Is Milestone Actually Making Any Money?

In the past 18 months, Milestone Systems has redefined itself as the low cost VMS champion, slashing prices at a feverish rate and introducing the industry's most well known free VMS offering. However, these actions have raised many questions, none more basic than "Is Milestone Actually Making Any Money?" We first examined this in our August 2011 review of Milestone's Financials and Profitability. Now we dig further into their profits, contrasting them to leading video surveillance companies around the world.

Milestone's (Lack of) Profits

According to Milestone's income statements. in the past 5 years, their net profit margins never exceeded ~10% with them recording a net loss in 2008 and ~3% net profit margin in 2009. Founded in 1998, this covers the 9th to 13th years that Milestone has been in business. These profits are low for leading surveillance companies who typically have profits in the 10-20% range.

Moreover, relative to competitor's financials, Milestone's accounting method skews its profitability significantly. Milestone capitalizes large amounts of R&D costs relative to their profits.

If Milestone's R&D expenditures were expensed as is common with competitors, Milestone would have losses in 3 of the last 5 years and barely broke even in the other 2. For instance, in 2010, one of their best profit years, Milestone's net profits were ~21 Million DKK. However they capitalized somewhere between 12 and 17 Million DKK in R&D expenses. If Milestone expensed R&D, their net profits would be a mere fraction of the already modest level reported.

To be clear, we are not questioning the legitimacy or legality of Milestone's financial accounting. Generally Accepted Accounting Principles (GAAP) vary by country. Whereas capitalizing R&D is typically not allowed in the US, our understanding is that it is in Denmark, Milestone's home country. The question here is purely an issue of cost accounting and competitive comparison. Just like one needs to normalize parameters for a technology test, ones needs to normalize accounting methods for comparing company's financials.

Comparing to Other Surveillance Companies

Axis and Mobotix are two publicly traded companies that capitalize some R&D costs but proportionally quite small levels. While Axis capitalizes a small amount of developments costs, it is tiny compared to profits. Additionally, Axis expenses over $50M USD of R&D cost (see the Axis 2010 annual report). A similar pattern is found with Mobotix. In 2010, while they spent nearly 7 million Euros on development, only 1.25 million were capitalized compared to a profit of over 13 Million Euros (see Mobotix 2010 annual report). Unlike Milestone, even after expensing/factoring in all development costs, companies like Axis and Mobotix remain very profitable.

Why Is Profitability Important?

Over the long term growth without real profitability is unsustainable. Though Milestone is making accounting profits by capitalizing R&D expenses, it is still has a low to negative operating cash flow balance. Market leaders, whether Google, Axis or Milestone's role model, Microsoft, generate a ton of operating cash flow (i.e., they 'print' money).

Milestone has recently declared their intentions to take 80-90% of the VMS market but there's no shot of that without being robustly profitable. As the old saying goes, you cannot lose money on every sale and make it up on volume.

Objections to Profitability Criticism

We see two reasonable objections to our critique of Milestone's profitability:

• VMS software have different economics than camera companies like Axis and Mobotix
• Milestone's investments into R&D will deliver much stronger long term growth boosting profits in the long run

Our response: Leading software companies in any market are structurally well positioned financially. The nature of software sales and their inherent high gross margins makes it easy for winners to be very profitable. Moreover, and specifically to surveillance, VMS software have financial advantages competing against incumbent DVR providers who incur expensive hardware costs. While Milestone emphasized in our August 2011 note that they are focused on reinvesting in a growth market, so too are companies like Axis and Mobotix without having to sacrifice profits.

One element that makes comparison difficult is that none of the other pure play VMS software companies have publicly audited financial statements, making it difficult to compare against direct peers.

The other potential objection we see is that Milestone's investment in R&D will generate strong longer term growth and profits. The best part of Milestone's R&D efforts is the breadth of their development as they are packaging and rolling out features across every size segment. However, there is nothing in Milestone's product offering that is their unique Intellectual Property that would somehow drive customers to only choose them. As such, we find it hard to believe that their R&D expenses alone will drive disproportionate future growth and profits.

The Future

Milestone is aggressively sacrificing short term profits, more so even than their income statement indicates, to grow their business. The two most significant growth differentiators we see is Milestone (1) developing a global sales and marketing organization and (2) forcing a price war.

The best case scenario for Milestone looks to be:

• Their global organization provides them the largest economies of scale of any VMS provider, allowing them to be much more profitable when the company's growth levels off.
• Having so many free and low cost options decreases Milestone's long term marketing costs as users find out and try out Milestone online.
• Their price war knocks out numerous competitors and allows them to increase prices in the future.

On the other hand, there are real risks, two of which are most worth noting:

• Does building a global sales and marketing organization really increase economies of scale? It's very expensive, it's hard to do and it's being done in an era where large organizations are becoming less valuable due to the power of the web.
• Can Milestone continue to operate on such low profits and low operating cash flow? At some point, if the business does not organically generate strong operating profits, they will need to raise more money, cut back on expenses and/or raise prices. If they do either of the latter two, it derails the current strategy.

Ultimately, we cannot guess how this will turn out. All that is clear is (1) Milestone is not making any real money today and (2) their market strategy is very risky. In the meantime, it will be very interesting to see how long Milestone can continue on this current path and how much damage they can do to their competitors.