% the next day. It canceled the offering. Furious, CEO Sanjay Kumar accused Moody's of "blindsiding" him. "What they did was unconscionable," he says.

The Moody's news comes at a crucial point in CA's 25-year history. Kumar is trying to shake off a series of blows that have pounded the company's stock down 62% from a peak of $75 two years ago. First came a blizzard of customer complaints about inattentive salespeople and overly rigid contract terms. Then there was confusion over the company's pro forma earnings. The capper came last summer when Texas entrepreneur Sam Wyly staged a mud-slinging, but unsuccessful, proxy battle to take control of CA's board.

Add it all up, and Kumar will be hard-pressed to get the world's fourth-largest software company out of its rut. The Sri Lanka native and 14-year CA veteran was appointed CEO in August, 2000, when combative Chairman Charles B. Wang gave up daily operations. Kumar has vowed to forgo the acquisitions that CA relied on to boost revenues, but he has not proven it can grow rapidly without them. Even analysts who rate the stock a buy say CA will grow only by single digits for years to come, vs. 30% growth in the late 1990s. "It's not a rocket ship. It's a modest grower," says Andrew Brosseau of SG Cowen Securities Corp.

The situation could get worse. Moody's is concerned about CA's ability to repay its $3.6 billion in debt. The agency forecasts operating cash flow will probably be $1 billion this fiscal year, ending in March, down from $1.3 billion in 2001 and $1.5 billion in 2000. That would leave CA, the only major software company with sizable debt, with a debt-to-cash-flow ratio of three to one. That ratio is on the high side of normal and could widen. "If their growth slows down a lot, they might be inclined to do a large acquisition to grow and pay for that with more debt," says Moody's analyst John D. Moore.

Kumar denies CA's best days are behind it. He predicts it will return to double-digit growth--fed by demand for new technologies. And he rejects the cash-flow worries. The company has paid down its debt by $850 million this fiscal year. Kumar blames the decline in cash flow from $462 million in the third quarter of fiscal 2001 to $354 million this year on an unusual $200 million upfront payment made a year ago by a big customer. Typically, customers pay for products in installments over the life of multiyear contracts and pay finance charges on the unpaid balance. This customer chose to pay upfront and avoid the finance charges.

Kumar also claims that CA won't be hurt by the canceled bond offering, which he describes as a discretionary move aimed at replacing bank loans with long-term bonds to save 1% annually on interest. About $700 million in debt comes due over the next five quarters, but CA expects to easily pay it off out of cash flow.

The cash-flow debate is a piece of something larger: CA's wrenching switchover in its basic business model. Starting in October, 2000, CA added a clause to new contracts allowing it to recognize revenue in equal increments over time. The goal is to smooth out wild ups and downs in earnings.

But the company got into hot water. Last April, it reported pro forma fourth-quarter profits of $274 million, while under generally accepted accounting principles it suffered a loss of $410 million because more revenue was deferred. CA prepared the pro forma numbers by recalculating past and current results as if CA had always deferred revenues. Analysts didn't entirely trust the results. "They're numbers created by CA and counted by CA," says RBC Capital Markets analyst Sarah Mattson.

Now, with five quarters of the new model under CA's belt, analysts say GAAP results show the finances are stabilizing. On Jan. 22, CA announced $749 in revenues in its quarter ended Dec. 31, down 4% from a year earlier. That's better than rival BMC Software Inc.'s (BMC) 17% decline. CA also reduced its loss from $342 million to $231 million. Analysts predict it will be profitable on a GAAP basis by the first quarter in 2003. The stock, now trading at $28 per share, has come off a low last September of $22. "We're 60% of the way there in remaking the company," says Kumar.

No doubt he has made progress. After being criticized for having a "rubber stamp" board during the proxy battle, CA is shoring up its governance. It's looking for two new outside directors. And Kumar is making nice with critics. He agreed to meet with Stephen Perkins, who ran for a board seat on Wyly's ticket. "I appreciate their response," says Perkins. "But the company still has a credibility problem. There's a lot more that needs to be done."

And that's how it goes with CA. Take customer relationships. Kumar interceded last year to stop a dissatisfied Wal-Mart Stores Inc. from dropping CA's software. To show he was serious about patching things up, he sent salespeople to work in Wal-Mart (WMT) stores for short stints. One rep was so gung-ho that he volunteered to mop out a vegetable department. "I saw a completely different CA," marvels Daniel F. Phillips, Wal-Mart's vice-president in charge of network operations. In addition to Wal-Mart, eight other customers--from Merrill Lynch to KeyCorp--tell stories of Hyde-to-Jekyll culture changes at CA.

But some irate customers don't change their minds overnight. According to a 2001 customer-satisfaction survey, only 10% of large customers felt they had a "constructive" relationship with CA. That's in spite of the fact that it created a 650-person customer-relationship staff in 2000. Even K. Wade Tolman, the executive vice-president at KeyCorp who changed his mind about dumping CA last year, still has his reservations. "We're waiting for more proof," he says. "We want to make sure this isn't a flash, that it's a true change."

Unless customers start to like CA a whole lot better, the software maker is going to have a hard time getting revenues fired up again. What's needed is a burst of new technologies, and analysts don't see that coming. "They're not an innovating company. They make incremental changes," says analyst Herb Van Hook of market researcher Meta Group Inc. Kumar insists CA can invent its way out of the no-growth zone. With a 20% market share, compared with IBM's 13%, it's the leader in software for managing corporate networks. It also has top-two positions in the fast-growing security and data-storage markets. Now, CA is adding to its products to handle wireless data and to support a new generation of applications called Web services.

What seemingly dooms CA to sluggishness is the fact that 47% of its product revenues are still linked to the old, slow-growth mainframe business. It's even more reliant on Big Iron than IBM (IBM) is. Kumar may gradually buff up CA's reputation. But given the company's reliance on yesterday's products, he'll be hard-pressed to make it more about the future than about the past. By Steve Hamm in New York


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