Errors at the management level at Mercury Interactive Corporation (Nasdaq: MERQ) are apparently the main reason for the profit warnings the company has published for both the second and third quarters this year, and for the US Securities and Exchange Commission (SEC) investigation into the company over incorrect reporting of options.
In addition, there is the continuing delay in submission of the company's 10Q report (full financials) and the offer to pay bondholders $42 million so that they won't empty Mercury's coffers of most of its cash.
This is not the first time that Mercury has stuttered over its results. In the third quarter last year, the company missed the lower end of its guidance by about $1 million. This was a minor hiccup that met with a very forgiving response from investors.
The profit warning that Mercury published for the second quarter this year was also treated tolerantly, particularly because, in the end, Mercury met its original guidance. Only with the second profit warning, for the third quarter, did investors start to lose patience. They sent the share tumbling about 16%.
A glance at Mercury reveals that there is no problem with its technology or with sales of its systems. The lowered guidance indicates that Mercury will post 29% growth for the third quarter in comparison with the third quarter last year. That's a very fine achievement for a company of this size. Few companies of comparable size can boast such growth rates. There is also no disputing that Mercury's technology is the market leader, especially in software inspection and application performance management.
Despite all that, Mercury is stuck in a cloying mire the like of which has not been seen for years. In a situation like this, when the company has leading technology and continues to grow, it seems that the series of mishaps that started in the third quarter of 2004, gathered momentum towards the end of the second quarter of this year, continued in the third quarter, and still shows no sign of ending, can only be ascribed to wrong management decisions.
All these failures start at the top, with company chairman and CEO Amnon Landan, who only two years ago announced his intention of positioning Mercury among the five largest software companies in the world. You will never hear a declaration of that sort from an American manager.
Landan is directly responsible for what happens at the company, but it doesn't take a higher business degree to work out that at some stage several senior managers are liable to lose their jobs. The first candidate to go may well be CFO Douglas Smith.
What made Smith come out with such optimistic guidance for the third quarter, after he had already been forced to change his mind and lower the company's guidance towards the end of the second quarter, is very unclear. True, Mercury did manage to reach the lower end of the original guidance in the second quarter, but in a situation uncertainty over the closure of deals, more caution would have been appropriate.
Smith, though, is not the only one responsible for the excessive optimism that suddenly gripped the company. The entire senior management, with Landan at its head, should have realized that, after president of EMEA operations Moshe Egert had left, and his replacement had not yet got things completely under control (that at least is how it appears on the surface), and with the company not managing to close all its deals in Europe, the guidance for the third quarter (and perhaps for the fourth quarter too) should have been made more conservative.
This is the kind of step taken by prudent management that sees what's around the corner. It may well be that the warning for the second quarter was due to a few deals that were deferred to the third quarter, which is the usual reason for profit warnings. Nonetheless, Mercury's top management should have understood that, following the loss of several senior managers, the company was in organizational turmoil.
It would therefore have been appropriate to be doubly cautious about the third quarter. Such caution would have saved investors the very uncomfortable feeling that accompanied the second profit warning. It is possible that the third quarter warning was also due to the deferment of a few deals, this time to the fourth quarter. However, there is no guarantee that these deals will indeed close in the fourth quarter. It is very much to be hoped that there will not be a third warning this year.
Another manager who had an attack of dubious optimism was chief marketing officer Christopher Lochhead, who came out with the statement, "This year, plus or minus, the company will do more than $900 million in sales." The declaration forced Mercury to rush to tell the stock exchange: "Mercury does not believe that this statement is accurate." The problem is not just with the statement itself, but also with the feeling it gives investors that the company's chiefs are not entirely aware of what is going on.
The second management failure is over the incorrect reporting of options. This mistake could cost Mercury and its investors the delisting of the stock from the Nasdaq exchange, and foreclosure on the company's convertible bonds, which, as mentioned, would mean farewell to most of the company's cash. Meanwhile, Mercury has offered the bondholders $42 million in exchange for leaving the bonds in place.
One must hope that the bondholders will accept the offer, and that a solution will be found to the whole mess that will enable the stock to continue being traded on Nasdaq. However, a great deal of damage has already been done, and it may be presumed that whoever was responsible for the reporting will be forced to quit at some stage.
The question now is whether Amnon Landan will accept responsibility and resign. After all, the failure to meet guidance and the reporting problems are only the tip of the iceberg. A further problem, no less material, is the replacement of the Israeli management that founded Mercury with American management. As chairman and CEO of the company, Landan is the person behind this move.
Replacing managers who are considered the most talented in Israel's high-tech industry with managers brought in from outside now looks like a bad mistake. Landan thereby signaled to the company's workers and managers that their promotion path was almost blocked. Even if they contribute to Mercury all their talents, time, and energy, their chances of reaching the top are pretty small.
Two of the imported Americans do come from senior software industry positions and have important connections at the highest levels at Mercury's customers. There is no doubt that these two are necessary and important appointments. However, Mercury needed to find the right balance between imported management and managers who had risen through its ranks. Besides, there is also the problem that most of the new American managers are unfamiliar with Mercury's high-motivation start-up culture.
It should be stressed that this kind of move, in which a substantial number of senior management posts are manned by Americans, is very rare among Israeli based companies. Even at Amdocs (NYSE: DOX), where most of the people in the upper levels of middle management are American, the core of senior management is Israeli.
As I wrote more than a year ago, the initial warning signs were seen in March 2004, when Zohar Gilad, who was vice president for products and was among the company's highest level managers, was moved aside. Gilad was replaced by an Israeli (Yuval Scarlat), but it is not clear why it was necessary to replace him at all.
Gilad was among the shapers of the company's business direction and was held in high esteem as a manager by both workers and customers. His removal did not exactly contribute to worker morale. At the same time, Ori Danieli, who was vice president of research and development, left the company.
In January this year, the warning signs became stronger and turned into flashing red lights when Egert announced his resignation. Egert was a very dominant manager. The workers followed his lead, and he delivered the goods. It turns out to be no coincidence that only three months after his departure, Mercury is not managing to close all its planned deals in Europe.
www.globes.co.il
