Netsuite Leaves a Sour Taste

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 - commentary - Cramer's Take) 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.

Click here for larger image.

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 - commentary - Cramer's Take) and Paychex (PAYX - commentary - Cramer's Take) 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 - commentary - Cramer's Take).

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.

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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.

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