Netsuite Leaves a Sour Taste

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.

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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 - commentary - Cramer's Take) 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.

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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.

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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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