Every IPO has a story to tell and a strategy that is going to take it to market leadership and reward its investors. Netsuite
(N)
is no different, but I fear that this supplier of software-as-a-service (SaaS) may be more wishful thinking by investors than the proverbial game-changer.
It's easy to complain about the valuation of stocks that are trading at many times their earnings, revenue or cash flow. That's what bears and value players do, particularly when a company's growth rate is leaving a vapor trail. However, when the vapor trail is actually smoke created by an engine that's firing on fewer than all cylinders, you really have to question those valuation metrics. Such is the case with Netsuite.
The enterprise-value-to-revenue ratio is a common metric to use, particularly when one or more of the entities is unprofitable. As is shown in the graph below, Netsuite carries the highest valuation (12.9 times) among all its cohorts in the SaaS market. Is it justified? I think not, given the metrics the company has reported.
Netsuite is a hot IPO from mid-December whose principal shareholder is none other than Larry Ellison of Oracle fame and fortune. The company provides all forms of enterprise resource planning (ERP) software capabilities as a service via the Internet. If you're a Netsuite client, you don't buy a software package, install it on your own servers and run it yourself. Instead, your company buys access via a subscription to the applications that run on the vendor's servers. For small-to-medium-sized companies, this can be a great alternative. This arrangement can be much more cost effective, and it scales with the company.
Payroll companies including ADP
(ADP)
and Paychex
(PAYX)
have been doing this in one form or other for decades. However, technology has allowed the market to take the concept far beyond simple payroll processing, and the paragon for this new market is the very successful Salesforce.com
(CRM)
.
There is nothing fundamentally wrong with Netsuite. However, there is a basic disconnect between the company's fundamentals and its valuation. Add to that the fact that investors are too frequently sucked in by the strategy that demands big-time investment for long-term gain, and you have a company that is "on the come" for years.
With Salesforce.com as the benchmark, let's see how well Netsuite compares on a number of metrics. Granted, these companies are not selling the exact same applications, although the Netsuite suite does include sales force automation capabilities.
When we compare their respective growth histories on a semi-logarithmic basis, you can see that the slopes were comparable several years ago but that Netsuite's growth is slowing at a faster rate in its most recently reported year (2007). According to estimates for 2008 for both companies, that trend will continue.
Because of the SaaS business model, one of the better determinants of future revenue is the deferred revenue that goes onto the balance sheet. When a customer subscribes to the service, the value of the contracted revenue stream is capitalized. As the customer is invoiced for usage over the life of the contract, the deferred revenue balance is reduced and the revenue recognized.
As you can see in the graph below, we have a wealth of history on Salesforce.com going back four years (16 quarters), and its deferred revenue balance and revenue track each other beautifully over that period, growing in line with each other. However, although we have far less data (five quarters) for Netsuite, there is a difference in the slope (growth rate) of its revenue and deferred revenue.
In fact, the deferred revenue balance is almost flat during the period in question. It's possible that this may be the result of Netsuite's efforts to move customers to one-year contracts where the capitalized amount of future revenue would be substantially less than with a multiyear contract. While that may be the case, it also makes for less certainty of the future revenue streams.
A common explanation for valuation by investors is the growth potential. But when growth doesn't appear to be in the cards, the frequent explanation is that the company needs to build out its organization (i.e., sales force) to leverage the "opportunities." That has certainly been the case with some companies in the past, but I think what gets missed by investors is the lack of production on the part of the existing organization.
If you go back to the first chart in this article (enterprise value/sales), it's interesting and instructive to note that of the top five companies in the list, only two are profitable (Concur Technologies
(CNQR)
and Salesforce.com). Investors have apparently bought into the idea that losing money is OK as long as you're in "growth mode." What should be more important from an investment perspective is not throwing money away but what return you get on the growth investment.
In the chart below, I have the revenue per employee of those top five companies. Obviously, a higher amount of revenue per employee leads to profitability. But it's not as if Salesforce.com and Concur Technologies are not growing their organizations. Both have been profitable for the last five years, and over that period the median annual increase in head count has been 64% for Salesforce.com and 14% for Concur Technologies.
I won't say at this point that Netsuite won't be profitable someday. However, some of those companies will always be "investing for the future" when their investors finally wake up to realize that their money is tied up in a perpetual black hole with red ink.
Whether it's Netsuite or any of the companies I've mentioned, valuations do matter. But what matters most of all is that the underlying fundamentals had better provide a solid foundation for that valuation. If they don't, you'll wind up very surprised.
At time of publication, Faulkner had no position in the stocks mentioned.Bob Faulkner has been in the investment business for 18 years with an exclusive focus on technology stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Faulkner appreciates your feedback; click here to send him an email.Interested in more writings by Bob Faulkner? Check out his newsletter, TheStreet.com The Telecom Connection. For more information, click here.
